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 onto 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. A good article by another SA author about a couple of reasons why the market may falter soon can be found here. It is a well-reasoned article, especially in the second half where the author discusses catalysts that could cause a market correction. The author is a portfolio manager which, to me, means that he needs to remain relatively positive in order to support the sales of fund shares. Thus, he predicts a muted correction in the range of 15-20%. The article debunks the idea that we are heading into a repeat of 1929. I suspect, on that point he may be right, but that reality will fall somewhere in between the results of the Great Depression and his prediction.
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.
I wanted to link to the article about the comparison to 1929 because of the author's lucid explanation of the problem that seems to be unfolding in China which relates to my next candidate. Sotheby's (NYSE:BID) is an auction house specializing in art jewelry and collectibles. Dent Research has already recommended selling options on BID (several months ago). I thought they were a bit on the early side, but now I am joining their ranks as a significant development in China begins to unfold. During the last two recessions BID's stock price tumbled 86 percent from $46.59 in 1999 to $6.42 in 2003 and 90 percent from $61.40 in 2007 to $6.05 in 2009. BID stock does well when new wealth is created via a bubble, whether it is in stocks or real estate. When the bubbles burst BID stock bursts, too. That is the Dent Research take. Here is mine: when fear enters the marketplace, no matter from what corner, BID revenues and profits fall because the rich are not willing to place record bids. The smart buyers swoop in to buy what "must" be sold when economies lose steam and income producing assets must be protected at the cost of selling collectibles (which pay no interest or dividends). Currently many of the record prices paid at auctions for collectibles have been paid by the newly rich Chinese who made fortunes in Chinese real estate. The wealth funds are only the tip of the iceberg.
A good measure of real estate value, in my experience, has been to compare the average cost of a home to the average income in a given locale. Three to four times the average household income is a normal reading in most parts of the U.S. In Beijing real estate is selling for 30 times the average household income. In Shanghai the cost is 28 times and it is even worse in the coastal city of Shenzhen at 35 times. Compare that to New York City where real estate costs about nine times the average household income or London at 15 times. We consider NYC and London real estate expensive.
BID's beta, according to Yahoo Finance, is 2.51. Revenue fell 31 percent from 1999 levels and EPS went from $0.56 per share in 1999 (already down from $0.96 in 1998) to a loss of $0.37 per share in 2000. Annual losses continued until 2004. During the Great Recession, revenues fell 48 percent from 2007 to 2009 and EPS dropped from $3.12 to a loss of $0.12. Common shares outstanding have risen slightly and debt is very nearly unchanged since 2009. One thing that sticks out for me is that BID suspended its $0.10 per quarter dividend in 2000, then reinstated a dividend in 2006 raising it to $0.15 per quarter by 2008 and then cut the dividend in 2009 to $0.05 per quarter. Since then BID raised the dividend to $0.08 per quarter in 2012 paying out $0.28 in the fourth quarter and then not paying any dividend in the first two quarters of 2013. It has since reinstated the dividend again at $0.10 as of quarter three of 2013. This tells me that BID management views the dividend as something like a go-to cash management tool. That does not set well with investors. Another recession is likely to cause BID to suspend the dividend again and, combined with the inevitable drop in both the top and bottom line, will cause BID shares to fall quickly. I expect that during the next economic downturn BID shares could easily drop below $16. BID shares are at $46.54 currently (as of the market close on Friday, February 14, 2014). This leads me like to the January 2015 put option with a strike price of $30 with a premium of $0.75. The cost per contract is $75 (plus commissions) and we need three contracts. The premium was well over $1 just a few weeks ago even though the stock price was higher. I do not wish to clutter the article with my suspicions but am quite happy that whatever is happening, while irrational, is giving us a better entry price.
With the cost per contract of $75 (plus commissions), if BID stock falls to the target price of $16, it has the potential of producing a gain of 1,767 percent ($30 - $16 = $14; $14 x 100 shares = $1,400; $1,400 - $75 cost = $1,325; $1,325 / $75 = 1,767%). Buying three contracts will provide protection for $3,975 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 three contracts. The cost is $225 (plus commissions) to protect slightly more than the required $3,750. That amounts to only 0.225 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 12 contracts (400,000 / 100,000 = 4; 4 x 3 = 12). 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 12 contracts calculated above by .5 and you find that you need to buy six 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.
My next candidate company comes to us from the precision instruments industry, where revenues can be pushed into the future by customers when economic growth slows. Veeco Instruments (NASDAQ:VECO) makes LED and solar process equipment as well as data storage process equipment. Demand has been soft for VECO's product lines primarily due to overcapacity issues in China. The company has lost money for five straight quarters and the consensus is for a continuation probably through the third quarter of 2014. The hope for a light at the end of the tunnel has kept investors from leaving en masse so far, but another recession before the company returns to profitability could quell all hope for recovery and demolish the share price.
The share price fell 93 percent from a rationally exuberant level of $122.25 in 2000 down to $9.14 per share in 2002. The stock fell 76 percent from $22.25 in 2007 to $3.22 in 2009. The company does not pay a dividend and debt is minimal. But this is an extremely volatile stock when encountering a recession. Equipment orders can be delayed until demand catches up to capacity. Capacity is already an issue for VECO customers and the addition of a slowdown in global economic growth could push these shares off the edge. My target price for VECO shares in the next recession is $12. The current price on VECO shares is $39.83 (as of the market close on Friday, February 14, 2014).
To take advantage of this situation I like the VECO January 2015 put option with a strike price of $20 selling for a premium of $0.55 for a cost of $55 per contract (plus commissions). The potential gain if VECO shares fall to my target is $745 per contract, or 1,355 percent ($20 - $12 = $8; $8 x 100 shares = $800; $800 - $55 = $745; $745 / $55 = 1,355).
We need five contracts to protect $3,725 of portfolio value. This amount is slightly below 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 $275 (plus commissions) or .275 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 onto 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.