We often talk about gearing your investments and I’ve recently had a couple of questions about what this actually means. So today I thought I’d take the opportunity to explain exactly what it is.
You might also have heard gearing explained under the term “financial leverage”.
In fundamental analysis a gearing ratio is how you compare the types of capital a company uses to fund its balance sheet. It can use either debt capital (i.e. borrowing money directly from lenders) or through equity capital (which would be selling portions of the company to investors in return for a share of the profits). Of course if you’re selling equity when the final profits of the company come round there are more people to divide it among.
If a firm has a high debt level it’s said to be highly geared or leveraged. And since there are fewer people to share the money with the returns are far greater.
Now it works in exactly the same way for investors. You can either fund the entire purchase of shares yourself by putting down the money up front or you can add a debt component to your transaction. If you’re highly leveraged, it means that instead of having to fund the whole amount of your purchase there is an element of credit. The money you put down is called “margin”.
So when you trade CFDs or Single Stock Futures instead of funding the whole price of the shares yourself, you can buy on “margin”.
This is both capital efficient and fee efficient.
The easiest way of understanding how gearing works is probably to look at an example of buying a house.
Let’s say you buy a million rand house. You put R100,000 down as a deposit (that’s your margin) but you now own a R1 million property. Next let’s imagine the property market goes up by 10%. Your house is now worth a R1.1 million but your deposit is still only R100,000.
So if you sold your house (ignoring tax, transfer fees etc.) you’d have made R100,000 on top of your R100,000 deposit. So from your starting position of R100,000, you now have R200,000 all thanks to financial leverage or gearing. That works out to a 100% gain.
Most investors use gearing as a way of making large gains very quickly.
I’ve already mentioned that this way of investing is capital efficient. What does this mean?
Let’s say this time instead of buying a house you decide to buy shares. But even if you had a million rand to invest in the stock market, with the gearing given to you by CFDs and SSFs you could use only R100,000 on margin to buy a million rand worth of shares. If your investment went up 10% you’d make a R100,000 just as if you’d invested the full million. This is capital efficiency. Because while you had exposure to a million rand’s worth of shares you could still have invested your other R900,000 in income generating assets to multiply your gains even further.
But maybe you’re still thinking it’d just be easier to buy the actual underlying equity in large amounts. And maybe you’re right, but remember whenever you buy and sell shares, you’re in for the regular brokerage, plus ITL, Strate, MST and all the other fees associated with buying shares on the JSE. And these fees can seriously eat into your gains.
But with geared instruments like SSFs and CFDs you’re actually only buying contracts and not the underlying share. That way you avoid all the additional fees and instead usually pay one flat brokerage rate (which is normally a lot lower than buying the spot equity). So if you’re trading actively and planning to buy and sell shares regularly then you’ll love the fee efficiency of SSFs and CFDs.
