By Mark Bern, CPA CFA
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 permanent strategy; rather, it is designed to be used only when a bull market is maturing. One never knows when the end will come, but once a bull market passes the average duration of all bull markets since 1929, I consider it time to protect against the next inevitable bear market. I like to hold onto most of my gains, while continuing to collect rising dividends. I use this method to reduce the negative impact on my principal position. I do not try to time the market. This is strictly a temporary position that I use when a bull becomes long in the tooth. It allows me to maintain much of my capital and continue to build from nearer the top, rather than having to dig out a hole every four to six years. In this article, I will explain the expected benefits of employing the strategy and provide two additional candidates for your consideration.
One of the indicators I watch comes from Warren Buffett. When the total market capitalization of U.S. stocks becomes higher than total Gross National Product, equities are overvalued. On this basis, we should be nearing the top of the current bull market trend. Please see this article that discusses the Buffett indicator in more detail, including a chart that compares where we are today to where the market was in 2000 and 2007. I will provide a few more indications of why I think we are nearing the top again in future articles in this series.
Let us assume that you had a portfolio value of $100,000 in January of 2000 and that you were invested in the S&P 500 Index. At the bottom in 2002, the value of your portfolio may have been down to as little as $51,000. Typically, a buy-and-hold investor would eventually reclaim the original value and watch their portfolio regain the original value of $100,000, especially if they reinvested dividends. This strategy is designed to reduce that temporary setback from $49,000 to something less than $20,000. The difference of saving as much as 30 percent of portfolio principle can add significantly to overall growth over the longer term. We give up a small portion (less than three percent) of the income/appreciation near the top of the bull, but save the majority of our capital from loss. This allows us to build wealth without having to recover huge losses. I will keep the examples relatively simple here and get more specific as we move through the series.
Continuing with the above example, and to keep this simple, I will assume that the investor is using the dividends in retirement and unable to reinvest the earnings. I will also assume that the investor is no longer saving and not adding capital to their portfolio. Now, all we are measuring is the capital appreciation of the portfolio.
You had a $100,000 equity portfolio in January of 2000 at the top and $51,000 in October of 2002 at the bottom. Your portfolio would have increased to $104,000 by July of 2007. Then, it would have fallen once again to roughly $44,000 by early March of 2009.
Today, your portfolio value would stand at about $116,000. Assuming your stocks pay a rising stream of dividends, you would be doing just fine. I would like to suggest a conservative application of the protection strategy introduced in Part I.
Instead of achieving a total value of $100,000 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 as much as 5%) to protect your portfolio, reducing your top valuation in January 2000 to about $95,000. Next, let us also assume that you deployed a hedge to protect only half of the losses sustained in the following bear market, leaving you with a loss of 24.5 percent and a portfolio value of $71,725 at the bottom in 2002. You remove your hedge near the end of 2002 and return to your normal buy-and-hold strategy, investing the gains from the hedge positions and collecting those rising dividends. Your portfolio would grow to about $137,000 by July 2007. We will now be even more conservative this time and assume that you did not deploy your strategy until January 2008 and the market had already dropped by 13 percent. Now your portfolio is only worth $113,000 (even after deducting another five percent for protection again). Let us also assume again that you only protected your portfolio against half of the losses. Thus, at the bottom of the cycle, in March 2009, your portfolio is down to $81,000. 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 $116,000, you would have approximately $190,000 in your portfolio. The difference is staggering, at $74,000! That is about 64 percent more in asset accumulation over a period of less than 15 years. And remember: we assumed only hedging 50 percent of the portfolio and imperfect timing. The timing will always be imperfect. We just need to be relatively close to win.
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. What makes the strategy work is the gain taken and reinvested from the hedge positions. This means that your income from dividends should increase as well.
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 second 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!
- History of stock price falling more than the Index in past bear markets.
- Above-average debt relative to the industry.
- Use of debt to pay dividends and buy back shares.
- Cyclical industry that gets hit hard during recessions.
- Cut dividends to deal with constrained cash flow.
- 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 begin by assessing the industries to determine those that are most likely to be impacted disproportionately more during recessions. I look for industries that rely on discretionary spending that can be postponed or for which substitutes readily exist. Once 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.
It is now time to take a look at the next two candidates that I will use for this strategy. Remember, you should choose a minimum of eight out of the sixteen candidates, and preferably no more than one from any one industry.
The two I want to propose next are both from the financial services industry, so you should only choose one from these two candidates. This industry, as a whole, usually experiences large losses during recessions due to the extreme levels of leverage employed. The first is E-Trade Financial Corporation (NASDAQ:ETFC). The stock is already experiencing some downward pressure, so I wanted to get this one in as early as possible. When stock prices tumble, equity investors tend to get cautious and hold onto their money, which results in lower volumes and less revenue after the initial panic selling. ETFC stock has been very 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. 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 $22.45 per share (11 percent off the recent high). To be fair, ETFC has a banking segment which has required significant write-downs on its mortgage portfolio, and the company had also made large investments in ill-fated mortgage-backed securities. There is still a lot of work to do in this area, and I think that the recent run-up is premature and only partially deserved. Management has made significant improvements to the balance sheet in recent years, but does not have ETFC in a position that warrants the current price, in my opinion. I believe ETFC 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 $15 selling for a premium of $0.49 per share. The cost per contract is $49 (plus commissions). This yields us a potential gain of $751 per contract, or 1,533 percent ($15 - $7 = $8; $8 x 100 shares = $800; $800 - $49 = $751; $751 / $49 = 1,533%). We will need five contracts to protect $3,755 in losses, or approximately 1/8th of a $100,000 equity portfolio.
Assuming a $100,000 equity portfolio and a market loss of 30 percent (or $30,000) to be protected against, eight positions would be needed to provide us with $3,750 in protection each. You can average into your position if you like, and perhaps get some contracts for an even lower premium if the market makes new highs.
Morgan Stanley (NYSE:MS) experienced declines of 93 percent and 74 percent, respectively, during the last two recessions. Granted, MS has been a great investment off the 2009 lows. Congrats to those with the nerve to buy financials at the bottom of the crisis! However, I believe that these shares have the potential to fall back to $12 per share again in the next recession. MS has already dipped to that area twice (2011 and 2012) without an economic contraction, and will likely do so again when a bear market hits.
The biggest problem with many financial institutions is that their respective balance sheets lack any transparency. Nobody knows for sure whether the risk levels have improved significantly or not. It may be assumed that the Fed bought much of the bad MBS to help clean up the books, on the one hand. On the other hand, it was stated by the Fed that only the highest-quality MBS were purchased by the Fed, which implies that some of the worst of it could still be sitting on balance sheets. It is this concern that could lead to another hard dip in the stock price of MS and most other banks. MS also has a significant presence in the brokerage business, which adds to the dilemma, because brokerage businesses tend to slow significantly after the beginning of a recession, causing damage to both the top and bottom lines. I like the January 2015 put option on MS with a strike of $17 and a premium of $0.11. If the share price drops to my target of $12 per share, the potential gain would be $489 per contract, or 4,445 percent ($17 - $12 = $5; $5 x 100 shares = $500; $500 - $11 cost = $489; $489 / $11 = 4,445%).
We will need eight contracts to protect against $3,912, or approximately 1/8th of a $100,000 portfolio. The total cost of this position is $88 (plus commissions). This equates to less than one-tenth of one percent of the portfolio. We are trying to protect against a 30 percent decline in the overall market, and that portion of a $100,000 portfolio is $30,000. One-eighth of $30,000 is $3,750. That is the gain we are trying to achieve in a declining market from each option position. If the market falls more than 30 percent, we will likely end up protecting more than we had planned for. Conversely, if the market falls less than 30 percent, we could end up with less coverage than hoped for, as these distant out-of-the-money options are expected to increase in value faster after the market has declined by about 15 percent. We will not be completely uncovered up to that point, but expect the return to be lower than general market losses in the early stages.
The next article will include a brief tutorial on options for those who are new to this derivative investment class.
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.
Additional disclosure: I own put options as described in the articles on both companies.