Microsoft Portfolio: Halftime Report

About: Microsoft Corporation (MSFT), Includes: AMED, CASY, CHD, FDRXX, LLY, MKC, SAVE, TWLO
by: David Pinsen

After the success of a hedged portfolio built around an AT&T position in 2017, I started presenting similar portfolios built around other conservative stocks, including Microsoft in 2018.

Here, I update the performance of the Microsoft portfolio halfway through its planned six-month duration.

This portfolio is lagging the market so far, but it declined significantly less than the market did during December's nadir.

Microsoft booth at the 2010 Consumer Electronics Show (photo via the Seattle Post-Intelligencer).

A Hedged Portfolio Around An MSFT Position

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 completed last month (each portfolio lasts for six months). Following that, I began presenting hedged portfolios built around other, putative conservative stocks, including Microsoft (MSFT) in mid-December. Let's see how it's doing three months in, given the excitement with MSFT and the market in general since then. First, a reminder of how the portfolio was constructed and what it consisted of.

Constructing The December 2018 MSFT Hedged Portfolio

We used the Hedged Portfolio Method to build a concentrated portfolio around MSFT in November starting with these premises:

  • You had $2,000,000 to invest.
  • You were unwilling to risk a drawdown of more than 12% during the next six months, so you wanted to be hedged against any decline greater than that.
  • You wanted to invest in a handful of names, including MSFT, with a goal of maximizing your expected total return net of hedging costs.

These were the steps involved, for those who wanted to do this manually (your returns would obviously have varied based on which approach you used).

Step 1: Estimate Potential Returns

The goal of this step was to find names that had the potential to generate high total returns to include alongside Microsoft - whether those returns came partly from dividends or not wasn't relevant (tax considerations aside). Our site, Portfolio Armor, calculates its own potential returns by analyzing adjusted price history (which takes into account dividends) and options market sentiment, but you could have derived yours from Wall Street price targets or the price targets given by Seeking Alpha contributors you follow. Your initial universe could have been 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 were going to hedge, gross potential returns were less important to you than potential returns net of hedging costs. To figure those out, you needed 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 have been looking for the cost of hedging against declines of 12% or greater. The lower the decline you were looking to hedge against, the narrower the list of names you would have been able to use.

Step 3: Rank Names By Net Potential Return

For each of the names in your initial universe that had a positive potential return, you would have subtracted the hedging cost you calculated in Step 2 to get a net potential return.

Step 4: Buy And Hedge

Here, you would simply have bought and hedged a handful of names that had the highest potential returns net of hedging costs. The automated approach we'll show below included a fine-tuning step to minimize your cash, and another fine-tuning step to decide whether to hedge with puts or collars, but those four steps were the basics.

The December MSFT Hedged Portfolio

Using the process outlined above, this was what Portfolio Armor's automated hedged portfolio construction tool presented us:

In addition to Microsoft, the site included Amedisys (AMED), Casey's General Stores (CASY), Church & Dwight (CHD), Eli Lilly (LLY), McCormick (MKC), and Spirit Airlines (SAVE) 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 selected the Twilio (TWLO) to absorb cash left over from the process of rounding down the primary securities. TWLO was hedged with an optimal, or least expensive, collar with a cap set at the then-current seven-day (annual) yield of the Fidelity Government Cash Reserves money market fund (FDRXX). The hedging cost of this was negative: The idea here was 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.

Performance Of The Underlying Securities Since

This is how the underlying securities in the hedged portfolio have performed since, unhedged:

Chart Data by YCharts

Microsoft has been the worst-performing name here since mid-December, down 10.09%. Assuming, for simplicity's sake, your portfolio was equally weighted, and you held each position from December 13 until Thursday's close, you'd be up 1.9% so far.

Performance Of The Hedged Portfolio Since

Here's how the hedged portfolio has performed so far.

The hedged portfolio was down 1.54%, while the SPDR S&P 500 ETF (SPY) was up 6.58%. This is the third of the 2018 vintage portfolios I've presented in free articles that was lagging the market at the halfway point, thanks to the market's rebound since the second half of January. One thing that's different about this portfolio than the previous lagging ones is that, in this one, the hedged portfolio is underperforming its constituent securities, unhedged. In this case, that's because the best-performing security so far, TWLO, is the one that was collared the most tightly. You can see the impact of that in the call option value column for TWLO in the table above.

Lagging, But Less Of A December Dip

Our December MSFT portfolio is lagging SPY so far, but it had a calmer December than the index ETF, as exemplified by the snapshot of the comparison chart below as of December 24th.

As you can see above, from December 13th to Christmas Eve, this portfolio was down 5.54%, while SPY was down 11.17%. Let's check back in a few months and see how this portfolio finishes versus SPY.

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.