Interview: Chris Abraham On Mixing Value Investing And Options

by: ValueWalk

By Rupert Hargreaves

Rupert Hargreaves: You run a unique, value-based options strategy, which is designed to take advantage of price inefficiencies in the market. Could you give our readers a brief description of the strategy and why you decided to use it?

Chris Abraham: It is basically a concentrated, long-term, all-cap value-oriented strategy primarily focused on the equities and options of high-quality companies. Ideally, I look for companies with a competitive advantage that trade at a margin of safety. I typically have around 10 to 20 equity holdings in my portfolio, preferably closer to 10.

Regarding option positions, the way I look at the strategy is kind of like running an insurance book along with existing equity holdings - similar to Buffett's concept at Berkshire (NYSE:BRK.A) (NYSE:BRK.B). Buffett has been able to create permanent capital for investing by using Berkshire's insurance subsidiaries' float. And that's the kind of business model that I've tried to create, except with options.

RH: So you write options to generate income and grow the float?

CA: Exactly. The vast majority of options trading is on ETFs, and most of that is short-term trading, for hedging and speculating. Because most traders concentrate on these limited markets, there's very little attention focused on longer-term options of individual companies. A lot of institutional investors just can't invest in this sector, because their investment mandates won't allow it and hedge funds are only interested in the short-term use of options to hedge positions.

The great thing is you can find some options with significant mispricing across the entire market. A couple of weeks ago, I found options on a company with a $100 million market cap! So, there are definitely opportunities out there to take advantage of with these derivatives, but structural reasons prevent many investors from making the most of the opportunities available to them. There's also a general lack of interest in this area.

If you find a security that is undervalued and has a margin of safety, generally speaking there will be an even bigger mispricing in the options. To profit from this, you can sell put spreads or buy call spreads - the former eliminates the tail risk. If you feel comfortable just selling naked puts that will help you generate even more float, but you have to be comfortable buying the stock at the set price if it comes to it

RH: One of the key caveats of value investing is minimising risk. Options trading is known for its high level of risk…

CA: I think options trading is perceived as higher risk but it all comes down to the underlying stock. I think the real risk stems from a lack of knowledge about option pricing and stock valuation. As we know, a stock price will fluctuate much more than the underlying business. This stock volatility leads to some extreme volatility in options pricing, which translates into more opportunities for the options investor. If you are buying into a higher quality business, this is a great way for greater returns and a higher margin of safety. The high quality nature of the business helps mitigate risk. Call spreads and put spreads also help mitigate risk as well.

RH: Do you buy the underlying equity as well or do you just concentrate on the options?

CA: I have an equity portfolio, but each situation really depends on several factors. This is more of an art than a science. Sometimes it depends on the liquidity of the options or the stock, and other times it depends how expensive the options are. For instance, if I have say 14 equity positions in my portfolio already, I might just buy the option to add to my options book rather than the stock. It really depends. Another example I can give is if I've owned a stock for a while, and the options suddenly become really expensive, then there's a situation where I might be inclined to add on the options side.

RH: What's your investment time frame?

CA: Generally, I invest on a one to two-year time frame with regard to options since those are the longest term options widely available on the market. The reason why I've chosen this time frame is because those are the options that are generally the most mispriced. If I could get options longer than that I would, sometimes I can get options for two-and-a-half years. Options are priced more or less on a bell curve with some skew around the current stock price. They are not valuation based, which leads to tremendous opportunities.

For instance, volatility, which is one of the primary factors in options pricing, is extrapolated for the term of the option. This leads to increased mispricing for options as the option term increases. For example, back in January and February, the market was extremely volatile and options were pricing this elevated volatility to last continuously for the next couple of years, which gave me the opportunity to sell options on strong, competitively advantaged companies at exceptionally high prices.

RH: Could you guide us through your investment process?

CA: Sure, let's say a stock is trading at $100 and under my valuation, I believe it's worth $130 to $150. If I can sell puts at $85 and collect $8 in premium, a premium that expires in one year, to me that would be very attractive. In this scenario, my net buy price, if I were forced to buy, would be $77, otherwise, the options will expire and I get to keep the float. In this specific case, assuming I'm buying this competitively advantaged company at a 40-60% discount, I would be okay selling the puts outright and not put spreads because I would be happy to own the stock at $77.

By looking at it this way, time becomes your friend because every day that goes by, the options are worth less, even if the stock doesn't move.

RH: Do you keep a lot of cash on hand to implement this strategy?

CA: Yes, I typically keep around 15% to 20% cash, in case of negative surprises, but it generally depends on the underlying environment. If the implied volatility has come down quite a bit and there's nothing attractive out there, I tend to stay away. I need to make it clear that valuation of the underlying business is not enough for me to be buying or selling options. The risk/reward is clearly more favourable when implied volatility is higher.

RH: You're not selling right now?

CA: No, I'm not selling right now because the payoffs available are not significant enough. I forget the statistics but the VIX has collapsed by something like 50% to 60% over the past month and we are at levels we were at pre-August last year. I've actually been buying a little bit of tail risk insurance one year out as it's fairly cheap here. So you need to work with what the market is giving you.

RH: Could you give us an example of something you are looking at or have looked at in the past?

CA: Sure, one of the most attractive options plays in the recent past has been Apple (NASDAQ:AAPL) in my opinion. This is a company that I've gotten to know well over the years and when the stock got down into the $90s, it was trading at a mid-teens free cash flow yield. The market was pricing in a massive decline in iPhone sales and profitability, which I felt was a fairly low probability event in the immediate future.

Every couple of years, it seems Mr. Market reflects this paranoia in the stock. At that level, you could sell puts at a strike price of $90 and collect $15 to $16 in premium, for options expiring in two years. And if you wanted to be more conservative, you could've bought some further out of the money puts, take a really nice spread on that, collect the premium and have a really nice float for a year. That was probably one of the best risk/reward and liquid opportunities I've seen in a while.

RH: When you're looking at plays like this, do you tend to stick to defensive sectors or branch out into the more cyclical sectors, which may offer a greater return but a higher level of risk?

CA: I tend to stick with defensives because with cyclicals, the volatility can be quite aggressive and you can really get hurt there. But I would be inclined to buy cyclicals if they were cheap enough and they had a competitive advantage over peers. Although if I did go down that route, I would buy long-term LEAPs to cap my downside, while leaving me exposed to a long-term cyclical recovery.

My priority is limiting my losses, so I tend to get to know a few competitively advantaged businesses very well, and then when the market throws up the opportunity, look at the stocks and the options and pick the securities that give you the best risk reward. There isn't really much to add to the process in terms of investing, the options just give you another avenue with which to profit from the underlying investment, another tool in the kit so to speak.

I think by selectively writing options, at times when the market is offering the best risk reward ratio, over the long term, the strategy should generate significant returns.

RH: I think one of the factors that would scare most investors away from using this strategy, are the potential drawdowns that are generally associated with using options, rather than the traditional buy-and-forget style of value investors.

CA: Well, first and foremost I'm a value investor. If I find a competitively advantaged business that I like, I'm more than happy to hold forever. When it comes to the drawdowns, that is a problem, but it's a problem that can be mitigated through strategies like using put and call spreads as well as buying tail risk insurance.

Sure, the performance may be a little bumpier than most investors are used to, but I think that if you're disciplined with your underwriting, it will work out very well over time. I think psychology is important here. Mark-to-market returns, like we saw in January and February of this year can be very violent. Although, at the same time plenty of new opportunities arise, so any new insurance you're writing will be very profitable. There is also position sizing to consider, you need to make sure your options portfolio won't drag you down.

If you're doing cyclical recovery stories, turnarounds, reversion to the mean plays, I don't think this strategy will work as well. You just don't have the margin of safety that you need in my opinion. Whereas if you're talking about companies like Apple or Berkshire Hathaway, that have strong balance sheets and competitive advantages, then you have something that you can base your value and a platform from which to base your option strategy on - you can clearly identify the price and value of the company along with the current call or put premiums to quantify potential returns. Most of the businesses I own right now have net cash balance sheets and double-digit free cash flow yields. Actually, believe it or not, when you write options on these sort of companies, there isn't much of a market. And that's where the opportunity is because not many people play in this sandbox.

RH: Options aren't something we cover much here at ValueWalk, and there's a good chance that some readers will never have used options before. So, could you just give those readers a brief rundown of options investing and how they should approach the market?

CA: That's a good question, I think one of the things that puts people off this market and trips them up is approaching the options market as a purely speculative market, without considering the underlying stock they are buying. One thing I will never understand is how so many traders use options but have no idea about the underlying valuation of the security. That's the equivalent of buying or selling insurance without knowing what your collateral is!

I think if investors want to get into this, they need to understand properly how options work, either by taking a class or reading up on the subject - Buffett himself has been a major user of options and derivatives but this doesn't get as much attention. There's so much misinformation out there and people really need to understand how the market works and how to apply that to their own trading strategy, as well as understanding what the actual upside and downside is.

A lot of people I've spoken to about it will say, "I've tried options and I've lost all my money" but what they don't realise is, if you put $1,000 down, you can lose the entire $1,000. It's even more important when you're selling naked puts or calls, because you have unlimited downside. To the uninitiated, one of the best and free ways to learn in my opinion is to look at how Buffett has written about the options market in his previous annual letters and then try and understand how Black-Scholes options pricing works, and how it doesn't work.

I started as a value investor, and then through learning about options pricing adapted my strategy to suit me and my investment background. I'm afraid to say there's no perfect answer to this, you just need to learn as much about the subject as possible and develop your own strategy.

RH: So your advice would be to find the stock, calculate the value, buy as a value investment and then look at the options?

CA: Exactly. Since your "collateral" is the underlying business, you need to gain a firm foundation in fundamental research to understand what it is worth. Once you have established a valuation range and a margin of safety, you have more flexibility in understanding which options to use. To me, it's easier if you understand the valuation first and then the derivatives. It's a much simpler and straightforward approach.

RH: Chris, that's great. Thank you for your time today.

CA: You're welcome. Thank you for the interview.

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