The "business" of investing and the role of asset backed leverage

Our fellow investor and blogger Dhwanil in this excellent post has highlighted the merits of considering investments in good businesses as an overall better venture than setting up your own business. 

It is often repeated by seasoned investors to stay away from borrowed money of any sort and invest only the surplus you don't need into equities. This might be true if you consider equities as just another asset class of highest risk and return, however if this is your primary source of earnings and a business, will you shy away from use of leverage in a prudent manner ? Let's explore.

Most of the growing businesses, where we are invested employ leverage in some form of other, either for longer duration asset building or meeting short term working capital needs. Many large FMCG giants and brand plays thrive on the ultimate leverage of "float" or "OPM" (Other people's Money). Read this brilliant post by Prof. Bakshi to understand this.

In case of businesses, the optimum level of debt is often determined by the capacity of the company to service the debt in terms of principal and interest payments, in good and specially during bad times. Prudent level of financial leverage is necessary specially as interest payments are tax deductible. We as individuals do not have the luxury of such tax deductible interest payments in our business of investing, hence leverage should be weighted in the context of merits and increased risks alone.

Loan Against Securities (LAS): Asset backed leverage

LAS or Loan Against Securities is a commonly available form of financing where you pledge your securities and get an overdraft limit to a certain cutoff percentage which is usually 50% or lower. For e.g. if one owns HDFC bank shares worth 2 Lac, he can pledge those and get a limit of around 1 Lac, which can be used as fresh capital for the investment business. 

This is akin to pledging your plant and machinery as collateral in obtaining a working capital loan, here the core assets of the business are "part ownership in other businesses" which is pledged. 

Here is the product info and details from ICICI Bank and Axis Bank who offers this facility at decent rates of interest. Note that all stocks are not acceptable as pledge. Hence, make sure to go through the latest available list of approved securities ( which are periodically revised) to see if you have enough pledge worthy stocks in your portfolio. Here's the latest list from ICICI Bank.

Servicing the Debt: Serve the interest every month.

Now the key concern here is the debt servicing. Like in case of many businesses, you can make monthly interest payments and pay the principal at the end. Businesses need to make sure that the Interest Coverage ratio is high, meaning even during worst times their cash flows should meet the interest payments effectively.

The biggest advantage of regular cashflows (as in salary/ rent received etc. ) is that you are free from the volatility of business cycles and hence can deduce a monthly interest payment as a moderate percentage of your monthly cashflow. It will be safe to target a monthly Interest Coverage ratio of 16-20 times, so that interest outflow in 5-6% of your net monthly cash flow.

Serving the interest will make sure the loan do not compound on itself and you do not pay further interests on interest, a key differentiator over longer tenure.

Optimum debt with enough margin of safety

As we know Leverage is a double edged sword, hence protecting the downside is of critical importance. Assume that only 60-70% of your portfolio holding is pledge worthy only. Hence, max loan you can take, with a 50% haircut is only 30-35% of your net equity portfolio. 

So portfolio value : 10 Lac
Pledge worthy portfolio value: 7 Lac (70%)
Maximum loan limit: 3.5 Lac (50% haircut)
Assume loan availed as 2 Lac (20% of total portfolio, around 57% of the max loan limit)

Now assume the worst case, a look at last 20 years of annual Nifty returns shows a worst possible drop of 52%. Assume a 60% drop in stocks, 

So portfolio value now : 4 Lac
Pledge worthy portfolio value: 2.8 Lac (70%)
Maximum loan limit: 1.4 Lac (50% haircut)
Loan availed : 2 Lac. 

Hence,  the value of pledge worthy portfolio is still double the loan availed. Of course, the loan limit is now : 1.4 Lac, hence bank will ask for more collateral or sell off your stocks. Note however, that total portfolio value in general and un-pledged stocks in particular can be sold off  to meet the liabilities. 

Also we are considering a once in 20 years event. Note that the reduced portfolio value still meets the criteria to take up to 14% leverage. Thus 10-20% at max will be the prudent leverage or a max gearing ratio (D/E of 0.2) will be considered safe.

Is it worth the risk ?

The obvious question comes in mind, that does the returns justifies this risk and all the headache of all paperwork, maintaining collateral, serve monthly interests and all. 

Let us see. Here are the indicative returns on investment of Rs 1000, without leverage, with leverage at 10% and with leverage at 20%.

Capital : Rs 1000, No leverage

	Capital	Return CAGR
	1000	15%	18%	21%	24%	27%	30%
Tenure (Years)	3	1,521	1,643	1,772	1,907	2,048	2,197
	5	2,011	2,288	2,594	2,932	3,304	3,713
	7	2,660	3,185	3,797	4,508	5,329	6,275
	10	4,046	5,234	6,727	8,594	10,915	13,786
	12	5,350	7,288	9,850	13,215	17,605	23,298
	15	8,137	11,974	17,449	25,196	36,062	51,186

Capital : Rs 1000, 10% leverage

	Capital	Return CAGR						@ 13%
	1100	15%	18%	21%	24%	27%	30%	Cost of Funds
Tenure (Years)	3	1,673	1,807	1,949	2,097	2,253	2,417	39
	5	2,212	2,517	2,853	3,225	3,634	4,084	65
	7	2,926	3,504	4,177	4,958	5,862	6,902	91
	10	4,450	5,757	7,400	9,454	12,007	15,164	130
	12	5,885	8,016	10,835	14,536	19,366	25,628	156
	15	8,951	13,171	19,194	27,715	39,669	56,304	195

Capital : Rs 1000, 20% leverage

	Capital	Return CAGR						@ 13%
	1200	15%	18%	21%	24%	27%	30%	Cost of Funds
Tenure (Years)	3	1,825	1,972	2,126	2,288	2,458	2,636	78
	5	2,414	2,745	3,112	3,518	3,965	4,456	130
	7	3,192	3,823	4,557	5,409	6,395	7,530	182
	10	4,855	6,281	8,073	10,313	13,098	16,543	260
	12	6,420	8,745	11,820	15,858	21,126	27,958	312
	15	9,764	14,368	20,939	30,235	43,275	61,423	390

Thus, one can see, a small leverage will add a significant boost to your overall returns over the longer term. 

Note: The minimum cost of this facility is around 13%. Hence one should only consider using this option when the potential returns are much higher than the cost of funds. 

Where it is readily useful

There are often scenarios, where there some sudden news driven sharp corrections. Being at the mercy of month end cash flows, it is often not possible to take a large position at one go. LAS often comes handy in such situation, where one can load up 10-15% of one's portfolio in a particular stock at one go.

One can later pay off the debt through monthly saving and contributions to equity. Since this is a debt with no payment commitments, foreclosure charges the overdraft facility is more helpful than other similar debt obligations. 

Another important case is while applying in IPOs/FPOs etc. Since you will most likely apply using ASBA, only a small part of the overall application money would be used in all practicality. Hence, you can avail LAS funds and return the excess back, without disturbing any of your long term debt or equity investments. 

The business of stocks

Coming back to where we started off, optimum leverage with adequate margin of safety and interest coverage will enable us to buy larger stakes in businesses we like to own. Further if we are not averse to the use of optimum leverage in our portfolio companies, why oppose to using that in our own business ?

Views invited.