Why cash covered puts are helpful to navigate market turmoil
We’re not alone when it comes to selling put options as an effective method to retain exposure to the market during periods of heightened volatility
One of the important facets while managing the International Growth Portfolio is that we remain flexible with our strategy, particularly when we are alert to evolving situations.
The sharp deterioration in the market throughout February and into March has exceeded our expectations. It now appears likely that investors will respond to day-to-day news events as they unfold, rather than paying attention to the longer-term fundamentals that have supported the multi-year bull run.
Because these day-to-day events are unpredictable in every which way, we have seen heightened bouts of volatility that are likely to hang over the market in the near-term.
Furthermore, while we would normally favour an approach that sees us retain core equity holdings as opposed to cash, developments of this dramatic and unanticipated nature often result in the market overshooting when it corrects itself.
In such instances, it’s necessary to refine our investment strategy in order to adopt an approach that we believe will serve as the most likely means of protecting the value of client funds, while also offering upside potential.
Selling put options is a strategy that aligns exactly with this objective. In essence, selling put options against stocks that we want to own allows us to generate income from the option premium that a buyer pays.
If stock prices deteriorate further, then we acquire stocks that we are happy to hold at a reasonable price for the long term. What’s more, there is also an additional ‘discount’ on the price we pay because of the option premium we receive.
This sort of strategy is a favourite of some of the most successful investors where they suspect the market is overvalued, due for a correction or caught up in a black swan type event.
Warren Buffett used this approach in the lead up to, and during the GFC. It ultimately allowed him to get ‘set’ and position his portfolio by investing in the market and by extension, numerous solid companies, for a long-term rebound. These sort of market-wide corrections can provide once-in-a-lifetime opportunities, which means that we don’t want to be doing nothing as it all unfolds.
One of the reasons why this strategy is particularly favoured during market downturns is that it still allows us, as a seller of the put options, to retain market exposure and remain actively involved in the stock market.
At the same time, we can also preserve capital while we wait and see how the downturn pans out, with the unpredictable nature of the Coronavirus and its effect on the global economy still unknown. All the while, we can derive passive income and maintain capital at the ready to be deployed when things become clearer.
Ultimately, if we can hedge our risk and follow in Buffett’s footsteps by positioning ourselves to potentially pick up quality companies like Apple, Microsoft and the like at a discount, then we believe selling put options is a prudent, risk-adjusted strategy that is appropriate for the near-term.
International Growth Portfolio
The portfolio declined 0.3% during February, significantly outperforming each of the key US indexes. By comparison, the S&P 500 fell 8.4% across the same period, while the Dow Jones lost 10.1% and the NASDAQ dropped 11.9%.
Once again, amid the volatility that emerged across markets, our currency hedging delivered us significant benefits that helped underpin the performance of the portfolio. With the USD/AUD increasing from 1.4951 to 1.5363, this had a direct impact on the portfolio, driving NAV growth by 3.1%.
While equities weighed on the portfolio’s NAV by 3.8%, the extent of the broad-based sell-off meant that our stocks for the most part fared better than the market. In particular, Zillow Group (ZG) managed to buck the trend and deliver modest gains, while several other stocks such as Alibaba (BABA), ResMed (RMD), Advanced Micro Devices (AMD) and Anthem (ANTM) held up well.
Zillow Group’s performance, up 20.5% across the month, was largely due to its fourth-quarter results and guidance. The real estate marketing services business posted year-on-year revenue growth of 158%, leading to a result that was well above the market’s expectations. The company’s premier agent business is growing strongly, and with another strong quarter expected, Zillow appears to be on the cusp of building enough scale to achieve sustainable profits.
At the end of the month we opted to sell all positions for the majority of clients. This meant that realised income for the month represented 17.8% of all assets from the month prior.
Given we like to retain direct exposure to equities at all times, our decision to liquidate holdings was not easy, nor anticipated, as the impact of the Coronavirus surpassed our expectations and those of the market. To date, however, we have managed to avoid some of the sharp trading losses experienced in the early days of March.
As alluded to in our newsletter, we feel market exposure may be derived from an alternative investment strategy in the short term that involves selling put options against the stocks that we want to own. This will remain our immediate focus during March and until such time that volatility subsides.
Australian Yield Portfolio
The portfolio fell 8.9% across February.
During the period we received a minor level of income from the dividend paid by Magellan Financial Group (MFG). No other dividends were paid during the month.
All but two of the equities within the portfolio contributed towards the decline in NAV, which was representative of the broader sell-down in the ASX and global markets.
The two positions that provided NAV gains were A2 Milk (A2M) and Challenger (CGF). Both companies benefitted from stellar results over reporting season.
Pleasingly, A2 Milk advised the market that demand for its products remains strong, even in China, despite the growing spread of the Coronavirus. While the company has flagged additional investment and a jump in strategic marketing costs, we view these measures as fundamental initiatives that will underpin the company’s future growth. Revenue growth and EBITDA margins still remain strong, which adds up to a compelling outlook.
Meanwhile, we took confidence from Challenger’s result. Although the company reported that net profit during the first half of the financial year fell 4%, the company has signalled that its full-year profit is likely to come in at the top of its guidance range. Combined with a better-than-expected return on equity, these fundamentals bode well for the business once volatility subsides, however, in the short term this sector will be impacted by diminishing investor confidence.
There were no trades made during February, with capital fully deployed into the market. Unrealised income represented -7.5% of NAV from the end of January, albeit with the sharp fall in the market last month, this result is not out of line given the portfolio has only been formed in recent months.
As this portfolio is oriented towards a long-term investment strategy focusing on sustainable income, we remain firm in our belief that the equities we have selected align with this objective and provide us with the best likelihood of realising that outcome.