Investing in Energy Infrastructure – TransCanada Corporation
Pipe dreams can come true. We just have to find the right pipeline company to make it happen. 🙂 In today’s post I’ll explain how to earn a tangible profit in the stock market with minimal effort and risk. And the best part is we don’t need any savings to do this. 😉 I actually use this strategy a lot for my retirement planning. It’s known as the Stable Leveraging technique.
The purpose of stable leveraging is to use credit in a low-interest rate environment to harness the high yielding potential and long term stability of energy infrastructure companies in order to make some easy money. And it only takes a few minutes to set up if we already have a discount brokerage account.
How does Stable Leveraging work?
We simply use borrowed money to invest in common shares of pipeline companies. Then we use the earned dividends from the investment to pay off the interest incurred from the loan until the economic situation changes.
This investment philosophy is very different than “I have $X. What should I invest it in?” because Stable Leveraging assumes we have no money to begin with and therefore puts the risk of investing on both the borrower, and the lender.
What do we need to make the stable leveraging strategy work?
- A publicly traded, large-cap, blue-chip, dividend growth stock in the pipeline sector that’s been operating for at least 50 yrs.
- This stock must also be trading at a discount relative to its peers, and its own historic P/E ratio.
- A reliable source to borrow cheap money from, that costs at least 1 percentage point less than the pipeline stock’s yield.
- A 10 year investment horizon minimum, and the stomach to deal with market fluctuations.
- An exit strategy.
These 5 criteria are the essential ingredients to pulling off this maneuver successfully with minimal risk. 😉 One company that foots the bill is TransCanada Corporation.
Earlier this week I purchased 100 shares of TransCanada Corp (TRP) using 100% borrowed money. I will use my example to demonstrate the advantages of implementing stable leveraging. TransCanada is publicly traded on both Canadian and U.S. stock exchanges. 😉
I used my margin account at TD to borrow about $4,200 to buy 100 shares of TRP at $42 per share. The rate of interest I incur on this borrowed money is 4.25%, which would be the same as anyone else using TD’s services. But since I borrowed the money to invest, my 4.25% annual interest rate is tax deductible which makes my effective after-tax cost 3.0% per year on the $4,200 loan.
I used the loan to purchase 100 shares (for $4,200) of TransCanada Corp, which at the time, had a dividend yield of 5.0%. Since these dividends are eligible for the Federal Dividend Tax Credit, my after-tax dividend yield is 4.8% per year.
Since my effective cost of borrowing is currently 3.0%, and I’m earning 4.8% on my TRP investment, the difference between the two (1.8%) is how much I take home each year. 1.8% of $4,200 is about $75. It’s not much, but it’s $75 of passive income nonetheless. The balance of my loan will remain at $4,200. The principal does not get repaid. Dividends are deposited into my account, and interest payments are withdrawn automatically. 🙂
Let’s go through the 5 criteria to understand why this works.
1.) TRP is a dividend growth stock because it increases its dividend payments regularly. Here’s a look at its astonishing dividend growth over the past 15 years.
TRP is a large, blue-chip stock which means it has a greater chance than other smaller companies to bounce back from market corrections. The reason why pipeline companies are particularly good candidates for stable leveraging is because pipelines and utilities are generally less volatile than other sectors of the market. Notice how the great recession in 2008 didn’t negatively affect the company’s dividend payments at all. Since dividends are distributed out of a company’s profits, this suggests that TransCanada’s profits held up well over the financial crisis. Consumers who use natural gas to heat their homes, gasoline to drive their cars, and electricity to run their appliances will predictably always have a demand for energy. 🙂 This is important for the leveraged investment to work properly because we require the stable profitable nature of these pipeline businesses to continuously supply us with dividend income, so that we can pay the interest on our borrowed money.
2) Valuation wise TransCanada is relatively a good deal right now. It’s current price to earnings ratio is 18.5x, which is lower than the 23.9x for the industry average. This is the lowest P/E ratio for TRP in several years. Also, according to Thomson Reuters, out of 14 stock analysts who cover TRP, their average price target for the stock in one year from now is 33% higher than the current price, which signals to me that they believe this is an fairly undervalued stock.
3) Famous investor Charlie Munger believes that we should choose investments with a “margin of safety considering the normal vicissitudes of life.” He means we should give ourselves a cushion to swing the odds in our favor. My cushion with TRP is 1.8%. This means that my cost of borrowing will need to be 180 basis points higher before I start losing money on this transaction. Central banks in North America will likely increase rates at 25 basis points at a time so I currently have a significant margin of safety. Furthermore, if interest rates remain low, and TRP continues to stick with its plan to grow dividends for shareholders by 8% to 10% annually, even after the U.S. rejected the $8 billion Keystone XL pipeline, then my margin of safety will actually grow. So that’s what I’m hoping will happen. 😀
4) This strategy works best with a long term investment plan. If for some reason we were forced to sell our stock within the next few years then we could lose money if the share price of our stock is lower than our initial purchase price. But after holding the stock for 10+ years, our chances of being underwater is significantly reduced, although it’s still a possibility. 😕
5) My exit strategy will be to sell when the cost of borrowing becomes too expensive and my margin of safety diminishes to less than 50 basis points. At that time, even if it’s prior to the 10 year mark, I will sell my shares and pay back the loan. A change in economic conditions means a change to the original plan. The $4,200 debt will be easier to pay back in the future anyway due to the effects of inflation.
The risk of stable leveraging is being forced to deleverage when the stock is in the middle of a correction. But historically it is not often that interest rates would move up while the stock market goes down. Pipelines are relatively good at holding their value anyway in harsh economic times. During the last recession TRP shares fell 25%, while the general stock market index dropped 50%.
When we take on debt, and invest that borrowed money into a financial asset, our net worth doesn’t change. However, we can earn extra income this way, in my case, $75 a year. This income can be saved which actually does increase our net worth. This means we can essentially produce something from nothing.
This strategy is a major part of my net worth growth plan. I’ve done this dozens of times already and I’m earning thousands of dollars in net passive income every year that I wouldn’t otherwise be making if I didn’t borrow. The cost of this benefit is the risk of losing money on the investment as mentioned above. But following the 5 criteria outlined in this post can help reduce a lot of that risk and stress. Is going into $4,200 of debt worth earning $75 a year, plus potential dividend increases and capital gains? It will be worth it to some, but definitely not to others. It depends on people’s risk tolerance and their understanding of money. I’ll write a follow-up post in 2025 to give everyone an update and share my personal results. ?
Random Useless Fact:
Sheep are really good at hiding.
This is a great idea in the current low interest environment. I am thinking of doing the same within my secured Line-of-Credit, but with other Canadian high dividend paying stocks like Corus (CJR.B – 10% yield), TransAlta (TA – 11% yield); Freehold Royalties (FRU – 7.9% yield) etc. What do you think about this strategy (higher risk stocks)? Thanks for your insights.
Those sound like great companies. It’s not often we see stocks with high yields these days. I wouldn’t use this leveraging strategy to buy those stocks though just because I’m not confident in their ability to stay profitable in the long run. Corus currently has a market-cap below $10 billion. Its bonds are losing value and trading below par, which has a negative effect on the 10+ year outlook of the company. Both TA and FRU have cut dividends in recent years. So all 3 companies do not pass the first requirement in my 5 essential criteria mentioned in the post. That doesn’t mean CJR.B, TA, and FRU are bad investment choices. They could easily perform very well and grow their earnings over time if managed properly. 🙂 In terms of choosing something to buy for myself using other people’s money, I would prefer picking a company with a high level of profit and dividend reliability such as TransCanada or Enbridge.
“The $4,200 debt will be easier to pay back in the future anyway due to the effects of inflation.”
You borrowed on margin but never mentioned if you are required to keep cash in your account (aka cash you cannot utilize for other opportunities and must be calculated into your total return).
1.8% is a slim profit margin. By how much would TRP have to drop, thus triggering a margin call, for an extended period to wipe out your $75/yr? TRP would have to drop by even less if/when margin rates increase.
You mention Munger, however, Buffett says using margin is one of the biggest mistakes an investor can make. Good luck!
Inflation devalues our dollar which will also devalue a debt balance, but I plan to explain this more in detail in an upcoming post. 🙂 TRP could lose all of its value by the next trading session and it wouldn’t trigger a margin call for me because I have enough credit already sitting in my margin account to cover a 100% loss on this investment. There were a lot of other things I forgot to mention like the topics you highlight. Opportunity cost is often an easily overlooked factor. I didn’t want the post to get too long but I was originally going to explain how I wanted to borrow from my HELOC instead, which has a lower interest rate, but didn’t have the available credit at the time. A margin loan was my next best choice. I don’t require any additional money in my margin account to purchase new stocks, but of course had to put money into the margin account in the first place. That initial seed money would have to be roughly $1,300 in order for me to pull off a 100 share purchase of TRP. From this perspective you’re right that I have $1,300 locked up… Read more »
Hi 35 I run a HELOC for this purpose as well. 2.7% interest on the borrowed monies You forgat to deduct the income tax you will pay on your “profit”. I would assume at least a 33% total income tax, maybe more in your case. So your 1.8% of “profit” is now down to 1.2% As I have run the Heloc for several years now it has built up a nice principal base. The dividends paid in to the account are automatically applied to the principal & monthly interest charges. As long as the dividends can pay off the monthly interest as well as lower the principal somewhat every month you are ahead of the game. Just remember that stocks can fall in value just as well as rise in value. If you would have bought TRP when it was close to $50 you might not have be so happy. I know I was not particularily happy about what happened to NT. You win some, you lose some! As long as the winners bring home more than the losers lose – you win Interest charges to date: $3,383 Dividends to date $16,286 So my principal oweing has gone down by… Read more »
It sounds like you have a really good system going. You are passively making over $10K a year from the difference between your dividend income and interest charges. HELOCs are usually less costly to borrow from than margins with big banks. Too bad I used most of my HELOC room up with other investments already. I’m not aware of my income tax on eligible dividends but whenever I sell the stock eventually I will have to pay capital gains tax since my shares are outside of an RRSP or TFSA.
You also didn’t subtract commission, which with TD would eat up about 13% of your dividend payout. So now you’re now down to a ~1% gain in the first year…if nothing changes.
Nice catch. After reading your comment I’ve added a footnote in the post below my trade summary image to declare my commission. If nothing changes then the gain for my first year would be slightly lower than 1.8%. I’m curious how you came up with the 13% decline in dividend payout. And who knows? Maybe TRP will increase dividends in the first quarter of next year and I’ll still make 1.8% return for the 2016 calendar year. The price of the stock by next year though is anyone’s guess lol.
$10/$75 = 13% of your first year’s dividends. Of course this ratio will decline, e.g. commission negates 2.5% of dividends after 5 years, but all costs must be taken into account.
In the spirit of Financial Literacy Month, to discount certain costs/fees in order to make things “simple and clean” is not only disingenuous but also insulting and dangerous. Be real and truthful with your readership, that’s the only way to transfer true education and literacy.
Another thing to consider is that TRP will pay you quarterly but the bank will charge interest every month on the principal. So your principal is $4200 plus transaction fee ($10?) = $4210 @ 4.25% interest you will owe approx $4254 at the end of three months You say TRP is paying you 5% divs on $4200 = $52.50 per quarter in my book. You are short $1.50 and your principal has not diminished. In fact it has increased. So next month you are even further behind. AHH! The miracle of compound interest. Sometimes it works in the banks favor Personally I would start out with monthly payers, IPL as an example but there are others. Keeping all the same percentages (IPL does pay more than 5%) to compare apples with apples Principal of $4210 Interest one month on Principal of $4210 @ 4.25% = $14.91 Div Payout on $4200 @ 5% = $17.50 Which gets applied to the money oweing Principal after one month = $4210 plus $14.91 minus $17.50 = $4207.41 You are going in the right direction with a monthly payer. Again, it is not all profit as the CRA and if you are so lucky as… Read more »
Monthly payers have an advantage of quarterly, especially if you reinvest the dividends every time. I’m going to take a look at IPL. Thanks for the suggestion.
Ah, that’s why your are my favorite site to visit. I love how you use leverage to your advantage. One thing if a guy would make 6-figures to build a sizable net worth, but you do it with 5-figures income and assets is now stand very close the $1M. You are very impressive.
As for this strategy, it sounds nice and all. I see you do it right in front of my eyes, but I don’t have the stomache for it. Did you read the news that the guy was trading option? Before he go to bed he has $30sK, when he worke up, he $130k indebt.
If there is a crash, wouldn’t the blockage, force you to sell? And most too the time, you miss the buy as after the stock crash, it bounce up very quickly.
Nonetheless, I still enjoy seeing how smart people make money. 🙂
Yeah, if a market crash happens I’ll be forced to sell potentially all the stocks I have, depending on the severity of the correction. And yes, that would probably be the worst time you want to be selling lol. People with a lot of leverage like myself will most likely lose quite a lot of money in a serious bear market. But my plan right now is the only one I have at a chance to reach my goals.
Liquid, your strategy would work MUCH better with an Interactive Brokers margin account…with margin interest at only 2% or less you would come out way, way ahead on arbitraging the dividend…food for thought, no?
I have two credit cards which constantly send me offers for 0-0.99% debt (up to 15 month terms)…I could use tools like that for an even more stable “Stable Leveraging” technique; more profitable, too.
credit card won’t work, they charge 3% processing fee to begin. Several people I know thought they could just do the 0% introduction and just pay it back right before the 12 months, they forgot or used it all, and couldn’t pay it back on time, and the 15-20% rate kicked in. It took them awhile to dig out of the hole. I wouldn’t go there. 😛
That’s good advice Michael. I’m planning to open up an account with IB in early 2016. I just have to save enough money right now to meet their minimum requirements. As you probably know, savings is not my strong point lol. I tend to spend or invest all my money as soon as I get it. But I could also sell or transfer my investments from TD to IB.
You ‘re paying a lot more interest than you need to. Transferring equities is fairly simple. And then both your quarterly profit and your margin of safety will have significantly improved.
Great Post Liquid. I’ve been looking to pick up some TRP in my Waterhouse account. I’ve been DRiPping the stock for a few years but don’t have a very big position. It’s not often that opportunities like this come along. I think the last time I saw something similar to this was when the threat of Verizon coming to Canada sank BCE shares for a few months.
That’s a decent position if you have enough shares to DRiP it. 🙂 Both BCE and TRP are great companies that will pay dividends well into our retirement years. Can’t go wrong with either one.
So do you thnk your head is above water or below water – interest charges by the bank versus divs paid by TRP?
Things could change at any time but at the moment my head is above water. 🙂 TRP pays more dividends than the interest charged by the bank, even though the bank charges monthly and TRP pays quarterly.
Don’t forget that the bank gets to compound the interest charge for two months while you await TRP’s dividend.
That is what I am saying makes the difference
Yup, that’s important. It’s too bad when compounding works against an investor like in this case.
Did you consider selling a naked put with a $42 strike price?
Good question. I haven’t looked at the options table for TRP. For now I’d rather own the stock outright, but might consider buying more in the future using naked puts. 🙂
“The $4,200 debt will be easier to pay back in the future anyway due to the effects of inflation.
Inflation devalues our dollar which will also devalue a debt balance…”
Inflation only makes debt easier to pay back if 1) your debt is at a fixed rate, and 2) your wage increases. Your margin loan is not fixed and you have no idea if your wage will increase. The margin debt will only become more difficult to pay back due effects of inflation.
“That initial seed money [margin requirement] would have to be roughly $1,300 in order for me to pull off a 100 share purchase of TRP.”
You bought on margin in order to reap $75/yr in dividends, when you could have simply bought using that $1,300 to reap $65/yr.
Doesn’t really make a whole lot of sense to go through all that extra work and risk for a mere $10/yr.
You’ve utilized debt in more intelligent ways than this play.
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Liquid, this is the first article i had ever read of yours – loved the idea but never pulled the trigger as i was just exiting university at the time.
what do you think of this idea, today, but for Enbridge? i’m doing some due diligence but would love to hear your opinion as obviously things have changed in the past two years most notably hawkish BOC and rising rates.
Hey Tom. I think Enbridge is a great choice today, especially for long term investors. I’m about to write a new post this week about buying 100 shares of ENB in my non-registered account to take advantage of the dividend tax credit. I’m not too concerned about the BOC’s plans since that’s already built into the stock price.
[…] How to Make $75 a Year with TransCanada Corp – TRP stock analysis […]