Buckle up. In today’s excerpt from the Spring letter I wrote to IMA clients, we’ll discuss stock options and Uber. If you have not read my in-depth writeup on Uber, it’s here.
Hedging the Portfolio with Weapons of Mass Destruction
Uber's business is doing extremely well. It has reached escape velocity – the company's expenses have grown at a slow rate while its revenues are growing at 22% a year. This caused profit margins to expand and earnings and free cash flows to skyrocket. Our investment in Uber was based on the assumption that its services would become a utility – just like water and electricity. The company's name is synonymous with ridesharing.
I must confess that the biggest risk to our investment in Uber is me. Yes, you read that right. Uber has an incredible growth runway. It is not just going after ridesharing and food delivery, where it still has plenty of room to grow, it is also making serious inroads into the grocery market. It has terrific management that is putting a lot of daylight between Uber and its competitors.
On one hand, we are managing your portfolio as though we were managing all of your net worth (this is actually the case with most, though not all, of our clients). Thus, we see it as our fiduciary duty not to let one stock dominate the portfolio. Bad things do happen to great companies.
On the other hand, we know that some companies which have a high return on capital, a dominant industry position, and a very long growth runway reward those who can maintain long-term focus. There are very few of those companies out there. Uber is one of them.
This stock requires an incredible ability to sit on your hands (not selling or trimming), which is very hard, especially when the stock more than doubles in less than a year and becomes a very large position in the portfolio and a good chunk of the company’s earnings power lies far into the future.
Therefore, we did the second-best thing to trimming your Uber position; we hedged a portion of it using what is called a protective collar.
Before, I get into the structure of this trade, let me discuss options.
As a shortcut, our brains categorize words as negative or positive. Psychologists probably have a fancy name for it, but I’ll just call them cognitive associations. For most people, derivatives and options are associated with giant Wall Street blowups and thus have a negative association.
Although cognitive associations can be useful (most people should not touch derivatives with a ten-foot pole), they can also be harmful, as they may lead us to overlook nuances. Warren Buffett famously called derivatives "weapons of mass destruction" in the late 90s, but a decade later he amassed a huge position in them. Many things are neither negative nor positive; it is our use that makes them so. Just as a hammer can be employed as a murder weapon, it can also be used to build a beautiful birdhouse.
Our approach to options comes from our guiding principle: Do no harm (don’t blow up). We are very cautious in opportunistically using options to reduce risk in the portfolio (usually as hedges). Though use of options may still lead to losses, these losses should be bearable and not life-changing.
Let's discuss our UBER hedge. In simple household terms, we sold a ceiling and with the sale proceeds bought a floor.
Let me explain.
When Uber was trading at $80, we sold (wrote) a call option at $100 and received a premium of $6. This created an obligation for us to sell our Uber shares at $100. We only implemented this in accounts where we own Uber shares, so it is an obligation that we can easily fulfill. We would have reduced our Uber position at $100 anyway. Therefore, we simply got paid for something we would have done regardless.
We took this $6 and used it to buy a put at $70 (an option, not an obligation to sell at $70 – think of this as buying insurance). Both contracts have the same expiration date, December 2024. At essentially no cost, we created a 12.5% floor under our Uber stock in exchange for a 25% ceiling. We love the asymmetry in this trade. Typically, put options are more expensive than call options, but not in today's euphoric market that has been continuously rising. We took advantage of this by putting this trade on. This is how we use options sparingly and opportunistically.
If UBER goes down to, let’s say, $55, the value of our shares will decline by $25 (from $80); however, the price of the put option will go up $15 – offsetting a loss on hedged shares.
We only put this collar on a portion of Uber shares. As I have mentioned, Uber has a very bright future, but risks do happen and thus we need to manage individual position sizes.
We may also use options to hedge our portfolio in the future. I wrote about it in 2018, and will discuss it below.
Options, Hurricanes and Hedging
Though first written in 2018, this article remains relevant to this day.
We always look at our investment process and ask ourselves, “What can we do better?” How can we increase returns and lower risk?
One way: We can hedge a portion of our market exposure with put options. Put options are contracts that trade on an exchange which give the buyer (us) a right, not an obligation, to sell stock (or Index, ETF, or other security) at a specific price for a certain period of time. Put options are cash settled, so when we exercise it or it expires we get cash in lieu of its value. Buying put options is very similar to buying hurricane insurance. We pay a premium, and that is the only cost we bear. Let's restate this: The only risk we take is that the hurricane doesn’t hit or, in our case, that the stock market doesn’t decline, in which case our premium was “wasted.”
When you buy hurricane insurance you don’t suddenly start wishing for a hurricane, but you do get peace of mind from knowing that if Richard or Betty (we name hurricanes like we name pets) pays you a visit, the insurance company will restore your house to its original state.
We look at options “insurance” the same way we look at any asset: It can make sense at one price but make no sense at another. As you will see, at today’s price they make a lot of sense.
For the sake of simplicity let’s make a few assumptions: First, your portfolio is 100% correlated to the stock market. Second, your portfolio is 100% invested. And finally, let’s assume we’d be buying put options to insure your whole portfolio. These assumptions will simplify our example – we’ll modify them later.
Based on our assumptions, we’d buy put options on ETFs that track a particular stock market index – let’s say the S&P 500. In January 2018, for example, if we bought options on the S&P 500 ETF, SPY, that expire in one year and that were 5% out of the money (they wouldn’t start paying us until the S&P declines 5% or more from that point – think of this 5% as our deductible), the cost of insuring the entire portfolio would have been about 4% of its total value. For a $1 million portfolio it would be $40,000.
If the stock market decline is greater than 5%, the insurance kicks in. After a 5% decline the value of our stock options starts going up proportionally to the decline in the portfolio. If the stock market falls 20%, the $1 million portfolio declines to $800,000, but this $200,000 loss is offset by the appreciation of our put options, which go up by roughly $150,000. Thus the value of the portfolio is now $950,000 (remember our 5% deductible). Actually that number will most likely be less – somewhere between $910,000 and $950,000, because we paid $40,000 for the put options.
Without getting too deep into the weeds, the price of an option is driven by two additional factors: time (options are not good wine; they get cheaper with age) and expected volatility, which we’ll discuss next.
Let’s say you are insuring a home somewhere on the Florida coast. The general formula to calculate the cost of insurance is probability of loss times severity of loss. According to a study by Colorado State University, the climatological probability that the coast of Florida will get hit by a major hurricane in any particular year is 21%, so once every five years or so.
A 21% probability doesn’t mean that a hurricane will pay a visit every fifth year; no, it actually means that over a 100-year period there will on average be 20 hurricanes hitting the Florida coast. Hurricanes may, however, decide to pay a visit two or three years in a row and then take eight or ten years off.
21% is the number an insurance company uses to figure out the intrinsic cost of the insurance. But this is where we have to draw a distinction between climatological probability of loss (intrinsic or true cost) and expected probability of loss.
There are other factors that go into the total cost of the insurance contract, including the size of the policy, its duration, and the deductible. But if you hold all these factors constant, the only number that fluctuates due to supply and demand in the insurance market is the expected probability of loss.
A year after a hurricane, homeowners are still licking their wounds from last year’s Richard or Betty. The pain is so recent that those who were hit expect that hurricanes will happen a lot more often and thus the expected probability (in the eyes of these consumers) rises to … pick a number; let’s say 50% (a hurricane every two years). (The insurance industry may have had its capital depleted by recent hurricanes, which will also drive prices higher, but we’ll ignore this factor in our discussion.)
However, if there is no hurricane for a while, let’s say for eight years, the memory and the pain of the last hurricane fade away. A new wave of homeowners moves in, who have seen hurricanes only from the comfort of their leather couches on the Weather Channel. Now the expectation of another hurricane drops to, let’s say, 10% (a storm every ten years).
Thus, though expected probability and thus insurance cost has fluctuated dramatically from 50% to 10%, intrinsic value has not changed; it is still 21%. This example is extremely oversimplified, but the key point is still the same: A rational homeowner would want to buy insurance when no one expected a hurricane to visit Florida and lock in that price for as long as possible. If you are an insurance company you want to write as much insurance as you can when hurricanes are priced at 50% expected probability, and you want to be out of the market when they are priced at a 10% probability.
In the options market, expected probability of loss is expressed in terms of the volatility that is priced into options. A long bull market (despite some small interruptions) has eroded even the most unpleasant memories of the 2008 decline. Fear has been replaced by euphoria that has been further amplified by the steady daily appreciation of stocks. The mindset that markets will never decline ever again has gradually seeped into the collective stock market psyche. This is why volatility is cheap! How cheap? Average volatility priced into options since 2004 was about 18%; today it is at 10%. In 2008 it reached 80%, and it has reached 40% a few times since 2008.
Volatility is quickly becoming one of the most interesting assets in the otherwise not very interesting stock market. But the situation in the stock market is even more interesting than in the hurricane insurance market.
Stock markets are fueled by two often contradictory forces: human emotions and movement towards fair value. Human emotions may divorce stocks from their fair value for a considerable period of time, but movement towards fair value can only be postponed but not suspended. During bull markets greed begets greed and stock market valuations go from cheap to average to high to super-high to extra-super-high – we are running out of superlatives, but we hope you get the point: Valuations march ever higher … until the music stops.
It is hard to know what will trigger the “stops” part, but in the late stage of the bull market, stock market behavior is driven less and less by fundamental factors and more and more resembles a Ponzi scheme (though market commentators come up with plenty of rational explanations to wrap around their “this time is different” narrative).
Stocks march higher until the market runs out of buyers and collapses under its own weight. This is how movement towards fair value takes place – except that, historically, markets have rarely stopped at fair value; they have fallen to levels well below fair value.
We’ll address the market’s current (over)valuation further on in this letter.
We are not meteorologists, but we believe there is an important difference between hurricanes and stocks. Just as when you flip a coin each flip is an independent event and completely unconnected to the previous flip, hurricanes are independent events – just because Richard paid a visit to Florida last year does not change the probability of Betty’s appearance next year. Betty is not aware of Richard's past misdeeds.
In contrast, the probability of a significant market decline is not constant; it is dependent on past movements of stocks. As markets stretch higher and higher, bulk of the appreciation was driven by expansion of price to earnings. Market valuation which was already high went higher. The gap between the price and intrinsic value creates a rubber band-like tension. The wider the gap the greater the tension and risk of eventually embarking on the return trip towards fair value.
Thus, in the case of the hurricane the climatological probability of 21% of loss remains constant no matter whether Richard or Betty appears, but in the stock market the probability of a sharp decline (an equities hurricane) increases as the gap between price and fair value widens.
In other words, today the value of volatility has increased while its price is making new lows. This is why we believe volatility is one of the most interesting assets we see now.
We are not market timers. We have no idea what the stock market will do today or tomorrow, but we look at buying put options as an opportunity to hedge our portfolios with what we believe is significantly undervalued insurance.
Let’s delve into the practicality of our hedging strategy and modify some assumptions we made in the oversimplified example above. First, our portfolios are not 100% correlated to market indices. Considering that we own high-quality companies that are significantly undervalued, we believe our stocks will (temporarily) decline less than the market if there is a significant correction. Second, we have a lot of cash, which doesn’t require hedging.
Let’s say your account is 60% invested. We only need to worry about hedging that 60%. And considering that our stocks will decline less than the market, we need to buy puts to protect less than 60%. How much less? Historically our stocks have declined a lot less than the market during significant sell-offs. Our average portfolio was down 17-18% in 2008 when markets were down 35-45%. Our guestimate, therefore, is that we need to hedge about half of 60% or 30% of the total portfolio. So the total cost of insuring the portfolio against a decline of 5% or greater for a year would be 1.2% (4% – the cost of “insuring” the total portfolio – times 30%).
You can see how this strategy can reduce risk, but can it increase returns? The answer is a bit more complex and has two parts: First, if the market takes a deep dive, our appreciated put options together with cash will have increased buying power, since everything around us will be cheaper. And second, depending on when it happens – how much time value is left in the option – the value of the option may jump dramatically, as the market will be pricing in not 10% volatility but a much higher number – 30%, 40%? – your guess is as good as ours.
IMA’s ultimate goal is to produce good risk-adjusted returns while keeping volatility of our clients’ blood pressure level to a minimum. We try to achieve this through our conservative stock selection, our transparent (sometimes overly long) communication, and now through buying inexpensive insurance on the portion of your portfolio.
Our view on what true risk is has not changed. To value investors, true risk is not volatility (a stock temporarily declining in price), but a permanent loss of capital (the stock price decline is permanent). Our hedging strategy goal is to take advantage of an undervalued asset – volatility – and to decrease your (future) blood pressure just a little.
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I'd love to hear your thoughts, so please leave your comment and feedback here. Also, if you missed my "From Twinkies to Rolexes (IMA Client Dinner 2024 Video)" article last week, you can view or read it and leave a comment here.
Below is my latest Youtube video:
Evita
This is a continuation of my journey into musicals (I discussed Juno and Avos last time).
In the early 1990s I was mesmerized by Evita, a musical composed by Andrew Lloyd Webber.
Let’s take a small detour and talk about Andrew Lloyd Webber. Webber composed Evita, Jesus Christ Super Star, Phantom of the Opera, Cats, Sunset Boulevard, and many other musicals. In 2001 the New York Times called him “the most commercially successful composer in history.” What is interesting is that Webber composed another dozen musicals that saw the light of day for only a very short time and were then consigned to obscurity. Failure is an important constant of success, even for creative giants like Sir Andrew Lloyd Webber (he was knighted by the Queen in 1992).
If you’d like to relive Webber’s best musicals and meet Sir Genius, watch this three-part concert:
Click here to listen.
Evita is a musical about Eva “Evita” Peron. Eva comes from a poor family in Argentina. She meets Juan Peron – a future three-time president of Argentina. During Peron’s presidency Argentina fell in love with Evita. Evita tragically dies of cancer at the tender age of 33. A lot of political events happen in between and some romance, but this sums up the musical. I must admit, I am somewhat indifferent to the story line of this musical. I don’t see many redeeming qualities in Juan Peron. And unlike Argentina, I did not fall in love with Evita. But I love the music. Pop singer Madonna and Antonio Banderas did a terrific job starring in the 1996 movie.
Here are my favorite songs:
Click here to listen.
Vitaliy Katsenelson is the CEO at IMA, a value investing firm in Denver. He has written two books on investing, which were published by John Wiley & Sons and have been translated into eight languages. Soul in the Game: The Art of a Meaningful Life (Harriman House, 2022) is his first non-investing book. You can get unpublished bonus chapters by forwarding your purchase receipt to bonus@soulinthegame.net.
Please read the following important disclosure here.