Turbocharged Value Investing

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DIVE DEEPER: MATTHEW PETERSON’S STRUCTURED VALUE INVESTING

Can options be useful tools for value investors?

Well, for Matt Peterson, they have been a key part of his investing philosophy, which he calls structured value investing. He claims that he never pays retail prices for a security and hasn’t used a traditional exchange to buy stocks since 2005 by implementing a straightforward options strategy.

Matt runs a concentrated, long-term value fund at Peterson Funds. Like many value investors, Peterson is looking for the best businesses run by outstanding management at great prices, hopefully selling at a discount to intrinsic value.

His stringent criteria leads to a very concentrated portfolio and eliminates most potential investments. He typically holds between just 10 and 15 positions in his fund.

What is structured value investing?

Structured value investing is a two-step process. As we said, Peterson first finds companies he wants to own currently selling at an attractive price.

He then adds a second step to implement his strategy: go to the Chicago Board of Exchange and write (sell) a cash-secured put on the underlying stock that he already wanted to buy.

A put gives you the right, but not the obligation, to sell a stock at a predetermined price (the strike price) and a predetermined date. For this right, the put buyer pays the seller a sum of money called a premium.

By writing the put, Peterson collects the premium from the buyer of the put and lowers his cost basis on stocks he already wants to add to his portfolio. The strategy eliminates the need to use limit or market orders.

It’s important to understand when volatility is high, Peterson says investors can get high premiums from selling puts because the demand to buy puts is much higher than the demand to sell these contracts. During market chaos when fear and uncertainty run high, structured value investing works particularly well.

After the expiration of the put contract, you ideally want the shares put to you. If not, you still collect and keep the premium which lowers your cost basis and adds in a margin of safety through collecting the premium.

In Practice

Let’s dive into a real example in Peterson’s portfolio with Seritage Growth Properties, which we covered here:

Earlier this summer, Seritage was selling at $10 per share, and let’s say, we believe it’s worth $25. Instead of buying it at a market order of $10, we can go to the Chicago Board of Exchange and write a put contract committing to buy the stock at $10 at any point eight months from now.

A premium of $2.50 was available at that time for a $10 strike price expiring in eight months. By selling the put contract, we collect $2.50 of premium, and hold $7.50 in cash that’s set aside if the stock is put (sold) to us. The option will either be “in the money” or “out of the money” at the end of the contract.

If they are out of the money and above our $10 strike price, the option will expire, and we will keep our $2.50 of premium paid to us. In this case, we made 33% over eight months from our $2.50 premium against the $7.50 in cash we had set aside.

Ideally, the shares decline a little below the strike price to around $9 per share. We now have the opportunity to buy for $10, but our net cost will be $7.50 because $2.50 of premium reduced our cost basis. So, we can buy the underlying position for less than the current market price.

Let’s assume our analysis is correct and Seritage climbs to $22.50. Instead of buying for $10, which would have led to a 125% return, our strategy allowed us to purchase at $7.50, which is a 200% return.

Four Possible Outcomes

Investing is filled with uncertainty, and this approach doesn’t always work out as we hope. There are four possible scenarios of how it could unfold:

• Our analysis is wrong, and the shares go all the way to zero. Instead of buying at $10, we bought at $7.50, so we’d experience the worst possible outcome, but not as bad if we did a market order and didn’t implement the options strategy.
• Ideally, the shares decline just below the strike price, and the stock is put to us, but we pay less than the current market rate due to our collection of premium. And then the stock resumes its climb to our target price.
• If the stock closes just above the strike price, say at $11 per share, the option expires worthless, but we still keep our $2.50 of premium and make 33% during the eight months.
• The second worst outcome is our analysis was correct, and the stock takes off to our target zone without us ever having the stock put to us. We still make 33%, but it hurts to have been right only to have missed out on a huge upside gain.

Peterson also sells call options to exit a position. If Seritage were to run above the target price to $30, he would write an out-of-the-money call option, with a strike price of $35, for example. He would collect $5 of premium, and if the shares went up above $35, his shares would be called and sold at $35, but his net proceeds would be $40 per share.

With this structured value strategy, we are buying shares at $7.50 instead of $10 and selling at $40 instead of $35. This results in a significant increase in our rate of return on the position.

Added Benefit

Structured value investing has another benefit: it forces you to buy during downturns when it can be very hard to pull the trigger due to negative emotions. The option strategy forces a purchase when you otherwise might feel too uncomfortable to proceed with action.

Structured value investing utilizing options is not without risks and is generally a strategy for a more sophisticated investor that understands the nuances of the options market. That said, taking the time to learn Peterson’s strategy can add significant gains to your portfolio returns.

WHAT IS FACTOR INVESTING?

The term factor investing gets thrown around a lot, but what does it really mean?

Let’s break it down.

Explained

Factor investing is a strategy based on exploiting what’s known as “factor premiums” in markets. These are persistent trends that have been academically shown to typically outperform market averages for extended periods of time.

A common factor premium is the value factor, which refers to the relative outperformance of securities priced cheaply with respect to their fundamental value, as reflected by low price-to-book or price-to-earnings ratios.

Other factors range from size (small cap vs large cap) to momentum (stock prices that are trending up or down more than the averages) to liquidity (volume of trading for a stock) to quality (credit rating, high returns on equity, low debts on balance sheet etc.).

Factors are, in some sense, the building blocks that explain your returns. They’re the characteristics of an investment that correspond to an underlying market reality that allows you to earn a return in excess of the risk-free rate (short-term U.S. government bond yields).

In fact, studies have shown that returns among professional money managers are often driven more by their varying exposures to underlying factors rather than actual skill, or “alpha”, in Wall Street parlance.

Wrapping it up

This raises serious questions as to whether most fund managers deserve the fees that they charge. The short answer, in our opinion, is probably not.

The factor style of investing represents an alternative school of thinking to classic active stock-picking or index-based passive investing, and many well-known factors are not just theoretical.

They’ve actually been proven to work in practice.

For factor investors, they seek to maximize their exposure to factor premiums in targeted ways so as to construct a fully optimized portfolio based on their desired risk level, as measured by volatility.

This approach isn’t for everyone, and we aren’t necessarily endorsing it entirely, but for the curious investor, studying this market perspective is sure to provide useful takeaways.

To learn more, checkout this great resource.