May 13, 2010

May you live in interesting times

There is a Chinese proverb – ‘May you live in interesting times’ which may be a curse in disguise. The essence of the proverb is that if you want to condemn a person, you would wish that the person encounters ‘interesting’ times or in other words a lot of change and turbulence.

I don’t think anyone has cursed us, but we are definitely living in interesting times. I think the really interesting times started from 2008 and there has been no letup in the excitement.

The Greek tragedy
If you have been following the news, we have quite a situation in Greece. If one leaves aside the nitty gritty of the situation, it can be simply described as living beyond the means. Greece as a country has been spending (the government that is) way beyond its means (tax revenue) and covering up the deficit by borrowing from the market.

They were able to do it for sometime, till things finally came to a head a few days back. The market decided, enough was enough and started hammering the euro and European bonds of countries such as Greece, Spain, Portugal etc. It became quite scary by Thursday when the US and other markets started dropping by 3% or higher and volatility spiked by more than 50%.

The EU and ECB (European central bank) came together over the weekend and have put together a financial package of 600 billion dollars to aid the countries in trouble. This package has calmed the markets for the time being and would give time to countries like Greece, Spain etc to set their house in order. It remains to be seen if they will bite the bullet and fix their deficits. If they do not, then the markets will force them to in due course time.

My reaction
I typically ignore market fluctuations and macroeconomic situations. In this case however, there was a real risk of a market meltdown in Europe and US and a corresponding crash in India.

As I have already stated, I have started liquidating stocks which I would not buy if they dropped by 20% or more. I have already exited my positions in stocks such as VST, Denso, Ingersoll rand and started reducing my positions in IT stocks such as Infosys, Patni and NIIT tech (see my portfolio disclosure
here)

My decision to sell is not a macro call. I have no clue how the macro picture will play out in Europe and how it will impact us in India. There are a lot of moving parts to be able to predict and all the opinions in the papers and on the TV are just that – opinions and guesses.

My decision to sell is based purely on valuations and my view of the future prospects of these companies. I am not too optimistic about IT companies at current valuations (key word is current valuations – the companies may still do well in terms of performance).

Exploring options
I am exploring the idea of ‘
Deep out of the money’ puts to take advantage of a possible crash in the market due to the European debt issues. There are multiple issues associated with this thought process.

The first issue would be the possible corruption of my value investing philosophy. The general wisdom is that value investors should not dabble in options. Options are more suited for a trading or quantitative approach to investing. I would disagree with that. Value investing is not some religion, where you are either a part of the cult or out of it. Value investing at its core is buying something for less than its value. The ‘something’ can be a stock, option, bond or even a TV. So if I can find an undervalued option, and can evaluate the risk intelligently then it is as much a value buy as a stock.

Options are priced based on a Gaussian distribution (difficult to explain in detail in this post) and hence underprice extreme events. So if a company in question is likely to show great performance in the next one year or crash completely, the options may be underpriced for such a scenario. Similarly, put options may be underpriced if the market crashes due to some extreme event. The risk is ofcourse that the extreme event may not happen and you will be out of the premium you paid for the option.

I have been studying derivatives for sometime and have been analyzing them. Although I still look at them as a hedge or insurance against extreme events, I have been exploring the idea of combining value investing with options.

The main risk I personally face with options is not monetary risk as my positions are very small. If I lose money, it is likely to be a small amount. The bigger risk is that I will look like a complete fool in my own eyes (that I will look like a fool to others is a lesser issue). In order to avoid the regret and learn from my experience, I have started maintaining a daily dairy of my options work and have started recording my thoughts, feelings, actions etc.

As an aside, I bought puts on ICICI bank and some other companies in late 2008 to hedge my portfolio and deposits with these institutions in the extreme event that one of them failed and took my savings down with them.

If you think a value investor should never touch options and I am being foolish to do it, please leave me a comment with your reasoning behind it.

19 comments:

optionsnut said...

I personally like options and try to adhere to value investing principals.

However that said i would likely not tilt much more than 10% of my portfolio into options as this a large enough amount when factoring options have large imbeded leverage characteristics.

I have mostly bought calls in the money, but have also bought puts for insurance and to profit from any drop in share price.

The hardest part about options is not that you aren't right its just being right in a specific time! I liked Buffets move on selling puts a few years back when he was aquiring BNI.

I always try to look at company debt and options issues when looking for investments however most small caps i like have neither.

I found Nassim Talib's take on options to be interesting, but not sure if i have the pyschological make up for 'death by a thousand cuts'.

Derek

Aniruddha said...

Hi Rohit
I think you are creating a base by modifying the definition of Value investing for your want of using F&O. I found nothing wrong in that.
Just like I advocate something because I want to use that. Perceptions can change over the period of time.

I am not able to understand Options as Hedging. You said you will buy option to hedge. Suppose you have 5L portfolio and you buy puts of say 10k. If mkt goes well then puts will expire worthless so you have lost your 10k, but if you sell your portfolio at the same time, then losing 10k is meaningful. otherwise You will never sell your portfolio and keep on losing on puts for hedging sake.

I sometimes do Options buy Nifty Put above 5200 and sell it around 5100, then buy Call at or below 5100 sell around 5200...

Neeraj Marathe said...

Excellent post as usual Rohit,
Although, tell me 1 thing. We buy businesses which are underpriced, sell them off when they become overpriced..(all this is relative, but whatevr..)
So why hedge? Thats my basic question. If one is not comfy wid an investment, one should get out of it. (I am assuming that your basic purpose of getting into derivatives is not to make money, its to avoid losing money..)
I am sure u will take this is good spirit..apologies if i was a bit too frank or sumthn..
cheers!
Neeraj

vikas said...

It looks more Black Swan theory instead of Value Investing.

But definitely Options are more exciting than actual value investment. It has thrilling, it has quick result. In short its twenty 20 match while Value Investing is Taste Match.

Sometimes we try to rationalize things which we actually want to do because we can not resist temptation. But to have good feelings of doing it, we try to find rational and logical arguments to back up our act. I don't want to say that you are passing through this emotional adventure. You are mature and well understanding value investor, but such things come in the way of value investor on his journey to become seasoned.

Pradeep said...

I do not have enough experience to talk about this, but I agree with your viewpoint that Value investing is not about equities only. In fact, the three tenets highlighted by Graham and Buffet are 1. Mr Market is there to serve you 2. Always have a margin of safety 3. Be within your circle of competence. So, as long as we are adhering to this, it is value investing. Seth Klarman dabbles in Distressed debt. Warren Buffet once wanted to buyout a "Town" up for sale since it was selling at distressed price. Warren Buffet's recent investment in BYD with CM's influence, he tells,he would'nt have made 10 years ago. Great blog BTW!

rayhaan said...

yo rohit, u bring up the same arguments as other ppl around me ,but i still believe it can b a part of a diversified portfolio(i guess i m biased coz i ve put a gr8 deal of my pocket money in it) , Coming to think bout it in todays apparently inflationary scenario many indian agro stocks seem cheap compared to their potential
i mean have a look at flex foods selling at a p/e of around 9 ,negligible debt and a dividend yield of 7% !!!!!!!!!
or as i recall in an earlier post u said u wanted a few cigar butts in ur portfolio y not have a look at panasonic carbon ? p/e of 11 , mkt cap of 80 crores and cash around 46 crores !! plus promoters own around 70% of it .Perhaps mr.munger a gr8 advocate of getting the incentives right would approve of this
anyways where do u get ur annual reports from dude? i really have trouble finding them i mean i had to pay rs 30 or so for panasonic s annual report(which i got inbits and pieces)
p.s looks like someone is influenced big time by NNT s black swan!! u really really really shud have a look at the big short by michael lewis especially the part about cornwall capital managemnt i ve good reasons to believe their story will help in ur quest

Navjot Kashyap said...

Its a good thing, that you are trying new things.Thats the way it should be.But,don't get carried away.Quit if it fails,else carry on...
Best of Luck...

talll.com said...

Rohit, you are falling into a familiar trap that would move you away from value investing. The black swan approach requires consistent betting looking for the fall. you will be caught in-between.

Anonymous said...

Though i dont qualify to comment on this topic, still adding my 2 cents. Rohit, I feel, is a true follower of Buffett, he wont dabble(like me) in stuff he doesnot know. Also, if he does Either he earns or he learns.And i guess that would be the purpose even if he hasnt read a lot about it, that too is highly unlikely. So, wishing him Luck.

Cant resist typing this quote i read In the morning, from the BIG "B" i feel this is true essence of him. He is talking in baseball terms: ''Investing is the greatest business in the world because you never have to swing. You stand at the plate and the pitcher throws you general motors at 47 ! US Steel at 39! and nobody calls astrike to you. There's no penality except the opportunity cost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it."

Rohit sir, need some recomendations from ur side(not stocks, though i wud love to get them)but for the time being i ll settle with some good books(on the "Big one" as well as investing).

Sorry for eating up a lot of space
Bunny

Anonymous said...

Re:"As I have already stated, I have started liquidating stocks which I would not buy if they dropped by 20% or more."


well am quite a novice and reading my way through the intelligent investor now. your statement seems to be a bit contrary to graham et al where if you are buying or own something you should very well find that more attractive once its price falls.

whats the thought process behind your comment ?

Rohit Chauhan said...

Hi derek
I am still exploring options and as you said you have to get the timing right which is very tough.
as of now i am still looking at deep out of the money options for black swan kind of insurance. at the same time i dont think i can handle a strategy advocated by nn taleb. would be too painful for me

rgds
rohit

Rohit Chauhan said...

Hi anirudha
i dont really believe in hedging short term movement. if i think the stock is overvalued, its better to sell than to worry about short term swings.
my concern is how to hedge against extreme events like the one in 2008 ..can we hedge and profit from it ?
rgds
rohit

Rohit Chauhan said...

Hi neeraj
its a good question ..i am not talking of hedging undervalued positions. however there are times when there is severe dislocation in the markets like it happened in 2008. all stocks irrespective of fundamentals will crash. one can just hold on and do nothing. i am look at ways of hedging or profiting from such extreme though rare events
rgds
rohit

Rohit Chauhan said...

Hi vikas
you are right ..its black swan type of investing ..a lot of times the market underprices such options which in a way is also value investing ..or some stretch of the concept.

i am not looking for the thrill of it ..more on how to hedge my postions which i know are undervalued but at the same will get hit in a severe crash

one way would be to just ignore and hold on ..the other way could be to hedge and use the downturn to add further to the undervalued positions

Rohit Chauhan said...

Hi pradeep
true ..the circle of competence is important. as of yet this is not within my competence and hence i am in a trail and error and study phase and will not commit much money.

rgds
rohit

Rohit Chauhan said...

rayhaan
yes i have read the big short and its a good book. liked it a lot

on the companies you mention ..look behind the numbers ..i have bought such cheap stocks in the past and a lot of time they remain cheap forever

rgds
rohit

Rohit Chauhan said...

navjot
i am dont plan to risk too much capital and will defintely not keep doing if it does not work. but one has to take a little risk to figure that out.

talll
in a way yes..it requires consistent investing and also deep puts or calls. that ofcourse requires a different mindset which is not easy to have

rgds
rohit

Rohit Chauhan said...

Hi bunny
thanks for the comments.

on the books - i think there are a few goods i am or planning to read
big short - by michael lewis
this time is different
snowball - if you like a book on buffett

rgds
rohit

Rohit Chauhan said...

Hi anon
i own several positions which were attractive in 2008 / 2009 and have now come to close to fair or full price. they are at a price where if they drop 30% or more, only then i would buy them. as a result i am selling such stocks