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Value In Exotic Asset, fade focusing on short-term returns
And finally, you mentioned in your August letter that Broyhill is buying mispriced options to generate short-term returns. What was your thesis behind this trade and how does it fit into your value mandate? Do you frequently use derivatives to boost short-term returns?
I wouldn't say that we frequently use short-term returns. But we don't think the words 'options' and 'value' are mutually exclusive. And to be clear, the single largest driver of our returns has been, and will generally be, driven by direct investments in individual securities.
We are fundamental investors, and we tend to worry more than most. As a result, we are willing to trade some upside during good times for the ability to sleep better at night. Holding cash in the absence of compelling opportunities helps us sleep. At the right price, and under certain conditions, hedging a portion of our risk through the purchase of put options helps us sleep even better. This was certainly the case last quarter as our declines were limited to a fraction of the losses experienced by stock indices. More importantly, while many investors were paralyzed by short-term fear and rapid price declines, we were positioned to buy more of the businesses we own at better prices, and as a result, we recouped our unrealized losses more quickly.
The occasional use of options in this manner serves to reduce our risk, rather than boost short-term returns. Our use of options is not unlike our other value-driven investments. We aim to buy low and sell high. Occasionally, us to sell high and collect rich premiums which give us the right to buy companies we'd like to own at lower prices. And since we typically have plenty of cash on hand, these positions are always fully collateralized. Again, we view this is as an inherently lower risk proposition than owning the stock outright.
We don't use leverage, but we are more than happy to enhance the return on our cash while waiting for lower prices and a wider margin of safety. In August, for example, volatility spiked to levels last seen in the wake of Lehman's collapse. In response, we sold options to increase our exposure to several core holdings in the portfolio earning returns on our cash approaching double-digits over the course of a few weeks. With the overall market barely correcting 10%, selling options with the a better risk/reward than buying the stock outright.
In addition to put selling, we will occasionally use options to exit positions by writing covered calls at strike prices near intrinsic value. This is less common for us as the premium rarely offsets the downside risk of holding onto a fully valued position. That said, the premium can serve to offset partially declines in market value when markets are falling. More importantly, in both cases, we are being paid to do something we would do anyway.
You run a unique, value-based options strategy which is designed to take advantage of price inefficiencies in the market. Could you give our readers a brief description of the strategy and why you decided to use it?
It is basically a concentrated, long-term, all-cap value-oriented strategy primarily focused on the equities and options of high-quality companies. Ideally, I look for companies with a competitive advantage that trade at a margin of safety. I typically have around 10 to 20 equity holdings in my portfolio, preferably closer to 10.
Regarding option positions, the way I look at the strategy is kind of like running an insurance book along with existing equity holdings — similar to Buffett's concept at Berkshire. Buffett has been able to create permanent capital for investing by using Berkshire's insurance subsidiaries' float. And that's the kind of business model that I've tried to create, except with options.
So you write options to generate income and grow the float?
Exactly. The vast majority of options trading is on ETFs, and most of that is short-term trading, for hedging and speculating. Because most traders concentrate on these limited markets, there's very little attention focused on longer term options of individual companies. A lot of institutional investors just can't invest in this sector, because their investment mandates won't allow it and hedge funds are only interested in the short-term use of options to hedge positions. The great thing is you can find some options with significant mispricing across the entire market. A couple of weeks ago, I found options on a company with a $100 million market cap! So, there are definitely opportunities out there to take advantage of with these derivatives, but structural reasons prevent many investors from making the most of the opportunities available to them. There's also a general lack of interest in this area.
If you find a security that is undervalued and has a margin of safety, generally speaking there will be an even bigger mispricing in the options. To profit from this you can sell put spreads or buy call spreads – the former eliminates the tail risk. If you feel comfortable just selling naked puts that will help you generate even more float, but you have to be comfortable buying the stock at the set price if it comes to it.
You seem to focus on a company's Net Operating Losses (NOLs) more than any other metric when analyzing its future potential. Why do you prefer to use NOLs to evaluate a company, rather than more traditional valuation methods?
The focus on NOLs is a moment-in-time focus. I don't know if the opportunity will be there five years from now.
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