A good business is one which - in the medium term - earns more than the cost of capital.
If you apply the same logic to investing, a smart investor is one who maximises gains by borrowing money to invest in shares that appreciate more than what it costs him by way of interest.
That, in short, is the case for leveraging your shares for investment.
It's risky. But when is anything involving equity without risk? The logic runs thus: if you own 1,000 shares of Reliance, you are effectively sitting on Rs 360,000 of capital at current market prices.
If you pledge these shares with a bank, you can borrow something like Rs 210,000 at interest rates of 10-12 per cent.
If you think you can invest the money in a share that will appreciate faster than that, the difference between your capital appreciation and the interest paid is money for jam.
The catch: you may make a wrong call and not only lose interest, but may also have to pledge more shares if Reliance falls in value.
The key to successful investing on leverage clearly lies in two skills - borrowing at the right time, when the markets are on an upswing, and investing in the right stock.
The question for now is: Is this the right time to borrow against shares?
Given the way markets are poised currently, financial advisors say it could be quite rewarding for investors to look at borrowing for investment in shares to make decent returns over the medium-term.
However, it is important to recognise the short-term risks. First, the market has rallied quickly over the past few months without any significant correction.
So it may be advisable for investors to wait for the correction to actually happen before taking the plunge.
Says G Subrahmanyam, assistant vice-president and head of capital market services, IDBI Bank, "The market is overheated at present. A 150-point correction in the markets would serve as a good reference point for an entry into the stock market with leveraged funds."
The second point is that investors should be sure of the return potential in the stock. This means they should only look at stocks that are expected to return at least 25 per cent over a year. This is because the net returns reduce to the extent one pays interest on borrowed funds.
Besides, if you invest in shares with borrowed funds, your losses could actually multiply if you are caught on the wrong foot.
Says Raamdeo Agrawal, managing director, Motilal Oswal Securities, "The gains that the investor can make by investing in the stock market are uncertain while the interest and the principal obligations for repaying the loans are of a fixed nature. This makes it unwise to borrow against shares to invest in the stock markets."
Some others feel that investors can look to the derivatives market rather than borrowing against shares to invest.
Says Rajiv Sampat, director, Parag Parikh Financial Advisory Services, "We do not recommend investment in the share market with borrowed funds, either borrowed against shares or against mutual funds. One can participate in the derivative markets to achieve the same results as investing in the markets with borrowed funds."
However, the minimum size of contracts in the derivatives segment is too large for participation by small investors.
If you are still undeterred and convinced about the medium-term direction of the markets, here are a few things that could help you make a informed decision.
How to get the money
Most banks allow you to borrow against shares, units of mutual funds and RBI relief bonds. For shares, banks are willing to accept a single share as well as a basket of shares.
For single shares, however, banks are more picky. They have scrips from the Nifty index, such as HLL and Infosys, against which they are willing to undertake single-scrip lending.
Outside the Nifty, banks are willing to undertake single-scrip lending only on a case-to-case basis. The liquidity of the stock, impact costs, and the stability of the business in which the company is involved influence the decision whether there will be single-scrip or multiple-scrip lending.
Each bank has its own policy on this. IDBI Bank says that the minimum number of securities must be two. Others like HSBC and ICICI Bank want a minimum of four scrips in a basket of securities.
HDFC Bank accepts a minimum of two, and stipulates that not more than 65 per cent of the value in a basket of shares should come from a single scrip.
RBI Relief Bonds can also be tendered to borrow money. The procedure is the same. Only, banks are more liberal in lending against these bonds.
Banks have also started lending against units of mutual funds, but the norms are more stringent.
Usually, they lend against shares with a margin of 40 per cent (that is, for every Rs 100 you pledge, you can borrow Rs 60). In the case of mutual funds, the margins rise to 50 per cent.
Normally, banks advocate borrowing against a portfolio of shares in order to minimise the risk of a depreciation in the value of shares.
Brokers recommend pledging old-economy shares because of the smaller changes in their values on a day-to-day basis.
Normally, high beta stocks (stocks which move more than proportionately with the index) are avoidable because fluctuations in the stock could necessitate margin calls every now and then.
Bankers cite the recent meltdown in April, when technology stocks fell nearly 50 per cent following the guidance given by Infosys.
Then again, bankers also recommend that investors should borrow less than the maximum permissible limit for any given portfolio so as to avoid that hassle of having to cough up additional margins every time stock prices fall, causing a diminution in the value of the portfolio pledged.
As is the case with most products, banks have prescribed a minimum and a maximum amount that can be given as the loan amount. The minimum amount starts with Rs 50,000 in the case of IDBI Bank and goes up to Rs 20 lakh (Rs 2 million).
However, in case a group of borrowers wishes to borrow against shares, banks are willing to increase the amount depending on the merits of the case. RBI bonds usually carry a higher limit, with IDBI Bank and HDFC Bank prescribing an upper limit of Rs 25 lakh (Rs 2.5 million).
How are loans against shares different from other loans? The main difference is the underlying volatility of the pledged shares.
Since their value fluctuates daily, your loan limits also change. In a bull market, this is a plus.
In a bear market, a huge minus. The second difference is that your ability to service the loan is less important than the value of the pledged shares to the bank.
When your banker lends against shares, and the value of the pledge fall, it will not be impressed if you regularly promise to pay interest.
You have no option but to either bring more shares for pledge, or reduce your borrowing limits. That's why it's never a great idea to pledge all your shares or draw down your limits to the full extent.
What you pay for it
The rate of interest on loans against shares ranges widely between 10-16 per cent, depending on various factors like the purpose for which the loan is availed of, the nature of the securities produced and the amount one wishes to borrow.
While the rates are lower if the loans are taken for personal purposes, they are higher if the money is to be deployed towards the capital market.
IDBI Bank lends money against shares at rates going up to 16 per cent if the money is to be deployed in the capital market.
However, if the same money is to be deployed for personal uses, then the rate of interest comes down.
This variation is primarily because borrowers would be taking on more risk if they invest in the capital market and lenders have to factor in the additional risk in the cost of borrowings.
Besides, banks can take exposures in the capital markets up to a maximum of five per cent of their total advances, according to RBI directives. So, banks are still slow in lending against shares for the purposes of redeployment in the capital market.
Borrowing prudently
Value at risk
Value at risk (VaR), a risk measurement system used by stock exchanges to collect margins for open market positions, tries to summarise the risk of a portfolio in an easy-to-comprehend way.
The concept can be easily used by individuals to prevent excessive exposures.
Excessive exposures can be harmful since the investor may have to cough up money to meet margin calls whenever the value of the pledged portfolio diminishes.
VaR-based safety margins for individuals can be particularly helpful in case of high beta stocks which see wild price movements and can result in huge and unexpected losses.
Simply put, VaR captures the magnitude of loss that would not occur for a specified period of time. Let's assume that your portfolio size is Rs 10,000.
Now, if 90 per cent VaR of a portfolio is Rs 1,000, it means that only on 10 out of 100 days the portfolio could incur a loss of that magnitude.
Similarly, if one says that 99 per cent VaR of a portfolio is Rs 1,000, it would mean that the chances of the portfolio incurring a loss of Rs 1,000 is one in 100 days.
How do you estimate value at risk? The easiest way to do this is to determine the daily change (profit/loss) in your portfolio for a sufficiently long period of time, say the last 100 trading sessions.
If the worst single day loss on the portfolio during the period was Rs 1,000, then the 99 per cent VaR would be Rs 1,000. That's the loss you would incur only in one of 100 days.
So, a single day margin may require you to keep a cushion of Rs 1,000. In other words, if the bank lends you Rs 6,000 (60 per cent of your portfolio size), then you would be better off availing yourself of a credit of Rs 5,000 to be on the safe side.
Most banks do a portfolio or margin review on a weekly basis. So investors can calculate VaR based on weekly gains and losses for a similar period. Again, the time period for VaR depends upon the risk profile of the investor.
For example, if an investor has a low risk appetite, he might set aside money to provide for a loss that would not occur more than 99 per cent of the time.
A person with a greater risk appetite would set aside money that would provide for loss that could occur only 90 per cent of the time.