Protecting Your Equity Portfolio For Less - Part II

Feb. 6.14 | About: United Continental (UAL)

Back to Part I

In the first article of this series I explained the concept of protecting your buy-and-hold equity portfolio using an options strategy that is generally different than most. I should be clear that this is not a strategy that should be employed continuously; rather it is designed to be used only when a bull market is nearing its end. We never know for certain when the end will come, but once a bull market has passed the average duration of all bull markets since 1929, I like to average into my positions to protect against the next inevitable bear market to hold onto what appreciation I have already gained while continuing to collect those rising dividends. I use this method to reduce the negative impact on my principal position. It is not about trying to time the market as some will undoubtedly claim in their comments. This is strictly a temporary position only deployed as the bull is a little long in the tooth which allows me to maintain my capital and continue to build from near the top rather than having to dig out a hole every eight or ten years.

If the equity position of your portfolio had been about $500,000 in January of 2000 and you were invested in the S&P 500 Index, at the low point in 2001 the value of your portfolio would have dropped to approximately $255,000. Yes, the buy-and-hold investors would eventually see their portfolio value increase again to levels above the original $500,000, especially if they reinvested dividends. What we are trying to do with this strategy is to reduce that temporary setback from $230,000 to something less than $100,000. The difference of saving over $100,000 in principle can add significantly to a portfolio's growth over the longer term. We give up some of the income/appreciation near the top of the bull, but save the majority of our capital from loss to continue building our portfolio without having to dig out of those huge holes. I will keep the examples relatively simple here and get more detailed as we move through the series.

To take that example a little further, let us assume you are using the dividends in retirement and unable to reinvest the earnings. Let us also assume that you are no longer saving from other sources and cannot add additional capital to your portfolio to increase your investments. So, now all we are measuring is the capital appreciation of your portfolio. If your portfolio value had been $500,000 in January of 2000 at the top and $255,000 in October of 2002 at the bottom, your portfolio would have climbed its way back up to $520,000 by July of 2007. Then it would have dropped back down to roughly $220,000 by early March of 2009. Today, the value of your portfolio would be back up to about $580,000. Assuming your stocks pay a rising stream of dividends you would be doing just fine.

Now, I would like to suggest a conservative application of this protection strategy. Instead of achieving a total value of $500,000 in 2000, we need to assume that you started getting nervous in April of 1999 and began using a small portion of your capital (maybe 5%) to protect your portfolio reducing your top valuation in January 2000 to about $475,000. Then let us also assume that your hedge only protected you from half of the losses sustained in the following bear market leaving with a loss of 25.5% and a portfolio value of $355,000 at the bottom in July 2001. You remove your hedge a little later in 2001 and return to your normal buy-and-hold strategy, collecting those rising dividends. Your portfolio grows to just over $690,000 by July 2007, even after holding out another 5% of assets to deploy your protection strategy again. But, let us get a little more conservative this time and assume that you did not deploy your strategy until the January 2008 and the market had already dropped by 13%. Now your portfolio is only worth $600,000 (again after removing another 5% to employ the protection strategy). Now we will also assume that you only protected your portfolio against half of the losses again. Thus, at the bottom of the cycle, in March 2009, your portfolio is down to $465,000. Again, you remove your options contracts a little later in 2009 (part of the reason you only achieve a 50% hedge against loss) and go back to your regular buy-and-hold strategy. Today, instead of having about $580,000, you would have approximately $1,200,000 in your portfolio. The difference is staggering at $640,000! That is more than double the asset accumulation over a period of less than 15 years.

You may achieve better results than in the example or you may achieve poorer results than in the example. The point here is not how to get rich; it is merely a strategy to reduce your losses to enable you to keep your portfolio working harder for you. Now, I want us to look at the income side of the equation. In reality, your portfolio of equities will fall by the full amount of the market loss. But the options contracts will increase in value to offset a portion of those losses. Your income remains nearly the same from your original portfolio (minus the 5% each time used in the protection strategy). But, when you unwind your hedge positions you sell the option contracts for a gain. Assuming you simply add more of the shares that you originally owned so the yield does not change, your income would now have increased by about 110% from what it would have been using a straight buy-and-hold strategy.

I hope that explains better the why of considering this strategy. I realize that some investors will never consider using options as part of their investing strategy. I respect that position and hope that those with that mindset can also respect other points of view. We can compare notes again in another ten years. Finally, the last thing I want to do before discussing the first candidate for the strategy is to list the criteria that I use in screening for the candidates. Not all criteria need to be met, with one exception being the first on the list. The more the merrier!

  1. History of high beta activity, falling more than the Index in past bear markets.
  2. Above average debt relative to the industry in which the company competes.
  3. History of using debt to enhance cash flow used to pay dividends and buy back shares.
  4. Operating in an industry that tends to be cyclical that gets hit hard during recessions.
  5. History of cutting dividends during past recessions or when dealing with constrained cash flow.
  6. Falling revenues, profit margins and significant reductions to capital spending or research and development during recessions (impeding future growth prospects).

Although I don't screen in that order, each of those criteria can cause a stock to fall in price especially when they occur in combinations. I start with an assessment of the industries to determine those that will be most likely to be impacted more by an economic contraction. I look for industries that rely more heavily on discretionary spending that can be postponed until better times or for which substitutes readily exist. The first candidate comes from the air transport (airlines) industry. Customer behavior is not sustainable through periods of lower wages or joblessness for this group. People travel less and tend to drive more to vacations closer to home more often when the household budgets get strained. Also, businesses become more restrictive on travel for conferences and meetings during economic downturns as a method of controlling costs. None of this bodes well for major air carriers when a recession hits.

I identify an industry I review the companies and their history of price action relative to the index during recessions; a quick glance at the charts and the current beta tells me all I need to know for screening purposes. That generally narrows the list significantly. I also need to check each candidate to ensure that options are traded and that the options durations are long enough to suit the strategy. Then I look at reasons why the companies' stocks sold off so much relative to competitors; generally the four remaining criteria can explain much of that. Then I analyze the remaining companies to determine which one is the most likely to provide a repeat performance in the next recession; the problems that existed before continue or have become worse. Finally, I look at the available put options to determine which strike price and expiration offers the greatest potential for us.

With that, I would now like to open up the box and reveal my first option protection candidate. During the last recession, certain airlines felt the impact more than their respective competitors in the industry. But the weaker competitors always seem to get hit the most during recessions. There are two companies that meet most of the criteria and would serve us well as protection in the next downturn but one stands out above the other. United Continental Holdings, Inc. (NYSE:UAL) looks to be potentially the weakest of those companies in this industry that are still standing and not in bankruptcy. Delta Air Lines (NYSE:DAL) came in second but has exhibited more resiliency than UAL in my opinion. I fully expect that UAL stock will fall further during the next economic recession and bear market; probably much further.

Let us take a look at some of the measures of the listed criteria. UAL has a beta of 1.4 according to Value Line and .26 according to Yahoo Finance. Either measure is closer to 1.0 (beta of the S&P 500) during the current environment that during a recession. Stock price activity is the big one for me and UAL performance in this area leaves all others in the dust. The stock fell 97% to $0.60 per share in 2002 and continued to slide over the following two years to bottom out around $0.10 a share. The company posted losses for six years from 2001 through 2006. The reaction to the Great Recession was slightly more muted in comparison with the stock falling from $51.60 at the peak in 2007 all the way down to $2.80 in 2008; a 95% drop. But the company only posted losses for two years, 2008 and 2009, before achieving profitability in 2010 again. Did you notice that the company had a profit for only one year (2007) over a stretch of nine years? Airlines are truly a boom or bust investment, appreciating more than the average during recoveries and crashing harder during recessions than the overall market by a long margin.

Now, I want to look at the other criteria: total debt equals 83% of capital as of September 2013. Standard and Poor's rating on UAL debt is B (below investment grade). Revenues dropped significantly in each recession. The company does not pay a dividend. Both operating and net profit margins have fallen since 2011 and, of course, when there is no profit (as in 2008 and 2009) the profit margin turns negative. Additionally, the trailing P/E is above 28. I consider that to be high for this company at this stage of the economic recovery. Overall, I think UAL is an exceptional candidate for the protection strategy.

Next, we look at the available put options. I realize that there are January 2016 options available (which could extend the protection over a longer period), but the prices in the range I want to buy are more than double what we need to pay for the same strike price for January 2015 contracts. If the economy keeps chugging along and the UAL stock price ends up higher that it is today, we should be able to purchase another set of contracts for January 2016 expiration for a price similar to what we would pay today for 2015 contracts. This makes it cheaper to buy the 2015 options and roll into the 2016 options when the time comes, if necessary. Why tie up more money unnecessarily? Looking at it another way; if the market falls significantly in 2014 we would make more from the 2015 expiration puts than 2016 expiration and do so for a lower cost.

My expectation is that UAL stock will once again fall below $10 if the U.S. economy dips back into recession. Remember: the stock dropped much further in the last recession from an even higher level. But, just to stay a little more conservative I decided to use $15 as a reasonable stock price target should we experience another bear market. The results are pretty amazing. Based upon that assumption, the sweet spot in the strike prices for January 2015 put option contracts on UAL is $20 with a price of $0.44 per share ($44 per contract of 100 shares). If the price falls to $15 on a put option with a $20 strike price our contracts would be $5 in the money. Depending upon how long the contract has before expiration we could end up getting all of the $5 or a smaller percentage. Collecting $5 per contract gives us a profit of $456 per contract (minus commissions). If we wanted to buy contracts on eight different stocks for diversification we would need to purchase about 8 contracts to protect against a 30% portfolio loss. The cost would be $440 (plus commissions) to protect 1/8 of a portfolio of $100,000.

Assuming a $100,000 equity portfolio and a market loss of 30% (or $30,000) to be protected against, eight positions would need to provide us with $3,750 in protection each. If you want to protect only half of your portfolio you would buy only four contracts for every $100,000 of value in your portfolio. But remember, I recommend averaging into the full position. So, there are multiple ways to do this: purchase a full position of put options on each stock you select for protection at intervals to save on commissions or buy a portion of all eight (or any subset) of the put options selected at different times. My purchases will be about three to six weeks apart and I plan on doing four purchases.

I had planned on providing a tutorial on options in this article, but since this one is already getting a little long I will start the next article with the tutorial instead so it does not get left out again. I hope that this is beginning to make some sense. The profit potential from each contract on UAL is over 1000% should we encounter another recession or bear market. That potential comes from the leverage available from using options. That is how we protect our portfolio; by offsetting our losses on our long-term hold positions with huge short-term gains on relatively small positions that we can then reinvest. I would be remiss if I did not also point out that we also have the potential to lose 100% of the cost of the option contracts. That is the price of insurance. Insurance is only good when you need it. But if the market crashes and you don't have it…well, that's the way the cookie crumbles. If you do not want to use this sort of protection, you could also consider using a trailing stop loss on each of your positions. Of course, the problem with that method is that you may end up having to pay taxes on all of your gains if the market falls and you may need to rebuild your portfolio from scratch. With this options strategy, we pay taxes (if we invest outside of a tax advantaged account) only on the gains from the options and we still own our original portfolio never giving up the income stream. Then we get into comparing whether the tax liability is greater for the long-term capital gains or the short-term gains as each requires us to pay a different rate. But that is fodder for another article perhaps later in this series.

As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.