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January 25, 2012

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The Danger Zone: When Margin Investing Is OK (Not Right Now)

This post is going to be a little off the very beaten path of MLP talk.  On a day when the fed says low interest rates will be around until 2014, the MLP Index hits fresh all time highs, and euphoria is back en vogue, people aren’t probably looking for me to tell them how great MLPs are for the 50th time.  So, why not shake it up a bit and talk a little investor psychology?
Margin investing is risky business.  If you buy a bunch of stock on margin, and that stock goes down, you will have lost money you didn’t really have.  Like most of the investment wisdom I have, avoiding margin can be related in some way to a movie from the 80s.  In this case, it’s Top Gun.  Investing on margin is the equivalent of your ego writing a check your butt can’t cash, like the commander in Top Gun accuses Maverick of doing at the beginning of Top Gun.

Margin can be taken to extremes, and even out of the realm of your brokerage account.  I remember an old boss, back when I was at Lehman Brothers, who espoused the virtues of using introductory credit card offers to borrow cash at 0% interest, and then plow that cash into MLPs, which he was able to collect distributions on that were around 7%.  This was a guy that didn’t need the money, but was eager to take advantage of high yielding MLPs and low interest rates.  I’m not sure what he was doing was strictly speaking legal, and I’m sure it didn’t work out well if he was still doing it in 2007 and 2008, when MLPs fell off a cliff.
But, like anything in investing and in life, there are grey areas.  Sometimes margin is OK.  For example, let’s say you were going to receive a lump sum payment at a date certain, like today (maybe an annual bonus or something similar).  If you knew that in September, but waited until now to buy MLPs (or stocks), you would have missed the last 20%+ run up since early October.  For the really level-headed, conservative investors out there, missing those big moves is fine.  Its all part of investing, it evens out over time, trying to time the market is impossible, etc, etc.
But for me, missing that 20% move would represent a big missed opportunity, especially if I have conviction that certain MLPs are being discounted unfairly in the market (as tends to happen almost seasonally).   I want to be able to jump on that opportunity in October, not in late January.  Margin allows you to do that.  If the money is going to be there in a few months, why not strategically use some margin?  The worst that can happen is you pay off the margin with money you’re expecting in January anyway.  In this case, you are metaphorically writing a check, and having the comfort of knowing your butt can cash it if need be (how is that for an uncomfortable image).
Also, is that same level-headed investor agnostic to valuation and content to plow that lump sum into MLPs (or stocks) at these prices today?  Investing after a huge move is probably when risk is highest, not the other way around, especially the way the market oscillates these days.  But there are volumes of books by very smart people who have run the numbers, like Ken Fisher, who say that the key to investing successfully is to be fully invested all the time.  Because if you had a lump sum of cash and did not invest in today, even when prices have moved 20% in a few months, you might miss the next 20% move from here, and if stocks keep going up, your panic level rises even more, and you may end up investing at an even higher peak.
I think there is a grey area on that point as well.  Loading up on stocks all the time is probably not the best strategy, conversely trying to time the market by waiting for the exact right moment to buy is probably a losing strategy.  The magic formula is somewhere in the middle.  There is certainly a point when euphoria can get ahead of fundamentals and you probably want to avoid those times.  There is also a point when despair peaks and it might be a good time to buy, like November 21st 2008, when the MLP Index troughed at 152.68.  Clearly early October’s trough of 331 on the index was one of those times as well.
HINDSight is always 20/20, its the foresight that causes problems with margin investing and regular investing.  The question for today is, have we entered the danger zone for MLPs, and would you feel comfortable putting massive capital into the market at these prices?  One thing is for sure, don’t use naked margin to buy MLPs today.  Good luck out there.

Disclosure: The information in this article is not meant to be financial advice, we are not your financial advisor and I am posting my comments for informational purposes only.  

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