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.
The first of our two new candidates comes from electronics manufacturing. This is a very competitive space that tends to produce very narrow margins. When consumer demand decreases, retail and distributor inventories pile up causing orders to be cancelled and demand for manufacturing turns lower until the inventories get worked down to meet current demand levels. With huge fixed costs these companies tend to experience significant drops in profitability during a recession. Jabil Circuit (JBL) offers turnkey manufacturing systems serving the computer and peripherals, communications and automotive industries. A downturn in any one of these customer segments can be very damaging to JBL's bottom line. In 2000 JBL stock reached $68.00 only to fall to $11.13 by 2002 for an 84 percent drop. During the more recent recession JBL shares fell 88 percent from $25.27 in 2007 to $3.10 in 2009. Debt-to-capital is reasonable at 27 percent but it is a bit concerning that total debt has risen more than 60 percent since 2009. JBL EPS fell from $0.94 in 2008 to $0.40 in 2009 while the margin dropped from 1.5 percent to 0.8 percent during the same period. JBL's share price has already fallen by nearly 30 percent in the last few months and now stands at $18.63 (all quotes between 2 p.m. and 3:30 p.m. on Wednesday, February 19, 2014). In the first quarter of fiscal 2014 (ended November 30) revenue was down one percent while net profit fell by 19 percent. I expect the bottom line to continue to be depressed for the remainder of 2014 due primarily to deteriorating demand in two of the company's primary sectors. The net margin could get nearly as low as it was in 2009. We may not need a recession, just a continuation of slowing demand, to make this position work for us. JBL shares could easily drop to $7 per share. I plan to buy the January 2015 put option contract with a strike price of $13 selling for a premium of $0.60.
With the cost per contract of $60 (plus commissions), if JBL stock falls to the target price of $7, it has the potential of producing a gain of 900 percent ($13 - $7 = $6; $6 x 100 shares = $600; $600 - $60 cost = $540; $540 / $60 = 900%). Buying seven contracts will provide protection for $3,780 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 chosen (eight out of 16) 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 seven contracts. The cost is $420 (plus commissions) to protect slightly more than the required $3,750. That amounts to only 0.42 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 28 contracts (400,000 / 100,000 = 4; 4 x 7 = 28). 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 28 contracts calculated above by .5 and you find that you need to buy either 14 contracts (your decision). 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 other candidate is Tempur Sealy (TPX) created by the recent acquisition of Sealy by the former Tempur World, Inc. The company produces and distributes mattresses and pillows; sales are predominantly domestic (69 percent of total). TPX has two potential factors that could spell trouble. The first is that household formations have slowed in the U.S. even though the real estate market has been recovering. It is important to note that all-cash purchases of homes accounted for 42 percent of all home sales according to a December article from Market Watch. I have read other articles placing the percentage even higher. What this means is that a significant number of home sales have been to large commercial investors such as The Blackstone Group (BX) and others. Here is an interesting article from Bloomberg with some numbers to consider. The point is that when home prices appreciate too much this source of demand will dry up and home sales (and prices) could fall again, further hampering household formations due to the fear factor. Why buy a home and make the biggest investment of a lifetime (for most people) into a falling market? The sluggish job market is not helping as more people remain single longer and choose to live with parents or friends. Increased household formations usually help TPX product sales; a slower trend hurts. The other potential problem facing TPX is that the company is highly leveraged (debt-to-capital is 67 percent) and a large portion of that debt is floating rate. This means that as interest rates increase so will interest expenses. I do not expect a spike in interest rates (which would be a major problem for TPX) for several years, but I do expect rates to rise modestly over the next year or more. Slack demand, high leverage and rising interest costs do not make for a strong position from which to enter a recession.
TPX was privately held prior to December 2003 so price history is not available for the earlier recession. In 2007 TPX stock hit $37.87 per share and then dropped by 90 percent to $3.84 in 2009. But even without a recession, but rather just a mere threat of slowdown in the economy took the price from a high of $87.43 in April of 2012 down to $20.70 in June of the same year for a 76 percent drop. I hope that adequately demonstrates how volatile this stock can be with a beta of 2.2 according to Yahoo Finance. The current price is back up to $48.96 and I believe that the share price could easily fall to $12 if a real recession were to occur.
To take advantage of this situation I like the TPX January 2015 put option with a strike price of $20 selling for a premium of $0.40 for a cost of $40 per contract (plus commissions). The potential gain if TPX shares fall to my target is $760 per contract, or 1,900 percent ($20 - $12 = $8; $8 x 100 shares = $800; $800 - $40 cost = $760; $760 / $40 = 1,900). Alternatively, if you can get the TPX January 2015 put option with a strike of $25 for $0.60 (last trade) the potential gain is over 2,000 percent. It is worth a try and gives us more potential protection earlier if we can get it (current ask price is $0.80 dropping the potential return to 1,525 percent).
We need five contracts to protect $3,800 of portfolio value. This amount is 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 $200 (plus commissions) or .20 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.