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Nearly every day there are market analysts suggesting an impending crash. An equal number seem to think the market will go up forever. Each side cites various forms of evidence to make their points, but the truth is, nobody really knows what will happen. Investors need to be prepared for either outcome. Ideally, we can use a portfolio strategy that provides protection against downside while maintaining upside in the event of a bull market. The portfolio we will present below does just that.

First, let us explore some of the most prevalent strategies portfolio managers have suggested for dealing with an uncertain market. We will detail why each of the methods presented below fails to simultaneously protect potential gains and reduce potential losses. I believe, however, that the portfolio presented herein succeeds in doing both.

Puts/calls

A common way to hedge long positions is to buy puts of the same securities; when the market price declines, the money lost in the long position is somewhat recovered by the put which is now in-the-money. Calls can be used similarly to cover short positions. These options have a limited duration, so investors have to keep repurchasing. If the market remains stable for a significant period of time, the investor will be out a lot of money.

I find this method to be counterproductive, as using puts/calls reduces both the potential gains and losses. If an investor is confident in a position, such a reduction is not desirable, and if an investor is not confident in a position, he/she should not be in that position.

Shorts To Balance Long

Shorting a stock in the same sector as a long position eliminates sector risk. The investor no longer needs to be concerned with the sector's or the overall market's performance. Instead, it is all about the specific long securities outperforming the counter-positioned shorts.

This method has a very nice function when an investor has insight as to which company will succeed, but it fails as an overall portfolio strategy for reducing losses, as It too inhibits the upside.

Uninvested

Some go so far as to suggest being completely uninvested. Cash is not susceptible to market crashes.

Clearly, an all-cash portfolio eliminates downside, but it also eliminates upside, leaving inflation to eat away at your assets, particularly with today's dangerously low interest rates on money market accounts and treasuries.

Every one of these methods works, but you have to pay for it. Use of any of these is essentially trading upside for downside protection. There is no net gain in average expected returns. As a solution, other portfolio managers have suggested methods that preserve the upside.

ETFs

ETFs retain all the upside potential of individual securities, and in many years, have actually outperformed hedge funds. The problem here, lies in the failure to reduce potential losses.

(click to enlarge)

The S&P 500 ETF (SPY) crashed with everything else during the great recession. ETFs are thought to mitigate risk through diversification, but it should be made clear that it only changes the risk profile and does not reduce the magnitude of average expected downside. Allow me to elaborate on this point.

SPY holds 500 equities of various weighting (approximately by market cap.). The argument holds true regardless of how the positions are weighted, but let us assume for simplicity, an equal weighing. When comparing the ETF to a single security in the S&P 500, we can see that a single company crashing has different effects on each.

SPY is guaranteed to be affected by the crashing company, but (once again assuming equal weighing), the magnitude of effect is 1/500 as large. A single equity (assuming random selection) has a 1 in 500 chance of being the company that crashed, but if it is, it will experience the full magnitude of downside. Thus, the risk profile for the ETF is {100% chance at 1/500 magnitude} while the risk profile for the single security is {0.002% chance at 500/500 magnitude}. The overall mean expected downside is identical. The only difference is the risk profile, which can be summed up in two phrases. When comparing an ETF to a stock in it with regard to a single event: The ETF has an increased chance of downside but a reduced magnitude.

Many investors prefer the different risk profile, but ETFs still fail to reduce the overall downside. Thus, the search for a viable method continues. Another popular approach to an uncertain market is to invest in precious metals

Precious Metals

Whether it be hard assets or stocks and regardless of the underlying precious metal, the argument presented below holds true. For our example, we will use one of the most popular precious metal investments; SPDR Gold Trust ETF (GLD).

While it is not traditionally considered a fiat currency, gold has little intrinsic value. Instead, its value is determined by what society, or in more modern times, the market, is willing to pay for it. Therefore, an investment in gold is subject to the emotions of the market just like any other security. There is no reason to believe that gold has a reduced downside. It simply has a different risk profile as a separate set of indicators and emotions can cause it to crash. In the chart below, we can see that GLD has dropped significantly in 2013, while the rest of the market is up materially.

(click to enlarge)

Gold preserves upside, but it too fails at reducing average expected downside.

Unfortunately, these methods do not actually protect against downside, they merely shift the factors which would trigger the losses. Properly using these methodologies would require an investor to predict the cause of the next correction which, in my opinion, is implausible. Few if any saw the financial crisis coming, and many predicted the fiscal cliff or sequestration would be doomsday. Attempting to predict the market is a loser's game. I find all the portfolio strategies discussed thus far to be unsatisfactory, as each of them either sacrifices upside or fails to reduce downside.

There is a better way

Do not waste effort trying to predict the market. Do not waste money protecting your portfolio from what could happen. There is a way to gain downside protection without paying for it and without trying to predict the future: a portfolio of independently strong equities with aspects that greatly reduce downside. Below, we will describe the types of adversity that should concern investors, and how this portfolio reduces the risk.

Protecting against downside can be a very tricky business as it can come from a variety of angles.

  1. Economic Downturn: This is where the actual functioning of the economy is the source of adversity.
  2. Market Crisis: A market crisis is where market prices tank. It may or may not be consequent to an actual economic downturn
  3. Specific Industry Crisis: A deleterious event for a single industry

I will admit that I have no clue as to when, or even if, a crash will occur. Nor can I even begin to speculate as to the source of it. With that in mind, the portfolio presented below is designed to outperform regardless of market behavior. These are generally strong stocks with superior earnings potential, and they just so happen to have fundamental aspects which ward off some unforeseen dangers.

The portfolio

Company (ticker)

Basic description of company

Which risks it mitigates

Ashford Hospitality Trust (AHT)

A highly levered upscale and upper-upscale hotel REIT

Market risk

American Realty Capital Properties (ARCP)

Long duration triple net lease REIT

Economic risk

CorEnergy Infrastructure (CORR)

Energy Infrastructure REIT primarily involved in natural gas

Economic & market risk

Omega Healthcare (OHI)

A healthcare REIT owning skilled nursing facilities

Economic & market risk

Weyerhauser (WY)

An international lumber REIT

Economic risk

Yum Brands Inc. (YUM)

An international fast-food franchise

Economic risk

Various Preferred securities

n/a

Market risk

Each of these securities mitigates a certain type of risk, but that means nothing without reasoning. Read the sections below to see specifically how these securities provide protection.

Ashford Hospitality (AHT)

At a price to FFO of only 7.01, Ashford Hospitality is undervalued. Its earnings are even more appealing once we consider the bright outlook of the hotel industry. The growth potential is clear, but how can I list this heavily levered and cyclical company as mitigating unforeseen risks? Well, despite a market cap of only $812mm, it holds over $185mm in cash. While such holdings will allow it to survive an economic downturn despite the cyclicality of its industry, the true benefit comes in the event of adverse market pricing.

During the great recession, AHT bought back nearly half of its outstanding common stock at a fraction of its NAV. This was directly accretive to shareholders and multiplied its FFO/share coming out of the recession. In a recent conference call, Monty Bennett expressed the readiness to do the same again. With a mountain of cash, unprecedented in its industry, AHT is uniquely positioned to slingshot out of a market crash.

American Realty Capital Properties (ARCP)

For ARCP the strong upside and downside protection come in the same package. It has long triple net contracts with investment grade tenants. These contracts contain annual rent increases, so its earnings will naturally improve over time, but it also secures revenue for a potential economic downturn. As the contracts extend over 11 years on average, the tenants are legally obligated to pay, even if their stores are failing. Of course, this raises concerns of delinquency or bankruptcy, which are very real threats. However, with 75% investment grade tenants, ARCP would fare better than most.

CorEnergy Infrastructure (CORR)

This tiny infrastructure REIT's primary asset is a liquid gathering system. It is operated by Ultra Petroleum (UPL) which pays contractual rent to CORR in exchange for its use. This asset alone produces strong earnings relative to CORR's price and will be an integral part of its stability going forward. This liquid gathering system is capable of producing 45,000 barrels of natural gas per day. While natural gas prices do fluctuate, the visceral utility of natural resources protects an undeniable intrinsic value. Regardless of what happens to the economy or the market, UPL is incentivized to hang on to this expansive gathering system.

CORR's market price is volatile, but investors need not worry. The cashflows from Ultra Petroleum will support its greater than 7% yield so investors can just collect dividends while waiting for price normalization.

Omega Healthcare (OHI)

Omega Healthcare owns primarily skilled nursing facilities, which it leases to healthcare operators on a triple net basis. In recent years healthcare REITs have enjoyed a robust pipeline of sale-leaseback acquisitions at impressive (8%-12%) cap-rates. Despite strong gains in market price, OHI still trades at an FFO multiple of only 11.8. Much like ARCP, Omega's contracts have fairly long durations and built in rent increases. Consequently, it also has strong upside and reduced downside based on contractually obligated earnings. OHI, however, does not rely on the credit worthiness of its tenants to prevent delinquency, but rather the nature of the industry.

No matter what happens to the economy or the market, people will always age and get sick. Healthcare is one of few industries with guaranteed demand support that relies only on human physiology. Medicare and Medicaid were among few government programs to be unharmed (so far) by sequestration, so the funding of skilled nursing facilities seems secure as well.

Weyerhauser (WY)

A number of positive earnings catalysts are in play for timber REITs. Demand for wood products both domestically and internationally is strong and growing. This is further bolstered by the domestic housing recovery with significant growth in housing starts. Weyerhauser is positioned to double dip. Not only does the housing recovery increase demand for lumber, but WY directly benefits through is homebuilding arm. Its upside is clear and so is its mitigated downside.

Much Like CorEnergy, Weyerhauser's products have intrinsic value. While wood products are susceptible to market prices, timber REITs have learned to defer harvest for opportune rates. Additionally, Weyerhauser's international sales presence mitigates losses from a local disruption.

Yum Brands (YUM)

YUM is the parent company of various fast-food franchises, most notably KFC, Pizza Hut and Taco Bell. It has tremendous growth potential from its company owned store expansion in China and India. Many of these stores return their initial cost within 3 years of operation. One need look no further than a 10 year 13% CAGR to know YUM has upside.

I feel it also protects from economic turmoil due to the countercyclical nature of domestic fast-food sales. Unfortunately, I cannot say the same of its Chinese branch, as it is considered a fairly expensive product over there.

Various Preferred Securities:

A set liquidation preference along with seniority in the capital structure ensures a constant value, regardless of the market price. Simply collect the dividends while waiting for the market to normalize. Upside is a little bit harder to find with preferreds, as nearly all of them already trade near or above par, but many provide 8%+ yield which in itself is a decent return.

The portfolio as a whole:

While none of the individual securities are safe from a specific industry crisis, each is in a different industry. Thus the protection from an industry-specific source of adversity comes from diversification. It should be noted that investing in a portfolio like the one above does not eliminate downside, it simply reduces it. A reduced downside without sacrificing any upside is a rare and powerful thing. The suggested portfolio is only one of many ways to prepare for an uncertain market. Give it some thought and perhaps come up with your own allocation to the same end.

Disclaimer: 2nd Market Capital and its affiliated accounts are long AHT, ARCP, CORR, OHI, YUM, and WY. This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer.

Source: Designing A 2013 Portfolio For An Uncertain Market