Buying Stock at a Discount

 

The easiest way to invest in equities is with a mutual fund. The surest way to match market performance is to use index funds. Then there are times we get the urge to do things the hard way.

Of all investment classes the broad market has performed best. The stock market, for all its fits and starts, has outperformed over long periods of time without the need or risks of leverage to accomplish the goal.

A simple strategy of consistent investing in index funds has plenty of adherents in the FIRE* demographic. The reason for this is simple: it works! Depending on where in the market cycle you start, a decade to decade and a half if all that’s needed to fund your retirement. Start saving half you gross income at age twenty and by 35 you are ready to either retire or carve your own path in life.

The plethora of blogs in this demographic are a testament to the successful strategy of wealth building with index funds. What is often forgotten is that you are investing in real businesses even when using an index fund. And it’s business, not stocks, which create the real wealth.

If it takes a decade or so to create an adequate net worth to retire, business can get you there in a few years.

Buying an index fund is a sure way to enjoy average growth. Average is good in this case because the economy grows, always has grown and will continue growing into the foreseeable future. As productivity and other advances and new technology come online you are in for the ride because your index fund owns just about every winner in the crowd. You also own old school companies still growing and/or throwing off massive dividends. There are also a few stinkers in the crowd as some former success stories are headed for the exit.

With this in mind, intelligent people sometimes want to strike out on their own with a small percentage of their portfolio. If you possess the mind of an accountant and the discipline of a saint you can ferret out opportunities with the potential of outperforming the market.

And armed with this knowledge it becomes clear the pickings are slim when the market has been straight up for eight years. There are plenty of great companies, but most sell for a dear price, unworthy of additional investment unless available at some future date at a better price.

A Clear View of the Future

Exotic securities have been devised over the years to hedge various investments. These very same tools are easily used to gamble, ah, speculate.

Farmers have had futures contracts available to them since before the beginning of time. It makes sense for a farmer to use futures to protect their investment in an uncertain world. Agricultural products have thin margins and farmers know it. A small shift in commodity prices between planting and harvest can destroy a farm financially.

To limit the risk of prices changing, a farmer can sell his future corn crop in advance. It works like this: A farmer probably knows his input costs of fuel, seeds and fertilizer. He also knows if it makes sense to drill the seeds into the ground in the first place. If the input costs are more than he can expect at harvest he either needs to allow fields to lay fallow, plant a different crop or hope to Mother Mary prices turn around.

Even if the farmer sees current corn prices are higher than his input costs there are no guarantees prices will stay favorable. A drought can devastate his crop and prices tend to decline into harvest as more of the commodity becomes available.

To limit risk the farmer can sell his expected corn crop coming off the field in autumn before he even plants in spring! If prices go up the farmer loses on his hedge, but wins on the actual crop. In prices decline he loses on the actual crop, but profits from the futures hedge.

Futures contracts are a necessary part of farm living. Without the ability to hedge farmers are one, or at best two, bad years away from bankruptcy.

The same tools can be applied to almost any asset.

You Have Two Options

Before we start this part of the discussion I want to give a warning. This is more a case of do what I say, not what I do. I use some very advanced methods when protecting my investments and when buying them. This discussion is on options. I do NOT recommend options except to the most knowledgeable and astute investor! Consider the remainder of this post informational only.

If you are unfamiliar with options and how they work, here is an article on Investopedia and another from NotWallStreet. Do NOT let anyone, me, a broker, a TV talking head or internet article, talk you into options unless you know what you are doing. You don’t.

There are two options in the world: calls and puts. Like futures for a farmer, an investor can hedge her investments against the price on some future date. The market has been rallying hard for years. If you are worried about the market declining, you can sell your stocks or index funds and pay taxes on the realized gains or write covered calls or buy puts. Each action has its own associated risk.

Selling causes tax issues, but at least the damage is known. Covered calls only provide limited protection and if the market keeps climbing you are likely to lose out on future gains. A covered call might provide a few points in premium only. If the market decline is larger you will suffer paper loses. Buying a protective put is a cheap hedge and frequently the preferable route. If the market declines you gain on the put option; if the market rises or stagnates your only risk (loss) is the put premium.

But that is not what I use options for. I’d buy a LEAP call option on the S&P 500 if I got the same deal Warren Buffett did nearly a decade ago. (Buffett paid a small premium for an at-the-money S&P 500 index call with a 10-year time frame with the market off nearly 50%. I wanted the same deal but they showed me the door.)

I rarely use covered calls to generate premiums as the market likes to steal your stock when you do. I don’t speculate or gamble with options either.

The one time I love to use options is in a market like we’ve had the last several years. The market has been doing well for a long time and when I’m looking to buy an individual stock I sometimes use options. (You can use the same strategy with index funds, but I never do. I still invest excess capital into the index fund and wait like a good boy.)

The problem with today’s market is good companies are selling at too high a price. Now if I could pick up some Facebook (FB) at 100 or Apple (AAPL) at 140 I’d be excited. (FB last closed at 179 and AAPL at 170.15.)

Most stocks don’t have much of a premium for short-dated options way out-of-the-money. Some stocks do. The best way to show you how I spike my returns using options is to list what I have in my current portfolio.

First, when I sell naked puts I consider them long-term buy orders in companies I want to own more of when the price is too high. If the price comes down enough the options will execute and I’ll get my extra shares. If the stock doesn’t drop enough or advances I keep the premiums. I never use this strategy in a down market as I can just buy the stock without waiting.

Here are my current naked put holdings:

 

Company             Sold Date             # Sold    Option Date       Strike    Sold $    Current $

AAPL                     11/15/17              -2            Jun 15, 18            140         3.04        2.87

FB                           6/9/17                   -4            Dec15, 17             120         2.05        .01

FB                           6/29/17                -2            Jun 15, 18            100         2.00        .30

MO                        7/31/17                -2            Jan 18, 19             65           8.03        5.90

NFLX                      5/25/17                -2            Dec 15, 17            130         4.05        .05

PM                         10/30/17              -2            Jan 18, 19             90           4.33        5.25

TSLA                      5/25/17                -1            Dec 15, 17            220         6.68        .26

 

If every stock declined to the strike price or lower I would be on the hook to buy $175,000 of stock! As you can see most transactions will expire worthless before the end of the year and I keep the premiums.

MO is the outlier. Option premiums are low for MO so I sold a LEAP out in January of 2019. I also bought more MO in the low 60s recently.

I am willing to buy each one of these stocks at the strike price should the market decline to those levels and probably will even without the naked puts.

Risks

There are two risks to consider. The first requires self control. You only sell naked puts in the amount you have current funds available to buy.

The second risk you can’t control. If the story changes and the stock crashes, you will end up buying back the put at a loss or owning shares in a company where the story is no longer compelling.

Simply put (pun intended), there is no risk free investment. Just wanted you to understand the two risks in this scenario.

The Cash Hoard and the Friends I Keep

Whenever I mention I use this strategy people ask why I don’t stay 100% invested all the time. My answer is, for the same reason Warren Buffett’s Berkshire Hathaway has around $100 billion in cash currently.

The truth is I like to keep my powder dry. I never have 100% of my money invested. There are a few nickels in my pocket when I walk around town to avoid vagrancy charges. As a business owner I need liquid working capital so I always have something tucked between the mattresses. I also like keeping some money available in case an unbelievable opportunity arises.

You do the same thing on a smaller scale. You might have an emergency fund. If so, it’s probably earning a whopping 1% while it waits for work to arrive.

Another brutal truth to why I keep a larger amount of cash laying around is because I am different than you. The higher your net worth the more liquid cash you will tend to accumulate during certain times of the year and during market overvaluations. I consider the current market overvalued.

Does my opinion of the market conditions change my core investing style? No! I max out all my retirement accounts (Mrs. Accountant’s too) and put it all in index funds. Those suckers keep getting filled.

When it comes to individual stocks I need to build a reserve to buy companies when they are on sale.

I’m not alone in using this strategy to generate income. Back in the 90s Intel (INTC) sold massive quantities of put options with the intention of using a down market to buy back shares. (I’m not sure if INTC still does this or not.)

Over the years INTC had such a large income stream from the naked puts they listed the income separately in their earnings reports and annual report. INTC’s intention was to structure the naked puts to force execution so they could buy back the stock and keep the premium. There was serious money in this for INTC.

I owned INTC for a few years back then. It wasn’t my favorite investment, but it had potential until my research discovered a terrible truth. I went back and reviewed over a decade of financials for INTC and discovered they bought back more stock than their entire earning over the previous decade and still had MORE shares outstanding. Such is the world (and risk to shareholders) of employee incentive stock option.

We’ll leave that discussion for another day.

A Steaming Pile of Schmoo

This was harder than I thought. Novices will be left bewildered and experts already understand the program. How do you present a complex idea like options in under 2,000 words? You don’t! I feel like I left a mish-mash of information. The information is accurate! The issue is communication. Did I get my message across?

There is so much more to this discussion than I could pack into one post. Naked puts are a viable investment strategy if used in a limited fashion, even if INTC used it to the nth degree.

Options in and of themselves are not bad. They do have the potential to cause great harm however and they are easy to abuse. Consider options the opioids of your investment portfolio. They reduce pain at first, but can do lasting damage when abused.

So why do I do it? Because if the market doesn’t decline I keep over $6,200 in premiums. The extra cash, added to an already growing stash, will come in handy when the market does decline and some companies become a steal.

Or I might be an addict beyond help. You decide.

 

* Financial independence, retire early.