“You don’t find out who is swimming naked until the tide comes out.”
Financial markets over the short-term are akin to middle school popularity contests. The euphoria or pessimism of the day generally reflects recent price performance. Because there is 24/7 coverage, media pundits feel like they have to give reasons why stocks are up or down on a given day. Many market “geniuses” arise in bull markets, only to be crippled in the ensuing bear market, as they are discovered to be swimming naked as the tide comes out. Cathie Wood and Ark Investments is a great example. The fund posted stellar returns taking extreme risks, building concentrated positions in the most expensively valued, and often least liquid stocks. Often these companies were losing money at prodigious levels, but her “genius” was based on the stocks performing well for a few years. Then in late 2021, the tide came out, and the fund dropped about 80% over the next year, absolutely devastating shareholders who put their hard-earned money into it. Cathie is a smart investor, but she is also willing to take extreme risks. Sometimes it pays off, but the risks are too high for most investors, and it is unlikely to be a strategy that outperforms over the long-term.
There will be great years in the stock market and there will be terrible years. There will also be a lot of rather mediocre years. We don’t know going into the year how it will play out. When stocks are extremely cheap, it might make sense to be a bit more aggressive, if that is consistent with your risk tolerance. When stocks are expensive, it might make more sense to be relatively conservative. But as we saw in 2020 and 2021, even though stocks were at some of the highest valuations in history, the bubble continued to build making those that didn’t take the most aggressive risks look foolish. The same phenomenon has occurred in just about every bubble, including 2000. From 2000-2003, the Nasdaq dropped 80% peak to trough. While volatility is to be expected, most investors can’t easily handle that type of a drop, and most of those funds that seemed so amazing in the late 1990s, ended up having to go out of business when the bubble burst.
Other investors are afraid to take any risk. The problem is that risk is only a relevant term when there is an adjective put before it, as every strategy incurs some type of risk, but they are all different. For instance, sitting on cash might seem safe, but one is risking the rapid depreciation of their capital, as their money buys less goods due to inflation. Investors thought they were smart buying bonds the last few years when rates were actually negative in many instances, as the prices of the bonds kept appreciating. In 2022 however, the bubble popped and bonds experienced the biggest losses in bond market history, as aggressive Fed rate hikes caused prices to decline. These investors took interest rate risks.
Many investors invest close to 100% of their liquid capital being long stocks. This strategy looks brilliant in a bull market, but it can be catastrophic in a bear market. Anyone pursuing such a strategy should be able to hold stocks for many years, not selling just because they are down in a given year or two. This type of strategy is also not particularly appropriate for someone that needs to draw cash in the near-term for various reasons, as this could cause them to have to sell stocks when they are beaten down.
At TTCM, our goal is to maximize risk-adjusted returns. To accomplish this, we start by identifying securities that trade at large discounts to intrinsic value. Then we look across the capital structure, to determine the best way to capitalize. Perhaps that means simply just buying the stock. Since the upside for stocks is technically unlimited, that can often be the most aggressive strategy we will deploy. Maybe the debt or preferred stock is the attractive play. We have done well buying distressed debt such as in the bonds of Transocean RIG, where the balance sheet had too much leverage putting the equity at risk, but high double-digit returns were available in the bonds with far more security and collateral backing them. As oil prices have risen and demand for offshore oil has increased, Transocean has been able to deploy more of its rigs at higher rates, improving the financial situation of the company, leading the bonds to rally substantially.
Unique to our strategy, we also have the ability to deploy cash-secured puts or covered calls to generate income and reduce risk. If we think a stock has 30% upside, but we can sell a put and generate a 20% return, while also creating a 20% margin of safety before we would actually lose any money, this might be more attractive on a risk-adjusted basis. The stock market isn’t always insanely cheap or expensive. Often, it is within a range that is relatively “fair” valued. During these times, we believe that selling cash-secured puts and covered calls on undervalued securities can provide better risk-adjusted returns. The options can add an element of timing, where the result is either generating cash flow, or buying or selling a stock at a price that you find to be attractive.
This week will be an important week with many major companies reporting earnings, and the Federal Reserve announcing their decision on interest rates. The expectation is for a 25 basis point hike and the guidance will be extremely important. It feels like the economy picked up a bit of steam in January, which is good in that it could delay the recession, but it might pressure the inflationary data if the trend persists. Car dealerships seem to be busier than they were in late 2022, and even housing has shown some signs of life. It’s nothing to overthink, but it will be something worth watching. This has been the most telegraphed recession in history, yet the unemployment rate is only 3.5%. The shock would be if a recession didn’t occur given what we are seeing on the yield curve, but we don’t have to accurately forecast the macro environment to invest successfully thankfully. We will keep you posted as things develop of course. Lastly, if you have any friends or family members that could use better financial advice and investment management, please don’t hesitate to pass them our info. We’ve taken great pride in being able to help families build a better financial future and I’m optimistic that the best opportunities are ahead of us.