The greatest hockey player ever Wayne Gretzky once said that “the key to scoring goals is going where the puck is going, not where it has been.” I’ve found this to be a very apt quote to describe value investing. You don’t chase performance irrespective of valuation, which is what most momentum investors do. Even ETF’s constantly buy more of the same stocks as they go up in value, which is the opposite of buying low and selling high. This created a situation in which ETF’s following the S&P 500 have now built a very high weighting in healthcare stocks, which I believe still are the most overvalued area of the market even after the selloff, with considerable risks in the years ahead.
Retirees and income-hungry investors have been in the ultimate quandary. Today’s record low interest rate environment has forced investors to take greater risks with their portfolios to seek adequate income. Many have jumped into junk bonds and have gotten beaten up quite badly, or others have advocated investing in MLP’s and REIT’s despite high valuations, and in many circumstances, dubious accounting practices. Real Estate Investment Trusts and Master Limited Partnerships have been attractive to income investors because they must pay out 90% or more of their income as dividends to qualify for a special tax exemption that allows them to avoid income taxes, which are then paid by the investors. Yields between 4-7% in some cases look great to retirees that might only be able to get .05% in a CD, or 2.06% in 10-year U.S. Treasuries. Here is the problem; both REITS and MLPS can only grow though issuing debt or through selling additional shares, as they are not able to reinvest into the businesses using organically generated free cash flow, due to the dividend requirement. Well this is absolutely fine when valuations are high as they have been and when debt is low cost. The massive decline in energy prices has caused a considerable selloff in MLPs and has pressured cash flows. Many contracts are likely to be renewed at lower prices, which could easily result in lower dividends. To fund capital expenditures, these companies have been and will continue to be forced to sell stock at increasingly lower prices. This means that to maintain these dividends, shareholders are going to be diluted at increasingly lower values. Therefore, those retirees that sought the safety of a 4% dividend yield, have likely lost 25-40% and now are going to face further dilution. This is a recipe for disaster, but this was a hugely common mistake and has been advocated by numerous market pundits, analysts and media personalities. At T&T Capital Management (TTCM), we have avoided these investment vehicles because we’ve studied the history of economic cycles and it was quite obvious that capital markets would not always be so forgiving, nor would valuations be so high.
This is why we employ a two-pronged approach, which both creates income and sets the stage for future income growth. I believe our strategy is as perfect for retirees as any out there, given this low interest rate environment. Firstly, we sell puts on deeply undervalued stocks to generate income. Right off the bat, we are reducing risk by focusing on valuations and we target annualized income returns of 10-20% on these options. Whether the stocks pay dividends or not initially isn’t a primary concern, as we want companies to do whatever is most prudent with their capital. Often for undervalued stocks we prefer stock buybacks or accretive acquisitions. There are no low-risk fixed income options available that yield anything close to 10-20% without excessive leverage and massive interest rate risk. Our options strategy is relatively low risk in my opinion over the long-term, but the key is understanding that we are equally happy to end up owning the stocks if our options get exercised.
This means that in a situation like we have now after the worst quarter since 2011 for stocks, we are likely to be exercised on some of the options that we have sold. There is still plenty of time so a lot can happen and personally I believe stocks are likely to rally, but our portfolios are positioned for massive growth at this very moment. By selling the puts we get into stocks at much cheaper prices than we could have initially bought them for. Of course many people will say, well you always could have just bought the stocks as they got cheaper, but these same people would have missed the 6 year bull market and would have to have had a crystal ball to have done so. If we end up owning more of these stocks at these prices, we can look forward to 3-5 years of above average returns in my opinion. Areas such as energy and financials are poised to see a strong recovery of this long-term time horizon.
Financial stocks in particular have historically been some of the biggest dividend payers of any industry. This hasn’t been the case over the last 6 years, as the big banks had to raise capital to meet higher regulatory standards, and tens of billions of dollars of lawsuits robbed current shareholders for the sins of the past. Those headwinds are abating, and record profits and capital levels have the big banks poised to dramatically raise dividends over the next 3-5 years. Many of these dividend payouts can double or triple over that time period. This means that if we are indeed exercised on these positions, not only can we look forward to 12-20% annualized returns from these low valuations in my estimation, but the dividends we will be earning will be absolutely huge for our retired and income-needy investors. This is how why we concern ourselves with where things are going, not where they have been. I don’t need to look at a chart to know energy is beaten up and the short-term outlook is terrible.
Yet, it is in those circumstances that opportunity presents itself. Many of these companies are likely to double or triple over the next 5 years. This is not unlike what happened to home builders during the Financial Crisis or financials for that matter, although they still obviously have a lot of upside. Conversely, other areas such as industrials, technology and healthcare, which are huge parts of the S&P 500, probably aren’t likely to perform that well. This is why you don’t want to chase short-term performance. Truthfully, that is a fool’s errand that always ends badly for folks as history has proven. Markets are volatile and many people panic. It is by focusing on the fundamentals, keeping your time horizon in mind, and maintaining discipline that I believe will lead to continued long-term strong investment results. Lastly, I always like to keep investors up to date with what I’m doing personally with my investment allocations as my family and myself are in the same stocks and strategies that we do for our clients. This recent selloff has created bargains like I haven’t seen since 2011. I’m immensely optimistic. Although I’ve recently purchased a house tying up some liquidity and am already fully invested, I’m actually going to be taking advantage of low interest rates to utilize a little margin into my personal positions. I certainly don’t advocate that for everybody but it makes sense for me and I have a lot of experience in these types of situations. If this is something you have an interest in doing or if you’d like to add money to take advantage of the downturn, give me a call at 805-886-8140 and we can discuss! Thank you very much and I look forward to a much better 4th quarter and 2016, as the stage is set for good returns in my opinion, as stocks are on sale.