Severe disruptions in emerging markets are roiling financial markets across the globe. Ineffective government leadership in Argentina and political upheaval in Ukraine and Turkey are some of the primary contributors. In addition, data out of the Chinese economy, which is the world’s 2nd largest, has been quite poor. While the S&P 500 was down about 3% last week and is down thus far today, emerging market currencies and stock markets dropped much more substantially. Unsurprisingly, we at T&T Capital Management (TTCM) are taking advantage of the volatility to acquire well-financed businesses that are trading at significant discounts to intrinsic value. There is a particular emerging market telecom stock that we have been acquiring a stake in, which I view as an opportunity to make 50-100% returns on from current levels. I’m choosing to be a bit more selective in stocks that we write research reports on as they are for the benefit of TTCM clients’, so I’ll usually only write them after we are fully invested.
As most of you know, we’ve been much more negative on the overall market than most market pundits. When stocks go up faster than business values appreciate, the investment opportunity becomes much less attractive. Our strategy of investing in a focused portfolio of businesses that are trading at deep discounts to intrinsic value should protect us from taking permanent losses of capital and weather any upcoming storms that may or may not emerge. It is interesting to note that even after the very strong appreciation that we saw over the last few years, many of our financial stocks still trade at material discounts to book value and in some cases tangible book value. These businesses are very well positioned to improve profits, while also increasing dividends and stock buybacks. Eventually the lawsuits against the big banks’ will subside and loan demand will improve. Rising interest rates will help net interest margins for the banks’, while also increasing the investment income for our large insurance companies. Low valuations on the sector continue to make it an exciting opportunity for prudent investment.
The freezing cold weather in the East Coast has greatly enhanced demand for natural gas and prices rose past $5. This is very good news for companies such as SandRidge Energy, Devon Energy, Ultra Petreleum and Chesapeake Energy. These companies all have more gas-centric exposure than peers giving them better leverage to take advantage of the improvement in realized prices.
Many people have asked why we’ve decided to sell such long-term put positions on many of our undervalued stocks so I thought I’d take a moment to explain. The market itself is very expensive, so a 10-20% sell-off is within reason at any time. This isn’t something to be scared of as it is strictly the nature of markets. The stocks we own are not expensive and would be even better buys if they declined along with the market. Selling long-term puts allows us to maximize the amount of premium that we collect, while also creating the most downside protection case of a market sell-off. Below is an example to show how it works.
Let’s say a stock is selling at $53 a share and we believe it is worth $65. If the stock were to reach our estimate of intrinsic value, our gain would be about 23%. Conversely, perhaps instead of just buying the stock outright we decide to sell a January 2015 $50 put for $8 per share, or $800 of premium. Two things can happen on this trade assuming we hold the option to expiration. If the stock closes above $50, we will keep our $800 target profit on a maximum risk of $4,200 for a 19% total return. This is very comparable to the 23% potential gain through owning the stock but let’s look at the risk profile. If the stock closes below $50 at expiration, we will own 100 shares at a breakeven price of $42 per share. From there we will have all of the upside or downside on the stock. Owning the stock at $42 is a 21% discount to the current price of $53, meaning that the stock can drop 21% before you would lose a penny. This makes the investment considerably safer and is a better risk-adjusted method than just buying the stock outright in this example.
This strategy protects investors of T&T Capital management much more than strategies of just owning stocks outright, particularly when the market is expensive. When we get volatility in the short-term, the options that we sold do increase in price creating a short-term mark to market loss, so the key is just letting things run out to expiration. It is imperative to not worry about day to day fluctuations in price or to get psyched out when news turns negative, as ultimately that is when we do our best work. Each portfolio that we manage has a considerable amount of protection embedded in it and you’ll likely see the benefits of this as we get closer to expiration on the options. Thank you very much and as always, please let us know if we can of assistance to you in any way!