Investment Iron Law IV: Making Money with Other People’s Money#
By applying the principle of financial leverage, an investment of 500 million can double your business.
Utilizing Leveraged Investing#
The path to wealth through investment relies on “making money with money.” Therefore, the prerequisite for investment is having capital. A common dilemma faced by individuals when investing is, “What if I don’t have enough money?” This can lead to missed opportunities. This book proposes a solution: “If you don’t have enough money, but someone else does and is willing to lend it to you, then borrow it.” This is the highest realm of investment management—leveraged investing.
Chen Youhao, President of the Tuntex Group: The Money-Making Method of Borrowing and Rolling
Starting in the textile industry, Chen Youhao used financial leverage to rapidly expand the Tuntex Group into chemical fibers, construction, cement, hotels, petrochemicals, and other fields. With over 30 affiliated companies, it became one of the top 15 largest corporate groups in Taiwan. He also planned to invest nearly 7 billion USD in Taiwan and Thailand to expand chemical fiber plants.
Tuntex’s growth never stopped, and its debt continued to rise. In 1995, Tuntex Group’s core business, Tonwin Construction, had total assets of 59.6 billion TWD, revenue of 15.7 billion TWD, and net profit after tax of 2.6 billion TWD, but its debt ratio was still as high as 60.99%.
A graduate of the Department of Economics at National Taiwan University, Chen Youhao always prided himself on his sophisticated money-making method of borrowing and rolling. He had full confidence in Tuntex’s financial management. His financial principles were: 1/3 self-owned capital, the rest borrowed from financial institutions; current assets must be greater than current liabilities, with a current ratio greater than 100%; and the ratio of self-owned capital to debt must not exceed 1/2.
Chen Youhao emphasized that whenever the company’s debt ratio approached its limit, he would strictly control it, so the company’s financial situation remained normal. However, whenever the construction industry was in a downturn, Tuntex would be plagued by rumors of financial difficulties. In June 1995, due to capital needs, Chen Youhao pledged 46.5 million shares of Tonwin, setting a record for the highest number of shares pledged by directors and supervisors that month. Chen Youhao repeatedly assured the public that Tuntex’s finances were absolutely sound.
Despite the rumors damaging the company’s image, Chen Youhao firmly believed that reasonable borrowing could enable the company to earn more profits. He was also confident that businesses funded by loans would be profitable because the return on investment was higher than the interest rate on loans.
Is Borrowing to Invest Wrong?
Is borrowing money for investment appropriate? Shakespeare wrote in Hamlet, “Neither a borrower nor a lender be.” This was once considered a golden rule. Our elders often warned their children not to borrow money from others or lend money to others; borrowing was not considered respectable and should be avoided unless absolutely necessary.
Indeed, most stories of financial ruin are caused by debt, such as the cases of Tsai Chen-chou of the Tenth Credit Cooperative and the stock market tycoon Lei Borong. Countless examples of bankruptcy caused by debt make people fear and avoid it.
However, among the famous wealthy individuals we know, such as Wang Yongqing, Kao Ching-yuan, Chang Yung-fa, and Wu Ho-Su, who didn’t rely on borrowing to invest in their journey from rags to riches? The answer is “none.” Moreover, the more successful people are at making money, the more they tend to borrow. Looking at the financial statements of listed companies, are there any renowned high-performing enterprises in Taiwan, such as Formosa Plastics, Uni-President, and Evergreen, that have zero debt? The message is clear: successful tycoons, like successful businesses, rarely achieve their wealth without using other people’s money. In business management, appropriate borrowing is not only necessary but also reasonable.
If Shakespeare were alive in the 21st century and understood how capitalism works and how people become wealthy, he might change his words to: “If you have no money, but others do and are willing to lend it to you, then borrow.”
After reviewing these characteristics of success, reflect on your own financial situation. What percentage of your investment funds comes from borrowing? If, like most people, 100% of your investments are made with your own funds, you are overlooking an important tool for building wealth: borrowing.
Borrowing is a Crucial Tool for Wealth Creation
American investment consultant Robert Allen repeatedly emphasizes in his bestselling book Creating Wealth: “You cannot become rich by investing without borrowing.” I disagree with this argument. The examples in Chapter 1 of this book clearly demonstrate that with proper financial management, one can become a billionaire without relying on borrowed investments. The American investment master Warren Buffett does not advocate leveraged investing. Without debt, he is a prime example of building wealth solely through his own funds. However, there is a prerequisite for accumulating wealth using only your own funds: long-term patient waiting. Warren Buffett only rose to prominence after three to four decades of investing.
Although Robert Allen’s argument that “you cannot become rich without borrowing” is incorrect, I must admit that the “leveraged investing” he advocates is an important means of building wealth, especially for those who want to accelerate the speed of wealth creation. Leveraged investing is a tool that should not be ignored.
In conclusion, whether you want to accelerate wealth accumulation or can tolerate the pressure of leveraged investing, you must understand the nature and impact of leveraged investing before deciding if this tool is right for you.
- Leveraged investing is a powerful tool, but it must be used wisely.
- It is possible to build wealth without borrowing.
- Leveraged investing, when used correctly, can accelerate wealth accumulation.
- Don’t be afraid of leveraged investing, but be very careful.
Aim high with your business goals, Once decided, go for it and never back down. The key to success in business lies in courage and strategy.
Weng Damming’s Revival of the Family Business#
In Taiwan, there are quite a few entrepreneurs skilled in financial leverage. Besides Chen Youhao, the president of the Tuntex Group, Weng Damming, the head of the Hualon Group, is also a master of this art.
Weng Damming, the head of the Hualon Group, became a highly controversial figure due to his unconventional style. After the death of his father, Weng Mingchang, Weng Damming shouldered the heavy responsibility of reviving the family business. Starting in textiles, the Hualon Group owned Hualon Textile, Hualon Microelectronics, Yixin Trading, Jiashin Livestock, and Kuo Hua Life Insurance, among other affiliated companies.
Weng Damming adopted a high-leverage approach to business management. In 1994, the Hualon Group had total assets of 130 billion TWD and debts as high as over 50 billion TWD, of which over 30 billion TWD were short-term debts. He used the stocks or real estate of affiliated companies as collateral for bank loans, with a pledge ratio of nearly 60%. Therefore, during the stock market crash and the real estate downturn, Weng Damming was troubled by rumors of financial difficulties. Due to the sluggish stock and real estate markets, the collateral value of the Hualon Group was insufficient, requiring him to supplement the collateral or face the pressure of being “liquidated.” However, the seasoned Weng Damming, with his flexible financial management, once again demonstrated that the financial crisis was just a false alarm.
As Hualon Textile, the parent company of the Hualon Group, enjoyed stable profits and increased earnings with the gradual recovery of the textile industry, Weng Damming was able to borrow money fearlessly and aggressively expand into new businesses. With a gambler’s mentality, Weng Damming can be said to have maximized the principle of financial leverage. The story of this legendary figure shows us both the rewards and risks of leveraged investing.
The Principle of Financial Leverage
- Act within your means; don’t over-leverage, or you risk being shaken out.
In finance, borrowing is known as “financial leverage.” Simply put, leverage is the principle of using a small force to achieve a large effect. Humans discovered the power of leverage early on and used it to move or lift heavy objects. The ancients used the principle of leverage to create magnificent engineering marvels such as the Great Wall and the pyramids. Modern wealthy individuals use the principle of financial leverage to create immense fortunes. Archimedes once said, “Give me a place to stand, and I shall move the earth.” In investment management, financial leverage implies: “Lend me enough money, and I can make any large investment.”
Leveraged investing involves borrowing other people’s money to make larger investments, thus utilizing the leverage effect. Proper use of leverage can turn small amounts of money into large profits. Conversely, improper use can also lead to significant losses with small amounts of money. Here’s an example to help readers understand how financial leverage works. Suppose you buy a house with 10 million in cash. A year later, you are fortunate enough to sell it for 13 million, making a 30% profit (R1). If you only paid 3 million in cash for the house and borrowed the remaining 7 million from the bank at a 10% interest rate, and then sold it for 13 million a year later, your profit margin would increase to 77% (R2). Conversely, if the house price unfortunately drops by 30% after a year, and you sell it for 7 million, the person who bought it entirely in cash would lose 30% (R3). The investor who borrowed 7 million would see their loss expand to 123% (R4), meaning not only is the original investment lost, but they are also in debt. The calculation of the above rates of return is as follows:
From the above example, we can clearly see how debt leverage exerts the power of “using a small force to achieve a large effect.” When the return on investment is higher than the interest rate on the loan, leveraged investing will increase the return on investment. When the return on investment is lower than the interest rate on the loan, the return on investment will decrease due to the borrowing.
The main reason for the leverage effect is that loan interest is a cost that must be paid under any circumstances. Regardless of the investment return, the interest cost of borrowing remains fixed. Therefore, when the investment return is greater than the loan cost, the excess profit belongs to the borrower, creating a positive leverage effect and naturally increasing the return on investment of the principal. However, when the investment return is less than the loan interest cost, the borrower must bear the difference, resulting in a negative leverage effect, which reduces the return on the principal. This is especially true when the investment incurs a loss, as the borrowing cost will magnify the loss.
Financial leverage is like a seesaw, It can lift you very high, It can also cause you to fall hard.
Two Major Principles of Borrowing#
Financial leverage is like a seesaw: it can lift you very high or cause you to fall hard, depending on whether the leverage effect is positive or negative. The key factor determining the direction of the leverage effect is which is higher: the return on investment or the interest rate on the loan. If the return on investment is greater than the interest rate, the leverage effect is positive. Conversely, if the return on investment is lower than the interest rate, the leverage effect becomes detrimental.
Return on Investment Must Be Higher Than the Interest Rate
Therefore, when deciding whether to use leveraged investing, the first things to consider are: What is the purpose of the loan? What is the expected return on investment for the target investment? Is it higher than the loan interest rate? If the return on investment of the targeted investment is significantly lower than the borrowing rate, the idea of leveraged investing should be dismissed early on. Otherwise, the result will certainly be detrimental rather than beneficial. If you can’t understand what the expected return on investment is or whether the return is higher than the interest rate, then I advise you to understand these issues before borrowing!
Debt is synonymous with risk. Increasing debt increases risk and the possibility of personal or family bankruptcy. There are two major principles of leveraged investing:
- The expected return on investment must be greater than the interest rate on the loan. For example, if the loan interest rate is 11%, it’s only worthwhile if the after-tax return on investment is above 11%.
- In the worst-case scenario, your cash income must be sufficient to cover the principal and interest payments. For instance, if the investment price falls instead of rises after a few years, you must have enough cash income to repay the principal and interest on time.
Furthermore, investors must keep in mind that leveraged investing should not be based on the expectation that the price of the investment target will definitely rise, but rather on the preparation for a price drop. Therefore, you should only engage in leveraged investing if you can still afford the interest payments even if the price continues to fall. You must also be able to withstand the psychological pressure that comes with leveraged investing.
Avoiding Improper Borrowing
Some readers may feel smug after reading this section because they are already engaged in what they consider leveraged investing. Upon further inquiry, however, it turns out they are borrowing money to buy lottery tickets, futures, or other speculative products, or even taking out loans to purchase consumer goods. I must emphasize that these actions do not constitute proper “leveraged investing.”
Futures markets, margin trading (such as foreign exchange and bonds), or any gambling activities like lotteries and horse racing all have negative expected returns. Long-term participation will inevitably lead to financial ruin. Coupled with the deadly effect of borrowing, the result will undoubtedly be rapid bankruptcy. Therefore, no matter how alluring these games are, remember: It’s okay to indulge occasionally for recreational purposes, but never borrow money to participate, or you will accelerate your path to bankruptcy with dire consequences.
Another point to remind readers of is to avoid borrowing money to purchase consumer goods. Borrowing to consume is like using future money to create “false wealth.” Unless absolutely necessary, the concept of borrowing for consumption should be avoided. Otherwise, the family’s financial situation will be burdened.
For banks, consumer loans are extremely risky and require high interest rates. Generally, consumer loan interest rates are above 10%. Readers should understand that high-return investments have an amazing compounding effect. Similarly, high-interest loans also have a dramatic compounding effect. Take car loans, for example. Assuming a 20% loan interest rate, after three and a half years, you will have to repay double the amount. This means that if you borrow money to buy a car now, three and a half years later, not only will the original car have depreciated significantly, but you will effectively have to pay for two new cars of the same model. My advice on car loans is: don’t take them. Wait until you can afford to pay in cash. Car loan interest rates are usually very high, often exceeding 15%, although there are occasional promotional periods with lower rates. Fundamentally, except for commercial vehicles, cars are consumer goods with no investment return. From an investment perspective, borrowing for car purchases is highly inadvisable.
Uncontrolled Consumer Lending Easily Leads to Bankruptcy
Credit cards, now a ubiquitous form of plastic currency worldwide, are also a typical example of consumer loans. Since the popularization of credit cards, consumer behavior has undergone significant changes. While credit cards offer great convenience, their widespread use has led to a surge in bankruptcy cases among American families, with outstanding credit card debt exceeding 700 billion USD. Some may wonder: how can credit cards lead to bankruptcy if you only spend what you have? In fact, from a borrowing perspective, credit cards have an irresistible allure.
The greatest temptation of credit card borrowing lies in its simplicity. With just a signature, you can make purchases in advance and even borrow cash from the bank, subtly inflating your spending power. Remember: when using credit cards, never spend more than you can afford to repay each month. Credit card interest rates are often above 20%, so you should always pay off your credit card balance promptly. My advice is: “If you can’t control your spending urges, it’s best not to apply for a credit card. If you apply for one for convenience, never use it for the sake of credit. Use it only when it truly offers convenience.”
While using credit cards for borrowing is convenient, those who entertain this idea should first understand the destructive power of a 20% interest rate. As mentioned earlier, if you save 14,000 per year and invest it in an investment tool with a 20% annual return, after 40 years, the 560,000 invested will grow to 102.81 million due to the power of compounding. Similarly, if someone borrows 14,000 per year on a credit card for 40 years, totaling 560,000, with a 20% interest rate, they will have to repay the bank 102.81 million after 40 years. This explains why the prevalence of credit card debt in the United States has historically led to numerous bankruptcies.
Another common type of loan is a mortgage. Generally, mortgages are a sound form of leveraged investing because, in the long run, the average return on real estate is above 20%, while typical mortgage interest rates are around 10%, which meets the first principle of leveraged investing: the expected return on investment is higher than the interest rate on the loan. Whether it meets the second principle depends on the purchase conditions. In recent years, with the real estate market downturn and oversupply, some pre-sale housing promotions offer “70% financing,” allowing you to own a 10 million house with only a 3 million down payment. This is quite appealing, but investors often overlook the fact that while borrowing 7 million sounds great, they must be able to afford the monthly principal and interest payments of over 70,000. Without considering this, there is a risk of foreclosure and being forced to sell at a low price within months of purchase, suffering losses before enjoying any benefits of leveraged investing. Therefore, when purchasing real estate with borrowed funds, careful calculations must be made beforehand to choose a suitable house price that does not jeopardize the family’s normal living expenses.
Although the initial burden of a mortgage is heavy, it becomes lighter over time as work experience and salary increase. If you wait until you have saved enough money to buy a house, you might miss the opportunity entirely due to the rapid appreciation of house prices. Therefore, young people without real estate should consider buying a house as an investment. It not only forces them to save but also effectively combats inflation. Moreover, they can utilize the principle of financial leverage, using the bank’s money to expand their credit and accumulate wealth.
How Much Debt Should You Take On?
If you decide to use leveraged investing, the next question is: how much debt should you take on? This is a crucial question. Too much debt carries high risks, while too little debt fails to fully utilize the potential of making money with other people’s money.
How much debt should a family take on? Like “how much debt should a company have,” this is a question without a precise answer. In practice, it depends on the specific circumstances of each family. However, one thing is certain: if a family has the capacity to borrow but chooses not to, it is being too conservative and not managing its finances optimally. Conversely, excessive borrowing is too dangerous. Before taking on debt, each family should consider its actual situation and make a wise judgment about its debt level. As for how much to borrow, I recommend considering the following factors:
- Income Stability: Loan interest must be paid on time regardless of investment performance. If your income source is unstable, you may not be able to make regular interest payments, making high-leverage investments unsuitable. Similar to companies with stable income, they have a greater capacity to utilize more debt.
- Personal Assets: Borrowing from financial institutions requires tangible assets as collateral. Therefore, owning more assets suitable as collateral allows for larger leveraged investments.
- Return on Investment: Other things being equal, the higher the return on investment, the greater the benefits of financial leverage.
- Inflation Rate: Borrowing is more advantageous during periods of high inflation, as inflation allows you to repay debt with less valuable money.
- Risk Tolerance: Everyone has a different risk tolerance, related to personality and individual circumstances. Those with low risk tolerance should not over-leverage, even if it could lead to large profits, as the stress could take a toll.
- Market Interest Rate Levels: Generally, when market interest rates fall and bank funds are ample, not only is it easier for investors to borrow money, but the benefits of financial leverage are also greater. Therefore, falling interest rates present an opportune time for investors to consider leveraged investing.
Keeping money in the bank makes a person poor.
The Bank is Not a Place for Saving Money#
What is the function of a bank to you? Many people believe banks are for saving money. However, for those who truly understand investment management, banks are not a place to save money, but a source of borrowing.
The function of a bank is to provide a place for those who are not good at managing money to save, so that those who are good at it can use that money to invest and make profits. Suppose someone deposits 14,000 per year into a bank at a 5% interest rate. After 40 years, the bank will owe this depositor 1.69 million. On the other hand, if an investor borrows 14,000 per year from the same bank at the same 5% interest rate and invests that money in stocks or real estate, achieving an average annual return of 20%, after 40 years, their investment would grow to 102.81 million, while they only need to repay the bank 1.69 million. In other words, the 101.12 million gained was made by utilizing the money of bank depositors.
How to Build Credit
In today’s highly developed financial markets, there are numerous financing channels for businesses. However, for individuals, banks remain the primary source of borrowing. Maintaining a close relationship with the bank and earning their trust is crucial for building personal credit.
Credit is the ability to borrow. A person with high credit not only demonstrates a strong ability to repay loans but also indicates wealth. How do you build credit? As the saying goes, “Loan and repay, and borrowing again is easy.” The first rule of building credit is to borrow money and repay it on time. Some people, to establish their creditworthiness (the ability to borrow), even borrow small sums of money for seemingly frivolous reasons, just to build a good borrowing record so they can borrow larger amounts in the future.
Discard the outdated notion that “borrowing is not respectable.” In the past, only those in dire financial straits would borrow money. Nowadays, such individuals can at most borrow small amounts from relatives and friends. They would likely be unable to borrow a cent from a bank. Today, those who can borrow from banks are typically wealthy individuals.
Based on current bank loan approval standards, without sufficient assets as collateral or evidence of stable future income and repayment ability, can anyone borrow money? Therefore, when I hear about someone heavily in debt, my first question is whether the source of the debt is banks or private loans. If the source is entirely from banks, my immediate thought is: “This person must be wealthy.”
Borrowing: A Double-Edged Sword
Those who don’t borrow cannot go bankrupt; similarly, those who don’t borrow can hardly become immensely wealthy in a short period. “Debt” appears in the lives of both the most successful and the most unsuccessful. While many wealthy individuals utilize debt to become rich, many poor people are ruined by misusing debt. Borrowing is a double-edged sword. Used correctly, it is a significant aid to investment and wealth creation. Used improperly, its destructive power can lead to complete ruin. Prudence is essential when using it. It’s like a double-edged sword that can save or harm, depending on how it’s wielded.
I advise against rushing into leveraged investing before fully understanding its principles. First, understand the nature of leveraged investing and carefully consider whether to use borrowing for investment. Before borrowing, thoroughly understand how leveraged investing works. Only then can you truly achieve the goal of making money with other people’s money without harming yourself.