Mohsin Bashir, CFA is a Research Analyst and Chief Compliance Officer at Highwater Capital Management
Managing risk using options doesn’t have to be a hard endeavour. In this interview, you’ll learn how one hedge fund analyst uses options to lower his average purchase price of a stock and boost the exit price, while collecting an income as a hedge. Furthermore, being an expert in preferred shares, you’ll also learn some of the metrics and ways he uses to assess the value of a preferred share as he outlines a past trade in George Weston Preferreds Series I. And if all that isint enough for 1 interview, you’ll also be left with the analyst’s highest conviction investment idea. So take a few minutes and relax, a bounty of knowledge and wonderment lies ahead.
Biography: Mohsin Bashir is a Research Analyst and Chief Compliance Officer at Highwater Capital Management. Previously at TD Securities, Mohsin worked as Senior Analyst covering preferred shares, convertible debentures, fixed income and structured products. Mohsin has also held positions at Sentry Select Capital and RBC Royal Bank and is a CFA charterholder.
This interview was conducted on October 29, 2010.
Q: Mr. Bashir can you talk a little bit about your macro view of the markets currently from an earnings, valuation, interest rate and investor sentiment standpoint? Given this view how do you at Highwater Capital capture market upside while remaining defensive?
A: Currently there exists a disconnect between investors regarding the risk-on and risk-off trade. This is demonstrated by the peculiar ways capital is flowing with rising stocks, oil and agricultural commodities all the while we are also seeing extraordinary gains in bonds and gold – characteristically investments synonymous with the phrase ‘duck and cover’. Unfortunately, treasuries are posting records low yields, so you may as well eliminate the term ‘cover’ from the above phrase. With modest gains in equity markets still awash in uncertainty due to sovereign deleveraging, high unemployment and housing oversupply, investors are likely asking themselves – where to go next? While the month of September was an anomaly for the S&P 500 Index returning 8.8% (the best September in over 70 years), a relative comparison of spreads between S&P 500 earnings yields and investment grade corporate bonds suggests that equities are still cheap. Looking back at the past 25 years, there have been only two occasions when corporate earnings yields have surpassed corporate bonds yields. The first time was in late 2008, and the second is now! Even the Oracle of Omaha, Warren Buffett, has gone on record stating that it’s ‘quite clear’ that equities are cheaper than bonds and “those who are buying bonds at record low yields are making a mistake”. I would have to agree but would also add that at times when markets have had a brief rally but the macro issues haven’t subsided, it does not hurt to consider protecting a portion of one’s portfolio by buying insurance when it is cheap to do so. This can be done in the form of buying put options either on an index or on the individual stocks held in your portfolio. At Highwater Capital Management, we tend to add to our index put options when the Volatility Index (VIX) is below its historical average and ladder the expiry of options out 6-12 months into the future. Remember, just like buying insurance, you don’t look forward to facing the negative outcome, but you are glad that if such an unlikely outcome occurs, you are protected to some degree. That said, my view can be summed up in two words: cautious optimism.
Q: What are your thoughts on derivatives and their benefits/disadvantages? Why do you think they’re perceived so negatively by most investors and do you think that characterization is fair?
A: Despite popular belief, derivatives are not synonymous with unbridled risk. Much of the negative spin ‘put’ on them (no pun intended) is due to the media and our human nature of fearing that which we do not understand. By definition, the term ‘derivative’ means an asset that derives its value from another asset. There are an infinite number of investment vehicles that can derive their value from some underlying asset, and perhaps the depth and breadth of that universe can be intimidating. Some derivatives provide leveraged exposure to an asset, and if you are on the wrong side of a levered trade, you can get burned. Such was case for many market participants during the market downturn of 2008 and consequently derivatives are now a dirty word, maybe even dirtier than the term ‘hedge fund’. Derivatives were not the sole cause for the global credit crisis. Derivatives are not evil. They are simply tools that (when appropriately used by qualified personnel) can help mitigate risk and generate greater risk-adjusted returns. Put another way, a scalpel in the hands of a qualified doctor can help save lives, while the same tool in the wrong hands can end a life.
To take it a step further and clarify the myth about hedge funds , let’s take a minute to review the history of hedge funds. One name that you would certainly come across would be a man named Alfred Jones, an Australian-born Harvard graduate and sociology PhD. While writing about investment trends for Fortune magazine in 1948, he was inspired to try managing money raising $100,000 with 40% coming from his own pocket. To reduce his long-term stock positions, he would short-sell other stocks and employ leverage in an effort to enhance returns. Jones used these tactics not to push himself further out on the risk curve, but rather the opposite. The theory was to reduce broad market risk and enhance risk-adjusted returns. Jones’s investors lost money in only 3 of his 34 years managing assets. During the same period, the S&P 500 had 9 down years. At Highwater Capital Management we utilize derivatives in order to fine tune our positions and reduce risk.
Q: Writing covered calls are appropriate for investors who …?
A: Covered call options are suited for investors who:
- Are neutral or moderately bullish on some of the equities in their portfolio.
- Are willing to limit upside potential in exchange for some downside protection.
- Would like to be paid for assuming the obligation of selling a particular stock at a specified price.
Q: Writing put options are appropriate for investors who …?
A: Writing put options are well suited for investors who:
- Are looking for added income.
- Are comfortable with owning the underlying stock should the option get exercised by the buyer of the put.
Q: Can you provide an example of how and when you came to use this covered call and put writing strategy in your fund?
A: One of the more recent examples illustrating our usage of put options and covered calls would be our holdings in IBM (IBM). This strategy works particularly well when a stock trades within a wide range. Our process first involves completing the fundamental work on a company and identifying those that are trading at a reasonable discount to our intrinsic targets. We then build a strategy to maximize the income and fine tune our entry and exit points. We decided to go long in IBM based on its attractive fundamental valuation, management expertise and proven shareholder-friendly behaviour. Using a combination of selling put options and buying in the open market, we were able to reduce our average cost on the stock to $126/share. When we sold a portion of our position, writing covered calls helped boost the exit price to $132.15/share back when the stock was trading below that level. The chart below illustrates this and includes premiums collected from options that expired. Technically, premiums from unexercised options also help to reduce the average cost of holding a security, but for illustration purposes we have separated them from our entry and exit points.
Q: Changing gears a little, Mr. Bashir, given your expertise in preferred shares, can you talk about some of the tools and metrics that you use to determine the value (and comparative value) of these types of securities?
A: Preferred shares are effectively a hybrid between debt and equity. Depending on whether the preferred shares have a fixed maturity or infinite duration, they will behave differently. Retractable and Fixed-Reset preferred shares (with high reset spreads) tend to be more bond-like while Floaters and Perpetual preferred shares tend to be more equity-like in their behaviour. The yield spread relative to sovereign bonds is an important metric to identify deviations. When evaluating these securities, it is important to compare similar duration securities to isolate the credit spread. Other important metrics to review include the yield-to-call, current-yield and yield-to-worst measures. One of the main valuation metrics that makes preferred shares more attractive than corporate bonds of similar credit risk and duration is the interest-equivalent-yield (IEY). This allows for an apples-to-apples comparison of preferred shares to corporate bonds. To arrive at the IEY, you would multiply the yield on the preferred share by the interest-equivalent-factor (IEF). The IEF is calculated by the following formula: (1-dividend tax rate)/(1 –interest-income tax rate). While each province has different tax rates, on average the IEF is about 1.4 resulting in the comparable yield being 1.4 times the preferred share yield.
Q: Can you perhaps walk us though the investment theses and research (metrics, valuations etc.) that was done when you purchased the George Weston preferred shares?
A: Having previously invested in George Weston equity, much of the fundamental analysis for the company was fresh in our minds. The improving credit quality of George Weston was seen in its higher operating income, heavy cash and short-term securities balances, higher current ratio and lower trending net debt/equity ratios. The next step was to observe the credit spreads on Weston perpetual preferred shares given the depressed rates on the long-end of the yield curve. Since the perpetuals have no set maturity date, they are highly vulnerable to rising long-term interest rates. Although Canada has been the only G7 country to increase short-term interest-rates, long-term bond yields remain historically low. When reviewing Weston’s perpetual preferred share credit spreads against the 30-year Government of Canada bond, it was clear that they were wider than usual at over 275 basis-points (bps). Even after accounting for the impact of the credit crisis, we believed that long-term spreads should normalize around 140 bps. Aside from a highly attractive 6.7% current yield, we participated in over 12% capital appreciation of the Weston preferred shares to date versus a moderate 5.6% appreciation on the S&P TSX Preferred Share Index.
Q: Before we wrap up, what is your highest conviction investment idea currently and can you talk about why you like it, its valuation, upcoming catalysts and potential risks that might hamper your thesis?
A: We have had some success in looking in areas that many others fear to tread in the current market environment. Specifically, there have been select opportunities in the consumer discretionary space that have been overlooked by the market. Our holdings in PetSmart (PETM) resulted in over 25% return since our purchase in early August, 2010. Looking at the sector alone can be misleading since overall it is highly cyclical and with U.S. households buckling down to spend less and borrow less, it’s gets more difficult to make the case to go long in consumer discretionary businesses. That said, I believe that we are not just in the business of picking stocks; we are in the business of understanding companies and part of that means looking past the noise and uncovering shareholder-friendly behaviour, sometimes even in the sectors that the broader market has dismissed. As a fundamental bottom-up analyst I tend to look for companies that have a differentiation-factor or catalyst that gives them a competitive advantage above and beyond attractive quantitative metrics which are still a prerequisite.
Currently, my highest conviction investment idea lies in the retail sector. Now this choice may be viewed as a departure from the defensive stocks that tend to make up the lion’s share of our portfolios. Nevertheless, the attractive valuation, shareholder-friendly behaviour and long-term thesis make the U.S. apparel retailer, Aeropostale (ARO) one of my favourite picks. From a quantitative perspective, ARO trades at a lower forward EV/EBITDA multiple relative to its peers at 4.3x, and despite it being a value-oriented retailer; it boasts better operating margins versus its competitors. Management has demonstrated commitment to shareholders through consistent share repurchases and operating efficiencies. While the environment remains challenging and larger players are pricing aggressively to take market share and reduce inventories, the catalyst for ARO lies in its build-out ‘P.S. by Aeropostale’ stores targeted at ‘tweens’ aged 7 to 12. When I remember being a kid in that age-range, I also remember wishing I was older. A recent analyst report suggests parents will be reluctant to dress their kids in logo-wear. I tend to disagree. Kids aged 7-12 tend to look up to older teens as role models. This is a situation where the want/need for the merchandise is identified by the highly impressionable young consumer aged 7 to12, while the budget is determined by the parent. While the U.S. economy remains on life-support for the foreseeable future and households continue to deleverage, parents will be compelled to keep their budgets in check while satisfying their children’s desires to be fashionable. Aeropostale’s niche is in providing lower-priced brand name clothing and the chart below illustrates its long-term value to shareholders while its competitors have essentially added no value. The challenge for ARO will be keeping up with fashion trends, maintaining strong relationships with suppliers and ensuring market share/operating margins are well insulated.