Gearing up for bigger profits

IT’S a remarkable feature of today’s investment markets that gearing remains a term that provokes apprehension.

IT’S a remarkable feature of today’s investment markets that gearing, or borrowing to invest, remains a term that provokes shudders of apprehension. It’s hard to fully explain this reticence; the only plausible explanation is that people are looking backwards rather than forwards because the costs of gearing have rarely been lower.

For a generation until the GFC, gearing was entirely conventional for many ordinary investors in the sharemarket. In 2007 there were a quarter of a million registered margin lending ­accounts in Australia — today the number is 170,000, according to research house Canstar.

And though we collectively quake at the prospect of gearing into investment markets, we ­merrily hock ourselves heavily into the residential property market where prices are actually falling just now and the yield — or rental income — might be just 4 per cent before expenses. If you think about it, we are ­enjoying the lowest rates in 50 years and a ­direct consequence of those 2.5 per cent cash rates is that gearing is equally cheap. Interest rates are at half their long-term average since 1990 of 5.3 per cent and at a fraction of the levels older investors would have experienced — how about 17 per cent in 1990?

Additionally, for the diversified investor the reality is that by most measures the residential property market — where just about everybody gears — is overvalued. Meanwhile, the sharemarket, where most people are afraid to gear, is by many key measures ­operating at reasonable valuations. It’s worth noting a key indicator of gearing conditions — the number of stocks considered ­acceptable securities for margin lending — has climbed from 390 in the torrid days of 2009 to 446 at last count. (See table)

Many investors recoil from the idea of gearing into the sharemarket because they equate the phrase with borrowing in the hope that share prices go up. In fact that is a very limited view of the business because we are in an era of high yields in the stockmarket — the average dividend yield in the market is 4.4 per cent. Now when you bring that return home and include franking it moves up to almost 6 per cent. If you bias the portfolio towards high yielding stocks such as the major banks and Telstra the grossed up (or post-franking outcome) can be more than 6 per cent.

To spell this out further, it means investors could cover their financing costs on the basis of dividends alone: Any price improvement in the shares would offer a pure profit.

Obviously the caveat here is you must understand the risk of gearing and understand the specific terms of any gearing ­arrangements before you act. The main risk of course is that just as gearing magnifies profits it can just as easily magnify losses. Share prices can drop, likewise dividends can fall or be dropped altogether in times of crisis.

The other point to make loud and clear is that gearing into the sharemarket does not automatically mean margin lending — this form of gearing, often encouraged by brokers and banks, can be restrictive and carry higher rates. The rates on margin lending at the moment are roughly about 7.5 per cent.

As an alternative to margin lending here are two interesting approaches;

1. Using geared instruments.

What happens here is that an investor buys a managed fund — or maybe an exchange-traded product — which itself borrows to invest. In others words the fund is internally geared. The common ­interest rates range at geared share funds is between 3.5 per cent and 5 per cent, though of course in the case of managed funds there are considerable fees and other expenses added.

2. Using general loans to fund share portfolios.

This is never written in the marketing brochures from banks or brokers but the fact is that many smart investors finance the gearing of their share portfolios through other forms of lending.

Money made available through the aid of personal loans or cleverly managed mortgages can be used to gear share port­folios and here the numbers are equally attractive. Mortgage rates are currently running at about 5 per cent.

So what’s the catch? The catch is the same as it always has been: if everything goes pear-shaped you finish up owing more than you would have if you used available — rather than borrowed — funds.

More realistically, the catch is confidence; a lightly geared portfolio in this market where the dividend stream can cover — or come close to covering — financing costs is hardly a high-risk strategy, but confidence remains low and as long as it remains so … gearing is going to be relatively cheap.

James Kirby is the managing editor of Eureka Report.

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