Queue the top…

Pretty dramatic headline. I mentioned in a previous post that I would be doing something to minimize my exposure to the Edmonton housing market. I have already slowed down the pace of making extra mortgage payments in favour of investing in my RSP and TFSA. The only reason I post this publicly is because I wanted to allow for feedback and experiences to help be get a better understanding of what can go wrong.

I have decided to try the Smith Manoeuvre. It is really risky if you don’t understand the potential outcomes to your thesis. What I am essentially doing is borrowing against my house to invest. It is really a function of cost to borrow vs. total return. Right now the cost to borrow is 3.5% FOR NOW. We all now that it will move up. If I invest in a Canadian dividend paying company that pays a 3.5% dividend then I will have enough dividend income to cover my interest expense. This factors in tax deduction on the interest expense as well as the dividend tax credit at my marginal tax rate (36%).

Though this sounds simple enough, there are huge risks to employing leverage. For one thing my cost of borrowing can (and most certainly will) go up. I could also buy at a market top and suffer a significant decrease in my holdings paper value.

The biggest advantage I have is that my outstanding mortgage is only 20% of the appraised value of my house. Secondly the household income will cover the outstanding mortgage balance more than 2x in one year. A rise in interest rates won’t affect my debt load too much.

I have the following rules for my Smith Manoeuvre:

  • Outstanding balance will remain small relative to money that can be readily accessed (liquid securities).
  • Negative net value (LOC – securities) will not be allowed for more than a few months. If I have to stop putting money in an RSP and pay down some HELOC balance, then I will.
  • Dividend yields must be 4% or larger.
  • Companies must employ minimum debt and have a history of raising dividends.
  • An assumption that borrowing costs will be 5% in 3 years has be factored in to the model.
  • All purchases will be tracked against an index to monitor the author’s ability to pick stocks. The Smith Manoeuvre stocks will the their own separate portfolio that will be different from the “growth” names and bench marked accordingly.

I only plan on doing this while it makes sense. I doubt that it will make sense to do this for more than a few years. I have essentially planned a 4 year timeline where dividend income covers interest expense and I get the capital appreciation as a bonus.

I have read a ton of blogs (like this one) and articles on the fallacies of this type of investment. From what I can figure, most people lose on this investment because they bet the farm on it. They get a 350k house,  it goes up and then they maximize leverage at the wrong part of the cycle. Then they panic and sell at the worst time.

There are 2 things that give me confidence in this decision.

1) I feel that a methodical approach to picking stocks will give me enough margin  of safety to employ this strategy.

2) I haven’t changed my lifestyle even though my income has risen dramatically over the last 5 years. I mean value investing doesn’t just happen in the stock market. It transcends into the rest of your life.

Any feedback is welcome.

Dean

8 Comments

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8 responses to “Queue the top…

  1. Pingback: Queue the top… - Petty Cash - The B-Hive - Waggle

  2. I’m in US so this maneuver and its tax benefits are new to me, but I’ll try to give some feedback anyway:
    – This seems overly complicated, you have several things wrapped together. High housing prices and low interest rates that you want to take advantage of, and then high dividend stocks that you want to buy.
    – I have no info on your housing market, but if you want to take advantage of it, the easiest way seems to be to sell and rent a similar house. Maybe that’d be shameful or something. But it would be more effective in protecting you from a decline in your house’s value.
    – I have no info on where rates are going. Maybe they’ll still be low in 6 months, who knows?
    – You have to find good investments for the cash. Can you keep the proceeds in cash until you do, or can you wait on the heloc until this third leg of the stool is in place? You don’t want to be like the Avon pension fund, that sold its high-priced Avon stock in the 70s, only to invest the proceeds in a portfolio of high-priced nifty fifty stocks.

    That’s all for me playing devil’s advocate. Congrats on finding this gusher in your backyard, and good luck monetizing it.

    • Thanks for the comment LolTradez.

      The housing market is overvalued here but considering the run-up I would pay almost double in rent what my current mortgage payments are. That includes owning the house outright. My thinking isn’t a crash in Alberta, but just a sideways market with a negative bias.

      I think that interest rates will stay low (though not this low) for quite a while. There are still a ton of risks in Europe and we haven’t seen any landing in China yet.

      The real issue will likely be finding decent bets to use the money with. I won’t access the HELOC until I find ideas, so until then the carrying cost is zero.

      Dean

  3. frank

    Hi Dean,
    I’ve implemented this for a while now. FWIW here are my thoughts…The problem I am having is finding Canadian companies with decent dividend yields and enough margin of safety all at the same time. Or sometimes the SM candidates that I have in the portfolio move up so that the price is too attractive to keep them just for the dividends and I would end up taking the gains… So I found having the flexibility to invest in anything that interests me outweigh the benefits of the interest savings on the HELOC… But i guess if I had to make that “coffee can” SM portfolio (buy and forget), I would wait for another meltdown (if i could get the timing right i guess).

  4. O

    PC…use of debt by a value investor is generally not desirable. Debt comes in 2 forms – recourse and non-recourse. If the value of an investment or asset falls, then the lender has recourse to demand payment to restore the value of the original asset or its collateral. In the case where an asset is valued at $100 and $100 has been borrowed against the asset, the lender can demand as recourse the $100 in full or the difference between the market value and the original purchase price. So, if the market value of the asset is $25, the lender needs to be made whole with an additional $75 posted as collateral or the sale of the asset at market price of $25 plus an additional $75.

    Klarman warns value investors pretty clearly that use of leverage needs upper bounds. The man turned in a track record of 24% annualized over a 25 year period without leverage — the man has serious credibility. If some leverage, say 10%, why not more at 20, 50, 100%? It’s pernicious, so set clear boundaries for yourself from the outset and consider holding adequate cash for contingencies. Personally, I’m in 7-figures, but my total investment leverage is $40K for 2 accounts total. It has been a convenience to bootstrap a couple of personal taxable accounts, so the leverage is entirely tax deductible.

    In Canada, mortgages are full recourse to the lender. With some ingenuity, but at some risk to you as the borrower, a mortgage (investment portion) can be structured to have non-recourse characteristics. As a value investor, you can mitigate some of the risk by only taking on investments that have a clear discount to intrinsic value. So, to construct a non-recourse loan, what you are really doing is taking out of play any temporary mark-to-market. The discount to intrinsic value is particularly important for mitigating mark-to-market, because your due diligence provides a probable normal intrinsic valuation, and the upper bound on leverage is the other key constraint to limit the damage if your valuation is wrong — believe me, it happens.

    I’ve taken 2 different approaches in the past. In the first case, I took a set of securities into street name (hold the certificates) and arranged a secured line of credit against the securities as collateral. It’s a proxy for a regular margin account, but by holding securities in street name, the opportunity for trading on the prime collateral (the certificates) is taken out. The names were well chosen free-cash-flow generators (BRK, NKE, UNS) that appreciated well in excess of any debt taken on. Today, the collateral is in excess of $100K, and the leverage is a modest $20K. Stock splits caused a couple of hiccups and the 2008/9 events caused a $3K margin call, but entirely tolerable because cash was on hand for events and because the leverage was modest.

    For the second case, I took an unsecured line of credit, transferred funds into a cash-only investment account and bought securities. Here, the leverage is completely separated from the security, so mark-to-market is entirely a non-issue, other than if the intrinsic valuation exercise was incorrect. Through a combination of debt repayments and good security selections, the account has built up to $45K with $11K of leverage. Again, the names were well chosen free-cash-flow generators (BRK, JNJ, WRB, GVC, EFH, UNS).

    From a portfolio perspective, I hold more cash than leverage. However, because of the need to spread holdings around for tax advantages, some accounts can’t be leveraged and some can. I’m quite comfortable holding large amounts of cash, but act quickly when presented with sizeable discounts to intrinsic value. Leverage is always modest and structured so that it never disrupts or forces decisions due to market events.

    The Smith Maneuver has portfolio risk if leverage is unconstrained as Klarman warns. If 10%, why not 20, 50, 100%? Securities are best bought at a discount and leverage tends to cause one to buy more of a security and at less of a discount to intrinsic value. The buys need to be structured. If I were running a Smith portfolio, I would prefer to let cash pile up, even though borrowed, as a personal constraint to demand a higher discount to intrinsic value. I would structure buys as time-spaced events (i.e. purchase 1/3 of a position at a time over a period of time). Further, I would put portfolio weight limits on positions. In an unleveraged account, I would be more likely to have large positions, but the use of leverage means that permanent capital loss due to misvaluation has a much higher cost since you need to replenish your own capital as well as replace someone else’s.

    In the end, the use of leverage has modestly accelerated the two accounts that I bootstrapped and probably added 1-2% to the returns. It has assisted in the timing of some purchases, but it hasn’t distracted me from the value investing approach. I would highly recommend reading Klarman’s MIT speech in 2007 before committing fully to a Smith Maneuver approach. The value investing framework really matters more for good decision-making than the use of leverage.

    http://1-2knockout.typepad.com/12_knockout/files/Seth_Klarman_MIT_Speech.pdf

    -O

    • Thanks for the comment O. And thanks for the link.

      I remember reading the speech by Klarman sometime in 2009 (I think). Either way it is definitely worth reading again.

      The amount of leverage will be quite small and the names will be more stable than I am used to. I also have a pretty structured approach that will limit position size and total leverage regardless of performance. I am also taking your advice and spacing out purchases regardless of my conviction level.

      Thanks again,

      Dean

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