Investing with debt - Opinions please!

[buns]

Two thoughts

1.
These Silver companies Shasta mentions probably do not return a dividend. So you are not getting any income to cover your borrowing costs, as Snoopy talked about. Also your lending options will be smaller as most of the time brokers do not offer margin loans on these types of investment which they call high risk.

You being (by the sounds of it) a newbie to silver, I think any exposure to this using borrowed equity should be small.

Shasta's bullishness on silver contains various macro economic factors, all of which can happen over any period of time. I wouldn't feel safe sitting on an investment (with no divys), limited knowledge, using borrowed funds any longer than short/medium term. I don’t think anyone can be certain silver will turn around in that timeframe.

2.
You may hear some stories on hear how easy it was to loan/invest coming out of the recession. Be careful what you take from this.

It’s easy to look back now and say how easy this was (borrowing to cover yields), but no one was ever sure we were out of the recession. A lot will tell you in hindsight they knew we were on the otherside and it was time to invest. I think a fair chunk of people would have thought the recession was over earlier than it was, and got stung massively borrowing (mainly with margins), but not many will ever share those stories.

I was so very close to buying a heap of NZX shares on margin at the end of the recession, and opted against it. Instead I only bought half the amount of NZX shares I originally intended on and used my other half to buy into more risky ASX companies.

So this gave me the same potential return as borrowing, but was using all my own capital. You could adopt the same approach, with the high risk companies being in something like Silver?

You will be amazed at how ‘low risk’ some of these small caps are compared to dividend returning companies. Being small, they are less complex and easier to understand. A lot of the time you can forget (most) macro trends and just value these companies bottom up. This gives me more piece of mind, so I now find a lot of these companies less risk than some of your standard dividend returning NZX 50 shares. Hence I sold the NZX half of my portfolio coming out of the recession and am now 100% invested in smaller ASX companies.

[h2so4]

I have been an avid watcher of ST over the past year and only just starting to post. I have been learning some of the ropes with the sharemarket since I was 17 and started investing with CEN being my first purchase.

I am now 22 and after some advice from the seasoned pros please!

My situation now has changed with two rentals properties (80% financed) and between them they have a secured 30k flexi loan at 6% floating IR.
Over the years I have increased my share portfolio to include BHP CEN RYM and NZO funded by cash. Also held PRC : S

So my question: Do I start investing using my equity from my rental properties, I have invested 10k of it currently but should I expose myself more? should I be aiming for yields exceeding the IR or taking on higher risk and aiming for capital gains? NZX or ASX? I am young so I don't mind talking risks provided I can understand them.

If someone has some spare time I would love to hear stories from your investing experience. I live in Hamilton but often frequent Auckland and Wellington. I will shout the first few beers if anyone is keen!

Nice one DR, I followed a similar path.

Expect the unexpected, sharemarket crash, commercial tenacy failure, a drop in personal or business income. Good debt quickly becomes bad debt when you have to service it with other good debt cashflows.

Anyway welcome DR, I am sure you will get all your answers.

Main thing, have fun.

[Snoopy]

I am not 100% on your second point about my debt position multiplying with the debt position of the company I am investing in. Help me out a bit here since I am playing the novice card. Ill have a stab at it but what I am getting is that my debt position and the the debt position of the company has an effect on my total debt position as far as I am concerned? The value of my personal debt is small in comparison compared to the $ amounts of some companies or should this be measured as a total debt position?

I think the best way to answer your question Darkred is to go through an example. Let's suppose you invest in a company. Let's call it 'P',
which is funded by having 50% shareholders equity and 50% debt. Let's say P is a $100m company by market capitalization. Now lets say
you buy a piece of the action by investing $10,000 in this company. Congratulations, you are now a shareholder!

$10,000 might seem a lot to have invested in just one company, but as far as the company is concerned you are now a holder of
$0.01m/$100m = 0.01% of the company. That is probably enough to earn you an extra biscuit at the AGM, but little more.

'Capital efficiency' is an often-toted topic around board tables. The idea is that if you can multiply your equity by borrowing some bank
funds against it then you can create a bigger pool of money and do more than if you had just used your own cash (much like you are doing but on a bigger scale). As long as whatever project the company P undertakes will pay back more than the cost of interest spent in maintaining the idea, borrowing is a good thing to do.

One line of thinking might say that if you can earn 10% and your cost of borrowing is 5% just borrow as much as you can. Older wiser business heads will know that business goes in cycles. That means your borrowing policy should be robust at the bottom trough of the business cycle, and not just be a match for today's business conditions. Some directors regard a 50% debt 50% equity funding approach as a good funding rule of thumb. In reality the amount of debt a company should hold is 'certainty of cashflow' specific. But let us say the directors of P have been through a complete business cycle plan and 50% equity 50% debt is indeed right for them.

Now back to your $10,000 investment. The company P may talk in millions. But in your case your $10,000 has bought $5,000 of owner
equity and an obligation to pay interest on $5,000 worth of debt before you see a cent of dividend income.

Here is the wildcard that I didn't mention before. You personally bank at the same bank as company P. That $10,000 that you spent on
shares consisted of $5,000 of your own money and $5,000 borrowed from the bank. Through your superb negotiation skills you have
negotiated a 5% interest loan rate, co-incidentally the same as company P is paying. So how much money are you paying in interest
to your bank per year?

Easy you say. 5% of $5,000 is $250. That is the answer! Well not quite.

Through the intermediary of company P's chief financial officer, you are also paying interest on the loan that the company CFO has secured against the share capital first raised at float time but now stacked up against your personal name at the company records office. The CFO has $5,000 of loan stacked up against the money you invested in the company via the sharemarket. So you are paying 5% of $5,000= $250 of interest via the CFO of P as well! That CFO is working behind the scenes on your behalf. So although you never see this payment, it is just as real as the $250 you are paying every year for your own private loan. Just ask the bank that received both payments. As far as the bank is concerned the interest payments they receive from you and from company P are equally good. Cash is cash.

The answer to the interest question then, is this.

You are paying $250 worth of interest directly and $250 indirectly for a total of $500 per year. Note that this is now 10% of the $5,000 worth of equity you originally put up to buy the shares which doesn't seem quite so cheap. That means that while the company can survive the next business downturn, there is no certainty that you will survive, paying twice the amount of interest that they are paying for the same income.

Here is the point I want you to think about when borrowing to buy shares. What you are really doing is saying that the company would be fine if it took on a lot more debt, even though the company directors having had a discussion about this at board level have decided this is not so. Not all company directors get it right. Sometimes judicious leverage on behalf of a shareholder can pay off. But before you make the decision to borrow against a certain share, take the time to consider whether your wisdom really is smarter than the collective wisdom of the board.

SNOOPY

[shasta]

Dont worry Snoopy i wont be advising Darkred into buying PGW!

All the companies i posted about have no debt (most have reasonable cash to fund drilling campaigns) & most are low EV's under $10m, with tight capital structures & many have larger JV partners funding the drilling

[DarkRed]

Just got home from work to find this thread full of advice. Cheers
Snoopy your example helps heaps in my understanding, thanks for providing so much detail.

Here is the point I want you to think about when borrowing to buy shares. What you are really doing is saying that the company would be fine if it took on a lot more debt, even though the company directors having had a discussion about this at board level have decided this is not so. Not all company directors get it right. Sometimes judicious leverage on behalf of a shareholder can pay off. But before you make the decision to borrow against a certain share, take the time to consider whether your wisdom really is smarter than the collective wisdom of the board.

I have another question now. I have been thinking about your comments regarding borrowing to purchase shares. Your explanation was great and I have a better understanding of how my personal debt and the debt of the company I have a shareholding relates to me personally.
My question now is about how the debt is used by the company compared to how the debt is used in my personal situation.
The borrowings that a company takes are usually long term and hence they need to factor the business cycle when they determine the level of borrowings they have. I am assuming that these borrowings are sometimes not very liquid in that fact that if outside factors were to change and they need to reduce their debt level they couldn't easily restructure their debt position.

In the case of me personally investing in a shareholding of a company the shares are relatively liquid and therefore I can change my debt position more easily then that of a business. Because of this I can personally increase my leverage and risk because I have more liquidity in my debt position.
I don't want to get into a position where I am so over leveraged that I become forced to sell due to the burden of my debt...

[percy]

DarkRed,
You are getting expert advice.Here is a funny,but horribly true saying for you.
"A banker is a man who lends you an umbrella when the sun is shinning,but asks for it back as soon as it starts raining."

[Snoopy]

Dont worry Snoopy i wont be advising Darkred into buying PGW!

All the companies i posted about have no debt (most have reasonable cash to fund drilling campaigns) & most are low EV's under $10m, with tight capital structures & many have larger JV partners funding the drilling

Having the money and technical backing to develop a mining site is dodging the question Shasta. The question was are they cashflow positive today? I suspect the answer is no.

SNOOPY

[Snoopy]

My question now is about how the debt is used by the company compared to how the debt is used in my personal situation.
The borrowings that a company takes are usually long term and hence they need to factor the business cycle when they determine the level of borrowings they have. I am assuming that these borrowings are sometimes not very liquid in that fact that if outside factors were to change and they need to reduce their debt level they couldn't easily restructure their debt position.

In the case of me personally investing in a shareholding of a company the shares are relatively liquid and therefore I can change my debt position more easily then that of a business. Because of this I can personally increase my leverage and risk because I have more liquidity in my debt position.

Your point Darkred, that it is relatively easier for you to quit a company stake small enough not to upset sharemarket liquidity, than it is for the underlying company to restructure their debt package with the banks, is credible. The only counterpoint I would make is that just because a company seems relatively liquid today, that does not mean it will be equally liquid if an unexpected problem comes up!

SNOOPY

[shasta]

Having the money and technical backing to develop a mining site is dodging the question Shasta. The question was are they cashflow positive today? I suspect the answer is no.

SNOOPY

Actually Snoopy, all due respect but you seem to be dodging the main point. None of the companies i posted have ANY debt, which was the premise behind your earlier post.

Thus Darkred is not multiplying his risk by utliising debt to invest into companies with debt.

If he requires companies with reliable cashflows who pay high yielding dividends (on a sustainable ongoing basis) i have many other options for him to look at

[Snoopy]

Actually Snoopy, all due respect but you seem to be dodging the main point. None of the companies i posted have ANY debt.

Thus Darkred is not multiplying his risk by utliising debt to invest into companies with debt.

OK , I see your point and agree with this.

SNOOPY