Protecting Your Equity Portfolio For Less - Part VII

Includes: ETFC, KMX, MS
by: Mark Bern, CFA

Back to Part VI

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 a 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.

One industry that always takes a beating during a recession is the auto industry. But since the restructuring and deleveraging that occurred during the last recession, instead of looking at the manufacturing side, we will take a look at the sales side: auto retailing. CarMax (NYSE:KMX) is the largest retail seller in the U.S. of used vehicles with 118 superstores located in 58 metropolitan centers and also the largest wholesaler of used vehicles through its on-site auctions (based on unit volume). I will admit that I expect some readers to not like using this candidate for the strategy because the company has shown tremendous growth since sales and EPS slumped in 2008 and 2009. But this is an industry that requires a lot of debt to carry adequate inventory and that can be a problem at the beginning of a recession. Debt-to-capital was at 68 percent as of the end of the November quarter. Total debt has ballooned from $27 million at the end of 2008 to over $6 billion. Inventory gets expensive when the rate of turnover decreases. During recessions auto sales (both new and used) plummet and so will KMX EPS. It will be temporary; but that is all we need. In 1998, the fledgling company (then a subsidiary of Circuit City) shares hit a high of $13.50, but fell 90 percent by early 2000 to $1.31 per share. KMX and Circuit City separated in 2002. By 2007, the KMX stock had risen to $24.42 per share. Subsequently, during the Great Recession, these shares fell once again; this time to $5.76 (a 79 percent drop).

While I do not expect shares of KMX to fall to the same levels as previously, I do expect that these shares could easily fall much further than the broader market. Yahoo Finance calculates a beta of 1.45, but I think that this is probably low due to the rebound in the auto industry sales since the Great Recession and does not fully represent the downside risk of an auto retailer during a recession. Most people just do not buy cars during a recession. Demand gets pushed into the future. The future is happening now as pent up demand from the Great Recession is being fulfilled. These demand levels will drop dramatically during an economic slowdown as more people put off major purchases (and a car is definitely a major purchase for most people). When layoffs are occurring all around us and being reported in the news daily people just do not buy cars at the current rate. KMX shares currently trade at $47.29 (as of the close on Friday, February 14, 2014). I expect shares could dip to $16 per share in the next recession. Therefore, I suggest looking at the January 2015 put option with a strike price of $25 selling at a premium of $0.25 (asking price). The cost per contract is $25 (plus commissions) which, if KMX stock falls to the target price of $16, has the potential of producing a gain of 3,500 percent ($25 - $16 = $9; $9 x 100 shares = $900; $900 - $25 cost = $875; $875 / $25 = 3,500%). Buying four contracts will provide protection for $3,500 of our portfolio.

Assuming a $100,000 portfolio, if we want to protect ourselves from a potential 30 percent loss of capital, 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 each 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 four contracts. The cost is $140 (plus commissions) to protect slightly less than the required $3,750. That amounts to only 0.14 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 16 contracts (400,000 / 100,000 = 4; 4 x 4 = 16). 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 to hedge against 50 percent of a potential loss. All you do is multiply the 16 contracts calculated above by .5 and you find that you need to buy eight contracts. This tactic can reduce the cost to fit your budget in case you just can't afford to give up any of the income or don't have enough cash available to do more. Some protection can be better than no protection.

Another industry that generally experiences trouble during a bear market is the securities brokerage industry. When investors get nervous as equity portfolios fall in value they tend to accumulate cash and stay on the sidelines. This is bad for business at companies like E-Trade Financial Corporation (NASDAQ:ETFC) and Morgan Stanley (NYSE:MS). Either company would serve our purposes, but ETFC stock has been more consistent in its declines, falling 92 percent from March of 2000 to August of 2002 ($34.25 to $2.81) and 98 percent ($25.79 to $0.59) during the Great Recession period. (MS experienced declines of 93 percent and 74 percent, respectively, during those same periods. If readers would prefer to use MS instead of ETFC just let me know in a comment and I will be happy to suggest a contract expiration and strike that should be effective.) ETFC turned profitable again in 2013 after having suffered heavy losses for several years; the stock more than doubled last year as a result and currently stands at $21.82 per share. In fairness, it should be pointed out that ETFC has a banking segment which required significant write-downs on its mortgage portfolio and the company had also made large investments in ill-fated mortgage-backed securities. But the company still has a lot of work to do and I think that the recent run up is overdone and only partially deserved. Management has made significant improvements to the balance sheet in recent years, but does not have ETFC out of the woods yet, in my opinion. Thus, I believe these shares could easily fall below $7 per share in an economic downturn. To take advantage of this situation, I like the January 2015 put option with a strike price of $12 selling for a premium of $0.22 per share. The cost per contract is $22 (plus commissions). This yields us a potential gain of $478 per contract, or 2,173 percent ($12 - $7 = $5; $5 x 100 shares = $500; $500 - $22 = $478; $478 / $22 = 2,173).

We need eight contracts to protect $3,824 of portfolio value. This amounts to slightly above the $3,750 that represents 12.5 percent of a potential loss of 30 percent on a portfolio of $100,000. The total cost is $176 (plus commissions) or .176 of one percent for a $100,000 equity portfolio.

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.

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.