Volatility has started to accelerate in the stock market, which has predictably led to higher anxiety levels. Many market pundits will point to specific catalysts such as Syria, Ukraine and Ebola, but the reality is that many of these risks have also existed while the market has been rising. Much of what is going on is simply noise and reflects the changing perceptions of market participants, which have historically been highly fickle.
The only thing that truly matters is how the businesses that we are buying are doing, relative to the price that we have been able to buy them. In this regard, I am extremely confident. Banks are seeing strong loan growth and are past the most challenging regulatory and legal hurdles that have haunted them since the Financial Crisis. Many of our insurance companies are still trading at large discounts to tangible book value, or a conservative estimate of liquidation value. Even better, many of these companies have excess capital and are aggressively buying back stock, thereby increasing the intrinsic value. We had already paired some of our energy positions as they had climbed earlier in the year, but the recent drop in oil prices has created compelling buying opportunities in that sector if one believes that global economy is likely to continue to expand.
We’ve been aggressive in taking profits as stocks have reached fair value and have reset into cheaper stocks and sold put options that offer us a larger margin of safety. When volatility accelerates the puts that we have sold do increase in price, which presents us with a short-term mark to market hit, which is absolutely meaningless assuming that we are willing to hold the options until expiration, which we are. At that point, volatility will go to zero and the only thing that will matter is where the stock is trading versus our strike price, and our worst case scenario is owning a stock that we want to own at an even cheaper price.
For example, let’s say that we sell a January 2016 $50 put on stock XYZ, which trades at $51, for a premium of $6.00. This means that we collected $600 and have a maximum risk of $4,400, so we are targeting a 13.6% return in just over a year, assuming the stock expires above $50 at expiration. Our breakeven price is $44. Well, if the stock declines to $49 quickly, that option might now be going for $7.50, putting us at a short-term mark to market loss of $150. Well if we were planning on liquidating, this would be a concern, but note that even if the stock were to expire at $49, we would be nicely profitable. In fact, the stock could drop 13.7% before we would reach our breakeven level at expiration, so we still have a nice cushion but time is required to roll-off because the option doesn’t expire until January 2016. If this is a business that we initially believed had an intrinsic value of $65 let’s say, and that intrinsic value is growing by 10% per annum, the margin of safety and long-term potential returns become that much greater. The temporary decline in price allows us the opportunity to buy more at cheaper prices. This is why it is often best not to obsessively worry about short-term performance or stock price movements because in the long-term they are truly meaningless.
Below is a quick excerpt from Warren Buffett’s interview on CNBC where he beautifully educates on how he looks at stocks as fractional shares of a business and why the only reason most people don’t, is because they get caught up in the liquidity trap of having constant access to second by second stock quotes. I hope that you enjoy and if you have any questions please don’t hesitate to contact us!