Monday, February 18, 2013

How to double your money investing in blue chip stocks

You can easily double your money investing in low-risk blue chip stocks if you can borrow at the same rate as the big banks.  This is a quick numerical example of how leverage improves return on equity.  This dynamic is currently driving up the S&P500.

The example: start with $35M in equity and borrow $1.0B from a big bank or your central bank (e.g. the US Federal Reserve).  Invest your total capital of $1,035M in Cheveron (CVX) stock which paid a dividend of $3.51/share in 2012.  Borrow the $1.0B at a pre-tax interest rate equal to the current LIBOR rate for 1 year of 0.82%.  The LIBOR rate is the rate that big banks charge each other for loaning money.  The big banks are currently able to borrow from their central banks for even less.  12 months LIBOR has been below 1.00% for most months since the end of 2009.  But, let's go with 0.82%.

Now sit back for a year and collect $3.51 per share of dividends.  Then sell the Chevron shares and pay off the $1.0B loan with the proceeds.  If you are lucky the shares may appreciate 4.3% in that year and you earn $44M on top of your $35M investment (scenario A).  If the share price is flat for the year you earn only $15M (scenario B).  As long as the shares don't lose more than 3.2% in price you win (scenario C).

Purchasing the $1.0B in shares will help drive up the price of the shares at least in the short term.  But, you need the share price to be up a year later when its time to sell.  Hopefully, you are early to the game and can count on others to make their initial investments when you want to sell.

This pyramid scheme is fueled by increasingly more dollars to be invested and an ever lower cost (interest rate) of those dollars.  Interest rates could increase.  It is difficult to imagine rates going any lower.  There could be fewer dollars to invest for 2 likely reasons.  First, allowable leverage ratios could be reduced.  The example used a 30:1 debt to equity ratio, which is common in hedge funds today.  Second, banks might lose the ability to borrow.  There could be a crisis in confidence where no banks wants to lend.  

The current stock market valuation is being propped up by low interest rates, high leverage ratios, and high confidence.  At least one of these dynamics is going to give out soon and take the others, and valuations (in real terms) along with it.  Valuations denominated in US Dollars may hold up.  In order to achieve that the Fed will need to print more and more dollars which devalues the currency.  So the S&P500 is likely to keep going up in USD (with some volatile quarters).  But the value of the S&P in terms of solid currencies such as gold, silver and oil will decline.

Today the S&P is at $1,519 and will buy 0.95 ounces of gold and 16 barrels of oil.

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