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Leverage sensibly for stock investment
Lim Siew May 
The best time to buy shares with borrowed funds is when the market crashes and value emerges – 123RF
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When buying a property, it’s almost a given that we need to finance this big-ticket item with a loan unless you are flush with cash. But when it comes to another popular asset class like shares, most people frown on the idea of taking a loan.

This is not completely unfounded, given that leveraging to invest in a more volatile asset is not for the uninitiated. On the flip side, with the right approach, stocks are arguably the most lucrative asset class over the long term. When combined with the power of leverage, it can accelerate wealth creation.

So, what’s an investor to do? By and large, most of us should not borrow to buy shares, says David Poh, founder of Spiral Thinker Alliance, a collaborative alliance that promotes intelligent value investing and financial

My idea of whether or not to invest in shares with borrowed funds is not premised on rewards, it’s risks, says Poh


and investment literacy among youth.

 

Three categories of investors

Poh categorises investors into three groups: the young and inexperienced who just started working, the middle class and the high net worth investor.

“The first group comprises working-class young people, who usually don’t have a lot of assets to back them up. Firstly, unless you know how to read financial statements, evaluate business prospects, the risks … you shouldn’t do it,” he says.

For the first group, Poh believes a better idea is to set aside whatever small amount you have today as your investment fund. He believes it is important to build discipline before borrowing money to invest.

 

Make saving a habit

“Whether you have RM2,000, RM10,000 or RM50,000, the size doesn’t matter. Commit to save from your salary every month. Once you receive your salary, put aside an amount that you are comfortable with, whether it’s 5% or 10% of your salary. The key is not the amount, but the discipline to do it consistently,” Poh says.

Cultivating this habit trains you to be more mindful about how you invest your money. “If your capital is made up of your hard-earned savings, you wouldn’t simply invest your money. If it’s borrowed money, you are more inclined to have a careless, lackadaisical attitude,” he adds.

In our pursuit of wealth, it’s easy to forget that debt comes at a cost. When you compound debt with ignorance and recklessness, you get a very lethal combination. “A lot of people overlook the risks they are taking,” cautions Poh.

“How many people actually understand the mechanics of the stock market, and determine whether a stock is worthy of investment?

“They are people who only see the stock market booming. If you take up share margin financing to buy shares, and the prices are rising, it’s all good. But what happens when things take a different turn?

“You’re going to have to pay interest, not just the principal. If you have a salary to cover them, it’s fine. But if you lose your job, and you have to tap on your stock portfolio to repay your loan, your capital is going to shrink,” he says.

Meanwhile, for those in the second group, what you do will depend on your ability to service your loan over the long run, and your investment know-how, says Poh. This group is usually made up of middle-class wage earners who have been in the workforce for some time. Again, this is assuming that one’s job security is not an issue.

“Most people in this group would have a housing loan. They can use their property as collateral and refinance it. There’s a caveat, though – you should have no problem servicing your housing loan. If you think this is not a problem, then consider doing this. However, you must also make sure you know how to invest in shares,” he says.

 

For the financially sound

Next comes the group from the other end of the spectrum – financially independent and high net worth individuals. “In the modern financial system, the rich get richer because they have access to borrowings. If I were a high net worth individual, I wouldn’t use my own money to invest too, provided the financing is cheap. If banks offer me a loan with 4-5% annual interest rate, I would take it,” he says.

Another factor is their reservoir of assets to serve as a buffer. “High net worth individuals have multiple sources of income to finance their loan. They can afford to lose money, even if they use other people’s money.”

Even if you’re a high net worth individual, you should still take smart, calculated risks should you decide to leverage.

“If you have this facility ready to be deployed, keep it. Everyone is boasting about how much they earn, and the stock market is going up. Let them. It’s not your money to make. My idea is not premised on rewards, it’s risks. Take care of the downside first. If you do this long enough, there will be an inflection point where you will see your rewards,” Poh says.

A fund manager, who declines to be named, concurs. “The character of a borrower is very important. You should know what type of person you are. Generally, the loan will benefit those who are less emotional. Sure, you need investment skills. But if you can’t control your emotions, they will take over your good skills,” he says.

When investing in shares, there are many reasons why your investment can go wrong, says the fund manager. “It can go wrong when your shares are bought at too high a price. Even if you buy a fairly-priced stock, the price can still go down in a bearish market. You can be a fundamental investor, which makes your investment safer, but there’s still no guarantee,” he explains.

For that matter, you need to have sufficient cushion. “Manage your margin position well by not using up all your financing. If you were given RM100,000 financing, don’t use all of it, or put all your money in one stock to avoid margin call. (See sidebar on what margin call is.)

“If you do this and the share price drops by 10% in a day, which is not uncommon, this may trigger a margin call,” he points out.

“If you feel more confident in a stock, you can put more money in it, but not 100%. If a bank gives you RM100,000, break it into portions. My rule of thumb is to deploy 10-20% of the loan for each stock,” the fund manager advises.

 

Managing your risks

As part of a risk-management strategy, investors also need to be mindful of the price they pay for a stock. Poh believes it would be ideal to take up share margin financing when the stock market crashes. “That’s when value emerges,” he says.

“If you have invested some money in a good company in 2008 and 2009, I am very confident it has gone up 400-500 times through capital and dividend gains.”

Poh explains that prices of overvalued stocks would eventually come down after the stock market peaks. In contrast, when the market crashes, it will take some time for some beaten-down good stocks to rise again. However, when the situation improves eventually, that’s when you reap the dual rewards of greater upside at lower risk, he adds.

Poh subscribes to the philosophy of Professor Bruce C Greenwald, Columbia University’s professor of finance and asset management, that an investment should deliver a 2-3x potential return on one’s risk-free rate. Applying this principle to the context of borrowing to invest, if the interest rate is 5%, you should get a 10-15% annual return from your investment, which Poh believes to be attainable when value emerges.

His view echoes that of the fund manager, emphasising the importance of risk management.

“This tool is only useful for people who know how to use borrowed money. The strategy is to start your investment with a small amount of your capital first, then learn how to invest with borrowed money. Once you have access to borrowed money, use it only when the opportunity comes. In that way, you manage your loan without exposing yourself to high risk,” he says.

Right now, Poh notes, valuations on Bursa Malaysia are stretched. “A lot of stocks have priced in future growth, and it’s quite tough to find value buys. I believe we should be a bit thematic now.”

 

Shipping sector undervalued

One industry that piques his interest is shipping. “The shipping industry has been valued so low for so long. The catalyst is China’s One Belt, One Road, which is predominantly an infrastructure programme. You need to build roads and railways, you need steel and oil, and all these need to be shipped,” he points out.

Meanwhile, the fund manager believes it is a good idea to leverage to apply for excess shares. The caveat is that you need to know which company’s rights issues are worth buying.

“They must be fairly good companies that offer a big discount. Normally, rights issues offer a discount. The risk is very low.

“Some investors may only own 1,000 shares of a company, but they can apply for 100,000 excess shares. If they are successful, they can make a lot of money with this through share margin financing,” he explains.

Unlike initial public offerings (IPOs) which are often oversubscribed, many institutional investors do not take part in rights issues, which frees up the quota for retail investors, says the fund manager.

“A lot of times, listed companies have rights issues, but they may be undersubscribed. This undersubscribed portion will be given to people who apply for excess shares. Some existing investors of the listed company may forget to apply, don’t have the money to apply, or they just overlook it.

“There are many rights issues at lower prices. You can buy the rights shares after the company has made an announcement on this,” the fund manager suggests.

Property loan vs share margin financing

Whether you are using share margin financing or tapping on your home equity, investing in shares with borrowed funds is a double-edged sword.

The former is a type of revolving credit facility provided to investors to finance their share trading and investment activities. This is backed by collateral, such as cash, warrants of certain shares, unit trusts, fixed deposits and quoted securities on Bursa Malaysia, according to comparison site Loanstreet.com.my. Meanwhile, the latter allows you to tap on your current property value minus the outstanding home loan balance – all without selling your property.

The interest rate for share margin financing is very attractive. In some instances, the rate can be more competitive than housing loans. CIMB Bank, for instance, offers its share margin financing package at a base rate (BR) plus 0.95% per annum, while for its home loan package, it is up to BR plus 1.45%. Given its prevailing base rate of 3.9%, this works out to an annual effective rate of 4.85% and up to 5.35%, respectively, for the former and latter.

Another key difference between the two loans is how they function. “For property financing, you service your loan every month. For share margin financing, you only need to service it when you deploy it. The loan amount is tied to the value of shares. For instance, if you have half a million shares, some banks may loan you half a million ringgit. If the shares go up to RM1 mil, your loan will increase to RM1 mil as well,” says a fund manager who declines to be named.

He adds that the actual quantum varies from bank to bank, and the type of shares you use to pledge. “The margin of financing can go up to 70%. Some shares, like blue chips, can give you up to 70% margin of financing. Some will be given 0% financing, for instance, warrants, PN17 companies and companies with poor fundamentals.”

When you take up share margin financing, be mindful that a margin call will be made by the lender when the value of the collateral falls below a certain percentage of the financed amount. The borrower will need to top up the value of the collateral, such as with cash, or pledge more shares to meet the required margin of financing within three trading days. Failing this, you risk having your margin account liquidated, explains Loanstreet.com.my.

Share margin financing means different things to different people. “It’s like a knife – you either cut yourself or find it helpful in accomplishing certain chores,” says the fund manager.

“Unfortunately, many investors are like kids with a knife, they don’t know how to invest and they end up losing money. Then, they blame the stock market and the people who suggest that they use share margin financing.”

But for knowledgeable investors who are skilled in risk management, they could benefit from this facility, he says. “The interest rate has come down a lot. It used to be 17% per annum at broking firms in the 1980s and 1990s. Few banks offered share margin financing at that time – only Citibank did,” he recalls.

“Banks have a better system on how to manage the risk of this loan now, so the risks and interest rates have come down. This is (a lucrative) opportunity for those who are willing to learn how to do it sensibly,” he says.



This article first appeared in Focus Malaysia Issue 253.