Battling for Investment Survival Part 2: Tactics

Normally, Part 1 comes before Part 2 but Part 1 is strategy, which I’ve written but am still mulling over some of the ideas. I’ve always used a hybrid value investing/macro approach but what’s the strategy when almost everything looks cheap and the macro picture is so clouded? A plausible case can be made for either a global recession (and Japan-style deflation here in the US) or massive inflation building in the pipeline. There are pundits whom I respect on both sides of the debate and the way forward from a macro sense is unclear. So perhaps a renewed focus on obscenely cheap stocks may be the best way forward.

Regular readers know I am a political junkie, though I have managed to refrain from blogging about the election for some time (though this post, liveblogging Palin’s introduction, seems mostly prescient). But in danger of having my portfolio blow up in the same manner as McCain’s campaign, I present some of the tactics I am using going forward, even though I haven’t posted the investment strategies guiding these tactics.

  1. Use options to leverage capital, diversify duration returns and take advantage of record volatility:
    1. Naked put writing — Premiums are extremely high.  Writing puts delivers short-term returns to smooth out volatility in the investment portfolio and enforces sell discipline on the front-end.  Since I’m only writing puts on stocks that I am seriously considering owning, being assigned simply lowers the entry price so it is a win-win situation, no matter how it feels afterward.  I’ve always believed value investors who can accurately identify stocks with mispriced intrinsic values can leverage their knowledge by writing naked puts.
    2. Covered-call writing — Writing covered calls take a little sting out of long-term positions falling drastically over the last few months.  I tend to think of these as creating my own dividends. If the stock is assigned, there may be some disappointment but remember Rule 1: Don’t lose money.  I try to write calls at strikes close to my estimation of intrinsic value or my initial entry point, if the stock is deeply underwater.  In the best case scenario, the stock will rise but below the strike price, allowing me to continue writing calls while still owning the stock and collecting dividends. With the VIX index so high, call options are fetching a nice premium right now.
    3. Call spreads — I use call spreads to open long-term positions in stocks paying no or insignificant dividends.  Call spreads can have the added benefit of favorably leveraging your position while also limiting risk.  For example, I opened a long position in Goldcorp (GG), buying Jan 2011 $20 calls and selling Jan 2011 $30 calls at a net debit of $3.50 per shares ($350 per contract) for an effective price of $23.50 per share (when GG was at $26).  The most I can lose is the initial $350 cost if GG closes below $20 in Jan 2011.  My upside is also capped at $650 if GG closes above $30 in Jan 2011.  The trade can be closed at any time before then for a gain or loss, whatever the situation may be.  Based on the underlying shares ($2,350 per 100 shares), that’s a max gain of 28% and max loss of -15%.  After watching some of my gold mining stocks lose over 50%, the idea of limiting downside risk is quite attractive.  In actuality, I’m putting up $350 per contract for the chance to gain $650, almost a 2-1 payout.  The odds of Goldcorp finishing above $30 sometime between now and Jan 2011 are very high (better than 50%, if not higher in my estimation) so taking a 50/50 bet to win 2-1 on my money is a no-brainer.  The only drawback is the time limitation.
  2. For long-term holding positions, insist on dividends and solid balance sheets.  One of the ideas I’ve been mulling over is the last 20-30 years of stock market action have been an anomoly and the norm is a market more reminiscent of US equities earlier in the 20th century, complete with decade-long bear markets, low PE multiples, higher inflation, deflation, stocks yielding more than bonds (because they’re riskier), etc.  To account for that possibility, I’m favoring stocks with decent dividends so I get paid if I have to hold for a very long time without capital appreciation.  Please see my review of Martin Whitman’s book for further discussion on the idea of investor pay-off. For high prospect stocks with no dividend, see my comments on call spreads above.  If no attractive call spreads are available, the stock should have decent liquidity so I can write covered calls.
  3. Diversify global allocation at contrarian moments — Two of my most disappointing investments were moves into NZT and SKM when those currencies were near record highs against the US$.  While NZT was a bad investment thesis, SKM has actually held up quite well in its native currency; unfortunately the SK won is down something like 40% this year.  While the dollar has shown remarkable strength in recent weeks, I don’t see this move being based on economic fundamentals or sustainable.  And even if it is sustainable, diversifying internationally is still a good idea.  As foreign markets and currencies are currently being slaughtered, I’m looking to take this opportunity to scout out foreign investments.  From that standpoint and past mistakes, I’ll be focusing on countries with strong underlying fundamentals, adequate FX reserves, good debt-GDP ratios, etc.  If this bear market has taught me anything, it is that there is simply no need to chase any investment.  With patience, opportunities to invest on attractive terms will always present themselves.
  4. Seek out more “work-out” opportunities — I don’t want to get too much into this as work-outs encompass a wide range of possibilities, from merger arbitrage to warrant hedging, and I am still researching these areas.  I am also looking at various bond funds.
  5. Looking at non-exchange traded opportunities — For me, this is most pertinent as it relates to residential housing.  I have been looking to invest in rental real estate for years now and the time may be near to look at buying in the housing market.  My feel is that 2010 may be the time when buying real estate makes sense from an investment standpoint (positive cash flow and/or mortgage close to renting).

Please keep in mind that these are some of the investment tactics I am using for my personal portfolio.  I am also no options expert and am still researching options and other strategies. I make no representation that they are appropriate for anyone else (or even myself).  As always, I refer you to my disclaimer.

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5 Responses to “Battling for Investment Survival Part 2: Tactics”

  1. The Enlightened American » ENSCO INTL (ESV) Q3 2008 Update Says:

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    [...] And of course, there’s always stocks but I would be very mindful of focusing on those in industries or with business models with strong long-term prospects. That may seem obvious but some industries and business models that seem viable now or in the recent past may not be viable going forward.  [I have a separate post discussing stocks.] [...]

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    [...] market fell through to new lows in November.  If the current rally has legs, I will continue implementing my previous equity strategy while researching corporate and US government [...]

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