Current stock market volatility remains extremely high and hysteria is quite significant. It is my opinion that we are in a classic stock market correction. I wouldn’t necessarily call it a panic yet, but clearly fear is very high. It is important to look at the underlying fundamentals and see if they line up with what is going on in the markets. Overall the economic data has been pretty consistent with what we’ve seen over the last 6 and half years. The U.S. is seeing modest growth with improvements in housing and autos. Europe is actually improving from a few years ago, although it is still growing at a very slow rate. The biggest difference is in China and other emerging markets, where growth is slowing and demand is declining. I don’t view a U.S. recession as being very likely with a strengthening job market, although I certainly don’t expect 4% growth either.
The strong U.S. dollar hurts U.S. exporters in the short-term but this is not a new theme. At T&T Capital Management, we aren’t exposed to a lot of export-driven companies where we haven’t seen compelling valuations for quite some time. Some of the few exceptions, such as General Motors, have much of their costs in foreign countries denominated in the same currencies as the revenues they generate, mitigating the impact to some extent. GM and American Airlines are two companies that trade at about 5-6 times our forward earnings estimates offering huge upside potential given their positive business performance.
On our largest position AGO, we received very good news that hasn’t really been appreciated by the market, which allows us to continue buying more stock on the cheap. The biggest concern surrounding AGO is its exposure to Puerto Rican government debt. I’ve written about this many times; AGO has only insured the strongest debt, that either is backed by specific revenues through tolls or the utility, or that is backed by the full faith and credit of the commonwealth. Well the worst credit of the bunch related to PREPA, which is the electric utility in Puerto Rico that has been poorly and bureaucratically run for decades. On Wednesday it was announced that a large group of uninsured bond investors agreed to take a 15% haircut on their PREPA debt holdings, which will provide material savings to PREPA. This is a far better result than the market was forecasting and this is the debt issue that was most concerning. The bond insurers didn’t go along with this deal as they likely believe that PREPA has the capacity to pay off its debt in full through cost savings and raising rates in line with other Caribbean islands. I’d look at the 15% haircut on that debt as being the worst case scenario and I wouldn’t be surprised if that is less than what the company has already reserved for.
The situation in Puerto Rico is evolving but I believe the risk profile is even less than it was before and the likelihood of the stock rallying significantly is even more likely than I thought before. This is the type of special situation investment that can do well even in a negative market environment, as it doesn’t need robust economic growth to be successful.
We have sold a great deal of puts on a variety of stocks and I thought it might be helpful to explain how they work. Let’s use AGO as an example. Let’s say in January of this year we sold a $25 January 2016 put for $3.00, or $300 per option. The risk on this investment is $2,200 if the stock were to go to zero, but obviously we don’t believe you can liquidate company for less than $40 so we see very little risk. The biggest risk is just short-term mark to market swings, which is irrelevant for the long-term investor. Well a $300 return on $2,200 of maximum risk is a 13.6% return. That is definitely quite attractive for a 1 year time horizon. Now in this volatility, let’s say the stock drops a bit and volatility increases and the value of the option increases to $4.00. This would show as a $100 mark to market loss on the option. Well the only thing that matters is where the stock price is at expiration relative to the strike price of the options that we have sold. If the stock is at $25.00, we will have made our original $300 profit and the $100 mark to market loss will also have reversed completely. If the stock price is below $25 at expiration, we will own the stock at a breakeven of $22 per share. This is a stock that we believe is worth between $40-$50, so we would get all of the upside from that level. Keep in mind that despite the stock market selloff, the business fundamentals of most of our investments are improving. These short-term price fluctuations mean very little in the big scheme of things, but instead create fabulous buying opportunities.
Many clients that have cash on the sidelines are adding to their accounts to take advantage of this volatility. I realize not everyone is in the position to do this, but you will still benefit as we make portfolio adjustments to maximize our risk adjusted return potential. When you are investing it is important to understand that your own emotions are likely to be your biggest enemy. It can be psychologically taxing seeing large swings in the value of your holdings in short-time frames but it is 100% to be expected from time to time. You must keep in mind that you are invested in fractional shares of businesses. These businesses aren’t changing in value at nearly the same rate as these stock swings would indicate. In the words of Warren Buffett:
“Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.”
“Inactivity strikes us an intelligent behavior”
“We continue to make more money when snoring than when active”
He is not a lazy investor as he is constantly researching. But trading actively and selling stocks as they get cheaper is just bad business regardless of charting, market forecasts etc. We have protections in place that I believe will have us in very strong shape as our options expire in late January. I also expect the earnings and intrinsic values of the businesses that we are invested in to continue to grow between now and then. The stock prices will eventually converge with intrinsic value and that is how we will make our money. If you can keep the emotion at bay and not panic, I’m confident we will do quite well over the long-term. Thank you very much and if you have any questions, please don’t hesitate to contact me directly at 805-886-8140.