Motley Fool Australia

The upside of leverage without the downside risk

Wouldn’t it be nice if you could enjoy some upside leverage without taking on extra downside risk.

Before I tell you how I think one stock has a similar return risk to the Australian market, yet offers a higher probable return, let’s refresh our beliefs on leverage.

The great thing about the leverage is it magnifies returns. That, as you know, is also leverage’s worst attribute.

Leverage – the wealth destroyer
The over use of leverage, or margin, is the surest path to financial destruction. Very few ever enjoy the fleeting moments of leverage-boosted wealth. Even fewer get out with their skins when they have had ‘enough‘.

Leverage – margin or debt – is the number one destroyer of wealth, both personal and corporate.

When I last wrote about Argo Investments (ASX: ARG) I claimed it “delivers instant diversification and a shot at outperforming the market“. These were high claims when diversification generally means investing in index tracking funds.

Before I up my Argo claims I should add that the diversification I’m talking about is Australian sharemarket diversification. A single investment, no matter the asset, leaves investors exposed to many other forms of diversifiable risk.

Double banger potential
Argo’s price to book is still around 0.9. That compares very favourably to the historical average of 1.15 and high of 1.5. When the Australian market enters it’s next bull cycle, Argo is highly likely to enjoy both a rise in its book value and price to book multiple.

 

(ASX:ARG) P/B price to book" src="https://www.fool.com.au/wp-content/uploads/2011/10/Argo-Investments-Ltd-ASX-ARG-price-book-charts.png" alt="" width="400" height="146" />Source: S&P Capital IQ

Argo is a leveraged play on the upside potential without employing leverage. It has a high probability of outperforming the S&P/ASX 200 index and therefore most fund managers over the medium to long term.

Naturally, there is some risk that it will underperform.

Show me the leverage
Argo has a long track record of outperforming the market. Though, like almost every successful fund does at some point, it has lagged the market for the last few years.

Here’s how Argo has allocated two thirds of its portfolio.

Company

% Portfolio

% S&P ASX200

S&P Position

BHP Billiton Ltd. (ASX:BHP)
8.6
14.6%
1
Westpac Banking Corporation (ASX:WBC)
5.8
4.9%
4
Wesfarmers Ltd. (ASX:WES)
4.9
2.7%
10
Rio Tinto Ltd. (ASX:RIO)
4.6
9.6%
2
Australia & New Zealand Banking Group Limited (ASX:ANZ)
4.5
4.1%
5
Commonwealth Bank of Australia (ASX:CBA)
3.9
5.6%
3
National Australia Bank Limited (ASX:NAB)
3.6
4.0%
6
Milton Corporation Ltd. (ASX:MLT)
3.5
26
Australian United Investment Company Ltd. (ASX:AUI)
3.3
5
Woolworths Ltd. (ASX:WOW)
3.2
2.2%
11
Telstra Corporation Limited (ASX:TLS)
3.1
2.8%
9
Origin Energy Ltd. (ASX:ORG)
2.8
1.2%
16
Macquarie Group Limited (ASX:MQG)
2.3
0.6%
26
Woodside Petroleum Ltd. (ASX:WPL)
1.7
2.1%
12
Orica Ltd. (ASX:ORI)
1.6
0.7%
25
QBE Insurance Group Ltd. (ASX:QBE)
1.5
1.2%
17
AMP Limited (ASX:AMP)
1.5
0.9%
19
Santos Ltd. (ASX:STO)
1.4
0.8%
20
Foster’s Group Ltd. (ASX:FGL)
1.2
0.8%
22
AGL Energy Limited (ASX:AGK)
1.2
0.5%
33

Source: S&P Capital IQ

Investors in Argo are buying an Argo ASX index at a 10% discount to the S&P ASX index.

Foolish bottom line

Argo comes with many risks, including permanent loss of capital.

My view is that it comes with almost the same return risk as the Australian market yet with a higher probable return – due to the current 10% discount from book and 20% discount to average price to book. Academically impossible I know, but there you have it.

This article contains general investment advice only (under AFSL 400691).

Dean Morel is The Motley Fool’s Investment Analyst. Dean has no position in Argo, and is now wondering why not. The Motley Fool’s purpose is to educate, amuse and enrich investors. Readers can click here to find out one company Dean does own, The Motley Fool’s Top Stock For 2011-12.

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