Restructuring The Portfolio - Crude Carnage 2.0?

| About: Black Diamond (BDIMF)

Summary

Decreasing the Portfolio's risk profile.

Selling off Black Diamond Group Ltd.

Crude Oil fundamentals do not support its current price.

Please note that this article was published on June 29th, 2016 on my website. Anything mentioned in this article refers to that period.

I've been contemplating a strategy restructure for a while now. I just updated the homepage with the holdings, and this is what the portfolio looks like today:

My goal here is to reduce my definition of 'risk' in the portfolio. I don't want any specific industry to command more than 15% of the portfolio except when:

  1. The security is a 'special situation' (like Solitron Devices (OTCQB:SODI)) with a more certain outcome.
  2. The company/companies is/are in a defensive industry such as Consumer Staples or an industry/company that is ill affected by downturns.
  3. Very rare occasions

So the first thing I want to do is get rid of anything that depends on a commodity to be profitable. Black Diamond Group fits that bill.

Crude Carnage 2.0?

While crude oil has seen a significant rally from its lows earlier in the year. The fundamentals are yelling that crude oil should be trading at lower levels. Supply still outpaces demand as of Q1 according to the IEA, and U.S. Crude Inventories have not declined like I hoped.

Click to enlargeSource: EIA

This inventory will unfortunately need to be sold at some point - likely at lower prices - and I believe this will cap the price of oil until it falls back to normal levels unless something happens in the middle east or some other OPEC country that disrupts supply. The recent supply cuts in Canada and Nigeria will soon become trivial - The Fort McMurray fire is now mostly contained and the Nigerian government is in 'negotiation talks' with the Militants. The higher crude oil goes, the more lucrative it becomes for others to produce. Today's prices coupled with the still high historical inventory levels leads me to believe that we may see another sharp downturn in crude oil prices in the very near future.

Black Diamond (OTC:BDIMF) will require higher prices to return to profitability - The higher Crude goes, the more housing contracts they are awarded since companies will start producing again. What I want for the portfolio, is companies that can stay profitable despite the commodity price. Gamehost, for example will greatly benefit from higher crude prices since it stimulates more activity in Alberta. The company, however, will still remain profitable even if we don't see $70 oil over the next 2 years. P & F Industries also caters to the Oil & Gas industry, but is diversified enough to not lose profitability over it. The company should benefit from a rising crude and the market has assigned a negative valuation to that aspect of its business. Those are the sort of companies I want to seek out going forward.

Strong Dollar

I think the U.S. Dollar will continue to strengthen against other world currencies given the uncertainty we're seeing in the EU and the Eurozone. MNDO derives half of its revenue from the U.S., but its expenses are in Europe, so we could see the current margin expansion sustain itself. PFIN purchases its goods and Raw Material from Asia countries in their local currencies. The portfolio will incur currency losses though because of Gamehost since I purchased it in Canadian Dollars, so this will also serve as a hedge against a weaker U.S. Dollar.

Options Strategy

I use the put options to hedge and they will rise in value in a bear market. One mistake I made early on was to buy shorter dated options. I told myself that I was going to stick to 1.5+ years, but soon found myself buying <1 year puts - it's a mistake I've found myself learning the hard way from. This has contributed to a net negative performance to the portfolio as they tend to fall at a much faster pce than the longer dated puts. Going forward, I'll no longer buy put options that expire within 1 year unless I have some clear catalyst that I can time to or close to perfection. I want to stick to the 1.5 - 2 year horizon.

My strategy initially was to run a 10% (put) 90% long portfolio. But I've decided to not hedge special situations, so stocks like SODI. So other parts of the portfolio will accompany hedges except for the aforementioned.

Another mistake I made early on was hedging before being fully invested. With the exception of this month, the portfolio had just been on average about 55% invested. 50% long and 5% puts (puts began in February). Beating the market becomes especially difficult when the 5% put options are declining exponentially and the 50% has to make up for that first with a 10% return, and then also has to hit double the market's returns to break even. So, matching every stock with a hedge before being fully invested was a bad idea. The cash was a natural hedge and I should have realized that. I'll now hedge half my previous 9/1 ratio until i'm fully invested.

Conclusion

The perfect portfolio clearly doesn't exist, but if I can improve one thing each time I take a look at my portfolio, I'll be satisfied.

Disclosure: I am/we are long SODI.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: No position in Black Diamond Group

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.