Leverage

Much has been said about using leverage in investing.

I would bucket them into three categories.

Safe, durable leverage

Famously, Berkshire has been built on using insurance float - effectively leveraging Company's investments. Because float is stable over time, even big drops in market prices of investments do not force asset sales. Similarly, real estate investments can be leveraged rather safely (assuming cash flows from these properties are safe themselves).

Unsafe leverage

Buying stocks or futures on margin is unsafe, in a sense that drop in instrument price can cause a margin call and selling at the bottom.

Hidden leverage

The less obvious is when the investment itself is leveraged (company with a lot of debt). Because of limited liability for stockholders, it can be perceived as inherent risk, rather than direct liability. Sometimes, though, I think it is instructive to think of it as investor's debt.

The flip side of the previous scenario is when company has material, positive net cash. I like to think of it as a my cash, even though I cannot force the company to distribute it. But when I have faith in company's management (including perceiving them as good capital allocators) I think it is a reasonable way of thinking.

To make it more concrete - Apple has enormous cash position (even after subtracting deferred tax liability) and consistently generates huge amounts of cash. In today's markets, with highly developed arbitrage, it is unimaginable for Apple stock to trade below it's net cash per share (in other words,  having negative Enterprise Value). It is even more so, for companies that are smaller and thus more susceptible to activist shareholders.

Putting everything together

When looking at my leverage, I prefer to think of all kinds of it.

Unfortunately, I do not really have as great source of safe leverage, as Berkshire. The one closest to it that I have, are 10 year employee stock options, which provide me with 'free capital' for ten years, as long as I keep this capital (and much more of it, actually, too) invested in Alphabet stock. For now I decided to do that, but within a few years this source will be gone.

Another concept that has some characteristics of the leverage is time-shifting of the investment. When I know for sure about an incoming cash flow, I can make and investment ahead of it using margin (unsafe) or options (safe, but costly).

Combined leverage

I do use margin when making stock investment. I do that, even though I have been bitten by using futures to go long Polish WIG20 around the 2007 highs. I thought I was being conservative then, but clearly I was not.

I strive to be careful in the amount of leverage I use. For example, when buying Berkshire not much higher than their buyback threshold of 1.2 of book value, I feel comfortable using relatively high leverage. But I also always want to be able to buy more and still not face a margin call if stock will go into what I would perceive as a bottom.

It is not an exact science, but I try to take into account all these pieces when deciding if and how much leverage to use. Another example is Valeant, where there are scenarios when it goes straight to zero, therefore no leverage can be used. And with standard RegT margin requirements (which I prefer), whenever security can drop by 50%, no leverage can really be applied anyway.

The picture could in theory be a bit more rosy for using leverage when considering diversified holdings, but that's a tricky path to follow.

To summarize, I keep the borrowed amount below my expected to-be-invested income from next 12 months. And also to such extent, that my planned buys when averaging down and unrealized losses will not cause a margin call in my "worst case" scenario.

Using some leverage "constantly" will prevent me from maximizing gains by buying more after severe declines, but will elevate returns at all other times.