On Monday August 5th, stocks plunged by about 3%, as escalating trade tensions continued to garner fear, after the worst week of the year last week. The Chinese government is allowing their currency to decline, which benefits their competitive advantage on trade. This was in response to last week’s news of additional tariffs on China. The likelihood of a deal in the short-term, seems fairly remote, but perhaps the increased volatility prompts a mutual agreement. As we wrote last week, we haven’t made any investments based on the premise of a speedy resolution of these complicated matter. With that said, when get a major selloff in stocks, it is only natural to feel a knot in your stomach. Over the years, I’ve developed some basic questions, which can help make dealing with volatility a bit easier.
1) When you invest, do you do so with the expectation that there will be major selloffs, corrections, and even bear markets?
This is the reality of investing and I tend to liken it with turbulence on an airplane. You know going in that turbulence is likely if not assured, so you don’t want to jump off the plane when you feel it. Many people that are unsuccessful investors panic when things get rough, which is why usually people that tend to worry are better off checking things yearly, instead of hourly or daily. Avoiding panic is one of the biggest determinants to your long-term success.
2) How does our overall strategy react to major selloffs?
If we thought the bull market would continue forever, we would simply be long stocks. Because we have been wary of market valuations, we have been extremely diligent at only buying stocks that trade at substantial discounts to intrinsic value, and that have reasonably strong businesses/balance sheets.
In addition, more often than simply buying stock, we have been selling cash-secured puts and covered calls. These strategies enhance our income/cash flow, while also providing a modicum of protection, versus simply being long stocks. Many times our break-even prices are 10-15% below the current price. During selloffs volatility spikes, putting short-term pressure on the options, but upon expiration (usually in January), you will see the full benefit of this protection.
3) What are the biggest risks we should be worried about?
At T&T Capital Management, our highest focus is on avoiding permanent losses of capital. Volatility is not something to be feared, as it is inevitable and can be used to our benefit. The surest way to take permanent losses of capital is paying too much for stocks. This is why I worry about those owning index funds and mutual funds in this expensive of a market. Many people don’t know what they own or why they own it. Short-term mark-to-market fluctuations are not something to be worried about. Over time, stocks converge towards intrinsic value.
4) How do we take advantage of this volatility to our advantage?
Many think that when we sell puts that we only want them to expire worthless. The reality is we are indifferent to them expiring or getting exercised. When we get exercised, the price is often at a huge discount to intrinsic value, making the upside potential enormous. Many of our biggest winners have come from getting exercised. Often this only happens after a 10-15% decline in the stock, so we are dollar-cost-averaging by design. Secondly, we continue to add stocks we like upon market declines. Thirdly, if you are able, market declines are a phenomenal time to add money to your accounts to take advantage of things being on sale.
5) What do you need to do and what do you need to avoid?
Your accounts are fully managed. We have 15 years of experience navigating markets of all shapes and sizes, and far more when you factor in the rest of the team. My suggestion is always to not spend one minute worrying about short-term market swings. There is nothing to be gained and I purposefully avoid watching news of any kind, as they tend to prey off of sensationalism and instilling fear.
The only thing you need to avoid is panic. That is who loses and falls prey to the market. At TTCM, our clients tend to be well-educated, long-term oriented investors, and we don’t have the problems other firms have with this, but that is the biggest way to lose. Even if the market continues lower, when would you get back in? Time and again, market pundits’ predictions are wrong and nobody is going to time things right all the time. Focus on your long-term goals and objectives. Things have gone very well and we are optimistic on our positions. Earnings have been great and we have some big reports still to come. I see a great opportunity to make money and I’ve added materially to my personal accounts on Friday and today to take advantage of stocks on sale.