Imagine that you have a newspaper from one year into the future. The top 10 best-performing stocks from the prior year are on the front page of the paper. In addition, a large bank has stated that they will provide you with as much margin as you want with no interest charges. The question is: Assuming you start with $10,000, how much would you borrow to invest in these top 10 stocks? Allegedly, this is the question that Jim O’Shaughnessy, author of What Works on Wall Street, likes to propose to investors. Think about how you would answer before reading on.
Most people get this dreadfully wrong by saying something like, “knowing the winners in advance makes this a sure bet, so the best thing to do is borrow as much as possible and make the most of this lucky situation.” The truth is that you would go bust with such an approach. As Jim puts it, “Your problem is the margin. With $10,000 to start, if you borrowed millions, you would lose all of your equity. In fact, having a leverage ratio more than 4:1 ($30,000 borrowed) would have wiped you out in most years. It’s not a matter of if, but a matter of when.”
Although you are privileged to know that those ten stocks would give you an exceptional return by the end of the year, the problem is that hitting a bad patch of too many negative return days in a row (which is pretty normal) could wipe you out completely if you used excessive leverage. The moral of the story is that the path matters; in fact, the journey is more important than the destination. Knowing the winners’ names is not enough; you would also need to know the exact path that the stock price will travel throughout the year to make borrowing money a surefire solution to win big. Unsurprisingly, the more leverage you use, the higher the probability that you go broke, simply because even small declines in your portfolio wipe out your equity with larger amounts of leverage. It’s not rocket science. The point is that even knowing the future with 100% certainty wouldn’t make borrowing money safe, so given that we will never know the future with any degree of certainty, leverage is one of the most dangerous things you can do as a retail investor.
Even Ben Graham, the father of value investing, had to learn this the hard way. He established his investment partnership in 1926 and got off to a really promising start. Then came the Great Crash of 1929, and the fund was down 20 percent. Graham, however, was convinced that the worst was over, so he borrowed on margin and plunged back into the market. It was a terrible decision, and by 1932 the fund had lost 70 percent of its value. Graham was wiped out, forcing the family to leave its park-view duplex in the Beresford for a small rear apartment in the nearby El Dorado. His wife had to go back to work. As the famous quote attributed to Keynes says, “The market can stay irrational longer than you can stay solvent.”
This, of course, doesn’t mean that you cannot have an opinion on the economy or the stock market. You are absolutely entitled to have your own opinion, but you should still not let it affect your investment decisions. Confused? I’ll make it clear in a moment. One of the most famous value investors, Seth Klarman, summed up this approach nicely by saying, “One thing I want to emphasize is that, like any human being, we can discuss our view of the economy and the market. Fortunately for our clients, we don’t tend to operate based on the view. Our investment strategy is to invest bottom up, one stock at a time, based on price compared to value. And while we may have a macro view that things aren’t very good right now—which in fact we feel very strongly—we will put money to work regardless of that macro view if we find bargains. So tomorrow, if we found half a dozen bargains, we would invest all our cash.” It is always a good time to buy a high-quality stock that offers good value.
As a side note on holding cash or being 100% invested, what I learned at Columbia Business School’s Value Investing course is totally aligned with how I approached the question of cash management before and what Klarman emphasized above. Namely that cash should be the byproduct of a disciplined valuation approach. You end up holding a lot of cash when you review idea after idea and see nothing of interest. So, when you end up holding a lot of cash, that may be a good indicator that perhaps markets are a little bit too expensive.
At the FALCON Method, we buy the shares of companies that are out of favor. This approach is contrarian by nature, so you have to get used to buying stocks that are down and are still getting beaten up hard. There is simply no way to pick the bottom, and as Howard Marks writes, “I’ve never considered it a legitimate goal to say you’re going to invest at the bottom. There is no price other than zero that can’t be exceeded on the downside, so you can’t really know where the bottom is, other than in retrospect. That means you have to invest at other times. If you wait until the bottom has passed, when the dust has settled and uncertainty has been resolved, demand starts to outstrip supply and you end up competing with too many other buyers. So, if you can’t expect to buy at the bottom and it’s hard to buy on the way up after the bottom, that means you have to be willing to buy on the way down. It’s our job as value investors, whatever the asset class, to try to catch falling knives as skillfully as possible.” And then, this is what Seth Klarman suggests: “You must buy on the way down. There is far more volume on the way down than on the way back up and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.” (I hope those complaining about being down 10% with a stock realize that this is part and parcel of thoughtful investing. If you cannot accept temporary unrealized losses, then stock investing simply doesn’t fit you.)
Notice that even if you are an exceptional investor, the best you can do is pick quality companies where the stock price and intrinsic value seem to diverge (the price being the lower) and closely monitor the operating performance of those companies after investing. You may be right with most of your calls but certainly not all of them! Even the world’s best investors have names in their portfolios that are not winners. Nobody is right all the time. (By the way, anyone familiar with the calculation of expected value knows that the frequency of correctness does not matter; it is the magnitude of correctness that matters. Simply put, you can be a successful investor even if most of your calls turn out to be bad or mediocre as long as those few calls you get right are exceptionally profitable.)
Seriously, if you only take one piece of advice from this post, make it this one: Leverage works both ways and can easily derail your quest for financial independence. The more you use it, the less likely you are to reach your goal.
Want to learn more about our stock ranking methodology and evidence-based investment approach? Start with this blog post!
Or read more like this in the Beyond Dividends book.
