86 lines
4.6 KiB
Plaintext
86 lines
4.6 KiB
Plaintext
The beauty - and beast - of leverage
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Analysis by Dianne Maley
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November 10, 1989
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Ever wonder how the rich get rich?
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Well, to start with, they usually have some money. But to turn a little
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bit of money into a lot, you have to follow religiously the golden rule of
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investing: borrow in boom times and retrench when things begin to slow.
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The magic tool is leverage. Real estate investors know it well. In times
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of rising house prices, you buy a property with a little of your own money and
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a lot from the bank. Say you put $10,000 down on a $100,000 house; the rest
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you finance by taking out a mortgage on the property.
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Over the course of the following year, the house price rises by 10 percent
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to $110,000 -- not an unreasonable thing in a healthy market. You have made a
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100 percent return on your money in one year.
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In a really hot market, house prices can rise even faster, making the
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returns stunning. This is the beauty of leverage.
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As we have learned from the U.S. takeover binge, leverage is not limited to
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real estate. When a big corporate raider wants to take over a company, he
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borrows against the assets of the target company to pay for it. Then he pays
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the debt back with its earnings or by selling some or all of its assets.
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This is known as a leveraged buyout, in which little of the purchase price
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comes from the buyer's pocket. The buying companies have made so much money
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doing this in the past while that they have lost interest in the stock market.
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Why buy stocks when you can buy the underlying company, break it up, sell the
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parts and make a huge profit?
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But when you are starting up a company, leverage may not be the best tool.
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Often, the start-up period turns out to be longer than you expected and the
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costs higher. If you are relying solely on your bankers, you run the risk of
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having them pull the rug out from under you before you have had a chance to
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get going.
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If you have an established business and you want to expand, though,
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leverage can work nicely. You can borrow against your existing plants to
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build a new one, for example.
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By and large, small investors have learned the leverage game well. Where
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they go wrong is in not knowing when it is time to reverse the strategy.
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Delightful as it is on the way up, leverage works in reverse on the way down.
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Your holdings can collapse like dominoes.
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To use leverage with the family home is downright reckless.
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The problem is to recognize when the tide has turned. Is your business
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about to boom or bust? One clue is interest rates. When the difference
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between what you are paying to borrow money and the inflation rate begins to
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widen, it may be time to retrench. A spread of more than five percentage
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points is a warning sign.
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Currently, the real or inflation-adjusted cost of borrowing money ranges
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upward from six percentage points, high by historical standards. The path to
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riches is littered with the bleached bones of investors who did not heed this
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sign.
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Often, people overextend themselves so that when the time comes to lower
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their debt load, they have no money left with which to do so. This points to
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another investment rule: what if? Smart investors always ask themselves, what
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if real estate prices fall by 20 percent rather than rise? What if oil prices
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plunge? What if the stock market crashes?
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To use leverage properly, you have to have assets in reserve so you can
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reduce your debt before it reduces you -- to insolvency.
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Another file downloaded from: NIRVANAnet(tm)
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& the Temple of the Screaming Electron Jeff Hunter 510-935-5845
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Rat Head Ratsnatcher 510-524-3649
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Burn This Flag Zardoz 408-363-9766
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realitycheck Poindexter Fortran 415-567-7043
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Lies Unlimited Mick Freen 415-583-4102
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