Blog 12 - Weaponizing Leverage

"What is comfortable is rarely profitable."— Robert Arnott, Founder and Chairman, Research Affiliates

Leverage is a privilege not available to every investor. It can multiply results favorably, or it can grind a debtor into financial and emotional misery. While this may sound dramatic, such is the power of borrowing.

When deployed intelligently, leverage can enable great gains in wealth. Yet, because of its magnification effect on volatility, debt can induce risk intolerance, leading to impaired capital markets decisions. To professional investors, volatility is not normally considered an investment risk, yet when large amounts of leverage are deployed, volatility can alter one's tolernace for uncertainty.

Despite its simplicity, debt will be the most potent weapon in an investor's arsenal. An investor should put mindful thought toward how to responsibly use their debt privilege.

Seven Critical Questions

1. When to deploy?

2. How to deploy?

3. Which assets?

4. How much?

5. When and how to unwind leverage?

6. Access to low-cost debt facilities (interest-bearing)

7. Debt without direct borrowing costs

1. When to Deploy Leverage?

The ideal moment to use leverage would be at a market bottom or within the early weeks of a recovery. Likely, the shock of a downturn and the uncertainty could still be mentally and physically reverberating. By their very nature, markets are unpredictable, so we can't expect to pick a perfect moment. Instead, focus on choosing a compelling moment, likely revealed by one's actual physical revulsions. Those queasy guttural sensations are your body reacting to your amygdala's interpretation of fear.

Yet fear not. This is the market, where all too many have been duped into capitulation when, in fact, they should have been averaging down. Quality assets will survive. And the best time to buy them is when there is palpable fear in the air.

"Do not fire until you see the whites of their eyes."— American Colonel William Prescott, Battle of Bunker Hill, 1775

In 1775, Colonel Prescott wanted every shot to count against the British Red Coats' overwhelming advance. This analogy describes well when to deploy precious debt reserves. Although not a matter of life and death, before sending debt into battle, the situation should be compelling. With an ongoing cost, debt should be the last tool deployed.

Note: With capital markets experience, a market correction of 10% should not feel emotionally compelling.

When a market correction accelerates into Bear Market (20-30+%) territory—historically, once every 4.3 years—your inner capitalist instincts should be perked. That's when the "whites of their eyes" will be most visible.

2. How to Deploy Leverage?

Leverage should be a tactical decision to be used over a relatively short period, targeting quality assets. Debt deployment should be reserved for when an investor perceives a capital market weakness but lacks the available cash to take advantage of an investing opportunity, such as during a correction (market down 10-20%). As a encouragement, reserve cash should be deployed first. Then, if a Bear Market (20+%) persists, an investor could then consider tactically deploying their debt reserve.

Experienced traders know intuitively when the market is bottoming. However, to time it perfectly would be fortuitous. Instead, the better plan is to capture bits and pieces by taking a Dollar-Cost-Averaging approach. This should result in buying on either side of the market bottom.

Note: Leveraging should not be confused with investing. Investing cash into individual core stocks during ordinary markets is a long-term strategic decision based on substantive selection criteria and portfolio design methodology. Whereas, leverage should be thought of as a rare resource to be deployed sparingly and temporarily until a solid gain has been realized. If debt is left unaddressed, it will become a problem, including that it will change an investor's behavior to the detriment. Ordinary volatility will exacerbate our fears when sitting on stale leverage.

3. What Assets to Leverage?

Individual stocks introduce specific corporate risks (unsystematic risk) that usually have a different recovery trajectory than the broad market. Some better, some worse. Therefore, using debt to buy devalued stocks may introduce unexpected challenges to your debt repayment schedule. The longer a position remains offside, the greater the interest bill and the higher the anxiety while waiting. Further, not all stocks recover.

Instead, Favor Broad Market North American ETFs:

✓ A bet on Western quality and ingenuity

✓ Represent the US economy with Central Bank support

✓ Exhibit more stable volatility patterns than individual stocks (minimal non-systemic risks)

✓ Generally low cost

Suggested North American ETFs:

• SPY (S&P 500)

• QQQ (Nasdaq)

• XIU (TSX)

Being Debt Smart

• Leveraging individual stocks introduces stock-specific risks. Temporary market illiquidity could trigger even a quality business to experience material problems, leading to a longer recovery period than desired. Time is the enemy of leverage.

  
  

• Never use leverage to invest in speculative, small-cap, foreign, or commodity stocks. Risks are multiplied (not additive). Using leverage on higher-risk assets is asking for double trouble. If you want to own any of these higher risk assets, use cash.

  
  

• Never borrow to invest in leveraged ETFs. Leverage on leverage will eventually backfire.

  
  

• Historically, Bear Markets last 15-18 months. Leveraging highly volatile individual or speculative assets or sectors might take longer to recover. When leveaging, stick to broad market assets to be able to unwind leveraged positions gradually along with the broad market recovery.

  
  

• Never deploy leverage during calm markets. Calm markets are full of deception. Be smart about when to use your precious debt. Seek quality assets during stressed markets.

  
  

• With leverage outstanding, make repayment your #1 priority. Always be preparing for the next market pullback.

  
  

Comment: These cautions are not to throw cold water on the use of leverage. Instead, as the most potent weapon in your arsenal, these comments are to encourage disciplined deployment.

4. How Much Debt?

"Opportunities come infrequently. But when it rains gold, put out the bucket, not the thimble."— Warren Buffett

As a maxim, Warren suggests taking advantage of opportunities when they prevail. Realistically, only lever a portfolio up to what can be comfortably repaid within 12 months. This rule of thumb is a backup plan in case the market stagnates while the debt clock ticks away. Peace of mind is having other cash flows (employment income, dividend payments, covered call revenues) to manage the interest costs and to eventually repay the obligation if the underlying asseet does not pan out.

This is why retirees should be far more cautious when considering to deploy leverage. They will need to rely primarily upon the recovery of the asset to justify the costs of borrowing.

5. When and How to Unwind Debt

History has shown that the average Bear Market recovery duration is around 15-18 months¹. Yet the depth of the Bear Market will strongly influence how the recovery proceeds (usually, the deeper the sell-off, the longer the recovery). Plan to unwind a tactical position:

• Once the leveraged asset has attained a reasonable profit (specific to each investor), or

• When the market has recovered to its previous market high and the asset values should have fully recovered.

For protection: Consider setting a Trailing Stop Loss (TSL) order about 5-10% below the ETF's ACB. This provides protection against a further decline but also introduces the possibility that the order would trigger a sale below the ACB.

6. Low-Cost Debt Facilities (Interest-Bearing)

Debt facilities are often too easily obtained. However, how we service our obligation ultimately decides whether we keep the privilege. Good debt management should increase wealth and improve creditworthiness.

Low-Cost Debt Options:

a) Margin Accounts (Trading Platform) - Usually the easiest and quickest leverage with access embedded directly within your account. Requires applying for margin privilege at account opening. The rate will be variable but check the fine print. Interest rates are often tiered according to total amount borrowed (Figure 1 shows a USD Margin Rate comparison).

Figure 1: USD Margin Loan Rates Comparison (March 2024)

b) Secured Personal Lines of Credit (via Bank) - When secured against your home or other viable assets, a LOC can offer the cheapest variable rate facility. The rate is rarely tiered, unlike brokerage accounts with multiple tiers.

c) Family Loans - Parents with capital often want to help children manage money responsibly. Consider setting up a loan agreement, complete with interest rate and monthly repayment terms (as would demand a bank). Parents earn a higher rate than banks offer; children pay lower than banks lend. Win-win. See your accountant for details.

7. Debt Facilities with Indirect Interest Costs

It is entirely possible to deploy leverage without incurring direct interest costs. In the first option below, leverage costs are structured into the product cost.

i. Leveraged Index ETFs - Offer leveraged exposure to several broad market indices with debt costs built into the management fees (~1.05%):

• SPXL - 3x leverage of S&P 500

• TQQQ - 3x leverage of Nasdaq

• TNA - 3x leverage of Russell 2000

• HXU - 2x leverage of S&P/TSX 60

ii. Selling Put Options Contracts on individual stocks or Index ETFs provides leverage without incurring interest costs whatsoever. Instead, the writer is rewarded with premiums paid by a speculator in exchange for writing the contract. For advanced investors only.

Managing Leverage Like a Capitalist

✓ Ensure an investment opportunity is compelling (market discount >20%)

✓ Only borrow what can be repaid within 12 months

✓ Only leverage on a broad market ETF (SPY, QQQ, or XIU)

✓ Set TSL orders to protect tactical capital

✓ Have a plan to deleverage—eventually the compelling opportunity will have passed. Time to prepare for the next one.

Contrarian Investing

Learning to invest opportunistically with cash and debt reserves requires:

✓ The discipline to proactively build up a cash reserve and eliminate debts

✓ The patience to await the arrival of a market correction, or greater

✓ The courage to deploy cash reserves and possibly debt during chaos

✓ The wisdom to unwind those winning positions upon return to stability

Despite the regularity of shocks to the market, most investors are surprisingly caught off-guard. Even with just a few basic preparations, this regularity of market downturns is an opportunity to capture value from the unprepared. Not losing ground while all around are panicking is still winning.

Summary

Reserves of cash and debt are advantages that not all investors have. When deployed well, they can render extraordinary results. However, too many investors are starved for cash and heavy into their margin territory when opportunity strikes.

Cash and debt reserves should only be deployed contrarian to the rhythms of the markets: accumulated in quiet times and deployed incrementally during mayhem. Without a game plan, their true potential will remain dormant at best and, at worst, could add to the Behavior Gap.

Building a cash reserve and holding onto your debt facilities for timely deployment are strategic advantages well worth the wait.

"Gold is the money of Kings. Silver, the currency of Gentlemen. Barter is the exchange of Peasants. Debt, the noose of Slaves."— Norm Franz, Ordained Minister and Biblical Economist

_________________________________

Resources:

• The Investing Oasis - Chapter 18: "Contrarian Cash & Leverage"

Resources:

1. Historical Bear Market recovery data ↩

Jay T. Mason, CFA, CFP manages the Oasis Growth Fund and is the author of

“The INVESTING OASIS: Contrarian Treasures in the Capital Markets Desert”,

as well as the blog series: ‘More Buck for Your Bang’.

______________________________

The Oasis Growth Fund is Series O of the Fieldhouse Pro Funds Inc trust series available by Offering Memorandum in Canada through select Financial Advisors. This education series is not intended as a solicitation for investment in the Oasis Growth Fund nor is it sponsored by Fieldhouse Capital Management Inc.