The High Cost Of Idle Cash
There are many recent articles published on Seeking Alpha, from highly respected authors, expressing concern at the possibility of a change in the market's direction, increased volatility and even a share market crash (see here, here, here, here and here). Eric Parnell, in his article, "Why Stock Markets Crash - And What To Do When It Happens," suggests, "One might consider keeping 25% of assets in easily accessible cash in order to be poised for new opportunities. That percentage might be too low but I am virtually certain that it is not too high. Whatever opportunity cost that you pay in terms of diminished return can be quickly recouped during the next market collapse." The problem with this approach is it requires considerable share price volatility for profits from opportunistic buying of dips to outweigh the loss of income through reduced shareholdings. In various articles, I have demonstrated that setting aside cash to buy the dips worked very well in the 2000 to 2010 period due to the considerable share price volatility during that time. But in the six years 2010 to 2016, the Fed, by virtue of its policies, has greatly reduced share price volatility. Back in 2008 to 2009 there was a lot of residual fear in the market following the GFC events. No one really knew whether the share market would go up, down or sideways. In fact, the share market has risen since then at an increasing pace as fear has faded. Those who stayed in the market have done very well compared to those who stayed in cash. In 2016, I would say there is again considerable fear in the share market. But, it is offset by the fear of unnecessary loss of income if investments were converted to cash and there was no market downturn in the short to medium term. There is a way to have cash availability without selling down 20% to 25% of your share portfolio, as explained below.
Using a margin facility as a form of overdraft facility - with wide margins of safety
Businesses, from small sole traders to the largest corporations, make use of overdraft facilities to deal with seasonal and other swings in cash requirements. This is found to be more cost efficient than holding idle cash in reserve for these contingencies. I would not suggest leveraging long-term share investments with margin loans at this time of elevated share prices. But, utilizing a margin loan facility can provide ready cash availability to buy any dips in share price. This appears to be a logical and cost effective alternative to converting shares to cash in anticipation of an uncertain happening. TABLE 1 below illustrates how a carefully managed draw-down of margin loans to buy share price dips can be done with a wide margin of safety.
Margin loans are generally only called when net equity gets down to the 35% to 40% level (It is necessary to be familiar with the precise terms and conditions of your margin loan agreement).
Provided a margin loan was drawn down to buy shares in accordance with TABLE 1 above, it would take in excess of a 55% fall in share price before there was danger of a margin call. Using Johnson & Johnson (NYSE:JNJ) as an illustration, the share price would have to fall from the present ~$118 level to less than $53, thus leaving a wide margin of safety. To put this in perspective, during the worst days of the GFC the S&P 500 fell by 57.0% while JNJ fell by only 35.5% per TABLE 2 below.
Buying the dips and Selling the Rises
Let us assume it has been decided to use a margin loan as a form of overdraft facility rather than selling down shares to create a cash reserve. It is of course possible to use both a cash reserve and an overdraft arrangement for buying dips in share price. I have described a system and procedures based on a cash reserve in my previous articles (see here, here, here, and here), so I will not go into that detail again here. But I will use those systems and procedures as part of demonstrating how use of an overdraft facility along the lines outlined in TABLE 1 would have benefited a JNJ shareholder in the period 2000 to 2016. I have chosen this period as it includes the last 6 years of low share price volatility and the previous 10 years of considerable share price volatility to which we may return. TABLE 3 below shows the very profitable results of the exercise.
From TABLE 3 we can see that utilizing a margin loan facility in a very conservative way, we have been able to generate an additional $350.000 over and above the returns from our core investment. A fine result achieved with not a lot of effort. As I have pointed out in my previous articles there is no prediction required here. Buys are triggered according to predetermined parameters that incorporate checks and balances to ensure a dip in share price is really a dip that should be bought.
Margin loan interest rate
For margin loan interest I have assumed a flat 8.0% on the margin borrowings. Current margin loan rates are ~3.5% for loans of $50,000 to $100,000. In the 10 years 2000 to 2010 ten-year bond rates averaged 4.34%, around 2.5 percentage points above current rates. Adding 2.5 percentage points to the current margin loan rates and a further 2.0 percentage points for conservatism gives the 8.0% rate used. As the margin loan facility is not required for much of the time, the results are not particularly sensitive to the margin loan interest rate.
Comparing results for shares plus cash to shares plus margin loan and to shares only
In TABLE 4.1 below, I compare the results for this exercise utilizing margin loans to one using a 20% cash allocation and also to just investing $500,000 in JNJ shares.
From TABLE 4.1 above, it can be seen there was not a lot of difference between setting aside 20% in cash with the balance in shares and keeping 100% in shares. The profit from buying the dips with the cash was largely offset by the effect of the reduced number of shares in the cash and shares option. The profit from buying dips with the margin loans was lower than buying with the 20% cash allocation. But, there was no offsetting reduction from a reduced shareholding. This made the margin loan option far superior of the three strategies by a long way. The margin loan option was over $300,000 ahead of either of the other options and grew the initial $500,000 investment to $2.1M. It is worth analyzing the results a little further into the period 2000 to 2010 and the period 2010 to 2016, as per TABLE 4.2 and TABLE 4.3 below.
The 2000 to 2010 period was one of considerable volatility for the JNJ share price and for the share market in general. The opportunities to buy the dips were more frequent in this ten-year period. The cash for the Buy the Dips strategy is designed to take advantage of share price volatility, so it is not surprising that results surpassed the shares-only strategy in this 10-year period. The margin loan strategy also was able to take advantage of this increased volatility and with no reduction in shares was again clearly superior.
To obtain a fair comparison of performance of the BUY the Dips strategy in this period we needed to start again with the $500,000 for shares only and margin loan strategies, and $100,000 cash plus $400,000 shares for the Buy the Dips strategy. As opportunities to buy the dips were less frequent in this 6-year period, the $100,000 cash was underutilized and fell considerably short of the shares only strategy. Once again the margin loan strategy was superior to the other options.
Summary and Conclusions
It can be seen the margin loan strategy will always be additive to the shares only strategy and gives the best result in times of either high or low volatility. If the market holds steady or rises there is no opportunity cost as there is with cash. If volatility returns, a margin loan facility opens up similar opportunities to cash for buying the dips. It truly provides the opportunity to have your cake and eat it too.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. I do not recommend that anyone act upon any investment information without first consulting an investment advisor and/or a tax advisor as to the suitability of such investments for their specific situation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.