Creating The Perfect Portfolio: Special Situations

by: Larry Meyers

I began this series of creating the perfect portfolio with an overview of asset allocation, followed by large cap growth stocks, large cap value, mid cap growth, mid cap value, small cap stocks, and fixed income securities. You can find them all here. Today, I’ll be looking at items that I classify as “special situations.”

These are investments, usually short-term in nature, that I am making because I have (or think I have) a specific and deep understanding of. It might be a company I have followed for a long time and have noticed certain patterns in the stock price that I can take advantage of. There may be a situation in which a stock has experienced a sudden, gigantic, and unjustified drop or increase in price. They may be a very speculative purchase or short. They may be almost entirely related to technical analysis. I allocate 10% of my portfolio to these situations. If all 10% is not being used, the rest resides in cash.

Because I’m not setting this real-money portfolio up until November, the special situations I’m describing now may not still be in play at that time. One such example is my recent short of Netflix (NASDAQ:NFLX), which I wrote about here. IMAX has cratered 55% in the past few weeks, and there may be a short term swing trade in play.

One of my favorite plays over the past several years has been the selling of naked puts on stocks I would like to own. I might even already own some and wouldn’t mind adding to the position. I have done this literally for years for EZCorp (NASDAQ:EZPW) and First Cash Financial Services (NASDAQ:FCFS). In these cases, I will sell three to six contracts one month out, and collect what is usually a 3% premium. For example, I might sell four First Cash August 45 puts for $1.55 and generate $620 in income. If the stock gets put to me at expiration, I have no problem owning the stock at this price. I would gladly sell a few DirecTV (DTV) August 50 puts for $1.58 today.

On the flip side, I might sell covered calls against half of a position on a stock I hold, but only if I can net a 2% premium or more. For example, I might sell Whole Foods Market (NASDAQ:WFM) August 65 calls for $1, which when combined with the $1.60 the stock would have to rise to even hit $65 from here, and nets me a 4% return for only 12 trading days.

During the financial crisis, I couldn’t believe that Ashford Hospitality Trust’s (NYSE:AHT) Preferred D shares were trading at $7, more than 70% below par, while still paying their $2.11 annual dividend. The company managed its balance sheet and liquidity so well that it felt like a value to me. I bought a lot of shares and sold out at $24. The same thing happened with the common stock. The price hit $0.86. I sold out at $10. Market panics like these are where I would make these special investments.

Once the real-money portfolio gets under way, my goal is to let readers know when I make these investments.

This concludes the series on Creating the Perfect Portfolio. Tune in again in late October as I form the real-money portfolio, or sooner if the market crashes enough that buying in makes sense.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.