How To Assess Performance

Sep.12.12 | About: Deere & (DE)

Performance is always a tricky thing to present. It is often most appropriately categorized in all three of the components that comprise the oft-uttered expression, "Lies, damn lies and statistics," which is a testament to the powerful nature of numbers when used to bolster weak arguments.

Although many convulse at the idea of government regulation and intervention, most would probably have to agree that some standardization in the way that mutual funds advertise their results have only been helpful to the consumer. That is, if you could still find a consumer who wanted to invest in a mutual fund outside of being forced to do so inside of an employment tax-deferred plan.

I always felt somewhat empty when receiving quarterly and annual statements back in the days when I used a full-service brokerage. I'd look at the table that represented returns from various indices and blended strategies and then wonder what that information really represented. Somehow, they never seemed to actually portray what my portfolio had been experiencing. Equally confusing was that the spin was always positive, even though my bottom line didn't seem to always corroborate that spin.

Now that I'm on my own in making investment decisions, I've become an inveterate covered option writer. Part of adopting any kind of investment strategy should require a dispassionate and rigorous analytical approach to its assessment. But how?

What has amused me in a number of articles that I've written for Seeking Alpha is the consistency of comments that attempt to belittle the covered option strategy. Emotion is apparently part of the rigorous analytical approach for some.

The three arguments against the use of covered options are somewhat similar to the arguments over the years against the use of systemic water fluoridation to prevent dental cavities. By the way, I happen to have been a pediatric dentist in a previous incarnation, with a taste for public health policy and advocacy. I can tell you that, in fact, fluoride is neither a communist plot nor an effort by the fertilizer industry to dump its toxic waste byproducts.

Neither do covered options limit your upside gains. To think that they do so is a statement that one is always perfect at timing their sale of appreciated stock at the peak of their pricing. It is as if humans could just simply throw off the yoke of greed, as share prices keep rising and rising.

Most investors, if they looked critically at their own portfolio performance while simultaneously looking at charts, would note that they missed all too many opportunities to take profits. Beyond that, the simple act of ignoring the fact that most options expire worthless paints a picture for some that there is no value to be gained from taking advantage of those who seek to leverage their investing funds by purchasing options.

Inexplicably, many cite the fact that the option premium wouldn't offset a large price drop. Conveniently, they overlook the fact that two investors buying the same stock at the same time would fare very differently if selling that same stock after a large drop. The difference comes not from a penny difference in bid and ask that one investor may achieve through a serendipitous event, but rather through the previous sale of a covered call.

Put very simply, a $50 stock that drops 10% in price requires an 11.1% share appreciation to reach its baseline. For a covered call writer, having purchased the same shares of DuPont (NYSE:DD), for example, and having received a monthly premium of $1.20, the gain required is only 8.4%. Class dismissed.

Certainly, nothing really compensates for bad stock selection and timing, but selling options helps. Somehow I have a very difficult time understanding how that concept seems to escape some people.

Finally, there are still some who believe the pricing structure for transactions is stuck in the 1980s. Either that or they can't conceive or develop the financial wherewithal to complete a transaction of more than 100 shares of a moderately priced stock.

The reality is that no one exercises consistently perfect timing in the sale of shares; we all make bad stock selections. Someday, if you open your eyes to alternative ways of enhancing portfolio value, you may find the wherewithal to purchase larger share lots and enjoy economy of scale in commission costs.

When it comes to assessing performance, I consider capital gains or losses on shares, cumulative option premiums and dividends received. For my own records, I incorporate transaction costs. However, in reporting return on investment statistics for subscribers I do not, as there can be a very wide range of fees. Combine higher fee structures without economy of scale and returns can be significantly altered.

However, the critical question is: To what do you compare performance? I like comparing my performance top a concurrently moving target.

I strongly believe in the concept of opportunity costs and that one should always compare each investment to what an index would have returned for precisely the same time frame. Comparing your results of a specific trade that encompassed 18 days to the quarterly performance of the S&P 500 is absolutely ridiculous and offers no meaningful information.

For illustrative purposes, I'm going to focus only on a single stock: Deere (NYSE:DE). However, you could easily do the same analysis for a number of other stocks that have provided opportunity to make multiple purchases, as result of assignment of shares. Such shares include Chesapeake Energy (NYSE:CHK), Caterpillar (NYSE:CAT), British Petroleum (NYSE:BP), Morgan Stanley (NYSE:MS), JPMorgan (NYSE:JPM), Abercrombie & Fitch (NYSE:ANF) and others, across a wide array of market sectors.

In the case of Deere, in the period from June 11, 2012 to Sept. 7, 2012, I recommended purchase of shares on six separate occasions. During that period of time, the perfect stock timer could have bought shares for as low as $72.42 and sold them for as high as $82.46. That would have represented a 13.8% ROI.

If you were one of those people, I doubt that you would be reading this right now, but amazingly many comments seem to infer that perfect timing is endemic. That's one infection that I would love to catch, but somehow I've become immune.

I'm not a perfect timer, but I do know that good companies have stocks that go up and down. Sometimes they do so when I'm not paying attention.

During that period of time, the S&P 500 advanced 8.4% with much of that gain coming near the end of that time, when there was some stability and optimism regarding the European Union and its monetary system. Deere, in the meantime, including a dividend payment, advanced 5.5% during that period.

Anyway you look at it, having bought and held on to shares was a losing proposition, despite the gain in share value. You could have done better by simply investing in the SPDR S&P 500 (NYSEARCA:SPY).

However, the use of covered options and serial purchases and repurchases during that time frame resulted in a return of $10.2%. When compared to the performance of the S&P 500 during each of those discrete periods of time, that approach to ownership exceeded the index by 1.0%

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Dissecting time frames for holdings is a far more instructive manner to assess a strategy, as well as an individual transaction's performance. By doing so, you continually monitor each and every position as reflected by all of the transactions that may be related to that position, such as the serial sale of options or accumulated dividends. Similarly, if a position is initiated by the sale of puts and shares are assigned to you, performance is assessed on the basis of the strike price at which assignment was made, the value of premiums for having sold put options, and all subsequent call option premiums and dividends received until the shares are sold or assigned from the investor.

Being a simple person, I look at things in very simple ways. First, that 1% performance advantage in the case of Deere shares, is an 11% relative advantage. Second, being someone who always wonders how long a particular strategy takes to double assets, the difference between a 10.2% and 9.2% annual return is about one year. That's a big difference, particularly when you consider that it was borne out of a technique that is designed to reduce risk.

In and of itself, during that period, Deere was a relative underperformer in the overall market. Again, nothing really atones for bad stock selection. Except for milking a stock for everything it's worth and banishing the ill-conceived prejudices against a technique that is conservative by nature, and can keep the individual investor actively engaged in advocating for their personal portfolio's health and integrity by consistently responding to markets.

What is not factored into this analysis, specifically as it relates to the use of covered options, is the increased opportunity to generate even more revenue as a position is assigned and cash is freed up for further investment. To adequately assess overall performance, it then becomes critical to systematically look at all open and active positions in a separate view, while also maintaining record of performance of closed positions, the ones that have been assigned, or closed for other reasons. Those closed positions create the funding to generate new profits and income. Those positions are a perfect reflection of the adage "it takes money to make money."

Looking at approximately 95 "closed positions" that were recommended to subscribers over approximately 15 weeks (see details here), the advantage over the S&P 500 was 1.2%. That includes some positions that underperformed the index for the respective holding period. Conveniently for me, that doesn't include some really bad stock selections that are still open positions. Unfortunately, some of those were made to subscribers as well.

Granted, I have some vested interest in seeing a specific strategy demonstrate itself to be a reasonable approach to navigating through an unpredictable market. But to continue to insist that it is so, in the face of data suggesting otherwise, is a surefire way to deplete your assets.

Whatever strategy you use, having a real way to assess its ability to stand up to the competition is critical if you want to keep playing the game well past that time others are able to do the same.

Disclosure: I am long BP, JPM, CAT, CHK. I plan to purchase shares of DE the next time it approaches $75. 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.