Leverage Your Cash Flow
Leverage crushed both companies and investors alike during the “great recession” of 2007-2010. You don’t need to search far to find a multitude of bankrupt and bailed out corporations or “zombie companies” that exist now merely to service their excessive debt loads. While it would be difficult to argue against the *potential for negative outcomes when utilizing leverage (we won’t discuss that here, multiple others have discussed at length) it can also serve as a great tool in the accumulation stage of an investor’s portfolio when used in *moderation and can actually be quite beneficial.
When I look at leverage as a whole in the context to my portfolio I focus on three aspects: Amount of Leverage, Use of Proceeds, and Risk Management.
Keep Leverage Low
The best method for keeping your portfolio under control is to limit the amount of leverage to a very reasonable level. During the great recession there were numerous banks, hedge funds and homeowners that took leverage to the hilt with their investments borrowing $30 for every dollar invested (or higher, commonly expressed as 30:1). When you are leveraged 30:1, a mere 3% reduction in the value of your portfolio (or home) will wipe out your entire equity investment. It is not hard to imagine a scenario where leverage can work against you, even if you keep a sharp eye on your investments you will need to actively manage your risk exposure at higher levels of leverage and even still may not be able to prevent a melt down.
In my personal portfolio, I drive leverage it two ways: (i) margin borrowing, and (ii) short option positions. Margin borrowing is quite simple and it involes borrowing money with the promise to pay it back to the brokerage firm typically using your invesments as collateral. Short options (almost always puts) are also a source of leverage (see the Short Option section for details on individual position selection), I utilize a matrix of governors and respect the most restrictive when looking to increase or take in a credit when rolling over an existing position. I currently look at the following two items when looking at leverage in the aggregrate: (i) market value of short option positions and (ii) monthly dividend income.
Increase Leverage or Roll Existing Short Position For a Credit
|Market Value of Short Option Position / Net Liquidating Value||No more than 3%||Unlimited so long as no new purchases are made / opened if greater than the target|
|Annual Dividend Income / Margin Debt + Margin Interest||Target 60 Months to repay all of the margin debt and interest at current divided rates (i.e. no dividend growth)||Unlimited so long as no new purchases are made / opened if greater than the target|
Given the restrictions on leverage for the portfolio, there is substantial flexibility for dealing with draw-downs and other temporary or lingering market calamities. For example, if the Short Option positions were to move sharply unfavorable forcing the closure of some or all of the open positions. There would be ample cushion available to repay the margin debt with the cash flow generated from the portfolio over time without the need to liquidate long equity positions at depressed market prices. I can’t reitterate enough how important it is to have a substantial cushion. In fact, I have gone out of my way to get portfolio margin so that I can leverage 6:1 if the SHTF.
Focus On The Return Of Your Money
When investing I have always been focused on companies that will provide a predictable, lower risk return. The seeking out of “multi-baggers” in the active investment community often entails enormous amounts of risk and is frequently accompanied with binary outcomes, either the company is successful and your reward is all or a portion of your “multi-bagger” or, more often than not, the company fails are you are left with nothing or a small fraction of your original investment in hopes of a “multi-bagger” return on your remaining capital.
When focusing on lower risk investments you gain the flexibility to do a high level of portfolio engineering to enhance your returns. Lower risk investments make for a great stable base of collateral (the initial standard margin provided by most brokers is 50%) that can be used to put on higher probability directional or non-directional derivatives that many times do require any additional cash collateral to put on (examples include verticals, butterfly, iron condors and many others).
My favorite lower risk investments are large and mega capitalized dividend growth stocks that have strong value characteristics (low P/Es), take a look at my portfolio holdings for examples.
Risk management is the last section and least important (ha! I am kidding, it is crucial). Proper risk management, for the context of the portfolio discussed here, really only boils down to one rule: never be forced to liquidate your dividend growth investments! My rule for risk management is to keep a close eye on the portfolio and make sure that any losses created by speculative positions or short options can be cured with income from the portfolio or regularly planned contributions to the portfolio over a reasonable period of time. While I may not always choose to cure losses with income or contributions, if I ensure that the rule is adhered to, it prevents the portfolio from getting out of wack from a risk management perspective.