Hello Everybody,
January has been a month of extreme volatility in everything including stocks, bonds, commodities and currencies. Historic moves have occurred causing massive distortions throughout financial markets. For instance; to deposit money at the German or Swiss central banks’, the depositor has to pay the bank. Earnings season started with financials selling off and as more numbers have come out, many other stocks have come down considerably. Stocks such as Microsoft, Alibaba, Caterpillar and scores of others have come down by 10% or greater, often in only one day. Oil has continued to head lower, as have stocks related to just about any commodity, as deflation fears continue to become more prominent. Volatility is to markets, what turbulence is to flying. It is an inevitable reality and the key is how you react to it.
Stocks are fractional shares of businesses. Short-term price fluctuations have absolutely nothing to do with the business value, just like if you own a farm or an insurance company, the value doesn’t drop just because the Dow drops 5% in a month. When we buy businesses, we buy at substantial discounts to intrinsic value. Often to get these discounts to intrinsic value we are buying businesses that are temporarily out of favor. By buying cheap, we have a foundation where over time, we shouldn’t lose money and actually should make quite a bit. The key is just waiting things out and being patient. We haven’t had any clients panic due to volatility, which is something that I think speaks volumes about the quality of client that we’ve attracted at TTCM.
Right now there are some incredible buying opportunities. AIG is selling at $49 with a liquidation value close to $80, that is likely to grow by 10-15% this year and possibly next. Just about every stock we own in significant amounts trades at a discount to a conservative estimate of book value and less than 10 times normalized earnings, despite being profitable. This should set the stage for a sharp and substantial recovery once fear subsides, not unlike what we saw in 2012, after the European Panic of 2011. If you are in a position to add cash, it is an absolutely amazing time to do so as the opportunities for fresh capital are quite robust. It is not an ideal time to withdraw cash if you are fully invested, as that may entail selling securities at a large discount to intrinsic value.
Lastly, I wanted to touch on our strategy of selling put options. There are a lot of really smart people that I’ve talked to that intelligently ask why we don’t always just buy the stock outright if we like it instead of selling puts. The rationale for their argument is that if you think a stock will likely rally 50%-75 over the next 3 years, why settle for 10-20% target returns by selling put options? First of all, we usually do a combination of buying stock and selling puts, so if the upside is that great we should capture it. Selling puts gives us the opportunity to generate income if the options expire worthless, or worst case scenario it means that we are buying the stock we want to own at an even bigger discount. We are now in year 6 of a bull market and the market is not cheap whatsoever, except for a few specific industries. Even though our stocks are cheap, in a general selloff most things will come down over the short-term. Selling puts is a prudent way to hedge the risk and it also allows us to establish bigger positions than we would if we were just buying the stock outright. The other benefit that I haven’t really written about before is that selling put options makes it easier to cash in profits. For example, last year as a firm we closed out hundreds if not thousands of Bank of America, Citigroup, and AIG put options at considerable profits as the stocks rose and time expired. We didn’t sell the stocks though because we believe all 3 have the potential to double over the next 3-5 years. If we didn’t use the options, we wouldn’t have made as much money because the recent selloff would have wiped out a good portion of our gains. In energy stocks, we closed out tons of APA, CHK and NOV puts last year with profits, despite the stocks not reaching our estimates of intrinsic value and this helped us avoid the worst of the major bear market in the energy sector. The benefits of these types of strategies will become more and more apparent, with the more difficult market conditions get. To realize the full value of the options, we just need to hold them till expiration and you’ll see that they can provide an incredibly valuable cushion and source of income in your portfolio.
Thank you very much and please feel free to give us a call if you need anything at all!