In the first article of this series I provided an overview of the strategy to protect an equity portfolio from heavy losses from a market crash of 30 percent or more. In Part II I provided more detailed explanation of how the strategy works and gave the first candidate company to use as part of a diversified basket using put option contracts. I also provided an explanation of the selection process and an example of how it can help grow both capital and income over the long term because it conserves capital during downturns without selling your long-held equity positions. In Part III I provided a basic tutorial on options contracts, which I believe is necessary to make sure readers understand the basic mechanics and correct uses, as well as the risks involved when using options.
In this and the remaining articles in this series I will provide a short summary of the strategy, at least two candidate stocks for use in this strategy and an explanation of the risks inherent in using this strategy. So, in future articles, those who are reading the complete series could skip over the summary portion because that will tend to be redundant for them. I am providing the overview primarily for the benefit of readers who are new to this series. However, if you are new to the series and like what you read here, I strongly recommend going back to the beginning to get the full picture when you have finished this article.
First, I want to reiterate that I am not predicting a market crash. I want to make that clear. But bear markets are part of investing in equities and I find that taking some of the pain out of the downside helps make it easier to do the right things: select superior companies that have sustainable advantages, consistently rising dividends and excellent long-term growth prospects; and then hold on to those investments forever unless one of the fundamental reasons we bought them in the first place changes. Investing long term works! I just want to help make it work a little better and be a little less painful. History teaches us that bear markets are inevitable. Those who believe that the market will just continue higher without ever correcting more than 15 percent again are in a state of dreamy denial. That is not to say that a bear market is imminent. No one knows with any great certainty when the next downturn will occur. But the fact is that we are closer to the beginning of a bear market now than we were a year ago.
We are already past the average duration of all bull markets since 1929. Actually, by April of this year, the current bull market will have surpassed in length all but three bull markets during that time period (out of a total of 15). Thus, I have decided that it is time to start preparing for the inevitable next bear market. I intend to employ this hedge strategy in four stages over the next few months which will allow me to average into the full position I intend to build. I do not know when the strategy will pay off, but experience tells me that we are probably within a year or two from needed to be protected. It is not fun to write about down markets, but the fact is: they happen. I don't mind sustaining a setback of five or ten percent or even 15 percent from time to time. But I do try to avoid the majority of the pain from larger market drops. To understand more about the strategy, please refer back to the first three articles of this series. Without that foundation, the rest of the articles in this series won't make as much sense and could sound more like speculating with options. That is absolutely not my intention.
A Short Summary
The strategy is simply based upon the expectation that the weaker companies in those industries which are generally more adversely affected by economic contractions will fall further than the market averages. We use this expectation, along with the power of leverage and limited risk provided by options to construct a hedge position designed to protect as much of a diversified equity portfolio as an investor wishes. I suspect that the strategy is best explained by a hypothetical example. For that, I will use an abbreviated version of the example provided in Part II.
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 2002, 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 smaller the better). 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.
To take that example a little further, let us assume that 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.
If the same investor had used the strategy outlined in this series of articles, but would have only achieved a 50 percent hedge against those huge losses, the outcome would have been drastically different. 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. For a more detailed explanation of how these results are calculated please refer back to Part II.
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 percent from what it would have been using a straight buy-and-hold strategy.
I hope that explains better the why of considering this strategy.
Now we will take a look at the next two candidate companies and why I believe those stocks will be likely to react more adversely than the market averages in another economic downturn.
The first candidate is Goodyear Tire (GT). Whenever a recession hits auto sales fall off and people seem to make those tires last a few thousand miles longer. It never fails to wreak havoc with GT's top and bottom lines. In 1999 GT stock traded as high as $66.75 but fell to a low of $3.35 in February 2003. Similarly, the high in 2008 was $30.10 and the low in 2009 hit $3.17. The percentage decreases were 95 percent and 89 percent, respectively. I like consistency. In 2000, the company paid a dividend of $1.20 per share, but suspended regular dividends in 2001. The company has recently reinstated a quarterly dividend of $0.05 ($0.20 annually) as of December of 2013. Common shares outstanding have increased from one year to the next. Debt is also increasing having risen from $2.2 billion in 2009 to $6.4 billion as of the third quarter of 2013. The aftermarket competition is heated and GT is losing share in some markets while gaining in others. Tire manufacturers in China are competing on price putting pressure on margins in an industry with already thin margins. GT net profit margins were up to about 3 percent in 2013 from 2.3 percent in 2012. There isn't a lot of "margin" for error. When sales drop, margins turn negative in a hurry. I expect GT shares to drop to $8 or less during the next recession from current levels of $26.76 (as of the close on February 14, 2014). I like the January 2015 put option with a strike at $12 and selling for a premium of $0.15. Each contract will cost $15 (plus commissions) and represents the right to sell 100 shares. The potential gain is $385 per contract, or 2,567 percent. This is very inexpensive insurance that would require only $150 for ten contracts to protect against a potential loss of $3,850; slightly more than the $3,750 that would represent 12.5 percent (1/8) of 30 percent loss to a $100,000 portfolio.
Remember, we are only seeking to avoid a loss by protecting that portion we may lose if the market falls by 30 percent. If in a bear market stocks fall even further, it is very likely that these (and the other candidate) options will fall below the target which would provide the additional protection needed. So, the calculation is as follows: to protect a $100,000 equity portfolio from a 30 percent loss, we need to create a hedge that will provide a gain to offset a potential $30,000 loss. We divide the $30,000 into eight nearly equal parts (positions) and use one of the candidate options to provide protection for 12.5 percent of the $30,000, or $3,750. Then we determine the number of contracts it would take to provide a gain of approximately $3,750. In this case we need ten contracts. The cost is $150 (plus commissions) to protect $3,750. That amounts to only 0.15 of one percent of the portfolio.
To adjust the number of contracts to fit your portfolio size, simply divide your portfolio value by 100,000. Then multiply that result by the number of contracts needed for a $100,000 portfolio. If you have a $400,000 portfolio, you will need 40 contracts (400,000 / 100,000 = 4; 4 x 10 = 40). To adjust the number of contracts in order to reduce the percentage of your portfolio that you want to protect, simply multiply the number of contracts needed to protect 100 percent of your portfolio by the percentage of protection you desire. Let us assume that you have a $400,000 portfolio and only want a 50 percent hedge against loss. All you do is multiply the 40 contracts calculated in the previous paragraph by .5 and you find that you need to buy 20 contracts.
The next candidate is from the retail sector and specifically from the soft goods (apparel and accessories) retail industry. L Brands (LB) is one of the largest retailers of apparel, lingerie and personal care products with approximately 3,000 outlets including Victoria's Secret, Bath & Body Works, Pink, La Senza, C.O. Bigelow, White Barn Candle Company and Henri Bendel. When the economy hits a rough patch many consumers tend to spend less on discretionary items and this company is brimming with products that fall directly into that category. From 2000 to 2002 sales fell from $23.63 per share to $16.15 and the share price fell 83 percent from $51.69 to $9.00. The drop in revenue was less severe during the Great Recession, but EPS dropped by 66 percent and the share price fell 79 percent as a result, from $29.05 to $2.41. The debt-to-capital ratio for LB was 121 percent as of November 2013, with total debt growing from $2.7 billion in 2009 to nearly $5 billion. Three uses that management has had for the cash from the added debt: buying back shares, raising the regular dividend and paying large special dividends. Investors love to receive the dividends, but will likely leave the stock when margins and profits begin to fall again. The company's balance sheet is in far worse shape than it was in either of the prior economic downturns, weakening the company's ability to withstand the next one. The return of all that money to shareholders has turned shareholders' equity and book value negative. This is a case of too much of a good thing, in my opinion. I expect that the stock price could drop to $16 or less during the next recession. The current price (as of the close on Friday, February 14, 2014) is $55.03 giving us a lot of potential downside. I like the January 2015 put option with a strike of $30 and selling for a premium of $0.35 per share. The cost per contract is $35 (plus commissions) yielding a potential gain of $1,365 per contract ($30 - $16 = $14; $14 x 100 = $1,400; $1,400 - $35 = $1,365). I would buy three contracts for a total cost of $105 (plus commissions) to provide $4,095 of loss protection for each $100,000 of equity value in my portfolio. That cost equals 0.11 of one percent of the portfolio to protect 12.5 percent of the portfolio against a 30 percent loss.
My feeling is that, due to the uncertainty of how much longer this bull market can be sustained and the potential risk versus the potential reward of hedging versus not hedging, I would prefer to risk a small portion of my capital (perhaps up to five percent) to ensure that I hold on to the rest rather than risking losing a much larger portion of my capital (30 percent or more). But this is a decision that each investor needs to make for themselves. I do not commit more than five percent of my portfolio value to an initial hedge strategy position and have never committed more than ten percent to such a strategy in total. The ten percent rule can come into play when a bull market continues longer than expected. And when the bull rages on longer than it should, the bear that follows is usually deeper than it otherwise would have been. In other words, I would expect a much less violent bear market to occur if it begins in 2014; but if the bull can sustain itself well into 2015, I would expect the results of the next bear market to be more pronounced. If my assessment is correct, protecting a portfolio becomes even more important as the bull market continues.
I also want to stress that this strategy, as with any options strategy, contains risk of loss. Since we are buying put option contracts, the loss is limited to the initial premium cost of the options contracts (plus commissions). However, the beauty of this strategy is that it only requires one of the multiple positions taken to work to cover the entire cost of all the options contracts purchased, including the commissions. If more than one position meets my expectations, we begin to benefit from additional gains, thereby protecting a portion of our portfolio. If there is no recession, then it is very possible that none of the positions will meet our expectations and that we will lose all of the money invested in this strategy. Conversely, since we are trying to choose some of the weakest players in each industry, there is always the possibility that it won't require a recession for one of these companies to stumble. Remember, it only takes one to work in order to cover our costs. That is also why I suggest that to properly employ the strategy we need to initiate at least eight positions in eight different companies' stocks. That also provides a more diversified approach so we don't miss better results because we focused our hedge too narrowly if a recession does hit.
Earlier in the series I mentioned that I would provide only ten candidates from which to choose. But after doing some more research, I feel I can provide at least 16 good candidates. I am doing this because I realize that everyone will not agree with my assessments on every company, so it only makes sense to provide a few more from which to choose. 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.