For the past four years, I’ve been thinking about investing differently with my dividend stocks. In fact, as soon as I started dividend investing, I thought of adding this strategy to my portfolio. But I couldn’t. It wasn’t the right time for me. This summer could be the right time. This is why I’m sharing my new dividend investing strategy with you today.
I’m Going to Buy on Margin
As you know already, the bulk of my portfolio is an RRSP (a Canadian tax sheltered investment account) where I can’t use margin borrowing. Starting this summer, I should have some extra cash to invest outside my retirement plan. This is why I thought of starting to use a margin account. The margin allows you to borrow money based on the value of your holdings. In other words, we are talking about leveraging. I know, this is an evil world in the investment industry. Most people think that the concept of leverage was created by financial advisors for financial advisors. When you think about it, if a client who doesn’t have money can borrow (so the advisor makes money off the interest) and invest (so the advisor also makes money on the investment fees), it’s the best of both worlds… for the advisor! But I’m not an advisor trying to sell you leveraging, I’m just going to explain how I intend to put my strategy in place.
How a Margin Account Works
A margin account works in a simple manner. Your broker is willing to lend you money at a variable interest rate to increase your buying power in the stock market. The more you invest, the more you can borrow. Most brokers will establish different categories of investments and give you a percentage of its value for each of them. For example:
Penny stocks (under $2): broker will give you 50% margin
Regular stocks (over $2): broker will give you 70% margin
Mutual funds (any kind): broker will give you 50% margin
Bonds (municipal, gov’t): broker will give you 90% margin
If you invest $1,000 in Johnson & Johnson (NYSE:JNJ), which qualifies as a “regular stock,” the broker will allow you to borrow 70% of this amount to invest in the stock market. Therefore, you will benefit from an additional $700 to invest.
The Magic Doesn’t Stop Here
When you think about it, after using the $700 to buy more shares of JNJ, your account will show the following:
Net account value: $1,000 ($1,700 – $700)
Stock value: $1,700
Available margin: $1,190 – $700 = $490
Where the $1,190 is coming from? It’s coming from the margin account rules. The broker allows you to margin 70% of whatever is invested, no matter where the money is coming from. But what happen if you invest the additional $490 left on the margin? Silence…
I wanted to start with this example to show how many people get it wrong: You must not start with the 70% of what you invest. In this example, what you should understand is that the broker requires you to invest 30% and borrow 70%. Therefore, the maximum you can invest with $1,000 in cash is… $3,333.33. You can either divide $1,000 by 30% or you can keep doing the calculation by investing what is left from the margin each time to invest from it and you will get to the same number.
Get the Dividend to Pay for the Interest
According to the Questrade website, their interest rate for a small margin account is prime + 3%. Therefore, you are paying a 6% interest rate at the moment to borrow money from them. The interest is charged on the amount borrowed. Let’s assume you borrow the maximum from your $1,000. This makes a margin of $2,333.33 (we'll discuss margin call in another post). The yearly interest on this amount is $140.00. If you take the $140 and divide by the total amount you have invested ($3,333.33), it requires a dividend yield of 4.20% after tax to pay for your interest.
When I think about it, I understand that this year, my leveraged portfolio will probably fall short in dividend yield to cover the interest. On the other hand, my current portfolio is paying about this yield in dividends after only 4 years. The interesting point about leveraging is that the dividends grow faster than the interest rate.
I’ll go deeper into my strategy in the next article, but I wanted to hear from you about the idea of leveraging first.
What do you think? Am I going to make lots of money or simply throw my hard earned cash into a deep hole and never see it again?