Maintenance CapEx

Companies make money by selling stuff they make. To make stuff, they need to invest capital.

This invested capital (IC) often takes the form of PPE for traditional widget manufacturers. From a business standpoint, one can take a broader view of IC, and recategorize any expenditure that is borne in a particular period, but “pays off” over longer time periods as capital. Thus, R&D or subscriber acquisition costs (in sticky businesses) may be thought of as CapEx.

This might involve reinterpreting the CapEx that appears on the cash flow statement.

CapEx (CX from now on) has two components: maintenance capex (MCX), which a business has to reinvest just in order to stay in place, and growth capex (GCX), which is the part of CX that increases sales.

CX = MCX + GCX

MCX is a “cost”. GCX is an investment.

If you own a rental business for example, replacing a broken heater is MCX.

Buying a new rental property is GCX.

Warren Buffet’s owner’s earnings (OE) or Greenwald’s adjusted earnings try to account for this “cost” of doing business.

OE = NOPAT - MCX

Calculation

Calculating MCX is both art and science. It is not a number that is directly broken out in financial statements. However, we can develop some intuition on how to think about it broadly, and estimate it.

For a mature company with stable sales (no growth or decline), there is no GCX. Thus, all CX is MCX. For such stable businesses, MCX is approximately equal to the depreciation.

MCX = depreciation

Another popular method uses the following algorithm:

  • estimate the sales to capital ratio, SCR
  • compute the change in sales dS = S(t) – S(t-1)
  • GCX = dS/SCR
  • MCX = CX – GCX

Additional Notes

  • average SCR over several years; compare with industry averages
  • some CX may not produce sales growth immediately (ex. building a new theme park). This may involve projection, if the past doesn’t rhyme with the present.
  • if stable or meaningful SCRs cannot be extracted, then be wary of the number you produce.

References

  1. CS Investing: Calculating Capex
  2. Old School Value
  3. Seeking Wisdom
  4. Gurufocus
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Cash Secured Puts: An Algorithm

Here’s a rough flowchart of my current CSP strategy.

Ideas - 31

I am still actively tweaking my process; so the following only represents a snapshot of my current thinking.

Search

The first step is to search a good candidate. Usually, I have about 20-30 stocks on my radar. These are stocks I am interested in owning. Some of these are companies I already own, but want to own more of.

In any case, I have a reasonable guess of the intrinsic value, IV, for this set of companies. Some of them may be trading below IV (price p < IV). If they trade at a sufficient discount, I will consider buying them outright. Usually, I like to buy stocks for at least a 20-25% discount to IV. This represents my margin of safety (MOS).

But what do I do, if the discount is not large enough? Say,

IV - MOS < p < IV.

I use this condition as an initial filter.

At any given time, depending on the overall market, 3-5 stocks may pass this filter. Two stocks, I am looking at, that pass this filter currently are MSM (IV ~ $85-90), and WFC (IV ~ $55-60). If MSM or WFC traded around $60-65 or $40-$45, respectively, I’d buy the stocks outright.

The second important filter is liquidity. When I am buying stocks, I usually don’t care about liquidity, because my holding periods are usually long. I don’t trade positions frequently. This freedom allows me to buy small-cap and foreign stocks.

With the CSP strategy, however, I need a fair bit of liquidity, since (option) holding periods (more on this later) are usually of the order of one month, and bid-ask spreads on illiquid names can be brutal.

This restricts the universe to somewhat large cap names, say market cap greater than $5B. This number is a guide, not a strict threshold. I like to see open interest for upcoming ATM options to be greater than a few hundred. Usually, both these facts are correlated.

WFC has a market cap over $250B. MSM is much smaller, ~$4B. The open interest for the $50 WFC put expiring on Oct 20 is about 5000. The comparable number for MSM is about 10. So WFC passes the second filter; MSM doesn’t.

The third filter is stock price. I like the stock price to be around $50 or below. This seems quite arbitrary, but is a self-imposed constraint because of position sizing and tactical considerations.

Right now, I like to restrict new positions that I ease into using CSPs to a maximum of 5% of my portfolio. At my current portfolio size, this means a total outlay of between $20-25K. Unlike many options traders, my goal – my ideal outcome – is to buy with a sufficient margin of safety. CSPs are a way to reduce the effective buy price below that level.

The main reason for the $50 stock price filter is that I might embark on long CSP campaigns. Sometimes, this means committing additional capital to the position if it moves deeper in the money.

I like to have 4 slugs in my revolver ($20K outlay/4 options ~ $5K/100 shares ~ $50 price threshold). This gives me added flexibility to adapt, adjust, and exploit volatility.

The final filter is price of the option. I target a minimum return of 20% IRR. If I commit a certain amount of cash to a new CSP, I seek annualized returns on that capital of 20% or more. I will discuss this filter in more detail in a separate post, because there is a fair amount of nuance.

If a stock has fallen in the recent past, its implied volatility is often high (say >30%). These are ideal candidates to chase, since the fall in stock price may have brought them close to value territory, making the pursuit all the more fruitful.

To recap, I search for the following characteristics:

  • attractive stock, but not cheap enough,  0.75 * IV < p < IV
  • liquid options market (generally large cap >$5B)
  • p <= $50, approximately
  • initial hurdle IRR > 20% (high implied volatility helpful – but check upcoming events)

Start Campaign

Okay, once we’ve figured out we want to pursue this strategy on an attractive candidate, we write or sell ATM puts on 1/4 or 1/2 of the intended position, with a duration of about a month. Why?

We sell at ATM options, because they have the thickest time value premiums. Ideally, we want to maximize these as we are going in. Later, we may be have to be content with ITM puts, which are less juicy, but we aim high to begin with!

How to size the initial position? This depends on how large the margin of safety is at the current price. If it is reasonably large, then I’d go with half. If it is not large enough, then I go with a quarter. This usually ties up $5-10K in the first round.

Finally, I usually try to sell options about one month out. You can get higher IRRs by using weekly options if they are available. This involves more frequent trading (potentially higher commissions), and careful upkeep. A frequency of one month is short enough to capture a fair chunk of the fastest decay in time value, and long enough to suit my temperament and schedule.

To summarize, we start a CSP campaign by,

  • writing ATM or slightly OTM puts,
  • on 1/4 – 1/2 the intended final position (depending on MOS),
  • with a duration of about a month.

Then we collect the premium and wait.

Quick Validation

Several things can happen. One outcome is that the underlying stock shoots up, and moves far away from the strike price of the puts we wrote. If that happens, it may be worthwhile to close the position prematurely. Suppose,

G = initial premium collected = maximum gain
T = initial duration of the put (in days)
t = current time to expiry 
g = gain on the position at current time (g < G)

Currently, I use a rough rule of thumb.

If the gain on the position exceeds 75% of the maximum possible gain, within the first half of the intended holding period, then I close position. Mathematically, this condition can be expressed as.

t < T/2 and g >= 0.75 G

The reason for not continuing to hold on to the position is that it frees up capital.

Thus, if the stock spikes, and then falls down again, you may be able to exploit the volatility by collecting twice on the same stock. In reality, things can work out even better. When the price of the security rises, its implied volatility falls. That, and the moneyness of the position make it cheap to buy it back. If the stock falls back, generally implied volatility increases, and you can juice out more time value from an ATM option.

Expiration

At expiry, you encounter one of three possibilities. Let’s dispose of the easy ones first.

If the stock prices exceeds the strike (p > S), you let the position expire. Depending on the price, you may consider reestablishing a new position at a later time.

If the stock prices hovers around the strike (p ~ S), or slightly below, you can roll out the position. This means you close the current put, and write a new put one month out. This lets you collect additional premium, or lower the effective buy price.

If the stock price has gone substantially below the original strike, things get interesting. This is where experience may be invaluable. I haven’t been doing CSPs systematically for long, but think that I have already gotten better at a few things.

In any case, you have several options; you could,

  1. take delivery – if you have reduced your effective buy price to a point where it is sufficiently below the intrinsic value, then it might be a good idea to take possession. Remember the overarching goal of the strategy is to buy good companies at a cheap price.
  2. roll out  – If you aren’t still happy with the effective buy price and have no new capital to commit, you can roll out the position. Note that the premium for ITM or deep ITM options may not be terribly attractive. Increasing the duration beyond one month might help add a little meat on the bone, but it will hurt your overall IRR. That said, it is a fine default strategy.
  3.  add position: if you have dry powder left (this is why I like four slugs in my revolver), you have more flexibility. There are multiple flavors, you could (i) keep the strike the same, (ii) lower it, or (iii) lower it and add extra duration. The first option (keep strike same) usually gives you the fattest premiums – it works best, when you think the stock has gotten really cheap and you want to lock in this cheapness. You fully expect the stock to rebound before the next expiry. The second or third options (lower strike/add duration) are worth considering, when you think the stock is headed even lower. You may take an IRR hit extending your position this way, but you are playing the long game. This way you reduce your effective buy price, and set yourself up to write future options that are less ITM (and collect fatter time premiums).
  4. use a wheel strategy: this involves some combination of the alternatives laid out above, and requires additional dry powder. You take delivery of the ITM options, write slightly OTM covered calls on these options, and use your dry powder to simultaneously write ATM or slighly OTM puts.

In future posts, I will highlight specific examples using this template.

CSP Example: WFC

Note: I wrote this memo for private consumption about a month ago. With the decline in WFC, I have re-established a short-put position.


I just got off a 118 day cash-secured put campaign on Wells Fargo. I pegged WFC’s worth at about $60 or more, and it has been trading in the $51-56 range since April.

It isn’t rich enough for me to write covered calls on, or cheap enough for me to add to the position directly (I require a margin of safety of 20%).

wfc_csp

On April 10, I wrote 1 $54 put 25 days out (5/5 expiry), when the stock was trading at $54.42. After earnings, which came out right away, the stock dropped to $51.53, when I wrote another put $52 put, expiring 5/12. I booked premiums of $128 and $158, after commissions.

On 5/5, the stock traded above $54, and the first put expired worthless. On 5/12, the second put also expired OTM, with the stock trading around $53.

I immediately wrote 2 more $53 puts ($128), and rolled them over twice. Once on 5/25 ($174) and 6/8 ($126). On July 14, the stock ended above $53, and I let the position expire.

Overall, I collected $714 in premiums after commissions (on $10,600 cash outlay) over 118 days, for an annualized return of 33.5%.

This campaign reduced by effective buy price to $49.50, even though I ended up not buying any shares.

If WFC falls to $53 or below, I will probably embark on a new CSP campaign.

 

Portfolio Activity

This year – so far – has been unusual.

Long Positions

I haven’t bought many new positions, except for the following.

  • increased my Oaktree Financial position by 33% at the beginning of the year for $40 (put got assigned)
  • doubled my position in Fairfax Financial around $435/share
  • started building a position in ALJ Regional holdings. Currently I am 1/2 or 2/3 full, at an average price just below $3.20.
  • bought a slug of IBM after the latest disappointment.

Consequently I am about 35% in cash.

My largest positions are “financials” BRK (15%), LUK (10%), FRFHF (8%), OAK (7.5%), and WFC (6.5%), and account for nearly 50% of my invested portfolio.

Options

I have been been trying to educate myself about using options more opportunistically. It has become a new weapon in my arsenal. It fits perfectly as an overlay to a long-term value investing strategy.

At some point in the year I’ve embarked on months-long cash secured put campaigns  on:

I’ve had shorter lived positions in HBI, FSLR, and NOV, in which the position moved away from me rather quickly.

I currently have open CSP positions on UA, GME, DIS, FAST, MSM, and STX.

Between 2010 and 2016 my total “income” from dividends and options increased from $3,000 to $9,000 (yield between 2-3%). So far this year (2017), I’ve generated about $18k of income from options and dividends, and feel reasonably confident about hitting $25k by the end of the year (yield >5%).

Investing Buckets

I like categorize stocks into three buckets.

Compounders

The first bucket is compounders.

This bucket includes stocks like BRK, MKL, WFC etc. that have solid revenue growth (secular or structural advantages), high returns on capital (good business/industry), and plenty of reinvestment opportunities.

These are the best companies to own. Their intrinsic value rises steadily with time. If you stick with them long enough, your returns will mimic the return on equity (~low to mid teens). If you can add to your position when the price dips significantly below the prevailing intrinsic value, your returns will be juicer.

Ideas - 39

With compounders, you let time do all the work. These stocks let you sleep soundly at night, and require hardly any upkeep.

The relentless increase in intrinsic value is forgiving of valuation mistakes. The risk of overpaying can be mitigated by long holding periods.

So what’s the catch? Why can’t we just invest in compounders?

Turns out, you and I are not the only people in town who have this “deep insight”. Since everyone sees how desirable such companies are, the market rewards them with high valuations. Opportunities to buy these companies at substantial discounts to intrinsic value are rare.

From my experience, they encounter blips about once in year or two, when some short-term setback gets temporarily mispriced. Here I am talking about decent prices, not “back-up-the truck” type prices. Those, unfortunately, are really rare.

Our edge here patience, decisiveness, and a long horizon. There is no informational or analytical advantage.

If you are like me (someone who has fresh periodic infusions of cash to deploy), the waiting can be frustrating, if that’s your only trick. You may think that having a list of 5-10 compounders on a watchlist might help. It does. But only partially. Often when opportunities arise in such stocks, they arise all at once (like the 2008-2009 crash).

Small Caps

The second bucket is small caps and foreign stocks.

Examples of these in my current portfolio include stocks like MNDO, CODAF, and RSKIA, which are all sub $500m companies.

These are profitable companies with strong balance sheets and decent returns on equity. In the past, I have invested in companies with poor or negative earnings, so long as the company’s assets provided a sufficient margin of safety. I have now mostly abandoned this cigarbutt strategy. Time is the enemy in such asset-based investments, as intrinsic value gets eroded by mounting losses.

If you can psychologically handle such investments, then you should absolutely invest in such companies. For a small investor, the universe of such companies is far larger than the universe of small profitable companies with light debt burdens.

I have tried to fish in that pond. But I have realized that I don’t enjoy fishing there as much. Being around morbid companies makes me feel pessimistic.

So these days, I focus only on profitable small caps with decent balance sheets. Our edge here is the relative lack of competition, and tolerance for illiquidity.

Some of these stocks will go months without trading. This is both a pro and a con. The small size and illiquidity keeps the big fish and traders away. The downside is that building reasonable positions in some of these stocks takes patience.

Liquid Mid and Large Caps

Finally, the third bucket of stocks is liquid mid and large caps.

Stocks that I currently own that fall under this bucket include AAPL, LUK, IBM, and NOV. Even though they are followed and owned quite widely their stock prices can fluctuate over a large range.

Consider AAPL for instance, the largest company in the world. Over the last year and change, its stock price has fluctuated between ~$90 to ~$155. During the dip last summer, I bought my last slug of AAPL shares at $96. I sold out of most of my position between $125-$135. I hold my last 1/3 position, which I plan to dispose of shortly. AAPL may not be overvalued, but I am not as comfortable holding it at $150 as I was when it was sub-$100.

In any case, this volatility creates an opening for overlaying some options strategies. The options on these securities have a vibrant market, due to their size and liquidity. Strategies like cash-secured puts and covered calls can be used to enter and exit positions, or generate income on the side.

A current example is NOV. The stock has been trading between $30 and $40 for nearly a year. At $30, I think NOV is cheap. At $40, I think it is reasonably priced. So every time it drops to the low $30s, I begin selling puts methodically. Every time it springs back to $40, I begin ratcheting some covered calls.

The Allure of Cash Secured Puts

Recently, I wrote an example of a CSP campaign on VFC.

The ideal layup for CSPs is the following:

  • you are interested in a liquid large cap stock,
  • options on the stock are available and liquid,
  • you have done a valuation and price is below the intrinsic value,
  • however, (intrinsic value – price) > margin of safety,
  • the stock has fallen in the recent past (greater implied volatility),
  • you have tons more cash than ideas.

Let’s consider my campaign on VFC, and how it ticks many of the conditions above.

Liquidity

VFC is a large liquid large cap stock. Its market cap is ~$21B, and nearly 3M shares trade every day. Monthly options are available on VFC, and the ATM calls have a daily volume of a few thousand. Bid-ask spreads on such options are usually between 5-20c. While this is not as liquid as a megacap like Wells Fargo or Apple, it is sufficient.

Valuation

I did a valuation of VFC, and determined that it was worth somewhere between $55-$70. Lets pick $65 as a point estimate of the intrinsic value. I like to buy stocks with at least a 20% margin of safety.

Thus, I would be interested in VFC at 80% * $65 ~ $52. Since VFC is a reasonably safe, unexciting, range-bound stock, which pays a 3% dividend – I really don’t mind buying it around that price – although I would really like to buy it under $50.

Environment

Two years ago, VFC used to trade over $70. In the past year, its range has been $48-$65. Thus, it has had a somewhat rough time.

At the same time, the overall market is going gangbusters. I haven’t found too many new opportunities. My cash balance is over 35% of my portfolio. The only stocks I have bought in the past six months are OAK, FFH.TO, and ALJJ. I have liquidated a lot more. I don’t mind diverting a small part (say 25%) of my cash balance towards CSPs.

Advantages

CSPs open up the universe of investable ideas. For ideas where there is insufficient margin of safety, it provides a method to work out a reasonable cushion by embarking on a campaign that can last several months. It lets you lower the effective buy price below what the market offers over that time period.

It also helps psychologically.

I know we are all supposed to be patient and wait for the really fat pitches. But the wait can be really hard and exasperating. It gets harder as you continue selling positions that have risen above your estimate of fair value, and the cash keeps building up. Furthermore, if you are adding external cash to your portfolio like me, it just compounds the aggravation. All that cash has nowhere to go.

CSPs help alleviate frustration, by keeping you productive and busy. They increase the size of the available opportunity set. They prod you to keep looking. If done carefully, they either lower your effective buy price, or help you collect some income on the side, while you wait for the market to swoon and offer better opportunities.

Either way they prevent you from splurging on something overpriced, or going crazy.

Cash Secured Puts: VFC Example

The most valuable skill I’ve learnt this year has been using cash secured puts (CSPs) more effectively. While I’ve used CSPs before, these resources at the “Great Option Trading Strategies”, especially on opportunistically rolling out options, greatly clarified the philosophy and mechanics of adjusting a trade for me. (Thanks, Brad Castro!)

The best part of a CSP is that it is completely congruent with a long-term value investing focus. It lets you buy securities on the cheap, or generate an income stream.

Let me illustrate its use with a real-life example.

Earlier this year, I looked at VFC, and guessed that it was probably worth around $65. At that time, VFC was trading around $53, having bounced back from a multiyear low of $48. I believed that there wasn’t much downside left.

So on 2/23, when the stock was trading at $52.55, I wrote 2 $52.50 Mar17 puts and collected about $205 in premiums. The stock hovered in the range $52.50-54 in the lead up to expiration, and the option died worthless (~$54 at expiry).

Screenshot from 2017-06-02 15-46-41

Five days later, the stock fell back to $53.09. I again wrote 2 $52.50 Apr 2017 puts for about $245 in premium. I closed the position 12 days before expiry on 4/10 for $35, after the stock jumped to $55. This allowed me to book nearly $210 in profits.

After that VFC continued to rise to nearly $58, and I lost interest in it. On 4/28, the stock fell back to $54.75, and I wrote 2 $55 May17 puts for $205.

After reporting lackluster earnings a few days later, the stock fell down to $52, and I learnt my first options lesson: be cautious of earnings announcements.

The stock recovered above $55, before falling to nearly $51.50 around expiry. My puts were now deep ITM.

In such a situation, there are a few options. Since I thought $51.50 was a great price, I increased my position, and on 5/17 rolled out the previous put, and committed more capital. Effectively, I closed the old puts, and wrote 3 new $55 Jun17 puts, for a net inflow of $452. The table below summarizes my actions so far.

Screenshot from 2017-06-02 16-04-10

Currently (June 2, on the day of writing) there are two weeks left before expiry. VFC is trading near $54. I don’t know what the stock will do between now and then.

Even if I decide to take delivery, I will have reduced the effective buy price to $51.50. I may be able to reduce it further if the stock remains range bound. If it jumps well beyond $55, I will happily walk away with over $1000 in earned premiums, and a solid return on capital employed.