Why Fools Don't Buy on Margin

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Back in March, longtime Fool Selena Maranjian told you how margin calls can hurt. Well, her examples are peanuts compared to the pain inflicted upon one of Fooldom's favorite CEOs in the midst of last week's meltdown.

Toward the end of the week, pretty much all E&P companies, from XTO Energy (NYSE: XTO) to Anadarko Petroleum (NYSE: APC), were selling off severely. But one in particular really stood out to me. That was Aubrey McClendon's Chesapeake Energy (NYSE: CHK) -- the largest producer of natural gas in the country.

I casually mentioned to some of my colleagues that Aubrey could be facing margin calls, because it was the only explanation I could come up with for the shares' savage treatment. I'm unhappy to say that I was exactly right.

Warren Buffett is quite well known for having virtually all his wealth tied up in Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B).Aubrey McClendon is another classic example of a CEO putting his money where his mouth is. Over the years, he has been featured in Tim Beyers' "Who's Buying Now?" feature more times than I can count. It turns out that Aubrey was so confident in Chesapeake that he often purchased shares on margin -- meaning that he borrowed from his broker against the value of his billion-dollar holdings.

Those holdings -- and the well-deserved wealth underlying them -- have largely evaporated, as Chesapeake's steady share-price collapse ultimately required Aubrey to sell almost everything in order to meet loan calls. The volume of his selling without question triggered something of a vicious cycle.

Since co-founding the company with SandRidge Energy's (NYSE: SD) Tom Ward in 1989, Aubrey McClendon has built Chesapeake into a marvelous machine. Aubrey knows the natural-gas business better than virtually anyone breathing. Yet he still got mauled by a margin call.

I think the lesson here for small investors is clear, but it’s worth making explicit: No matter how well you think you know a company, and regardless of how cheap it appears to be, buying on margin is a dangerous game.

Related Foolishness:

• This wild buying is looking poorly timed.
• It's time to review Buffett's first rule of investing.
• You might also want to read up on his magic number.