Global equity and fixed income markets have been in a state of tremendous trepidation, as fears of central bank tightening, combined with still slow economic growth have market participants frightened. These issues really have been quite predictable and I don’t view much as having changed, as it is inevitable that at some point, interest rates will rise, and it has been pretty clear that global growth has been relatively anemic. The real problem in my estimation, is that most market participants are so focused on the short-term, that they create speculative positions along with the crowd, and then they try and stampede out of the movie theater at the first sign of smoke. This is not investing, which is why I differentiate between market participants and investors, as they are two very different groups of people. The common trade has been buying bonds and high yielding dividend stocks regardless of valuation, because of the limited options to generate income due to low interest rates. This sounds good on paper, but whenever you are paying a premium to intrinsic value, you are subjecting yourself to the risks of permanent losses of capital when price and value converge, which they almost always tend to do at some point.
At T&T Capital Management (TTCM) we use a deep value investing method predicated on extensive research and analysis. There are several other firms that I think also do a good job employing a value investing strategy, but what makes our firm unique is that we also intertwine various options and fixed income strategies to generate income, reduce risk, and to instill a disciplined selling process. None of our options strategies are speculative in the way that most market participants utilize options, but instead they enable us to generate very high fixed income-like returns when the options expire worthless, or at worst, we are able to dollar-cost-average into stocks that we already deem to be deeply undervalued. In bull markets, many investment managers look to be highly intelligent just being long stocks, but by using the options we provide ourselves with enhanced income and protection on the downside.
When long-term investors such as us, buy stocks, the holding period can be several years or more. For example, let’s say that we believe Citigroup is worth $70 a share, we might be willing to buy the stock aggressively up to $50 per share, thereby allowing us an adequate margin of safety. We rarely will sell a stock significantly below intrinsic value unless we have a much better opportunity, or if the client is looking to take out cash. The problems with just owning stocks outright is that you have no control over timing, and if you want to buy more of the stock, you need to hope that the stock declines in price. By selling put options, we can manufacture the terms of our investment with a specific expiration date and return expectation, and the biggest risk that we take is that we will own the stock we want to own at a much cheaper price than is currently available. Most often these options will expire worthless, allowing us to generate cash and to redeploy the capital, but when markets trend lower we will often get exercised on our options, allowing us to buy the stocks at a deep discount to intrinsic value. This is a disciplined way of only buying when there is blood in the streets.
Options enable us to scale into stocks, building bigger positions than we would be able to do buying stocks outright. It also allows us to take profits on our option positions, without selling any of our long-term stock positions. As long-term investors, this is very attractive because we maintain the favorable tax attributes of holding stock for long periods of time, while supplementing that with income that can be redeployed at attractive rates of return. Because we have alternative ways of generating income, we aren’t forced to load up on fixed income or high-dividend stocks at ridiculous valuations. Unsurprisingly, those areas of the market have been hammered in the recent sell-off.
Now while all of this sounds wonderful, it is important to balance our presentation. At TTCM, we seek to minimize the risk of permanent losses of capital while maximizing risk-adjusted returns, and I believe our strategy is the best way to accomplish this. We do not attempt to mitigate short-term mark to market losses though, because we believe that is virtually impossible, and more damaging than helpful. When stocks go down and volatility goes up, our portfolios’ will likely go down as well. Much of our options value is predicated on time and volatility, so when volatility goes up, our sold options go up in price, often putting us in a losing position. As long as we are willing to hold our options till expiration though, volatility and time will go to 0, and the only thing that will matter is where our stock prices are in relation to the strike prices of the options. This is often why we have seen substantial rallies towards the end of the year, as time decay picks up steam in our accounts.
Our strategy really forces us to only buy stocks when we have a tremendous margin of safety. We have bought very little stock in the last 6 months as markets have rallied, and instead we have focused on selling long-term put options on the most undervalued securities in our portfolios’. This should greatly reduce our chances of taking permanent losses of capital but you should expect to see a lot of volatility over the short-term and the smart move is to ignore it. Of course, we will be looking to buy aggressively when our favorite names go on sale, setting the stage for attractive long-term returns.
As always, if you have any questions, please don’t hesitate to contact us. We put this information out to educate and update you, as it has been our experience that the more educated you are on investing, the less likely you are to be prone to panicking, which in our experience over the years has been the biggest mistake that we have seen market participants make. Fortunately, our clients seem to take a different and more long-term approach, and I believe that if we continue to do that we will be quite happy with our results. Thank you very much!
INVESTING IN THE FINANCIAL MARKETS INVOLVES RISKS. OPTIONS ARE NOT SUITABLE FOR ALL INVESTORS.