By Mark Bern, CPA CFA
In the first article of this series I provided an overview of a strategy to protect an equity portfolio from heavy losses in a market crash. In Part II I provided more explanation of how the strategy works and gave the first two candidate companies to choose from as part of a diversified basket using put option contracts. I also provided an explanation of the candidate selection process and an example of how it can help grow both capital and income over the long term. In Part III I provided a basic tutorial on options.
In this article I will provide an explanation why I do not use ETFs or the respective put options. I will also provide two more candidate stocks to consider for use in this strategy.
I want to make it very clear that I am not predicting a market crash. Bear markets are a part of investing in equities, plain and simple. I like to take some of the pain out of the downside to make it easier to stick to my investing plan: select superior companies that have sustainable advantages, consistently rising dividends and excellent long-term growth prospects. Then I like to hold onto to those investments unless the fundamental reasons for which I bought them in the first place changes. Investing long term works! I just want to reduce the occasional pain inflicted by bear markets.
What could cause the next recession? There are those who believe that stocks, in general, are overvalued by as much as 50 percent. Take a look at this short article indicating a prediction by Jeremy Grantham, asset manager at GMO. He seems to think that the market could go higher until about the time of the next Presidential election in 2016. That would indicate that politics are involved. I am sorry, but I do not believe that our Federal government can control the economy that well. I know that our leaders believe they can, but I do not have that much faith. Thus, I think 2016 is a stretch. But, then again, Mr. Grantham is a very smart guy.
We are already past the average duration of all bull markets since 1929. The current bull market has now surpassed in length all but three bull markets during that time period (out of a total of 15). So, I am preparing for the inevitable next bear market. I do not know when the strategy will pay off, but experience tells me that we are probably within 18 months of when we will need to be protected. I do not enjoy writing about down markets, but the fact is: they happen. I don't mind being down by as much as 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 and second articles of this series. Without that foundation, the rest of the articles in this series may not make sense and could sound more like speculating with options.
I will start by addressing my decision to not use ETFs as candidates since this question came up in the comments section several times in different articles. I took a look at many of the ETFs that represent cyclical industries. Most of those ETFs have not been in existence long enough to adequately analyze the degree of protection that could be expected during a recession. Many ETFs were created since the Great Recession. Very few of those that remain have options available with long enough duration to fit my strategy. As for the index ETFs, I do not use them for this strategy because, while such ETFs do provide a relatively good match for a diversified portfolio, the indexes represented by these ETFs include all of the best companies as well as the average and worst companies. That means that our potential downside is diluted by all the great companies that will tend to fall less than the weaker companies. This translates into higher premiums for less coverage in the case of a major downturn in stocks. When I hedge my portfolio, I like to do so without committing too much of my capital to the hedge. Using index ETFs does not meet my criteria. It is more expensive to create a similar level of protection in case of a crash. Remember, I do not know when or even if equities will tumble within the next year. That means the cost of the hedge may be totally lost if the market churns higher right on through January of 2015. Therefore, I want to minimize the expense of placing the hedge while maximizing the protection of loss to my portfolio.
I will lead off with a company that produces equipment used in construction and mining, Terex (NYSE:TEX). A bear market generally occurs because of a slowdown in economic activity. When economic activity slows down new construction projects get put on hold and demand for products from TEX usually slows down even more dramatically. The debt-to-capital ratio is not excessive for the industry but debt has risen since 2008. At the same time, shares outstanding have also increased. When the Great Recession began in 2008, TEX posted EPS of $5.33; by 2009 EPS had turned negative in a big way falling to a loss of $4.22 per share. The share price dropped from $35.50 in 1999 to a low of $9.84 in 2002 and from $88.74 in 2007 to $7.34 in 2009. According to Yahoo Finance the beta on TEX shares is 4.39. TEX derives 32 percent of sales from the U.S. market and 33 percent from Europe. A recession in the U.S. would likely spill over into an even weaker Europe. Earnings, sales and margins all remain significantly below 2008 levels. I expect the share price to fall as low as $12 during the next recession or bear market. I like the January 2015 put option with a strike price of $20 selling for a premium of $0.25 per share ($25 per contract representing the right to sell 100 shares). That works out to a potential gain of $775 per contract and 3100 percent ($20 - $12 = $8; $8 x 100 = $800; $800 - $25 = $775; $775 / $25 = 3100%). The purchase of five contracts would allow us to protect $3,875 at a cost of $125 (plus commissions).
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 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 five contracts. The cost is $125 (plus commissions) to protect slightly more than the required $3,750. That amounts to only 0.125 of one percent of the portfolio.
My second candidate is USG Corporation (NYSE:USG) which manufactures and distributes construction materials worldwide. I expect a slowdown in housing in the U.S. and in several markets around the globe possibly by late 2014. China has a glut of empty housing units in third and fourth tier cities and prices are actually falling in 42 percent of those markets according to Nomura Holdings in this article from WSJ.com. And then there is the 10th Annual Demographia International Housing Affordability Survey: 2014 which shows potential problems in Australia and New Zealand as well. For additional deliberations on the subject of the U.S. housing market you might consider my recent article, "U.S. Real Estate - Are We Out Of The Woods Yet."
The point here is that in a recession housing sales are likely to slow considerably and when that happens USG does very poorly. During the 2000-2002 recession, USG shares fell from $60.75 to $2.80 for a decline of 95 percent. The Great Recession hit USG shares nearly as badly as the price dropped by 92 percent from $52.21 to $4.16. Debt is 77 percent of capital at USG and increased by 36 percent since 2008. The company finally posted a profit in 2013 after recording five consecutive years of losses. The beta is 2.78 according to Yahoo! Finance and the recent share price is $30.86, off a bit from the 52-week high of $36.22. In a recession I believe we could easily see USG shares fall to $12. That leads me to the January 2015 put option contract with a strike of $18 and a premium of $0.45. The cost per contract is $18 (plus commissions) and, if the target price of $12 is achieved, would produce gains of about 1,233 percent ($18 - $12 = $6; $6 x 100 = $600; $600 - $45 = $555; $555 / $45 = 1,233). We need seven contracts to provide approximately $3,885 of downside protection against a 30 percent bear market.
I want to discuss risk for a moment now. Obviously, if the market continues higher beyond January 2015 all of our option contracts could expire worthless. I have never found insurance offered for free. We could lose all of our initial premiums paid plus commissions. If I expected that to happen I would not be using the strategy myself. But it is one of the potential outcomes and readers should be aware of it. And if that happens, I will initiate another round of put options for expiration in January 2016, using from three to five percent of my portfolio to hedge for another year. The longer the bull maintains control of the market the more the insurance will cost me. But I will not be worrying about the next crash. Peace of mind has a cost. I just like to keep it as low as possible.
Because of the uncertainty in terms of how much longer this bull market can be sustained and the potential risk versus reward potential of hedging versus not hedging, it is my preference to risk a small percentage of my principal (perhaps as much as three percent) to insure against losing a much larger portion of my capital (30 percent). 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 may come into play when a bull market continues much longer than expected (like three years instead of 18 months). And when the bull continues for longer than is supported by the fundamentals, the bear that follows is usually deeper than it otherwise would have been. In other words, I expect a much less powerful bear market if one begins in 2014; but if the bull can sustain itself well into 2015, I would expect the next bear market to be more like the last two. If I am right, protecting a portfolio becomes ever more important as the bull market continues.
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 on both of the companies discussed in the article.