In my previous article on “Sendai and margin finance: the most valuable lesson” in the link here,
James has learned an important lesson of avoiding using share margin finance (SMF) in investing, basing on the experience on the stock of Sendai he had dabble with.
There, I have received a good comment from a regular reader of my article as below,
KC, since you said there's pros and cons on leverage i do suggest you to write an article on how to use leverage wisely next time. Include some strategies, awareness of traps. Using case study on the darkness alone doesn't actually help them understand SMF as whole.]
In all my articles on SMF, although I do illustrate that margin finance cuts both ways, with details come with numbers, I always emphasize more on the dark side of it. This is simply because, I have to admit, I do not know how advice people to use SMF wisely.
As it was requested, here, I will try to do whatever I can. However, I have to borrow the wisdom of someone who is an expert in it, one who appeared to have made a fortune using it and has written numerous articles about it, to illustrate the “Unimaginable From Margin Finance”. I have to copy some concepts from his article in the link below,
I will use Jaks Resources for illustration as it is a stock I am familiar with, have traded on it a number of times. Jaks is also an excellent example as it was also a high-flying stock familiar with most people dwelling in i3investor for the last three years until this very present moment. At that time, Jaks was touted as “the stock” every savvy investor must own. It had obtained a power plant project in Vietnam which would be the game changer for the company. It would made hundreds of million of profit from its construction in the next 5 years, and then the recurring income from the operation of the plant would be in the hundreds of millions to Jaks for the next 20 years. Its share price would be easily worth $3.00, at the minimum.
Heavy SMF was also involved and numerous articles also had been written touting the wonders, as well as blunders (mostly by one kcchongnz) of SMF on this stock.
The unimaginable Magic of SMF on Jaks
Figure 1 below shows the share price movement of Jaks in the last three years.
Figure 1: Share price movement of Jaks
The share price movement of Jaks in Figure 1 above shows that the stock was trading at about RM1.00 three years ago at the end of year 2016. Assuming Jesse, a stock genius had a capital of $1m. He further used another $1m from SMF to make up a total initial capital of $2m. Jesse utilize all the money to buy 2m shares of Jaks at $1.
Jesse's buddy, Ben, also got interested in Jaks as recommended by Jesse, and he also bought 1m shares of Jaks at the same time with his own money without borrowing money.
Jaks share price went up to $1.40 two months later in February 2017 as shown in Figure 1 above and Scenario 1 in Table 1 in the Appendix. The market value of Jesse’s 2 million Jaks was worth $2.8 million and his buying facility would be increased by $800k. With the additional buying facility, Jesse bought another 571400 Jaks at $1.40. Jesse then had a total of 2.5714 million shares. Note Jesse had used a total of $1.8m in SMF then.
Another month later in March 2017, Jaks share price went up another 15 sen to $1.55 as shown in Figure 1. The market value of Jesse’s 2.5714 million Jaks was worth $3.986 million as shown in Table 1 and his buying facility would be increased by another $386k. With the additional buying facility, Jesse bought another 248800 Jaks at $1.55. Jesse then had a total of 2.82 million shares. Note Jesse had used a total of $2.186m in SMF then.
Another month later in April 2017, Jaks share price went up another 15 sen to $1.70 as shown in Figure 1. The market value of Jesse’s 2.5714 million Jaks was worth $3.986 million as shown in Table 1.
At this point of time, Jesse could have taken profit and sold all his Jaks shares at $1.70. After paying his margin loan of $2.186m, he would have an equity value of $2.61m, or a profit of $1.61m, or 161%, within a short period of just 4 months. Here we ignore loan interest and all transaction cost.
However, Jesse is just human. He thought it would be damn stupid to sell Jaks at $1.70 while the target price was $3.00 or more, but not less. With the increase in share price and hence increase in buying facility, he thought he was so clever, and he bought another 249k shares of Jaks at $1.70. Jesse then had a total of 3.07 million Jaks shares. Note Jesse had used a total of $2.61m in SMF then.
After rising 70 cent, or a whopping 70% within four months, Jaks Bull finally decided to take a break, as the saying in the stock market goes, “there is no stock which can continue to go up”. A couple of "stupid" analysts from investment banks had given a target price of $1.30, instead of $3.00 for Jaks. For this, Jesse had given them some fiece condemnations.
Without buying support for half a year since then, the share price of Jaks dropped and continued to drop to $1.30 in October 2017, for a drop of 30% from its previous peak of $1.70.
Jesse was so sure of the future of the power plant development of Jaks in Vietnam and its target price of minimum $3.00, he decided to hold on to the shares as he was able to transfer some other shares into the account to top it up and avoid margin calls.
Sure enough, the share price of Jaks recovered and galloped to $1.80 within four months in February 2018 as shown in Figure 1 above. The market value of Jesse’s 3.07 million Jaks galloped to $5.52 million as shown in Scenario 4 in Table 1.
At this point of time, Jesse could have taken profit and sold all his Jaks shares at $1.80. After paying his margin loan of $2.61m, he would have an equity value of $2.92m, or a profit of $1.92m, or 192%, within a short period of just over a year. This ignores the cost of borrowings and transaction costs which are negligible compared to the profit made.
And that is the “Unimaginable Magic” of margin finance.
Ben, who did not utilize any additional buying capaciity as a result of the rise of the share price, only managed to make $800k. Jesse has been laughing at Ben as such a stupid person who doesn't understand the ünimaginable Magic" of margin finance.
However, for those who are new to my articles, please read this article with a fistful of salt. This is just the chapter one of a story. I do not advocate you to follow this trick of Unimaginable Magic.
There is this famous saying,
“it ain't over until the fat lady sings”
That would be the next part of the story.
For those who wish to know more about my philosophy and methodologies in stock investing for reasonably good return with little risk, you may write to me for a eBook which I have written at the following address,
This eBook is given out free of charge.
Table 1: The Unimaginable Magic of SMF on Jaks