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Summary

  • The article begins with a brief overview of the series.
  • Some more reasons why it is time to hedge. Things to think about.
  • Two new candidates are presented for consideration to use in the strategy.
  • The article concludes with a discussion of the risks of employing this strategy versus not being hedged.

The Time To Hedge Is Now! Do It For Less - Part IV

Back to Part V

Bullets:

The article introduction contains a brief overview of the series, links to more detailed explanations and some reasons why I think now is the time to begin the hedging process.

Some more reasons why it is time to hedge. Things to think about.

Two new candidates are presented for consideration to use in the strategy.

The article concludes with a discussion of the risks of employing this strategy versus not being hedged.

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? In Part V, I mentioned the viewpoint of Jeremy Grantham that stocks could fall anytime but that his expectation is for the market to remain trending upward until sometime around the 2016 Presidential Election. My take was that he seems to think that politicians will do something to undermine the markets. I had to think about that more to come to a better appreciation of what he was saying. If I understand his view correctly, it may mean that he expects that the next presidential race will be loaded with fear and accusations from both sides. The Republicans will tell us that we cannot afford four more years of expanding government, higher taxes and more regulations; or something along that order that will probably include something about healthcare as well. The Democrats will tell us that to change course would do irreparable damage and that the "other" party will do bad things to many different demographic groups. Both will somehow try to lead us to the conclusion that the economy is in danger if the other group wins.

I suppose that could happen. It could also happen during the mid-term elections coming up later in 2014. But it is more likely that not enough investors put much faith in the banter from all those lightweights in Congress, so the message may not be strong enough to create the kind of fear that could come during a presidential race.

For my part, I believe that the market will continue to climb the wall or worry until an event pulls the rug out from underneath it. I confess that I do not know where the event will come from but the world is chock full of possibilities. European banks appear to be more leveraged now than U.S. banks were prior to the financial crisis and the quality of assets is only as good as the economies in the southern part of the Eurozone since many of the major banks across all Europe are sitting on huge piles of sovereign bonds that are priced at face value. I am not sure I want to pay face value for Greek sovereign bonds after bondholders were forced to take a 50 percent cut in value in 2011. Tell me that cannot happen again with Greek unemployment over 26 percent overall and over 56 percent for those under the age of 25. But EZ banks carry them at 100 percent and are still buyers because those bonds are counted as riskless assets in the stress tests. The current rating from Moody's on Greek sovereign debt is Caa3. That is a junk bond rating. Junk bonds are not risk free. I do not know when the charade will end, but I have my doubts about a happy ending.

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.

Our first candidate comes from the recreation industry. The rules that apply to travel and discretionary spending also apply cruise lines. Royal Caribbean Cruises (NYSE:RCL) offers some great vacations (I have already booked a cruise for my family on an RCL cruise as a present for our two graduates this spring). During the recession of 2001 RCL did not suffer a decrease in revenue, but EPS fell from $2.31 in 2000 to $1.35 in 2001 due to discounting and competition. From 2007 to 2009 revenue did drop and EPS fell even more, from $2.82 to $0.71. Going on a cruise is definitely a discretionary expenditure and many would be vacationers either stay home or go on a cruise only if the price is deeply discounted. The margins get totally destroyed! Management has been paying down debt and, at 49 percent, the debt-to-capital ratio is manageable. But in 2007 the company was paying a dividend of $0.60 per share per year. The dividend was suspended in the fourth quarter of 2008. The company began paying a dividend again in 2011, and recently raised the quarterly dividend to $0.25 per share. The dividend would be in jeopardy again during an economic slowdown, in my opinion. That, along with the inevitable drop in earnings that would also occur, would likely pummel the stock price again. In 1999 the share price hit a high of $58.55 and then fell to $7.75 in 2001. The shares got as high as $45.17 in 2007 only to fall to $5.40 in 2009. Yahoo Finance calculates the beta on RCL to be 2.3. If the economy slows enough to cause a bear market in stocks, I believe RCL stock could dip below $16. This stock is currently trading at a price of $52.10 a share (as of the market close on Tuesday, May 6, 2014). I like the January 2015 put option with a strike of $30 and a premium of $0.32 per share. The potential gain is $1,368 per contract, or 4,275 percent on an initial cost of $32 per contract (plus commissions).

Buying three contracts would provide protection against a loss of $4,104 in our portfolio. 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 for this hedge position is $96 (plus commissions) which represents approximately 0.96 of one percent of a $100,000 equity portfolio.

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 1.41, 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 $43.63 (as of the close on Tuesday, May 6, 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 $0.20 (asking price). The cost per contract is $20 (plus commissions) which, if KMX stock falls to the target price of $16, has the potential of producing a gain of 4,400 percent ($25 - $16 = $9; $9 x 100 shares = $900; $900 - $20 cost = $880; $880 / $20 = 4,400%). Buying four contracts will provide protection for $3,520 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 $80 (plus commissions) to protect slightly less than the required $3,750. That amounts to only 0.08 of one percent of the portfolio.

In fairness I need to point out that there are several contracts that will work for us on both of these companies. If you do not remember how to do the calculations please go back and review the detailed explanation in Part II. For KMX you could buy January put options with strikes up to $40 and still get decent coverage with about 1,000 percent gain potential. On RCL you can get a slightly higher return from the January put option with a strike at $28. I personally do not think that the extra little potential gain is worth reducing your gain per contract though. You could also go as high as on the strike as $45 and keep the return over the 1,000 percent threshold. But every move up on the strike also increases the cost. If you do decide to move up on the strike the $35 strike in January 2015 provides a potential gain of $1,868 per contract. Buying two contracts at a premium of $0.52 each would give you the right coverage and keep the cost down close to one tenth of one percent of a $100,000 portfolio. I already own some at the $30 strike price and will probably add some more at $35. Everyone needs to find that strike price that feels right.

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 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.

Source: The Time To Hedge Is Now! - Do It For Less - Part VI

Additional disclosure: I own put option contracts on both companies presented in this article.