“The most dramatic way we protect ourselves is we don’t use leverage. We believe almost anything can happen in financial markets… [so] even smart people can get clobbered with leverage. It’s the one thing that can prevent you from playing out your hand.” Warren Buffett

The First M, the BAD, Margin Financing

I have to admit that I am a very nagging person as far as the subject of using margin finance in speculating or investing in the stock market is concerned. My first exposure to margin finance was when I was under training to be a unit trust sales agent many years ago. Our trainer showed us how we could and should convince our potential clients to borrow to invest in the unit trust funds we sell to gain amplified return from the stock market. Many of the participants were convinced and they did just that, proudly presenting their success during the meetings and the crowd applaused.

If you happened to go to some of the free investment seminars organized by the investment banks, you see some YST from the banks talking to the seminar participants and giving them forms to sign up for margin financing to “invest” in the stock market. Many of those seminar participants are young professionals, some are retirees. I could see many are convinced about the potential exaggerated returns the speaker was telling them. Their faces glow with excitement. Why not? You only need to come up with say RM100000 and you can borrow another RM200000 and follow the tips given in the seminars and at the end of the year make RM90000, or 90% of your own money when the market goes up by 30%. There are big fat frogs jumping all around in Bursa. This type of scene always makes me shudder. That is why I always write about this subject and it has become my favourite subject about investing.

I wrote my first article about margin finance in i3investor on 5 Jan 2014 here.

http://klse.i3investor.com/blogs/kcchongnz/44344.jsp

I showed the optimistic outcome that if you use a 3:1 margin in stock investing, you can make 90% if your stocks go up by 30%. However, you would have lost all your money if the return of total investment is minus 30%! I also showed how a popular fund then, the Dominion Fund, a foreign leveraged fund meant for smart and wealthy investors which licensed financial advisers (me included) were selling, went totally kaput in 2009 and investors were left with nothing. Most other funds then went down in value too but they have all recovered.

KLCI has dropped by 13.7% from 1829 to 1579 now since then. It doesn’t seem much but let us look at the drop of some randomly selected good shares, some of them my favourites too at that time, as shown in the Table 1 in the appendix. Note most of these weren’t and aren’t bad stocks. Some of them were even touted as “the most undervalued stock I have even known” type. Look at how much their share prices have dropped since one year and eight months ago as shown in Table 1 in Appendix.

The 8 stocks have dropped an average of 59% during the period, the minimum is -47% for Costal Contracts, a very good company in my opinion, and the maximum loss is 74% for Daya Material, a high flier then. An excellent company which has been doing very well in the past, Mudajaya, was also not spared. It has dropped by a whopping 64% from RM2.92 then, far out of my expectation. A plantation stock, once touted as the most undervalued plantation stock three years ago by a famous local blogger, dropped by 48%. The drop was more than 60% if you compared the price when it was first promoted in the blog then.

If you have RM10m and borrow another RM10m from banks as margin finance and you were so unlucky that because you were so bullish about the oil and gas and plantation industries then and you invested in a portfolio of those 8 stocks, you would have lost all your RM10m capital, plus still owing a couple of million to the banks. That was how scary it is if you use margin finance.

I wrote again on this subject nine months later here on 15^th October 2014 when a friend of mine asked me to examine his portfolio and to give him an opinion then of what stocks to sell and buy. The appended link was my opinion after considering his personal risk profile.

http://klse.i3investor.com/blogs/kcchongnz/61822.jsp

I was shocked that two thirds of the value of stocks then belonged to the investment bank, meaning that he was at a three times leverage in his stock investment. I gave him my opinion that he might be better off selling some of the stocks to reduce or even get rid of all the leverage, rather thinking of what stocks to buy any more. He was very angry with my opinion and he would not regard me as his friend any more. Well I have lost nothing.

The broad market has dropped by another 11.6% from 1787 from 15^th October 2014 to 1579 now. The two major stocks he has in his portfolio has dropped by an average of another 46% since then.

The last article on margin finance I wrote was on 3^rd July 2015 about margin finance for the Shanghai Stock Exchange. I actually fist commented about the euphoria about the Shanghai Stock Exchange (SSE) in early June when SSE was at 5023 points.

http://klse.i3investor.com/blogs/kcchongnz/79429.jsp

SSE is now trading at 3105 points, a loss of 38%. What would be the loss of the individual stocks? What happened to those who use margin finance speculating in SSE?

I don’t know about you, I am scared to death about margin financing in investing. No, I have not lost big in the market, but in the contrary. My goose bumps always appear when I read about the propagation of the use of margin financing in investing to the general public. If you are still not convinced by its perils as shown above and attracted to those YST from the investment banks, with the hope of making exaggerated returns from the stock market, I wish you good luck.

Let us move on to the next M, the GOOD, in Part 2.

KC Chong (8^th September 2015)

Table 1: Return of stocks from 5^th January 2014