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.

Comparison of Apparel Companies

Earlier this year, I looked at a bunch of apparel companies. Sometime during my research, I compiled the following table to take a cross-sectional view of the space.

Untitled

NKE at $90B+ market cap is the big kahuna. It has stable growth of nearly 8%, high ROIC. Not surprisingly, it commands a premium price.

Adidas is also quite large. It seems to be getting its act together. Historically ADDYY has been a laggard in terms of ROIC, margins, and growth.

LULU and UA had spectacular growth spurts that seem to be slowing. LULU has delicious margins, and ROIC, but view from the wind-shield is not as rosy as that in the rear-view mirror. Unlike LULU, UA’s margins and ROIC have been okay, but not great. LULU is more expensive than UA.

VFC is a mature, boring, slowing, and solidly profitable company. Operationally, HBI seems the lousiest of the lot. However, it uses leverage and tax shields to play in the big leagues.

Note that good companies (growth, margins, ROIC) are more expensive than so-so companies. This is the free market at work.

Inside versus Outside View

The Brooklyn Investor has a thought provoking post on reading too much into market valuations that are high, but not obscenely so.

I’m referring to the fallacy of assuming that since all bank-robbers had guns, that all gun-owners must be bank robbers.

We all look at these long term valuation charts and go, hey look!,  the market P/E was over 20x before 1929, 1987 and 1999! So, the thinking goes, the market is now over 20x P/E so a crash must be imminent! But then we tend not to look at all the people who own guns that are not bank robbers.

Also, when someone says that the stock market is 90% percentile to the expensive side, there is a tendency to want to believe that there is a 90% chance that the market will go down in the future. Well, if the market is 90% percentile to the expensive side over the past 100 years, then it means that the market will be valued at a lower level 90% of the time in the next 100 years if the same conditions occur.

Poring through historical data, he finds something “counter-intuitive”. Expensive valuations are often characterized by positive 1-year prospective returns.

As I was reading the blog, I was reminded of Kahneman’s inside versus outside view, which I first learned through Michael Mauboussin’s discussion of Triple Crown winners. Here is a PDF link, which discusses some of the same issues.