Tax | Leverage - A Discussion

11th Jan '14 by mpat89

10 comments 8751 reads

I'm under 25 years old and when I look around, it's clear that within the older generation, ordinary people were able to create fortunes by purchasing property with borrowed money and taking the income and capital growth.

Well, I know the same principle would have worked with a sensibly diversified and leveraged portfolio of stocks that outperformed the market (easily done using Stockopedia) - outperformed being pretty key here.

I can't be arsed to buy a property, I prefer stocks. They're like a computer game. So I'm thinking that when the market next takes a dramatic dive, I'd quite like to fill my boots with some leverage and reap the rewards over the long term. Brokers such as Interactive Brokers make this accessible at extremely competitive rates (albeit the leverage is limited to companies within the FTSE 350 - not the end of the world, maybe even a forced personal safeguard due to the leverage element).

FIRST QUESTION: But all my stocks are in my ISA and my annual investment into the market is done by way of using my ISA allowance. What's the solution here?

My portfolio yields 3% in dividend income, at the higher tax rate this will leave me out of pocket and god forbid I have to pay capital gains tax.

SECOND QUESTION: What's more valuable, tax exemption or access to leverage? Lets assume I hit the higher rate in 3 years time.

My secondary thought is to save a secondary pot to use with leverage and as I earn more I can add to that as well but that will make things tight in the short term.

My overall goal here is to eventually end up with a F@!K OFF passive income, or at least one that will make a nice supplement should I ever decide to use it.

Is anyone else using leverage? Please could you discuss this with us.

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jjis

13th Jan '14

Hi mpat89, first of all congratulations on being young and being interested in investing at this stage in your life. By doing so you will give yourself the advantage of having time on your side and being able to allow the magic of compounding work for you. However, you seem to be in a hurry to get rich quick using the stock market and leverage. You say this is easy with Stockopedia (I'm sure Ed would like to agree with that statement) but as David Bowie sang "It ain't easy". But you will give yourself a chance starting early and selecting your own stocks if you know what you are doing.

I would say tax is far more important than leverage and you should maximise your contributions to ISA's as a first priority and go for your yield investments in there and compound up the dividends in a tax free environment. As John Templeton said (he was a famous investor) the simple aim of investment should be to maximise real returns after tax.

By starting early you have put yourself well on the road to getting rich SLOWLY. Once you have your ISA filled if you have enough surplus income left over then by all means invest that outside an ISA if you can afford to lose it. This could be on a dealing account alongside your ISA and it can then help fund your ISA from dividends and capital gains. Some providers do I believe allow you to borrow against your stocks but I wouldn't recommend it as you may not be able to ride out the inevitable down swings otherwise. Again to avoid tax you could focus this on lower yielding / growth plays and aim to utilize your CGT allowance. By way of illustration if you contribute to your ISA for 20 years, compound your investments in there at 15% per annum you would have a million £ portfolio and the nice passive income that you desire - easy?

If you must have leverage then consider Investment Trusts which can gear and can swing around in discount terms to give a double benefit if a discount closes. This can be done in an ISA. For example back in 2008 when I thought the market was getting cheap I bought in my ISA some Edinburgh Investment Trust Closed Fund (LON:EDIN) as it was on around a 9% discount and Neil Woodford had just taken over the management of it and it was 20% geared. This worked out OK and I doubled my money by the end of last year. However, I am out now as Woodford and the discount are gone and the market is looking more expensive these days so reducing my risk.

If you positively must have leverage then you can try spread betting or CFD's but these can be very risky if you don't keep it under control or know what you are doing - and these firms win most of the time. If you do go down that route please use IG Group (LON:IGG) as I hold them (results tomorrow)!

Hope you find this response useful but you should also check out Boros's post on his advice about becoming an ISA millionaire. Regards jjis.weebly.com

cig

Leverage is one of the best ways to turn a big fortune into a small one, but then if you must, you can access cheap leverage within your ISA by biasing your portfolio towards leveraged companies (thin equity, big pension deficits, etc). They will do (much) better on the upside, and on the downside you can't be worse than wiped out and you don't have margin calls and counterparty risk.

Micro Focus International (LON:MCRO) is a good case study of intentionally leveraged equity (purposefully going to negative book value!)

You also have operational leverage with cyclical businesses, Paul explained it recently:
http://www.stockopedia.com/content/small-cap-value-report-7-jan-2014-tpt-snty-netd-cost-80291/

(Paul also often writes about his past use of leverage, you'd be a fool not to read what he has to say.)

A secondary pot with leverage does not make economic sense, as you pay a broker to effectively borrow your own money. If you must do leverage, do it only if your entire portfolio is geared.

mpat89

Thanks both for your comments. I have to say that you're wrong to put me in the get rich quick camp. Unfortunately I'd never touch an investment trust, spread betting or CFD's.

I don't think I can focus on buying thin equity companies. My logic for this is fairly straight forward: for the thin equity company to represent value based on its thin equity therefore must have a low P/B ratio. Usually this would represent poor quality earnings as the earnings have not been worth valuing. It's not really fair to call this a leveraged strategy as the P/B strategy coupled with F-Score is a well known value strategy. Similarly it can't be sound advice to go for companies with negative book value due to the inherent going concern risk and lack of adaptability.

With regards to the second pot with leverage, if your first pot is fully invested, I don't see how leveraging a second pot would be paying to borrow your own money since your own money is already fully invested. This was just a way of applying leverage to a mirrored portfolio held outside of the ISA, such that a percentage of my overall portfolio was geared. i.e. if 20% of my funds are non-ISA and leveraged to 150%(invested/equity) and if 80% of my funds are in an ISA, and if both portfolios hold equal allocations of the same stocks, then my overall gearing on the total fund would be 10% (debt/equity).

I'm surprised by the overall lack of enthusiasm to apply gearing in a conservative manner to leverage the advantage of deflated stock market valuations (when they arise, I don't mean the present!)

Ah OK you mean to do leverage with plain margin trading. I thought you wanted to use CFDs because you mentioned a FTSE350 restriction, and I thought that applied only to CFDs. Don't know what their rules are exactly on marginable UK stock, but good choice here, that's reasonably cheap leverage (though futures are cheaper if you just want to leverage an index).

My objection re pots doesn't apply with margin trading (with CFDs you typically pay funding on gross borrowing).

Re leveraged equity, if you do client side leverage you're effectively doing the same thing that you find unacceptable when the company does it. Two economically equivalent deals structured differently should generally be treated the same. Of course some companies may be too leveraged, but you can pick the ones whose leverage level fit you and the circumstances. Any company with some net debt is leveraged to an extent. In distressed times they are cheaper still (as leverage becomes frowned upon), so are a good fit for your strategy.

Gearing often goes with kamikaze strategies, hence the health warnings. You seem prudent enough after all, just be careful not to over extend yourself and be prepared for the worst case scenario (e.g. you enter before the actual bottom and have to cope with some drawdown), and you can do well.

intuitive6191

14th Jan '14

Easily done using Stockopedia

I would suggest some caution. Stockopedia is the latest incarnation of stock data analysis which offers direction but does not provide answers.

Prior to Stockopedia there were other stock data products such as CD Refs which Jim Slater used and promoted in his monthly magazine" Investing for Growth". Jim used it heavily to analyse stocks according to his PEG system and duly write these up as share tips in IFG.

I seem to recall that for just about every issue of IFG I purchased, Jim would tip a stock called SFI. The PEG said it was cheap and that it was a growth stock at a very reasonable price. In addition to the glowing write ups in IFG many analysts also pushed SFI as a buy - right up to 2002 just before it went bust with a black hole of £20 million.

The problem appeared to be the dubious accounting method used by SFI for determining cashflow. Various people who were knowledgable about the pub industry queried the SFI balance sheet and I seem to recall that TMF Mayn was one of those who was unconvinced. The moral of the tale is two fold:

A stock selection system is a starting point. It is also necessary to have some knowledge of the industry and the market where the company operates. This then helps you spot rogue growth stocks. This is quite important as there are quite a lot of rogue growth stocks in my experience.

The second moral of the tale - and the achiles heel of any stock data system is that to a certain extent it relies on analyst forcasts. As we can see from the SFI tale, many analysts were still pushing SFI as a buy just weeks before it effectively went bust. Data produced from their analysis was therefore understandably flawed.

Paul's daily analysis is very useful as quite often it helps identify stocks to avoid as well as ones to possibly buy. Clearly this takes a lot of effort for Paul to produce this information and this should give new investors an idea of the level of work required to be successful. Yes - data systems like Stockopedia are very useful - but they are only a starting point for further investigation.

peterg

Well, I know the same principle would have worked with a sensibly diversified and leveraged portfolio of stocks that outperformed the market (easily done using Stockopedia)

Perhaps not as easily as you think? Even the most succesful of us have periods where all our bets go wrong. Good stock selection may make it possible to beat the market over time, but you are certain to have periods of underperformance - some of them significant. If you are heavily geared up on the assumption you can't lose you probably will - big time.

god forbid I have to pay capital gains tax.

The beauty of paying CGT is that it means you've made a profit - that's never something to complain about. By all means use ISA, and other ways of reducing your potential CGT bill, but don't let the tax tail wag the investing dog - far better to have to pay some CGT than waste time and profit making opportunities trying to avoid it.

Peter

AnonymousUser37567

"but don't let the tax tail wag the investing dog - far better to have to pay some CGT than waste time and profit making opportunities trying to avoid it." I reckon that sounds like a phil fisher quote.

Ive never checked Interactive Brokers but i do know with HSBC you can leverage but! HSBC automatically will take all the dividend payments to pay off the leverage. Just check IB doesn't do the same if you want to use your dividend payments for something else.

IB just charges libor + spread on your negative cash balance, dividends are credited as usual.

The method you describe sounds bizarre, as it seemingly means you don't pay if you buy only non-dividend stocks.

HSBC is currently 6.75% compounded daily and charged monthly. Just say 675 interest on 10k a year. A nice incentive not to use leverage! I guess in the fine print your shares will be sold to pay the debt if you go over the leverage limit. Their offering is still a little bit in the dark ages.

Interactive Broker is the only feasible broker that I know of (I appreciate Saxo Bank may be in the running). On FTSE 350 stocks I believe IB require 50% margin and charge interest on negative cash balances at LIBOR+spread with the spread not being unreasonable. Beats any CFD/spread bet.

Leverage - a discussion

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Mpat89

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