When it comes to the stock market, the word "leverage" can have a lot of negative connotations. Once the word pops up, the majority immediately think of borrowed funds or margin. Then we have the derivatives market which according to Warren Buffett contains "financial weapons of mass destruction." As you can see, the work leverage (when it comes to the stock market) comes with plenty of negative connotations. Through future contracts, call options, leveraged ETFs, etc, one can essentially aim for much higher returns by taking aggressive risk.
However, we like to view leverage by asking the following question. How can we do attain better results with less force (effort)? This is a really important question as we all know there is only 24 hours in a day. This means that your personal effort can only bring you a limited return on investment. Away from the stock market, many astute people progress quickly financially through their ability to be able to leverage other people's capital, labor, skills or their own capital to name but a few. How can we get this leverage game going though in the stock market is the question.
Many passive investors would state that by going long an index remains the best option. Warren Buffett also echoes this view. Consensus believes that despite the huge increase in asset prices over the past 50 years or so, history always repeats. Quantitative easing also has helped this argument due to an obscene amount of currency having being printed over the past decade or so. Over the long term, depreciating currencies lifts stocks. Yes there will be recessions along the way but the general direction should remain firmly up. Therefore, below are three ways we can leverage this long term tailwind, which we always aim to do in our portfolio.
Compound interest is definitely the biggest way one can gain leverage in the stock market. What we mean here is how the total return of an investment gets compounded over time through dividend re-investment for example. Market timers who try to time entries and exit really miss this point when it comes to long term gains. Why? Because the most important metric when it comes to compound interest is time in the market and not necessarily annual returns. When one undergoes a dollar cost averaging strategy by remaining invested in the market and just investing consistently (through re-investing dividends) even in difficult conditions, this actually gets compounding working faster.
Why? Because those dividend checks can pick up shares at much lower prices and at much bigger yields when the market drops. One sure fire way of gaining extra leverage here is to redistribute the dividends coming off the portfolio into the most beaten up stocks. Obviously this cannot be done if one is just invested in an index but it can certainly be done if the portfolio is holding a basket of quality underlyings. One such stock at present (even though its dividend has just be cut) would be something like Anheuser-Busch InBev SA/NV (BUD), for reasons we have outlined here.
Another way to gain leverage or improve our results is by the way of valuation. Value investing which is buying quality companies ( which temporarily may be out of favor with the market) at a low historic price has consistently bore fruit over the decades. We primarily look for companies with low book and sales multiples, have positive earnings, low debt and pay a dividend. Anheuser-Busch InBev SA/NV, for example, made the right decision (for the long term) with respect to the cutting of its dividend.
The funds that will be saved from the cut will be used to shore up its balance sheet. Presently, the company's long-term debt at around $108 billion is over $36 billion higher than the book value of the company. The reduction in the debt, though, is really going to bring down that difference, as well as the book multiple. Out of all of ABI's key financial metrics, the one which may have been out of sync with the others was its debt to equity ratio. This is now changing for the better, however.
Selling high implied volatility is another way of gaining leverage from one's portfolio. A simple strategy such as the sale of a covered call or a naked put in periods of high implied volatility (see below) can increase returns due to the extra income received. Back on Nov. 1, ABI was trading with an implied volatility of 25.5% which is above average for this stock - especially so soon after earnings. Implied volatility is mean reverting, which is advantageous for options sellers.
With respect to the covered call trade, many investors do not avail of this strategy due to the inherent risk of shares being called away. However, one can decide to sell covered calls around earnings or when the respective shares are clearly overbought. Furthermore, it's not the end of the world if shares are indeed called away. One can then pick up cheaper stocks or wait until the stock in question comes back into your buy zone.
This told us that the market was still pricing in a large move despite the post earnings slide we witnessed post earnings. This brought opportunity to the table especially in a stock like ABI that still looks to us heavily undervalued. Therefore, we sold the Dec. 21 regular puts for about $0.96 per contract on Nov. 1. We got this price due to the high IV of 25.5%. Fast forward to Nov. 8 and look at how ABI's implied volatility has now dropped to 20.6% (see below). This means we can now buy back our put options cheaper as the market now believes that the expected move has come down by about 20%.
To sum up, there are plenty of ways to gain leverage in one's portfolio to try and maximize gains, from re-investing dividends to value investing to taking advantage of high implied volatility. ABI continues to tick all of these boxes when traded correctly.
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Disclosure: I am/we are long BUD.
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.