When to Borrow, And When Not To

Published on February 2017 | Categories: Documents | Downloads: 55 | Comments: 0 | Views: 436
of 5
Download PDF   Embed   Report

Comments

Content

 

Body

23/06/2012 17:41

When to Borrow; And When Not To  In only a few cases it makes sense to borrow; in most cases, it doesn't 

Three weeks ago, in these columns, I wrote about John Templeton's advice to people on various matters relating to money. One such advice was about borrowing money. Quite rightly, r ightly, Templeton advises people never to borrow money to finance personal expenditure. But what about borrowing money for investment? Are there situations, when borrowing money to finance the purchase of stocks makes sense? An excellent answer to that question can be found in Templeton's book, "The Templeton Plan: 21 Steps to Personal Success and Real Happiness: " Sensible Borrowing: An Example When Hitler invaded Poland in 1939, America had just gone through the worst depression in its history. There were more than a hundred companies whose shares had dropped below one dollar each on the New York and American stock exchanges. But Templeton, at age 26, was alert to a fundamental economic reality. In wartime, there's great demand for so many kinds of products, so that even the inefficient companies can make a profit. Although the United States wasn't yet in the war, Templeton, who had done his homework carefully, was convinced that the U.S would be supplying the Allies and that it would most likely get involved in a direct way itself, before too much time passed. Translating these broad conclusions about the economy into practical reality, he decided in September 1939 to buy one hundred dollars of every stock on the exchanges which was selling for no more than one dollar per share. To finance the venture, he borrowed ten thousand dollars from his employer. Borrowing money for personal expenses - for paying for a vacation trip, for example - was anathema for him. This instance was different, however, because it involved a business venture in which the borrowed funds would be used to make money. In other words, if he'd borrowed for consumer purposes - say to buy a new refrigerator or a car - the value of the object he'd purchased would inevitably have depreciated. As a result, he'd have had a debt to repay, and no chance to make money from this purchase to cover that debt. But in borrowing money for business purposes, he was betting that the profit from his investment would greatly exceed the principal and interest he would be paying on the ten thousand dollar debt to his employer. This was, by the way, the only time in his entire professional career that he ever borrowed, even for business reasons. There were two other factors that reduced the risk in the investment that he was making. First of all, he'd done thorough research during the previous two years on the performance of stocks selling for less than one dollar and he'd found that if their past records continued, it would be very unlikely that he'd lose money. Secondly, through other wise investments and a stock purchase plan he had with his company, his personal investment portfolio was now worth more than thirty thousand dollars. So he had enough assets to cover the ten thousand dollars he'd borrowed if his theory proved wrong. With this analysis firmly in place, he asked his former boss who was a stockbroker to place the order. His ex-boss said that the order was most unusual. He warned Templeton that he would do so reluctantly because thirty seven of the companies on his list were wer e in bankruptcy. "That doesn't matter," Templeton told him. "Buy everything, whether it's in bankruptcy or not." Manyhis might call thiswell a high-risk move, especially when heawas betting borrowed money. done homework as usual. He knew that there was chance thatwith his scheme might fail. But But he he had also knew that he had gathered the information and analysed it as thoroughly as one could. His risk, in other file:///Volumes/Data/sanjaybakshi/Dropbox/Pe file:///Volumes/Data/sanja ybakshi/Dropbox/Personal%20Site/SB's%20S… rsonal%20Site/SB's%20S…_Bakshi/Articles_&_Talks_files/Wh _Bakshi/Articles_&_Talks_files/When_to_Borrow_And_ en_to_Borrow_And_When_Not_To.HTM When_Not_To.HTM

Page 1 of 5

 

Body

23/06/2012 17:41

words, was a reasonable one, with the odds stacked as much as possible in his favour. The result? Of the 104 companies whose stock he had bought, only four turned out to be worthless. Within a year, young Templeton was able to pay back all the money he had borrowed. After he sold all the stocks - an average of four f our years after he bought them - his original ten thousand dollars had swelled to forty thousand dollars. . .  A few Rules About Borrowing Templeton's ideas on borrowing money can be compressed in a few rules.  Rule 1: You must never borrow money to buy things whose value will fall.  For example, almost all credit card debt will fail this rule. Most credit card debt is incurred for spending on items which will not yield any profits. Indeed, most credit card debt is incurred for spending on items which will be consumed immediately, e.g., a meal in a restaurant.

Borrowing money to finance personal expenses, is not  going  going to help you in accumulating capital in the long run. There are two reasons rea sons for this. First, you will pay interest on the money you have borrowed to finance personal expenses such as a meal in a restaurant or a holiday. That interest adds up to a lot of  money. Calculate the amount of interest charges you have paid to your credit card company over the last few years, and you will be amazed to see the final total. Second, if you use your credit card to finance personal expenses, then you are also likely to habitually spend your money on an impulse on things you would never had spend, if you did not have the cash in your pocket and no credit card either to pay for them in the first place. You might say that this rule runs counter to what w hat credit card companies say in their advertisements. I would agree with that statement. According to these advertisements, credit cards offer you a convenience. Never ever is there a mention in these ads about those credit-card-debt-trapped individuals these companies will chase to get back their principal and interest. Never ever is there a mention of the fact, that even though you may pay off the whole of the balance before the interest starts accr accruing, uing, you will still end up spending more money that you would have otherwise done, if you had no credit card because you would yield to the temptation of buying unnecessary things on an impulse. There is a perfect irony ir ony in this rule when applied to credit cards. c ards. Most people will not follow this rule. r ule. The irony is that precisely because most people will not follow f ollow this rule, the credit card business is a great business to be in. Credit card companies make money from two sources. First , is the commission they get from retailers r etailers who sell goods and services to credit card holders. If you spend Rs 500 on buying a lunch from an expensive restaurant, the restaurant r estaurant will get about Rs 490 and the remaining Rs 10 will go to the credit card company.

The second source is the interest which accumulates on the credit card balance, which can run r un to as much as 25% per annum. Therefore, if you earn a lot, spend a lot on your card, and if you don't pay off all the balance at the end of the month, you become a "most valued" customer for the credit card company. In other words, you become its cash cow. My philosophy on credit cards is very simple: it's far better to be a shareholder in a credit card company than to be its "most valued" customer. If you follow this simple rule, I guarantee that you will be better off  because of it.  Rule 2: Borrowing money to finance a business venture venture is OK, provided you are certain that the profits  from the funds borrowed will be well in excess of the cost of the borrowing. borrowing. file:///Volumes/Data/sanjaybakshi/Dropbox/Pe file:///Volumes/Data/sanja ybakshi/Dropbox/Personal%20Site/SB's%20S… rsonal%20Site/SB's%20S…_Bakshi/Articles_&_Talks_files/Wh _Bakshi/Articles_&_Talks_files/When_to_Borrow_And_ en_to_Borrow_And_When_Not_To.HTM When_Not_To.HTM

Page 2 of 5

 

Body

23/06/2012 17:41

No businessman borrows money if his earnings from borrowed funds are likely to be less than their cost. And yet, many businesses become bankrupt primarily because this assumption turns out to be wrong. Therefore, the emphasis should be on the  probability that the business venture you are financing from borrowed funds will yield profits at least many times the annual interest payments on the borrowed funds. Determining this probability is not easy. If it was, then no business would go bankrupt. However, there are certain types of situations where this probability is high. I will explain this later in this article. Can this concept of borrowing money to finance a business venture be applied to stocks? The answer is yes. Every investment in a stock should be looked upon as a business venture because that is exactly what it is. By buying a stock, you are putting your capital at risk, just like you would have done, had you bought a part-interest in a private business. Later in this article, I will give you an example, when borrowing for stockmarket operations was sensible. Before that, however, I want to tell you about  Rule 3.  Rule 3: Never borrow more than what you can comfortably comfortably pay off on a worst-case-scenario basis.

This too is a simple rule, but most often it's forgotten precisely when it is most needed. For example, during the height of bull markets it's common to find banks, and other financial intermediaries willing to offer cheap loans to buy stocks on margin. The collateral for these loans is the stocks which are bought from borrowed funds. As the value of the collateral rises, the lenders become more and more eager to give more loans to borrowers. The borrowers, seeing the value of their portfolios rise are ar e even more tempted to take up on these loans. This vicious circle creates c reates an asset price bubble which inevitably bursts. When that happens, many, if not most, borrowers go bust because they are unable to pay off the loans. The important question to ask is why did these people borrow to the hilt in the first place? The answer is that it never occurred to them that stock prices can even fall. Or perhaps, they thought that they will get out at the top. Whatever the case, they failed to consider the worst-case scenario before they borrowed money to buy stocks. One of the fundamental rules about the stock market is that when prices have fallen to bargain levels, there is no guarantee that they will not fall by another 50% or even more. Stock prices have always shown a tendency of going to the extremes. Therefore, whenever it might make sense to borrow money to buy stocks (because of Rule 2), you must restrict your borrowings to a level which will not make you uncomfortable if your idea turns out to be a flop.  A Recent Example Three months ago, in these columns, I had written an article on dividend capture (See Strategic S trategic Commentary in Intelligent Investor dated 7 July 1997). At that time, the stock price of the company whose example I had given in that article - Cholamandalam Investment and Finance Limited - was Rs 33 per share. The current market price is Rs 35 per share ex-dividend. The dividend paid was Rs 4.50 per share. I had stated in that article that the shares of Cholamandalam at Rs 33 per share were suitable for a dividend capture strategy. If such a transaction had been carried out with borrowed money, the results would have looked similar to those given in the table. If, If , for example, using the information in the table, you had invested Rs 1 lakh of your own money in the shares of Cholamandalam, that investment would have grown to Rs 1.62 lakh (net of borrowing cost and taxes) in just three months times. The table shows how leveraged dividend capture strategy worked in the case of Cholamandalam. The investor invests a total of Rs 500 in the shares of Cholamandalam at Rs 33 per share, thereby buying a total of 15.15 shares. Of that Rs 500, only Rs 100 is his own money and the remaining Rs 400 has been file:///Volumes/Data/sanjaybakshi/Dropbox/Pe file:///Volumes/Data/sanja ybakshi/Dropbox/Personal%20Site/SB's%20S… rsonal%20Site/SB's%20S…_Bakshi/Articles_&_Talks_files/Wh _Bakshi/Articles_&_Talks_files/When_to_Borrow_And_ en_to_Borrow_And_When_Not_To.HTM When_Not_To.HTM

Page 3 of 5

 

Body

23/06/2012 17:41

  borrowed at an interest rate of 18% p.a. After three months the investor received Rs 68.18 as tax-free dividend, out of which he was able to pay off the interest on the loan for f or three months amounting to Rs 18.00. He also paid a short-term capital gains tax of Rs 18.18 and was able to sell his shares, after three months for Rs 530.30. The sale proceeds could then be utilised to pay off the loan principal of Rs 400. The net cash flow of this strategy comes to Rs 62.32. Remember, this is the net cash return after the interest on the loan, the loan itself and taxes have been paid off. In other words, this is the investor's return on his own investment of Rs 100 over a short period of only 3 months. Annualised return on investment comes to 249%. There were two reasons why using borrowed funds in this case made sense: (1) the company was not likely to skip or cut its dividend per share (in reality, the dividend per share was actually raised from the level of dividends paid in previous years); and (2) on ex-dividend date, the market price per share was not likely to fall below the purchase price of Rs 33 per share. (For the logic behind these two predictions, you should see my July column.) Since, the cost of borrowing was less than the dividend return and there was little risk in the shrinkage of stock price on ex-dividend date, borrowing made sense. Such cases, however, are few and far between. And when they can be identified, full advantage of using leverage to enhance investment returns should be taken. 'Dividend Capture Strategy: Using Leverage to Enhance Returns Initial investment

Rs100.00

Borrowed funds (interest 18% p.a.) Total invested

Rs400.00 Rs500.00

Price per share

Rs33.00

Number of shares bought

15

Dividend per share

Rs4.50

Interest rate for borrowing

0

Stock price after 3 months

Rs35.00

Cash flow statement

 

Time: Now

Cash Flow

Loan taken

Rs400.00

Cost of shares bought Time: After 3 Months Tax free dividend @ Rs 4.5 per share

-Rs500.00   Rs68.18

Interest on loan

-Rs18.00

Proceeds of shares sold

Rs530.30

Loan paid off Tax on short-term capital gain Net cash flow Own Investment

-Rs400.00 -Rs18.18 Rs62.30 Rs100.00

Return on invesment in 3 months

62%

Annualised return on investment

249%

Note

file:///Volumes/Data/sanjaybakshi/Dropbox/Pe file:///Volumes/Data/sanja ybakshi/Dropbox/Personal%20Site/SB's%20S… rsonal%20Site/SB's%20S…_Bakshi/Articles_&_Talks_files/Wh _Bakshi/Articles_&_Talks_files/When_to_Borrow_And_ en_to_Borrow_And_When_Not_To.HTM When_Not_To.HTM

Page 4 of 5

 

Body

23/06/2012 17:41

This article is submitted by Sanjay Bakshi who is the Chief Executive Officer of a New Delhi based company called Corporate Investment Research Private Limited. © Sanjay Bakshi. 1997.

file:///Volumes/Data/sanjaybakshi/Dropbox/Pe file:///Volumes/Data/sanja ybakshi/Dropbox/Personal%20Site/SB's%20S… rsonal%20Site/SB's%20S…_Bakshi/Articles_&_Talks_files/Wh _Bakshi/Articles_&_Talks_files/When_to_Borrow_And_ en_to_Borrow_And_When_Not_To.HTM When_Not_To.HTM

Page 5 of 5

Sponsor Documents

Or use your account on DocShare.tips

Hide

Forgot your password?

Or register your new account on DocShare.tips

Hide

Lost your password? Please enter your email address. You will receive a link to create a new password.

Back to log-in

Close