This is the first episode in "Gambling Insights" series.
What is that "Gambling Insights"? Actually we can call this as investment strategies.
But the problem with these strategies is, people get carried away with these and will take it to extreme level.
Though 5% of the folks use these strategies in a disciplined manner, 95% of the folks will abuse it to make it as gambling.
So instead of calling "Investment Strategies" for those 5% of the folks, I am calling this as "Gambling Insights" for those 95% of the folks.
The word "Gambling" will serve as a warning as well. "These investment strategies can easily become a gambling" warning.
Just like the warning, "Fragile - Handle with care".
So this series, just like I warned in the last episode, will be on aggressive, advanced stock market strategies - err... gambling insights.
This is not needed for normal investors at all.
So conservative investors, save yourself some time.
Pause the video right here and switch to something that is useful for you.
You are still here? You are a certified Dare Devil.
Topic for Today is Leverage.
What is leverage? How can we use leverage to our advantage in a business?
What are all the risks involved? As an investor, would we be able to take advantage of it?
This episode is to get into those details. Hi. My name is Vijay Mohan. You are watching - not investment insights - but Gambling insights.
Let's give a scientific start to this episode. What is lever?
What Archimedes is saying about lever is, give me a place to stand and a lever of enough length. I will move the world.
So a lever is something that helps to move heavy objects with less force.
In finance, leverage is something that gives more "Chances" to have bigger gains with smaller investments.
Note the word "chance". Leverage does not mean that we will definitely end up with gains.
Let's check this out using an example. What do we use for example? What else - our favorite "Tea Shop".
Let's use the same numbers that we used in "Compounding in Business episode". We will at least have a continuity.
The initial cost to set up a tea shop is Rs. 10 Lakhs.
Sales from that shop is 10 Lakhs per year.
Expenses to run that shop per year is 8 Lakhs.
Then our profit will be Rs. 2 Lakhs per year.
What will be our return then? For an investment of 10 lakhs, we are getting a profit of 2 lakhs. So our return is 20%.
This will be a straight forward business.
How can we run the same business using leverage?
Instead of dropping 10 lakhs from our hand for the shop, let's use just 2 lakhs from our hand.
We will get the rest of the 8 lakhs thru a small business loan.
So we are getting a loan that is 4 times our own investment money.
That is, we are investing 2 lakhs from our hand and getting a loan that is worth 4 times our investment - 8 lakhs right? That is 4X leverage. Also called as 400% leverage.
Let's say the interest for that loan is 10%.
Annual sales is same 10 lakhs and annual expenses is same 8 lakhs as well.
Profit is same 2 lakhs as well. But we do have to pay the interest for our loan.
A 10% interest for 8 Lakhs loan would be Rs. 80,000.
If we take that amount from our profit, then it becomes Rs.1,20,000.
You might think that this amount is lesser than the amount we would have got from non-leveraged normal business.
But we invested Rs. 10 Lakhs in that scenario. But here, we have invested only Rs. 2 Lakh.
That is first difference. Another difference is our return.
When we invested 10 lakhs, we got 2 lakhs as profit. 20% return.
But in the leveraged scenario, we are investing just 2 lakhs and getting 1 lakh 20,000 as profit. 60% return.
So by using this leveraged option, we have freed up the rest of the 8 lakhs, which can be used for any other investments.
What if we invest that 8 lakhs in this same tea shop business in the same leveraged style?
If we need 2 lakhs for opening one tea shop, how many can we open with 8 lakhs? We can open 4 more.
So for a total of 10 lakhs, we can open 5 tea shops with a loan of 40 lakhs.
Interest is same 10%. Now the annual sales is 50 lakhs.
Total expenses 40 lakhs. Total profit 10 lakhs.
After paying for the interest, the profit that comes to our hand is 6 lakhs.
So if the profit from normal business is 2 lakhs, the profit from leveraged business is 6 lakhs.
Its good if we get the profits. But what if the business does not go as we thought and end up with loss? What do we do then?
Just file for bankruptcy and run away like Mallaya.
Just kidding... don't be that guy. Be responsible.
Don't get into debt. If you do, pay it off without failing.
Let's check out what happens if our business does not make profits like we expected.
We started with just one shop. But got carried away by the 60% profit from that one shop.
Thinking what could go wrong in running a tea shop business, took the risk of getting a loan for 40 lakhs and opened 5 shops.
All of a sudden the villain "Corona" showed up unexpectedly.
Had to close the shop for more than 3 months.
Because of that slow down, our sales happens only for 35 lakhs instead of expected 50 lakhs.
But the expense remained the same 40 lakhs.
A loss of 5 lakhs from 5 shops. When we add the interest 4 lakhs to this, we end up with a total loss of 9 lakhs.
When we look at the final return, it is at -90%. That is for an investment of 10 lakhs, we end up with 9 lakhs loss that year.
When the sales slowed down by 30%, the return has gone from 60% to -90%.
This is the dark side of using leverage. And for this reason, we are calling the leverage is "Double edged sword".
It cuts both ways. Could be favorable. But could end up harmful.
Many business vanished because of high leverage.
They flourish well during the expansion of business cycle. But when they are hit by a recession, it will be very hard for them to survive.
This is business leverage. We use leverage in another place without even realizing. Can you guess?
Our house loan. Let's say that we own a home with no debt with a value of 50 lakhs.
If the home appreciates 10% in a year, then its return rate is 10% as well.
Our profit, 5 lakhs.
But instead of buying this home with all cash, let's say that we are buying it with a down payment of 10 lakhs and a loan of 40 lakhs with interest 7%.
What is our leverage here? 40 lakhs debt for 10 lakhs investment. A debt of 4 times our investment. So leverage - 4X. 400%.
What would be the profit in this scenario for the home appreciation of 10%?
After paying the interest from our 5 lakhs profit, we would end up with Rs. 2,20,000.
2.2 Lakhs profit for 10 lakhs investment. 22% return.
But what if our home has appreciated 20% instead of 10%?
Then our return will be 72%. This is the power of leverage.
Leverage will magnify an asset's appreciation to a much bigger return for us.
But like we already saw, it does not just magnify the positive returns, it magnifies the negative returns as well.
Instead of appreciating, what if our home depreciates?
Let's say that our home is depreciating by 5%, then our return for that year will be -53%.
What if the depreciation is 50%? Return will be a depressing -278%.
If that happens, house value would have come down from 50 lakhs to 25 lakhs.
40 lakhs loan for a home that is worth 25 lakhs? We can let the bank keep that home and walk out of it.
If you are surprised that it is even possible for something like this to happen, then you do not know what happened during 2008 financial crisis in US.
We will cover that more in detail in another episode.
Would we be able to use this leverage in equity (stocks) investments?
Definitely. It is called as "Margin". We will dig deeper into that in the next episode.
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