Money Smarts Blog

Buying on margin is a fairly straightforward, but somewhat dangerous way to buy stocks. Basically the idea is that you buy stock using money that you borrow from your broker. The broker has your stock as collatoral to force you to pay your debt, and will use the value of your account to determine your credit limit.

Usually the interest they charge you on what you borrow is based on how much you have invested and prime (for example, in my E*Trade account right now I’m paying prime + 1%, or 7% interest). If you can earn more then this amount through your investment, borrowing is good. If you can’t it’s bad.

Every book and article on investing that mentions buying on margin says how dangerous it is. Basically it magnifies your returns. If you make money, you make more, if you lose money, you lose more (because you’ve bought more stock and because you have to pay the interest).

If you’re buying very volatile stocks, your “credit” will fluctuate wildly (when the stock is high, your broker will loan you a lot, when the stock is low, he won’t). This can lead to a “margin call” when your debt becomes higher then your limit. At this point, if you can’t “top up” your account to deal with the loses, your broker will sell your stock to cover it. Since the stock is down at this point, you probably won’t be happy with the sell decision.

In Canada you can deduct expenses for investment, including interest, which can make trading on margin more attractive. Instead of paying 7%, I’m actually paying 7% * (1-marginal tax rate). Say my marginal tax rate was 25%, I’m actually only paying 5.25% after I get my tax deduction. With the Bank of Montreal stock I bought recently, I’m anticipating a 4% dividend-yield, which should be 3.5% after I’ve paid taxes (since dividends are taxed at 1/2 the income rate). Therefore if the long term appreciation of this stock is greater than 1.75% buying it on margin makes sense (which is what I did).

The additional benefit is that I won’t always have the opportunity to buy Bank of Montreal stock when its at 4% yield. By the time I’ve saved up more money to buy more of the stock, its price may have gone up and it might not be as attractive. By buying on margin, I can buy when the stock is attractive, then use my savings to “pay off” my broker.

Obviously buying more speculative stocks on margin is far more dangerous than buying “blue chips”. Additionally, anything I owed to my broker, I’d want to feel confident I could pay it off in the near future, whatever happened to the stock.

I used to wonder why anyone would buy Disney or Coca-Cola or any of the big name companies. Sure they were leaders in their fields and great companies and all that, but there stock price seemed pretty stead (with modest gains year-after-year) and it just seemed like GICs and more conservative investments could match them with zero risk (instead of the slight risk these companies seem to offer).

Even when I started getting into dividend stocks, I looked at the dividend-yield on these companies, and just couldn’t figure out why anyone would buy them (at 1% dividend-yield it still seemed like a savings account was a better bet).

What I was missing was the rate of the growth of the dividend. Sure Coca-Cola’s dividend might be 2.58% today, but given there 5 year dividend growth of 11.49%, means the dividend should be 4.4% in 5 years and 7.6% in 10 years, 13.2% in 15. Along with that dramatically increase dividend-yield (relative to our original purchase price) will be the new dramatically higher price for the stock to support the higher yield. Rob Carrick and Tom Connolley make a very convincing case that over the long term these high-growth dividend stock prices will keep shooting up, supported by the ever increasing dividends. A retirement income that increases by 11.49% per year is exciting both from a “easily fend off inflation” perspective as well as a “no worries about running out of money” perspective.

Consider instead a stock that pays a high yield, but which doesn’t increase. You’d be happy receiving the higher amounts in the first years, but when a growth stock overtaxes the yield and keeps going you then might become a little less happy.

I’m convinced there’s some way to factor in the current yield and the growth yield to figure out which is a better buy, but am somewhat at a loss how to calculate this. One idea I had is to get a “short list” of companies I like, which are all blue chip, long term increasing dividend payers. Sort the list in order of the 5 year dividend growth and throw away the bottom half. Then rank the remainders in terms of dividend-yield and examine the first few companies as potential “buys”. Repeat when funds allow.

Alternatively, you could only look at the top half of the current yield, then examine the first few when you order for growth. I’m not sure how much weight should be given to each element of a stocks history if you wanted to order them taking both ratios into account (naively I’d guess 50/50). Define “dividend strength” as yield x growth and rank. Start at the top and look for good buys.

There’s probably a mistake in this overly-simplistic approach, if any readers know better than I do (and have been good enough to read this far), I’d love to have my error pointed out in the comments!

About a year ago I got really excited after reading Stop Working by Derek Foster. His basic idea is that you buy stable, well established companies that are leaders in their industries which have paid a regular increasing dividend for a long time when they’re on sale. You determine this by looking at the Dividend-Yield (which is basically the last quarterly dividend, multiplied by 4, divided by the share price). The Dividend-yield tells you how much of your purchase price you’ll get back annually (so a $100 stock with a 4% dividend yield would pay you $4 per year, $1 each quarter).

His idea is that these companies aren’t going anywhere, their share price should increase over time, and since the dividends increase you can basically live off of the dividends and use the increases to compensate for inflation. Apparently Derek very aggressively built his portfolio, and he is now retired in his early 30’s with a family of 4.

After reading his book and looking at some stocks I was excited to buy Merck and General Motors. The problem with this strategy is that these companies will only have a decent dividend-yield after there is bad news, so everyone will tell you you’re crazy to buy (which could be considered another good reason to by – they call this contrarian investing). At the time, the bad news scared me off (GM was losing money every quarter, and Merck has a lot of its patents expiring soon with no other popular drugs in the pipeline to replace them).

I never gave up on the strategy, and have recently begun mulling it over again. With the new Canadian tax laws giving very favourable tax rates for dividend income combined with the abysmally low interest rates currently (great news for mortgages, not so great news for GICs), I finally bit the bullet this week and put $6773.77 into the account and have bought 242 shares of Rothmans (a tobacco company) for $5349.87 (including a $20 trading fee, which gives a dividend-yield of 5.45%) and today I bought 65 shares of Bank of Montreal at $68.88 (which would give me a dividend yield of 3.95%) for $4477.20.

For the mathematically astute, yes 4477.20 + 5349.87 > 6883.77. I’ll discuss buying on margin in a future posting.

So far since buying the Rothmans its gone up 5% (so I’ve made a cool $270). Share prices for dividend stocks are somewhat unimportant if your following a buy-and-hold dividend strategy (as you only really care how much you’re getting per quarter – if you’re not planning to sell, the current price doesn’t matter).

One modification on the general strategy that I’m considering is to sell any stock that drops to a dividend yield of 3% or less. This would mean that either they’ve cut the dividend (which would suck if you’re counting on the dividend payments for your retirement) or the price has gone really high (which it might make sense to sell at that point and buy stocks with higher yields). Most people who write about this strategy seem to favour a hold-forever outlook, so I’m not totally committed to this approach yet.

Do you lose sleep trying to calculate if you should convert your index fund holdings to ETFs now or wait another month? Was it a tough decision to go with the brokerage with the $8 trades vs. the one with the $5 trades? If so then you might want to consider the fact that as investment DIYers, things have never been better.

Here are some of the reasons why:

Stock trading commissions – In the past you could only buy and sell stocks through full service brokerages which would charge in excess of $100 for a trade that you can do now for $5. A frequent trader would go bankrupt pretty quick with those commissions and even for a buy and hold strategy, lower commissions represent a big saving.  Read a BMO Investorline review here.

Mutual fund costs – Prior to the advent of the dreaded DSC (or back end) option in 1987, front end commissions were as high as 9%. The DSC option was actually an improvement over the front-end option because all of your investment dollars would be invested instead of being lopped off for commission. Now you can get most funds with front end option and no commissions. You still have to shop around for lower MERs however.

Information – The number one improvement in this area is the internet. Financial blogs, forums, websites, company sites, investment book reviews, learning pages, online research reports all help DIYers not only learn more about investments but allow them to carry out the execution via online brokerages. Television is also another area where there is much more information on dedicated business channels than in the past.

Index Funds – These first appeared in the US in the mid-70s although they were slow to catch on. According to GlobeFund.com there are only 6 Canadian index funds that have 15 year returns with the oldest being established in 1985. These passive investment funds provide a low cost alternative to actively managed mutual funds.

ETFs – The first Canadian Exchange Traded Fund established in 1990 was called TIPS and was the first ETF in Canada or the US. The last several years has seen a huge increase in the number of ETFs traded on the TSE and the US markets. ETFs are valuable building blocks for a low cost diversified portfolio.

If you can think of any other reasons why DIYers have it much better now than in the past then feel free to leave a comment!