Keeping the dream alive

So you wanna be rich do you? I don’t mean ‘own your own home, car and take the family on a holiday some place nice once a year’ rich. I mean really rich. In an ‘I have an investment portfolio so super-charged it’s going to keep me and the next six generations living the high life’ kind of way. With shares in booming businesses and investments in mega-successful managed funds — the works.

It’s the stuff money-making dreams are made of. Take out a margin loan, Joe Investor is told, and your powers to invest in the stock market and managed funds will skyrocket.

Why settle for shares in mediocre companies when, with a margin loan, you can have the best of the best?

Borrow from us, the lenders cry, and you’ll know wealth beyond your wildest dreams.

It’s perhaps no surprise that so many Australians have been seduced by margin lending’s promises of untold riches, particularly during the bull markets of the past few years.

But now that the stock market is in a tailspin, credit’s in crisis, liquidity’s drying up and interest rates are rising, is it really such a good idea?

The answer, it appears, depends on individual circumstances and, importantly, one’s appetite for risk.

Looking for long-term love

The industry experts who spoke to Money Management agreed margin lending can be a successful wealth creation strategy, even in times as turbulent as these, provided investors are in it for the long-haul and understand and carefully manage risk.

Colonial Geared Investments (CGI) Head of Investment Lending John Clothier said although the company had made an unusually high number of margin calls in the past month and the number of clients seeking to repay their loans had increased, most clients are well-diversified and conservatively geared and, therefore, weathering the share market storm fairly well.

“[Recent share market losses] are having a bigger impact on clients who are traders or holding single stock portfolios that are highly-geared. They haven’t really impacted a lot of our clients who are geared at 50 to 60 per cent and have a 10 per cent buffer. These clients have also benefited from the 2007 increases in loan to value ratios (LVRs).”

While Clothier expected the number of margin calls and clients seeking to repay their loans to increase in the short-term, he is confident most clients are prepared to ride out market turbulence.

“I don’t think clients who have invested in managed funds [on the advice of a financial planner] are the type to panic or change their overall strategy because of market volatility.”

In Clothier’s opinion, these clients are not at much risk of defaulting on their loans, particularly because their gearing levels are relatively low and their planners are keeping them up-to-date on how they’re coping with market slides.

Likewise, Macquarie Investment Lending (MIL) division director Peter van der Westhuyzen said although there had been a marked increase in margin calls over the past few months, particularly in January, most clients had no cause for panic.

Like Clothier, he said that because most clients are conservatively-geared — MIL’s margin loan book is currently geared to 49 per cent — there is plenty of spare equity to help manage volatility. He said this is why MIL has not seen an increase in defaults on margin loans.

“The main reason for this is that, in our experience, financial advisers who recommend margin lending also recommend appropriate gearing levels and plan cash-flow requirements at higher interest rates than are actually being paid. This means that an increase in interest rates can more readily be accommodated.”

Jammal Bassen, managing director of independent, Sydney-based margin lending specialist Lift Capital, is a firm believer that margin lending can be a successful strategy for all investors in all market conditions, and that most clients appreciate that they may experience serious market downturns over the course of their investment period.

Like Clothier and van der Westhuyzen, Bassen said that because most of his clients are conservatively geared (at about 45 per cent), they’re able to withstand even dramatic market corrections.

In his 20 years in the financial services industry, 14 spent running a margin lending business, Bassen has weathered some serious financial storms, none of which, he said, have given him reason to believe that margin lending is anything other than a robust investment strategy.

“I think there’s a misconception in the marketplace that when the market’s falling, Australian investors sell their shares, pay back their loans and run for the hills. That’s actually not the case at all. There have been numerous market corrections over the past seven years that evidence the fact that fluctuations don’t have a significant impact on margin lending.”

Figures from the Reserve Bank of Australia (RBA) show that most Australians with margin loans are conservatively geared (at about 45 per cent). There are, of course, those who like to push the boundaries — something the experts agree is not advisable at present.

Martin Dale, an authorised representative of Sydney-based Fiducian Financial Services, said those who have disregarded the golden rules of borrowing to invest, such as diversifying their portfolios and maintaining prudent gearing levels, are almost certain to land in hot water in times like these.

“Investors borrowing up to the maximum LVR (usually 75 per cent) with little liquidity and without a contingency plan are at risk because of the combination of falling markets and rising interest rates.”

While Dale said that margin lending can be a beneficial strategy in both rising and falling markets, it is definitely not for the risk-averse and there is no one-size-fits-all strategy.

“It is only wise to borrow to invest if you’re aware of all the pros and cons, that it’s a long-term strategy [of at least seven years] and it fits with the plan you have developed to achieve your financial goals... If it’s likely that these goals can be achieved without borrowing, one would have to question its relevance.”

In Dale’s view, if an investor does take out a margin loan, it is imperative that he or she is fully-informed of all risks however small.

“It almost goes without saying that investors need to understand what a margin call is, the likelihood of one occurring and the consequences if it does.”

He emphasised the importance of heeding margin lending fundamentals and developing a contingency plan for when times get tough.

“In the same way a driver knows where he or she is going before setting out on a journey, an investor should know his or her destination and the route he or she intends to travel to get there, without deviating.”

In Dale’s view, even prudent, well-informed investors need to tread especially carefully in such volatile times.

“All things in moderation are usually okay ... As Warren Buffet said in a 1984 address at Columbia University, ‘medius tuttissmus ibis’, meaning you will go safest in the middle course... Well, who could possibly argue with Warren Buffet? Just don’t go to extremes.”

Margin calls

Falling share prices and higher interest rates have led to a huge increase in margin calls recently, particularly in the past month.

At the time of going to press, the Australian share market had suffered its biggest one-day fall in 18 years and margin calls were resounding here, there and everywhere.

However, van der Westhuyzen said it is important to consider these numbers in context.

“[As at January 17], 64 per cent [of MIL margin calls] have been satisfied on time and with cash. This means that many investors are well-informed and prepared with backup plans for if and when a margin call occurs.”

In his view, margin calls are often viewed in an undeservedly negative light when they can in fact be treated as inbuilt risk management tools.

“If you are being asked to adjust your portfolio in peak times of market volatility, it is easier and better to take a few small steps along the way than to be put in a position where you are unable to respond to the degree required and left with no other option than to sell when your investments are at a low point.”

Interest rates

Although interest rate rises amplify the costs of borrowing to invest, the experts Money Management spoke to did not expect any future increases to inflict much pain on most investors.

Clothier, van der Westhuyzen and Dale all said their clients had been largely unaffected by rises in November last year.

Said van der Westhuyzen: “Despite the rises, our margin inflows have been consistent and I think that’s because investors still see value in their investments. Interest rates are just another consideration you need to work into your calculations to understand the net cost of your investment.”

He said that if interest rates rise further, investors will need to look at the after-tax impact and, if necessary, adjust their investment strategies accordingly.

“As interest on a margin loan facility may potentially be tax-efficient, the impact of interest rate rises can be reduced compared to other, non-deductible debt.”

Dale said investors would be well-advised to respond to interest rate rises in the same way as managers of managed gear funds, namely by reducing their gearing levels.

“The gearing level is determined by the level of interest rates and dividend income and managed daily.”

Glass half full

The experts Money Management spoke to all emphasised that retreating markets present risks as well as opportunities, particularly the chance to buy stocks at bargain bin prices on the premise that they will eventually appreciate in value.

Clothier said that some CGI clients (many of whom are experienced financial planners) have been eagerly awaiting a market correction for some time so they can get their own clients into quality shares and funds at a much cheaper price.

Likewise, Van der Westhuyzen said although market volatility had prompted some clients to reduce leverage on their portfolios, still others had seized upon the opportunity to buy quality stocks cheaply.

“They are investing into the market weakness through regular gearing plans, lump sum margin loan share purchases and settling large protected lending positions. For some people, this period has therefore represented a great buying opportunity and complemented what they see happening over the period of their investment time horizon.”

Bassen agreed now is the time to buy quality stocks that provide them with a good dividend income.

Charlie Karalouka, managing director of Brisbane-based financial advisory firm Investment Central and authorised representative of dealer group Consultum, said times likes these enable clients who are conservatively-geared to turn what is generally seen as a negative situation on its head.

“We think 2008 could be a volatile year, so we’re preparing our clients for the worst. But we’re also saying ‘don’t panic’. When the economy is poor, it’s a great time, if you’re holding cash, to capitalise on attractive valuations. In that respect, there are more opportunities now than there when the economy was booming. We firmly believe you make your money on the buying, not the selling.”

Tread carefully

Economic uncertainty, market volatility, credit concerns and the possibility of further interest rate rises all mean 2008 will be a very different year for margin lending.

Although their views on margin lending differ, the industry experts Money Management spoke to are united in their belief that investors need to tread carefully for the time being.

Investors who charge in Rambo-style, guns blazing, are likely to come under fire themselves.

So what do the experts advise?

Van der Westhuyzen said that, first and foremost, investors need to decide whether they are comfortable with the level of risk associated with investing in a volatile market and, if so, whether they would prefer to use their own funds or take out a loan.

“Each of these has their advantages and disadvantages and it’s important to understand what they are to make the right decision. There are other ways to invest and reduce your downside risk by using protected loans or buying put options on your margin loan.

“It is important, too, to remember that gearing itself is not an investment strategy, it’s just a funding mechanism. So if you don’t think the market is the place to be at the moment, you shouldn’t be investing using your own or borrowed money.”

Bassen, Dale, van der Westhuyzen and Karalouka agree that most investors are best advised to keep their gearing levels conservative (that is, less than 50 per cent) and focus on quality stocks with good dividend income.

Karalouka said investors also need to be willing and able to withstand short-term pain.

“It’s prudent to be cautious in these volatile times,” Bassen said.

“But, at the same time, you need to maintain a long-term perspective. You shouldn’t be managing long-term investments, such as margin loans, on a day-to-day basis ... You can use margin-lending to your advantage now. Buy when the market dips to position yourself for wealth creation long term.”