It’s only October 3rd, but the month is already off to an ugly start. The hurricane and flooding which ravaged the Southeast has caused immense suffering and damage. Our prayers and thoughts go to anyone that was impacted by those horrendous conditions. In truly terrible timing, a major Port strike impacting much of the East Coast threatens to pressure an already weakening economy, just as supplies are needed to help those impacted by the flooding. If the strike lasts long, inflation or supply shortages could become issues once again. The war in the Middle East continues to expand with direct conflict between Israel and Lebanon, as well as Iran now. Beyond the Middle East, but related to it, the Ukraine vs. Russia war continues with very little talk of peace. An Axis and Allies has formed between the Nato powers and Russia, China, and Iran. The cherry on top is that there is an immensely contentious and volatile election coming in a month, in case you hadn’t heard yet.
With all of this said, how do you invest? Do you stuff your money under your mattress. Stocks have been really hot, with no major sustained selloffs. Do you keep playing until the music stops? The reality is that in every year, there are hugely concerning events. Reacting to each one is a great way to lose money. With that said, some circumstances are worse than others. The stock market reflects extreme optimism, despite all of the major risks that are present. Conversely, interest rates are still quite high relative to the last 20 years. Value stocks and international stocks are far cheaper than U.S. Growth stocks. We have to be balanced and smart in what we are doing. Conditions don’t warrant extreme exuberance in valuations; therefore, I think it would be very silly to be 100% long stocks. Stocks might continue to do great, but there are tradeoffs to everything, and I’d prefer sound risk management in times like this. At TTCM, we’ve been taking advantage of areas such as real estate stocks trading at huge discounts to intrinsic value, offering dividends between 5.5-8%, that are likely to grow for many years. We also took advantage of bonds when the opportunities were plentiful, and these positions are performing exceptionally well. There were bonds we bought with yields to maturing of 11-14%, that now have yields to maturity of around 6.5%, as they have rallied with rates going down, and the worst fears assuaged a bit.
One never knows when it will happen, but if you are 100% long stocks, you should be prepared to take a 30-50% hit without being forced to sell. Most people aren’t comfortable with that type of risk, particularly the closer one gets to retirement. At TTCM, we are focusing on extensive risk management to protect our clients. This means hand-selecting securities, focusing on only buying those trading at large discounts to intrinsic value. It means diversifying across asset classes that can benefit from tumultuous market conditions, offsetting potential hits to stocks. We utilize conservative, income-generating strategies such as covered calls and cash-secured puts to enhance income and reduce risk.
An example of an investment that we recently made could be seen in the following:
A business development company, which owns a diversified portfolio of mostly first-lien loans trades at a 26% discount to its net asset value. It pays a quarterly dividend of 12%. The credit quality compares well with high-yield bonds, but high-yield bonds are yielding around 6.7% on average. This investment offers a great opportunity to attain an attractive income stream, while also retaining upside as the discount to net asset value converges. If credit quality weakens, we have a very large margin of safety built in, so I still wouldn’t expect to lose money.
The bottom line is that investing, and money management is about balancing risk and returns. Retirement planning is about responsibly creating a strategy to have the best retirement possible, while minimizing the painful risks of retirement failure. None of these goals are compatible with maintaining an aggressive, homerun hitting approach during all market conditions. When the odds favor us, meaning stocks are valued cheaply with extreme pessimism priced in, we want to swing big. In times like now where there is excessive optimism priced in, we want to put a huge focus on protecting our downside, which is what we’ve been doing. Fortunately, with rates where they have been and with our strategies, we are still seeing very attractive returns, but with a dramatically lower risk profile, as exemplified by the successful options trade that we outlined in our last newsletter article. While there are a lot of concerning issues in the world and in this country, we can only control the things we can. Taking a businesslike and sensible approach to investing and financial planning is something that we can indeed control, and something we focus on doing each and every day for our clients.