Last year I invited 15 financial experts to share their thoughts on borrowing to invest. At the heart of the debate was a question I received from a reader about using leverage to invest in a single stock:
“With Canadian Oil Sands (COS) paying a juicy 8 percent dividend, does it make sense to borrow money at 4 percent to invest in this stock? The dividend is more than enough to pay the interest on the loan, and there is potential for capital gains.”
I can see why an investor might be tempted to double-down on a stock after a big sell-off. But was it a good idea?
At the time of this question, Canadian Oil Sands stock had just dipped from $21 to around $17 – an approximate 20 percent correction – but still paid a generous quarterly dividend of 35 cents per share.
Since then, the price of oil continued its sharp decline from $80 per barrel down to $44 today. Canadian Oil Sands stock plunged right along with it, falling from $17 down to $6.46 today. The once juicy dividend has all but been eliminated. Today COS pays a quarterly dividend of 5 cents per share – a yield of 3.1 percent.
Related: Why living off dividends no longer appeals to me
So how did that leveraged investment work out? Let’s say our investor borrowed $20,000 on his line of credit at 4 percent interest. He executed the trade in October 2014, when Canadian Oil Sands was trading at $17. He purchased 1,175 shares.
The current market value of his investment is $7,590.50 – representing a 62 percent loss. He would have received dividends of $411.25 in November 2014, and then payouts of $58.75 in February, May, and August of this year.
The market value of his investment, combined with $587.50 worth of dividends, brings his total value up to $8,178 – still a 59 percent loss.
Remember that our investor borrowed the $20,000 at 4 percent, and so he made interest-only payments of $66.67 each month for a total of $800 for the year.
It looks like the dividend wasn’t nearly enough to pay for the interest on the loan after all.
In summary, our investor still owes the bank $20,000 on a line of credit, and his investment is worth just $8,178 (including dividends). He pays $66.67 every month to service the loan, but his investment only brings in $58.75 per quarter in dividends.
Related: Leveraged investing – A guide for those who can’t help themselves
The obvious lesson here is that you’re taking a huge gamble when you invest in a single stock, and you’d have to be certifiably insane (or Derek Foster) to amplify that risk with leverage.
