The possibility of success with my master plan – to grow R100,000 to R1 million over the next two years by investing in a few neglected shares and others that offer recovery potential – looks extremely slim.
After doing a lot of reading and number crunching, it looks like the best I can hope for is that the little portfolio will grow to R241,000.
That in itself is an optimistic goal. Every share in the portfolio must basically more than double to reach the rather disappointing figure. In addition, the calculations exclude brokerage and other costs.
A few of the shares are also quite risky propositions as indicated by their low standing in the market. The basic assumption of strong recovery from big problems is equally risky, thus demanding a high return.
My solution to get even higher returns from the risky portfolio is to increase the risk even further by supercharging performance with massive gearing by ignoring the stock market and rather getting exposure to the shares with derivatives.
A few alternatives are available, with single stock futures (SSF) contracts and contracts for difference (CFDs) the two more commonly traded and very liquid alternatives.
They are similar in the aspect that an investor can get exposure to a share by putting down a deposit of only around 15% of the value of the “shareholding”.
Instead of investing around R21,000 to buy 8,000 Comair shares at R2.69 each, an investor can put down the R21,000 as margin on a CFD or SSF trade and acquire a much larger position.
The margin requirement for larger companies is 15% of the share price, while brokers require 17.5% in the case of smaller companies such as Comair.
An investor can thus buy exposure to 45,000 Comair shares to the value of more than R121,000 with a margin of around R21,000.
An increase of 20% in the share price to R3.22 would push the value of the 45,000 shares to nearly R145,000, boosting the return from 20% on the R21,000 investment to nearly 600%.
Unfortunately, the opposite is also true. If the share falls by 20%, an investor does not lose 20% of their investment, but everything.
In fact, their loss would be greater than the R21,000 they invested.
Brokers who make a market and offer platforms to investors and speculators to trade SSF and CFDs also warn their clients about the high risks inherent in trading derivative instruments. They all have similar examples to the one above to show the effect of gearing on profits and losses.
The reason why losses can exceed the initial margin is that the investor is gaining exposure to the full value of the underlying shares. If Comair falls by 40% (in the case of buying 45,000 Comair shares), my total loss will be more than R48,000, exceeding the initial deposit of R21,000.
Investors are liable for these losses as they effectively “own” all the shares. They would also receive all the dividends paid on the total number of shares in the transaction.
Dangerous, yet appealing
Derivatives are dangerous, but the appeal for boosting performance in my portfolio remains.
There are different ways to handle risk. Firstly, I am willing to accept the risk of further declines in the prices of the selected shares, as it looks like further downside is limited.
Secondly, the four shares offer a bit of diversification over different sectors. These shares will be affected by different factors, and will hopefully not decline all at once.
It might help a bit to reduce risk, even if the portfolio is by far not optimally diversified with perfect negative correlation, as taught in investment management courses at university or calculated by highly paid risk analysts working for portfolio managers.
The best defence against the dreaded margin call is not to push the leverage to its maximum. Putting down a margin of 35% to 40% of the value of the portfolio would give enough leverage to enhance returns but leave ample leeway for temporary adverse movements in the share prices.
This level of gearing would increase the exposure to the shares from the initial R100,000 to R310,000.
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