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Leveraged investing: The pitfalls

Feb 9, 2004

The current stock market rally began in April 2003 last year. However, it was post July 9, 2003, that the primary market (for equities) saw much activity. The market we are talking about here is the IPO segment (primary market). The stock, which listed on the bourses that day, was that of Maruti Udyog, India's largest passenger carmaker. After listing at almost a 50% premium to the allotment price, the stock continued to gain ground and outperform the benchmark indices by a considerable margin. Just to put things in perspective, while the BSE-Sensex has gained 58% since July 9, 2004, the Maruti stock has surged 280%!

CompanyDate of
listing
Allotment
Price (Rs)
Price as
on Feb. 5, 2004
% GainHigh/Low
Maruti UdyogJuly 9, 2003115437280%454 / 156
UCO BankOctober 9, 2003122388%26 / 17
Indraprastha GasDecember 26, 2003489291%165 / 89
TV TodayJanuary 16, 20049513845%225 / 132
Note: Maruti and TV Today are Rs 5/- face value

The IPO market has benefited immensely from the sentiments prevailing in the secondary market, which is vindicated by the fact that a slew of IPO offerings are slated to hit the markets in the next 3-6 months. According to reports, as many as 30 offer documents are awaiting Securities and Exchange Board of India (SEBI)'s approval, which plan to raise capital to the tune of Rs 160 bn over the next 3-6 months. One big factor prompting companies to come out with IPO's has been the strong acceptance and appetite seen for the IPO offers both, from the institutional as well as the retail segments. This is also evident from the fact that all the IPO's (since mid-2003) were oversubscribed several times and are currently trading at significantly higher prices as compared to their issue price (see table above).

In this backdrop, we conducted a poll on our website wherein we asked our readers about their source of financing for these IPO's. It was encouraging to know that over 2/3rd of those who took the poll put in personal funds to finance their IPO investments, while the percentage of those who either borrowed funds or liquidated their (current) holdings was a much lesser 18% and 13% respectively.

While all of the above sources of investments would have some positives and negatives, the riskiest amongst these would be, but of course, financing from borrowed funds. It must be noted that in this article, we are not limiting ourselves to investing in IPO's but rather investments in equities as a whole.

In today's times, where practically every second bank is providing loans to invest into the secondary markets and moreso, into the primary markets, it makes much sense to look at the possible pitfalls of investing through borrowed funds, also known as leveraged investing. For the advantage of the 18% readers who voted for borrowed funds and also for those who are planning to opt for this style of financing their investment needs, here is why borrowing to invest could be hazardous.

Firstly it must be understood that leveraged investing is a high-risk proposition, especially if one fails to consider the risk-return profile. This form of investing undoubtedly increases your profits but at the same time, it significantly enlarges the quantum of losses that the investor might have to bear, just in case the markets decide to go into reverse gear. Here, if the investor has failed to assess his 'bearable' risk, then it could lead to some serious consequences.

This is because, though the banks/institutions would have readily sanctioned the loan, in a falling market they would be forced to call for additional margins (in case of margin trading) or further collaterals, in order to make good their losses in the market value of the portfolio of the investor. If the investor fails to provide either of the above two, the probability of he losing his pledged collaterals as security is very high, which would permanently terminate all his possibilities of recouping his losses, even if the markets bounce back.

This is one big advantage in case of the other two types of investments. Since investments (primary/secondary) are made from either personal funds (assuming that the investor is not going overboard by stretching his personal financial situation) or by liquidating current holdings, the investor has the option to hold on to his investments despite sharp movements in stocks (especially on the downside). It must be noted that volatility has been the order of the day for sometime in the case of Indian stock markets, where 150-200 points intra-day index movements has the potential of unnerving even the most savvy of investors. However, if investments are made through borrowed funds, and the markets correct, even if temporarily, the investor might have to let go off his holdings (probably at a loss).

Thus, to conclude, while leveraging one's investments is not entirely the incorrect option, we feel it should definitely not be the favoured one. Further, before investing into equities (either through personal or borrowed funds), certain key issues like assessing one's own risk bearing profile, the investment time horizon and investing in fundamentally sound companies must be adhered to.

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