Should you borrow to invest?

Right now, valuations have corrected, some stocks are yielding upwards of 6%, and borrowing rates are low, so the math works out

Ruth Saldanha 4 May, 2020 | 1:36AM

 

 

Editor's note: Read the latest on how the coronavirus is rattling the markets and what you can do to navigate it.

Ruth Saldanha: In our experience when markets are near high, retail investors often come to us with questions about "whether it make sense to borrow to invest?" Our answer is usually, no, because sometimes interest rates might be high, stocks could be overvalued, and timing the market is never a good idea. But this time around interest rates and borrowing rates are low. Canadian banks and some other stocks are yielding upwards of 5% or 6%, and stock valuations have corrected from previous highs. So, is now a good time to borrow to invest. Tom Bradley is the Chief Investment Officer at Steadyhand Investment Funds, and he is here today to discuss this. Tom, thank you so much for being here today.

Tom Bradley: Delighted to be here, Ruth.

Saldanha: With low borrowing costs and cheaper valuations, it seems like there might be a buck to be made in borrowing to invest right now. Does the economics of the situation make sense?

Bradley: You know, Ruth, I think the math does work right now. And it's mainly because of interest rates. I mean, when we have as lower interest rates, as we do today, you know, the hurdle on investment return doesn't have to be that high. And so, indeed, the math does work today.

Saldanha: The market, however, has significantly recovered from the lows of late March, are valuations still depressed enough to justify borrowing to invest?

Bradley: Well, that's an interesting question right now, because, as you know, I'm very much a valuation-driven investor. I think that valuation is the closest thing we have to gravity in investing. And it's not a great timing tool. But in the long run, buying assets that are reasonably priced, I think will work out. So, by putting valuations on things today, when the E and your PE ratio is very much undetermined, it's pretty difficult. You know, I do recognize that most of the value in companies comes from the medium and long-term earnings, and so we can make assessments as we look farther out. But it is a difficult time to value things.

Having said that, those really cheap valuations we had on the panic days in March, I think are behind us. And I would say, we're kind of in the mid-range, which is perfectly fine. Okay, valuations mean we can make good money for clients over a long period of time.

Saldanha: In the past, we've said that behaviorally speaking, you believe that most investors borrowing to invest is a bad idea. Why is that?

Bradley: Well, first of all, you said that you get these questions. And I got to say that, we do too, even though our clients generally don't do this kind of thing. But – one of the reasons that questions come is this cheap money that we have today is so intoxicating. And even people who don't have any debt, haven't had a mortgage for years come to me and say, I feel like I'm missing out; I need to use my credit line. But you're exactly right. I think we don't think it's worth, or it's appropriate for everyone. Indeed, we don't think it's appropriate for all, but the very few investors. And the reason is, is because it's very hard to execute on. And I'll give you two reasons why I think that's the case.

First of all, debt amplifies the volatility of the portfolio. And we did some work, Ruth, a number of years ago, and we compared a levered or a portfolio bought with borrowed money that was balanced and we compared it to an unlevered all-equity portfolio. So, clearly, a more aggressive portfolio. We've played with all the assumptions, and we came out with the conclusion that returns in volatility were very similar. So, even though somebody might buy a pretty conservative portfolio with their borrowed money, they have to be ready to buckle in because it is a much more aggressive strategy.

The other reason it's so hard is, as you know, markets bounce up and down and if we go down before we go up, and your portfolio value is lower than your loan value, the pressure is really on. And it's very hard to do the right thing. It's hard to do the right thing at the best of times when markets are down, we've just lived through March of 2020. But add on to that the fact that you are underwater on your loan, it makes it very hard and puts pressure on you to do something that you shouldn't do, namely, sell when things are down.

So, as I said, I think it's sort of a buckle-in strategy. The experienced investors, people that have been through bear markets before and have the resources behind them can do it. But I think for the most part, it's a rare strategy for most people.

Saldanha: However, if investors do want to go this route, are there any tips to reduce the risk?

Bradley: I do. I think, you know, given I've made my case for how hard it is to do. I think if you're going to do, you need to be very methodical. And I've laid out – wrote a recent article in National Post on this, and I laid out sort of five steps that I think are hurdles that people have to get over before they drop down to the bank and borrow money. And the first one is with their existing portfolio, their RRSPs, TFSAs whatever they might have. First, they should be maximizing the return from that portfolio. So, in other words, going all equities are – certainly mostly equities, maybe some high yield debt or something else in there. And if they can't get their mind around that and the volatility that goes with an all-equity portfolio, then they certainly shouldn't be going to the next step to borrow money.

So, the first step in maximizing return is to do it with the existing assets. Second step is commit to, I'd say, five years, fairly arbitrary number but the point being is this isn't a six month or a one year strategy you should – this debt capacity you're using and the cash you're investing should be really tucked away for five years to let the plan play out.

Third thing is something that I've had some feedback from a few financial planners that think it's basically often forgotten. And that is, take care of, not only the asset side what you're going to invest in, but also the liability side, make sure that however, you're borrowing money, that it's there for the long-term, the bank can't pull the plug on you. You don't want the stocks to be down and you're more inclined to buy than sell. And they come knocking on your door and say, we'd like our money back. So, you've got to make sure you have a solid loan set up for that.

Fourth thing just, and we talked about this, I think already, but make modest assumptions, probably assume a higher interest rate than is currently the case. And don't crank up your equity and bond return estimates. The math has to work with modest assumptions because when you bring debt into the equation, you need a cushion. You need a margin of safety.

And then finally, you know, where this strategy mostly comes up to us any way, Ruth is. People say, I'm going to buy the bank stocks – borrow money and buy the bank stocks. They're yielding, I think, on average, now around 6%. It's more than the interest cost, and that's great. I still think you have to diversify when you set up the strategy. Bank stocks are very dependent on one economy, Canada; and one type of client, the Canadian, highly levered consumer. And so, if you want to use dividends to offset the interest, and fine with that. But you should also want some utilities, some pipelines, even some foreign stocks to build yourself up an appropriately diversified portfolio. So, it can be done, it's not for everyone, but I think you want to be very methodical in going through those steps, if you're going to do it.

Saldanha: Thank you so much for joining us with your perspectives, Tom.

Bradley: Thanks, Ruth.

Saldanha: For Morningstar, I'm Ruth Saldanha.

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Ruth Saldanha

Ruth Saldanha  Ruth Saldanha is Senior Editor at Morningstar.ca

 

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