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

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 |  Includes: MAR, WSM
by: Mark Bern, CFA

Summary

The article begins with a brief overview of the series and links to earlier articles that provide more detailed explanations of how the strategy works.

Why I believe it is time to hedge and why I believe that the U.S. economy will eventually grow more normally again in the future.

Two new candidates are reviewed for consideration of use in the strategy.

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

Back to Part VIII

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.

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.

Today, instead of providing another indication of economic weakness, I would like to send a positive long-term message to readers. I do expect better days ahead. The U.S. is an incubator for discovery, invention and entrepreneurship. So many economist and analysts believe that China will overtake the U.S. as the largest economy in the world; that it is merely inevitable. I disagree with that notion. I have lived long enough to understand that our culture and freedom will overcome temporary setbacks. Many folks believe that the U.S. has entered a period of decline. History has witnessed many great powers rise and fall, it is true. And the U.S. may eventual find itself on the same path someday. But that day is not on the foreseeable horizon, in my humble opinion. I came across a great article that expresses my belief in the American system better than I could state it myself on BloombergView. I have lived through all of the previous periods of supposed American decline only to see our economic and governing systems prevail again and again. This time will be no different. There may come a day when our Constitution, government and economy become so convoluted that our economic miracle begins to crumble. But that time is not yet upon us. We are swinging too far to an extreme for now, but this too shall pass. There are so many incredible innovations coming from American minds over the next few decades that the rate of progress will once again overwhelm the imagination. Take the time to read the article. It is well worth the short time required.

The next candidate comes from the hotel and gaming industry. Many of us travel less during a recession, staying closer to home. And of those who do continue to travel, there is a tendency for some to economize by using less expensive lodgings. Additionally, business travel slacks off as well and those hotels that cater heavily to the business traveler tend to get hit harder at the outset of a recession. Marriott International (NASDAQ:MAR) has some great facilities (I have stayed in many Marriott properties and have always been pleased). Unfortunately, the company's stock finds itself in investor cross hairs for selling when a recession occurs. The stock lost only 48 percent during the 2001 recession falling from $50.51 to $26.25; but the stock got hurt more during the Great Recession, falling from $52.00 to $11.88, a 77 percent drop. One of the major differences that contributed to the a steeper drop was that in the earlier instance the company continued to raise its dividend modestly each year right through the recession, whereas during the latest recession management cut the dividend from $0.34 to $0.09 per share. Currently, the debt to capital ratio is over 100 percent. The dividend now stands at $0.64 per share (and is expected to rise to $0.68 in 2014); twice the pre-recession level. EPS are expected to rise above the pre-recession levels in 2014 for the first time. MAR is using increased debt to buy back shares to boost the share price, though not in a big way. The company tends to hold very little cash, thus it is not well positioned to withstand the next economic downturn. The dividend is susceptible to being cut again, in my humble opinion. I expect the shares could easily fall from the current level of $59.22 down to $24 per share during the next downturn. We can buy January 2015 put options with a strike price of $33 for a premium of $0.10 per share (ask price as of the close on May 13, 2014). The total investment is $10 per contract which represents 100 shares (plus commissions). If the share price is $24 or lower next January the return will be 8900 percent. ($33 - $24 = $9; $9 x 100 shares = $900; $900 - $10 = $890; $890 / $10 = 8900 percent).

So, to protect 12.5 percent of $100,000 portfolio value (assuming a total of eight hedge positions) here is the calculation to determine how many contracts to purchase. To protect a $100,000 portfolio against a drop of 30 percent we need to protect $30,000. So, 12.5 percent of $30,000 equals $3,750; the amount we need to gain from one position in our strategy. The gain per contract is $890 ($9 minus the cost of the $0.100 premium per contract multiplied by 100 shares). This is one of the less expensive contracts so I will round up to five contracts to help keep the costs down. Five contracts will cost a total of $50 (plus commissions) or about .05 of one percent of your portfolio.

The other candidate for this article is Williams-Sonoma (NYSE:WSM), operator of about 580 retail stores, including the five concepts of Williams-Sonoma, Pottery Barn, Pottery Barn Kids, West Elm and Rejuvenation. The company also sells products through eight catalogues and seven e-commerce sites. The stock has been on a tear since the lows of 2009. But history and the results from the recent recession suggest to me that WSM stock will be very susceptible in the next recession too. Everything that WSM sells is nice to do, but can be either delayed into the future or cut from a budget when things get tight. In 1999, the shares rose to $60.31, only to fall 74 percent to $15.50 in 2002. Then, by 2007, the share price had rebounded to $36.96, but fell again, this time by 88 percent all the way down to $4.35 in 2008. This is one of those companies that generally gets hit early in a recession. My target price for WSM in the recession is $20, assuming a 30 percent bear market decline.

I prefer to buy the January 2015 put option with a strike of $33 selling for a premium of $0.15 (ask) for a cost of $15 per contract (plus commissions). The potential gain if WSM shares fall to my target is $1,285 per contract, or 8,567 percent ($33 - $20 = $13; $13 x 100 shares = $1,300; $1,300 - $15 cost = $1,285; $1,285 / $15 = 8,567 percent). We need three contracts to protect $3,855 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 $30 (plus commissions), or .03 of one percent for a $100,000 equity portfolio.

Remember, we are only seeking to avoid a loss by protecting that portion we may lose if the market falls by 30 percent. If stocks fall even further in a prolonged bear market, it is very likely that these (and the other candidate) options will fall below the target which would provide the additional protection needed.

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 the options described in the article on both companies.