Building A Bulletproof Portfolio Around Verizon

About: Verizon Communications Inc. (VZ), Includes: FDRXX, MKTX, NXST, NYT, SBUX, T, TWLO
by: David Pinsen

Last August, I mentioned how a bulletproof, or hedged, portfolio built around an AT&T position last year generated strong performance while strictly limiting risk.

Here, I use the same hedged portfolio method to build a hedged portfolio around a position in Verizon.

I show how you can construct one of these portfolios yourself, and I explain how this one differs from the ones I present to subscribers.

Workers in Verizon's Wireless’s National Accessibility Customer Service (NACS) Center. Photo via Verizon.

VZ And The Hedged Portfolio Method

Last August, I wrote about the performance of a bulletproof, or hedged, portfolio built around a position in AT&T (T) in 2017 and presented a new one, which recently completed (each portfolio lasts for six months). Like AT&T, Verizon (VZ) tends to attract conservative investors, so I thought it would be interesting to try the hedged portfolio approach with Verizon this time. As we did in previous examples, we'll use the Hedged Portfolio Method to build a concentrated portfolio around VZ.

We'll start with these premises:

  • You have $500,000 to invest.
  • You are unwilling to risk a drawdown of more than 12% over the next six months, so you want to be hedged against any decline greater than that.
  • You want to invest in a handful of names, including VZ, with a goal of maximizing your expected total return net of hedging costs.

Here's a recap of the steps involved, if you want to do this manually.

Step 1: Estimate Potential Returns

The goal of this step is to find names that have the potential to generate high total returns to include alongside VZ - whether those returns come partly from dividends or not isn't relevant (tax considerations aside). My site, Portfolio Armor, calculates its own potential returns by analyzing total returns and options market sentiment, but you can derive yours from Wall Street price targets or the price targets given by Seeking Alpha contributors you follow, if you like. Your initial universe can be as big as Portfolio Armor's (the ~4,500 stocks and Exchange-Traded Products with options traded on them in the U.S.) or something smaller, such as the Dow 30.

Step 2: Calculate Hedging Costs

Since you're going to hedge, gross potential returns are less important to you than potential returns net of hedging costs. To figure those out, you need to figure out the optimal or least expensive way to hedge each name. We wrote about how to find optimal hedges here. For this example, you would be looking for the cost of hedging against declines of 12% or greater. The lower the decline you're looking to hedge against, the narrower the list of names you'll be able to use.

Step 3: Rank Names By Net Potential Return

For each of the names in your initial universe that has a positive potential return, you'll want to subtract the hedging cost you calculated in Step 2 to get a net potential return.

Step 4: Buy And Hedge

Here you simply buy and hedge a handful of names that had the highest potential returns net of hedging costs. The automated approach we'll show below includes a fine-tuning step to minimize your cash, and to determine whether to hedge each position with puts or collars, but these four steps are the basics.

An Automated Approach

Here's how the process looks using my site's automated hedged portfolio construction tool.

First, we enter "VZ" in the optional tickers field, along with the dollar amount we're looking to invest ($500,000) and the maximum decline we're willing to risk (12%).

Screen capture via Portfolio Armor.

After clicking "Create," we see the screen below, where we're asked if we want to enter our own potential return for VZ. That's optional, so I leave it blank.

Screen capture via Portfolio Armor.

And then click "Create," and see this message, while the system is processing.

Screen capture via Portfolio Armor.

After a few moments, we're presented with this hedged portfolio:

Screen capture via Portfolio Armor.

In addition to VZ, the site selected MarketAxess (MKTX), Nexstar Media (NXST), New York Times (NYT), Starbucks (SBUX), and Twilio (TWLO) as primary securities, based on their net potential returns when hedged against >12% declines. The site attempted to allocate roughly equal dollar amounts to each of those names, but rounded down the dollar amounts to make sure it had round lots of each stock.

In its fine-tuning step, it used TWLO again, hedged a different way, to absorb cash left over from the process of rounding down the primary securities. TWLO is hedged in this case with an optimal, or least expensive, collar with a cap set at the current seven-day (annual) yield of the Fidelity Government Cash Reserves money market fund (FDRXX). The hedging cost of this is negative: The idea here is to get a shot at a higher return than cash while lowering the overall hedging cost of the portfolio and limiting your downside risk in accordance with your risk tolerance (to a drawdown of no more than 12%).

If you're curious why there are so few positions in this portfolio, the short answer is that hedging obviates the need for more and enables a winning position to have a larger impact on portfolio returns. For a longer answer, this article offers an elaboration and an example.

Note that each of the primary securities is hedged with optimal puts or with an optimal collar (for TWLO). Here's a closer look at the VZ optimal puts (screen capture via the Portfolio Armor iPhone app):

Optimal Put Hedge for Verizon via Portfolio Armor

Portfolio Armor's hedged portfolio construction tool tries hedging each primary security with both an optimal collar and optimal puts, estimating the net potential return both ways, taking into account the historical incidence of outliers. Essentially, the lower hedging cost of collars is weighed against the chance for higher upside when hedging with puts. In the case of VZ and most of the other primary securities here, the optimal puts won out.

Portfolio Characteristics

Here's another look at the data summary at the bottom of this portfolio:

The Worst-Case Scenario

The Max Drawdown is the worst-case scenario. That's what would happen if each of the underlying securities went to $0 before their hedges expired (the idea is to hold each position for six months or until just before its hedge expires, whichever comes first). In that case, you'd be down no more than 11.38%.

The Best-Case Scenario

The best-case scenario is the net potential return of 16.81%. That's what you'd get, net of the hedging costs, if each security hit its potential return, which is unlikely.

A More Likely Scenario

Each time Portfolio Armor estimates a potential return for a security, it tracks how that security actually performed six months later, and it continually updates the ratio of actual returns to potential returns. The expected return of 6% takes that ratio into account, along with the hedging cost. The odds of hitting that number on the nose in a particular portfolio are slim, but, on average, the actual returns tend to track fairly close to expected returns.

Wrapping Up - How This Portfolio Differs

Each week in my Marketplace service, I present five portfolios to subscribers with dollar amounts ranging in size from $30,000 to $2,000,000. This portfolio differs from ones in my Marketplace service in that I let Portfolio Armor pick all the securities for the portfolios in my service, unlike here where I foisted VZ upon it. Let's check back in a few months and see how this portfolio is doing.

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