My Investing Confession

It’s time to talk about my little investing secret – one that I’ve been thinking about for the last year or so and one that I put into action when I re arranged my portfolio a couple of months ago to include proceeds from a flat sale and newly self managed pension.

I have started using leverage.

This is something that our hero – WEB – famously warns against, and for good reasons, which we are well aware of.  I’m going try and explain why I am ignoring the wise advice of many my investing heroes and pursuing a path that introduces a brand new risk to me – liquidity risk.

First, I should point out that as with so much about WEB, there are many layers of nuance to what he says, and while one can learn a lot by taking his statements at face value, when one peels back the layers, one really realizes the genius of the man.  So, OF COURSE Warren has always used leverage.  He used leverage in his pre Berkshire Hathaway partnership days when he paid his partners to deposit cash with him early and he used it when he did merger arbitrage.  And for the last 50 years or so he has used it in Berkshire Hathaway by acquiring insurance companies and using their investment portfolios (or “float”) to buy equity securities – something that most insurance companies don’t do because they perceive it as too risky, but something that WEB can do because of his stock picking skills.  This strategy is described in many of the Berkshire letters, and also by many external commentators, including academics (http://www.economist.com/node/21563735).  What Buffett has done brilliantly has been to use a form of leverage that is a) cheap and b) reasonably permanent – as long as people are using insurance, they will be giving Berkshire money to invest.

So how did my decision evolve?  Well the first step was the fact that I use spread betting anyway to synthetically buy lots of my equities.  This is because, in the UK, spread betting is tax free and allows me to avoid paying c30% on capital gains, as I would have to in the majority of my portfolio.  Of course I take advantage of the £15k per year allowance that I have to put into ISAs and one day I hope that my whole equity portfolio is in ISA accounts.  But that day is a couple of decades away.  Of course, there is a cost to using spread betting and that is their cost of funds, which is around 0.5%, plus around 2% per year to roll positions quarterly.  So let’s say 2.5%.  If one is earning around around 12% per year on an investment portolio, being charged 30% tax on gains and 40% on dividends brings the return down by about 3-4%.  So already spread betting compares favourably with a taxed portfolio, even if fully collateralized.

But the thing is, spread betting doesn’t require full collateralization.  Indeed, depending on the liquidity of the shares you are trading in, and where you are prepared to place stop losses, you can get by with as little as 10% margin, though that would be very aggressive.   Of course, using the ability to margin to lever up into more shares is a fool’s game.  But what if it were possible to buy an asset that offers full downside protection (like cash), but with a juicy yield far in excess of 2.5% that will compensate for the costs of spread betting as well as juicing up returns?

Well I believe that asset is TLI – Alternative Asset Opportunities.

(https://wexboy.wordpress.com/2012/11/21/an-investment-to-die-for/), This has now made two distributions of cash, and the maturities have been coming at a decent pace, with the average life expectancy being less than 5 years now.  As time goes by, the share price will become less and less volatile and more and more will begin to mirror the performance of the portfolio.  That, I believe, puts a floor under the shares.  That is important, because I need to be able to sell these shares in case there is a sudden liquidity requirement in the spread betting account – a market crash.  But if the spread betting account is able to operate with, say 35% margin, then returns might look like this:

Spread Betting Portfolio Return Assumption: 12%

Costs: 2.5%

TLI Return: 10%

Portfolio: 100

Annual Return = (0.65*10%) + (1*0.12%-2.5%) = 16% overall return.

The crucial thing with this strategy is not to suffer any losses in the spread betting portfolio, permanent or not, that require me to sell TLI and put cash back into the spread betting account.  The disaster scenario would be a 2008 esque crash that depresses all assets well below their intrinsic value.  In that event I might have to sell TLI at a loss to prop up my spread betting portfolio or alternatively close out spread betting investments at an inopportune time.  That’s why I need to believe TLI is now on an inexorable path upwards at a clip of 10% or more per year.  And also why I need to concentrate more on finding cash generative, low beta, “boring” stocks that will outperform in a downside scenario.  In addition, because larger and more liquid stocks have lower margin requirements, I should  favour these, although it’s tough to find fair or undervalued large caps in the current market. 

Anyway, that’s the path that I’ve chosen to go down.  Only time will tell how it works.

Onto my current portfolio performance:

Last year I was hurt in a big way by a collapse in Emeco and Hargreaves Services.  They were classic value traps in an industry I don’t understand – commodities.  I was looking for bargains but was way too early and bought them both while they both had a long way still to go down.  With Emeco I failed to understand how margins could collapse as much as they did.  In retrospect it is obvious – when there is a massive over supply of equipment, rental companies will obviously be price takers.  Today Emeco looks vulnerable to its huge debt load and I am minded to sell.  That said, rivals have talked of contract wins and recovering second hand prices for machinery.  In addition, a rival has proposed a merger, with resultant cost savings and a bigger footprint, so I might just wait a while.   My focus going forward will be on rotating into these “risky” small caps into low margin larger caps.  IBM and Deere both look interesting to me at the moment.   Today I also put in an order to buy Markel.  The reasons are fairly straightforward.  First, it’s exactly the sort of company I described above – low risk due to an outstanding management team that are focused on shareholder value and a Berkshire Hathaway like model.  The reason I preferred Markel over Berkshire is size.  With a market cap of only $10bln, the universe of available investments is far larger than those that WEB can access.  At 1.45* book value, it’s not super cheap, but I think there is downside protection in that management have a proven record of conservatism and buybacks will always put a floor on the share price.