62 The Business of Value InvestingMargin, or the use of borrowed money, takes all of these goals
and renders them useless. For that reason, most value investors
avoid the use of margin like the plague. To put it simply, using mar-
gin in an investment fund is much like using debt in a business.
Although there are important differences, this much is certain:
Too much debt can cripple, if not kill, your business. Another criti-
cal reason to avoid the use of margin is that it places the destiny
of your investment returns in the hands of your broker or banker.
And the only time you will ever get a margin call is not when your
securities are up in value but when they have declined and your
broker demands that you sell your investments to raise cash. Finally,
more people should consider the cost of margin. Once you invest
using margin, your returns are now infl uenced by the interest rate
charged on that borrowed amount.
It seems rather silly to participate in a transaction where
the disadvantages clearly outweigh the advantages. And that ’ s
exactly the kind of bet you make when you decide to use mar-
gin. Margin essentially involves you agreeing to sell securities at
even lower prices and better valuations. Instead of buying more
of a business at a cheaper price, margin can force to you sell
perfectly sound businesses at fi re - sale prices. The fi nancial crisis
that came to a head in 2008 illustrates the destructive nature of
an overdose of borrowed money. Some of most respected names
in fi nance and banking — Lehman Brothers, Washington Mutual,
and Wachovia — have either collapsed or have been chopped up
and sold off because they couldn ’ t restrain themselves from bing-
ing on leverage.
Imagine a $ 1 million portfolio that juices its purchasing power
to $ 1.5 million by taking on 50 percent margin. For every dollar
of equity, you have taken on 50 cents of leverage, or debt. Assume
your cost of debt is 6 percent a year. You invest in a collection of
perfectly sound businesses at very sensible prices. For simplicity,
we ’ ll assume three outcomes:CH004.indd 62CH004.indd 62 9/2/09 7:06:52 PM9/2/09 7:06:52 PM