Dear Investors,
It is very easy for market participants to project recent history far into the future. How many people remember that between 1995 to March 2009, the S&P 500 returns actually lagged those of lowly Treasury bills? That might not seem like a big deal today looking in the rear-view mirror, but for people retiring in the late 1990s, only to see their retirement accounts get butchered, it was a big deal indeed. Imagine if your retirement savings barely budged between now and 2029 and how that would impact your goals.
2000 to 2010 was a lost decade for stocks. This was more a reflection of high starting valuations than weak economic growth. With stocks having staged a strong and rapid recovery from the short-lived global bear market of 2018, many market participants are ramping up their aggressiveness once again. One of the biggest reflections of this aggressive posture are funds flowing to passively managed index funds with zero attention to price paid. An investment in the S&P 500 is a 100% equity allocation. Stocks have dropped over 20-50% on a variety of different occasions, but would all of these “passive” investors be able to hold through that type of downturn? Of course not, which is why funds flowed out of passive investments during the downturn in late 2018 when stocks went on sale. For retirees, or people close to retirement, being 100% invested in a passive fund like the S&P 500 is almost certainly too risky.
I believe that one of the most underrated aspects of our strategy at T&T Capital Management is our use of income enhancements strategies (IES), such as covered calls and cash-secured puts. These strategies allow us to position our portfolios more conservatively than owning just stocks, while generating more attractive income streams than what fixed income offers in today’s still low interest rate environment. The combination of deep value investing and our IES creates an efficient and evolving asset allocation strategy that I believe to be superior to anything else I’ve seen in the registered investment advisor industry.
“The combination of deep value investing and our IES creates an efficient and evolving asset allocation strategy that I believe to be superior to anything else I’ve seen in the registered investment advisor industry.”
Earlier in the month, I had the opportunity to visit with many advisors at a TD Ameritrade conference to see how they were managing money. Most of them were simply bundling a plethora of mutual funds and ETFs in an asset allocation, and their core focus was on raising assets, as opposed to maximizing long-term returns. We also had the chance to visit with many of the asset managers, and especially on the fixed income side, there were very few products that seemed attractive when you factor in fees and risk/reward. Targeting 3% and paying 1.5% in fees, is not an attractive endeavor in our estimation, but you’d be surprised at how many people are doing just that. When we do portfolio reviews, it is very common to see these types of products blended into the “asset allocation.” In Europe it is even worse, as hundreds of billions of bonds still trade with negative interest rates.
Income enhancement strategies make our investment decisions significantly easier. If we set a target price on a stock and then sell a covered call at that price, we are making a decision that we are willing to sell the stock at that price. In doing so, we are able to lock-in profits, as opposed to just holding in perpetuity and awaiting major cyclical downturns. From that point at which our option is exercised and we sell our stock, we can then invest the freed-up cash into our most attractive risk-reward investment opportunity. Our decisions are based on a fundamental analysis of the prices that the stocks are trading at versus our estimates of intrinsic value. We make these decisions on a regular basis, which is why in year-10 of a bull market, we have a portfolio of stocks where the majority of our positions trade at either a discount to book value, or less than 10 times normalized earnings. These are the types of positions that provide an ample margin of safety when times get tougher.
Our favorite and most common (IES) is selling cash-secured puts on stocks that we want to own anyways. When we utilize this strategy, we are creating a very favorable dynamic where if the option expires worthless, we generally realize a 10-15% annualized rate of return. Our worst-case scenario is that we end up owning the stock that we want to own anyways at a discount of at least 10-15%.
Many investors hold a large percentage of their portfolio in cash, as they wait for markets to go on sale. We are able to remain invested using these strategies, while having the best of both worlds, as we either keep the premium or get the stock at the discount. The option values get marked to market over the short-term, but at expiration we get one of the scenarios that we are looking for. When we sell puts, we collect the cash but must reserve for the possibility that we will end up buying the stock at the cheaper price. On our brokerage statements, this will reflect a large cash position which can be misleading as that cash really is invested, securing the sold puts. What is really nice is that we are basically able to earn two sources of return on that cash, because it sits in a money market earning a decent interest rate and is also backing the options targeting double-digit returns. Over time, this is a very powerful compounding tool.
“What is really nice is that we are basically able to earn two sources of return on that cash, because it sits in a money market earning a decent interest rate and is also backing the options targeting double-digit returns. Over time, this is a very powerful compounding tool.”
Another aspect that we really enjoy about cash-secured puts is that it is easier to lock-in profits than with simply owning stocks. Over the last 8 years, we have owned a lot of stocks in various industries, due to their attractive valuations based on short-term fears. We have been able to sell the puts countless times and either lock-in profits on the options or acquire the stocks at cheaper prices. These purchases have in many times led to covered calls, which have gotten exercised at higher prices. If we hadn’t been using the options, then each time the stocks took a 20-30% decline, as they have on several occasions, we would have felt the whole brunt of the downturn. Instead those selloffs have allowed us to reacquire the positions at cheaper prices, setting the stage for future gains.
Today’s 10-year Treasury rate sits below 2.7%. That is barely higher than inflation and I’d argue that real inflation is higher than 2.7%, as reflected in our everyday costs for things like healthcare, housing, etc. Even junk bond yields are less than 6%, and late in the cycle it would seem very rational to expect increasing defaults, reducing returns on junk. Interest rates increasing can significantly damage fixed income returns, as was evidenced in 2018. Debt is higher in the capital structure of companies than equity, but I don’t necessarily believe that bonds are a safer option than a well-designed cash-secured put strategy on value stocks, despite the higher returns that the latter strategy can offer.
The caveat here is that one must be willing to wait till options expiration to see the full benefit. If the market drops 10% in the next two days, bonds would obviously hold up much better, but for investors that can allow time to do its thing, the cash-secured put portfolio offers some considerable advantages. There definitely isn’t the same interest rate risk or inflation risk that plague fixed income. In the 1970’s, bonds were basically a license to lose money as inflation ravaged returns and interest rates had to be ratcheted up in the early 1980s to combat it.
I don’t believe markets are extremely overvalued currently, but they aren’t absurdly cheap either. The Federal Reserve’s newfound conservatism towards raising rates reduced my biggest concern. Stocks have rallied strongly, so it wouldn’t be shocking to see things pullback even if a trade deal with China is announced, as the expectations seem to be priced in somewhat. Ultimately, what matters is the underlying performance of the businesses that we own and the prices we own them at. On that front, I am extremely optimistic. We’ve done well over the last eight years despite one of the worst environments for value investing in history. Our IES strategies are a big reason for that and if you have any belief in mean reversion, we should see a huge benefit as value comes back into fashion. For those that have fixed income investments elsewhere, please don’t hesitate to have us take a look to make sure you are optimizing your hard-earned capital.
As always, if you need anything whatsoever, please don’t hesitate to contact us!
Sincerely,
Tim Travis