Margin Lending explained

Ever thought of borrowing to buy shares? If our subscriber queries are anything to go by, using debt, usually in the form of a margin loan, is a popular topic of discussion.

What follows is an examination of the problems of borrowing to buy shares (the advantages receive way too much coverage in our view, and the dangers too little).

When a bank lends money, its primary concern is getting it back. That’s why most loans require security, in the form of your home or car. Margin lending is simply a loan that uses shares as security.

You put up some of your own money, the bank kicks in some more and you go off and buy a few shares. But the bank keeps all the shares under its control. That way, if things start going wrong, it can sell some of the shares to ensure it maintains its required level of security.

The bank determines how much it is prepared to lend based on how much capital you are putting up and which stocks you are going to buy. For some big blue chips, the loan-to-value ratio, or LVR, might be as high as 70%. This means that, to buy shares worth $1,000, you’ll need to provide $300 of capital while the bank will lend you $700. Smaller or more risky stocks generally have lower LVRs.

The benefits of a margin loan are simple. If you pick stocks which do well you’ll make more money than a debt-free portfolio. Unsurprisingly, this is the line pushed by lenders.

On the ComSec website there’s an explanation of margin lending and an example that shows (sort of) what would have happened had you purchased shares in Woolworths at $5.05 in March 1999 and held on for five years. The example shows that if you used a margin loan to acquire extra shares, then you’d have made more money.

Fair enough, although had the broker chosen Coles Myer as the example, it wouldn’t be so impressive. And let’s not even talk about tech stocks or other popular stocks from five years ago.

Risky

The fact is that margin loans are risky. Unlike traditional forms of loan security, share prices move up and down every day. And when your shares are being held as security, you’d better hope they head up rather than down. Otherwise, you’ll get what’s known as a ‘margin call’. This is where, to maintain the lender’s required LVR, you have to stump up more money. That means finding more cash.

If you can’t do that, the lender will start selling your shares, perhaps at the time when it’s least favourable to do so. What banks and other lenders won’t tell you is that a stock can do very well in the long run but have a horrible time in the short term. And that’s the biggest risk with margin loans. You can be right picking stocks that do very well over the years but get your timing a little wrong and it won’t matter.

In fact, even Commonwealth Securities’ Woolies example would have worked differently in reality. If, as the example showed, you put in $30,000 and then borrowed $70,000 to acquire one stock—Woolworths—you’d already be on the maximum LVR of 70%. So when the shares went from $5.05 in March 1999 to $4.63 in February 2000, you would probably have received a margin call.

If you didn’t have the cash, you’d have been forced to sell some shares at this low price. So, when you read about all the extra money you could have made with a margin loan, view it sceptically. The example in the table (illustrating the effect of a 40% price fall on a $30,000 portfolio) shows how a margin loan can hurt. In this case, not only do you lose all your equity but you still owe the bank $10,000. This isn’t scare mongering either.

Consider Aristocrat as a case in point. If you had followed our recommendation in issue 126/May 03 (Long Term Buy—$1.56) you’d be smiling about the current price of $7.03 Or would you?  If you’d used a margin loan to buy the stock, probably not. By the time the shares bottomed at 76 cents later that month, you may well have been margin-called out of your entire Aristocrat holding.

So, while a debt-free investor has made four and a half times their money, you’re sitting on a big fat capital loss. That may seem like an extreme example but seeing a stock price drop by 30% or more, after you buy it, happens more often than most investors care to remember.

But when your portfolio is ‘juiced up’ with a margin loan, you’re sure to remember these instances better than most. Taking a ‘portfolio approach’ won’t always help either. Just because one or two stocks in your portfolio are getting hammered, doesn’t mean the others are nicely moving up to avoid the margin call.

With margin lending, not only do you have to be right on the stock in the long term but also the short term. And that’s very, very difficult.

The bank is happy to lend you plenty when things are looking good and stockmarkets are expensive but it can force you to sell at the exact moment that shares look cheap. That’s hardly sensible investing, is it?

Margin loans do have their place but too many investors fail to appreciate the risks inherent in them. If you do intend to use a margin loan facility, we suggest you spend more time thinking about what can go wrong than doing your sums on examples provided by brokers, bankers and other product spruikers.