Value Investing and Options

by

Brad Castro

A Short History of Value Investing

But in order to replicate the advantages of value-oriented investing through the strategic uses of trading stock options, we need to establish a basic foundation for understanding what it is we’re actually aiming for. And the best way to do that is to highlight some of the leading (and most successful) individuals associated with value investing.

#1. Benjamin Graham

He focused on what he deemed a company’s Intrinsic Value, or real value, to be and then looked for situations where stocks were trading at significant discounts to that intrinsic value. His initial threshold was for stocks to be trading at 2/3 of the intrinsic value or less.

Although Graham had an extensive methodology for calculating intrinsic value, he knew that intrinsic value could never be arrived at with complete precision. Although rigorous, it was still a partially subjective process—one’s assumptions and calculations might be incorrect, and unforeseen bad news could always emerge at some point in the future. That’s why he required a stock to be trading at a significant discount to what he saw as its intrinsic value—it afforded him a Margin of Safety, one of his key concepts.

He also developed some other important key concepts. Among them were:

• An emphasis on shareholders recognizing that they are actually part owners of the business whose stock they own.
• An understanding of the irrationality of the stock market—he used the analogy of Mr. Market, an emotionally-driven and manic figure who one day would be euphoric and offer to buy your stocks or sell you his at very high levels and then on some other occasion would be feeling dejected and depressed and offer to buy your stocks or sell you his at much lower levels—his point was that you should use Mr. Market’s whims and bouts of irrationality to your advantage rather than being influenced by them to your disadvantage.
• The idea that in the short term, the stock market is a voting machine, not a weighing machine—he underscored the difference between price and value.

Graham detailed his ideas and methodology for evaluating businesses and their shares in Security Analysis, his 1934 classic that he wrote with David L. Dodd. In 1949, he published The Intelligent Investor which was written for the individual investor.

Warren Buffett, Graham’s most famous and successful disciple, is fond of repeating one of Graham’s sayings: “Be fearful when others are greedy, and be greedy when others are fearful.”

Recommended Reading: Security Analysis, 1934; The Intelligent Investor, 1949 (2003 updated edition edited by Jason Zweig)

#2. Warren Buffett (and Charlie Munger)

He was deeply influenced by Graham’s ideas. He was a student of Graham’s at Columbia and then later an analyst at his investment firm, Graham-Newman.

In 1956, Buffett formed an investing partnership in Omaha, Nebraska. Initially, it had seven other partners (including relatives) and was later expanded to include limited partners. Returns for the partnership outpaced gains in the Dow by more than 10:1. In 1969, concerned about a market that was wildly overvalued, Buffett liquidated the partnership, but kept his interest in a couple of the partnership’s holdings, one of which was Berkshire Hathaway, a sometimes troubled textile operation headquartered in New Bedford, Massachusetts.

Buffett continued to run the textile operations while using the cash flow of the business to expand into insurance, purchasing the National Indemnity Company and taking an equity stake in GEICO. The textile operations were eventually shuttered in 1985. Insurance companies typically invest their “float” (money received from insurance premiums but not yet paid out in claims), and Buffett has used Berkshire’s strong cash flows to masterful, exponential effect.

Buffett would later be influenced by his business partner, Charlie Munger, to expand Graham’s notion of value investing to incorporate more qualitative measures over the strictly quantitative. These included such intangibles as: the power of a brand, quality management, and sustainable earnings growth.

In a departure from Graham, Buffett has famously said, “It’s far better to buy a wonderful business at a fair price than it is to buy a fair business at a wonderful price.” A key reason, perhaps, is because Buffett’s ideal holding period is “forever.”

Another significant characteristic of Buffett’s value investing style is his incredible patience. He has compared investing to being a batter who has the luxury of waiting for the exact pitch he wants before taking a swing. In investing, Buffett says, there’s no penalty for not swinging, for waiting for that perfect pitch.

But when Buffett himself swings, he usually swings for the fences. Unlike Graham who believed in the importance of diversifying (a result, no doubt, of witnessing the bankrupting carnage of the Great Depression), Berkshire Hathaway’s equity portfolio is typically concentrated among long term positions in just twenty to thirty companies. That’s in addition to the periodic acquisitions of entire companies. Charlie Munger, at the 2005 Berkshire Hathaway annual shareholder meeting was quoted as saying, “You don’t get rich by diversifying.”

Recommended Reading: The Berkshire Hathaway Annual Shareholder Letters; and also, Leveraged Investing Strategy #9 - Pretend You're Warren Buffett

#3. John Neff

Neff has been labeled both a value investor and a contrarian investor, although he personally seems to prefer the term, “low P/E investor.”

One element of Neff’s methodology included dividing a company’s total return (earnings growth rate + current dividend yield) by its P/E, targeting ratios that exceeded 0.7.

Focusing on stocks that were “out of favor and unloved,” Neff sought not only low P/E stocks but high dividend yielding stocks. Although by definition a low P/E stock implies a higher dividend yield (since there’s an inverse relationship between price and yield), dividends were crucial to Neff’s approach. Not only did dividends add to an investment’s total return, they also acted as a buffer and allowed the investor to get paid to wait for the market to come to its senses and re-price the undervalued investment.

Unlike Buffett, Neff felt that any security he owned was for sell, providing the market was willing to pay a high enough price.

Recommended Reading: John Neff on Investing, 1998

#4. Bill Miller

He considers himself a value investor, but he has taken a very non-traditional approach to defining the discipline. In a 2006 letter to investors, Miller wrote: “Value investing means really asking what are the best values, and not assuming that because something looks expensive that it is, or assuming that because a stock is down in price and trades at low multiples that it is a bargain.”

As such, he has historically taken significant positions in seemingly growth-oriented companies such as Yahoo, eBay, and Google.

[>i>Update: Bill Miller had an absolutely horrible performance in 2008. Both funds he ran suffered losses of more than 50% for the year. I'm leaving his mini-profile here, nonetheless, not as an endorsement of him or his funds, but rather to illustrate a point (see The Common Denominator section below).]

#5. Wilbur Ross

Ross’s approach isn’t to acquire those distressed assets at a substantial discount in order to make quick and minor changes in the hopes of reselling for a quick profit. On the contrary, the acquisition of distressed assets is frequently a gateway to gaining influence or control of a company, either through defaults or as a way to gain seats on a struggling company’s board.

He has been quoted as saying that he sees himself as “a private-equity investor that helps rebuild companies” (source: CNBC.com). He typically liquidates his holdings only after a company has been “rebuilt.”

Ross further helps his cause in that he’s considered to be an effective, skilled, and credible negotiator, important attributes when negotiating with unions during the turnaround process.

He also operates long term, conservatively run (i.e. low or zero leverage) businesses such as International Auto Components in the auto parts industry.

The Common Denominator

The reason why all these seemingly contrasting approaches have proven successful is two-fold:

1. The differences between the preceding investors are, in the end, minor and superficial. They do, in fact, share a common denominator after all. The underlying principal of all successful value investing methods is the ability to acquire valuable assets for less than what those assets are truly worth.
2. They are authentic, individualized approaches. The only value-oriented approach that’s going to work for you in the long run is the value-oriented approach that best matches your own personality. We learn from each other, we’re influenced by each other, but in the end, we only find success when we discover our own path.

The Case for Options-Based Value Investing

Although options trading is typically associated with aggressive and speculative short term trading strategies (or, less frequently, with conservative income-producing strategies), very little attention has been given to the ability of options to enhance the portfolios of long term investors.

But there are, in fact, definite strategies that you can employ to do just that. There are strategies that I group under the broad umbrella of what I call Leveraged Investing Strategies. Leveraged Investing has just two goals: to acquire quality assets at substantial discounts and then squeeze more out of those assets once you’ve acquired them.

One of the great principles of value investing is that the purchase price of a stock is absolutely crucial to the investor’s success. That may seem obvious, but an illustration may be helpful to underscore just how crucial it is:

If you purchase a stock at $10/share, and a year later it trades at $20/share, you’ve made a 100% gain. But if you were able to get that stock for $5/share, your gains would be 300%. Adding another $5/share of profits only in the first scenario (the $10 stock moving to $25/share, your gains only increase to 150%. Here’s the important lesson: the purchase price has far more impact on your rate of return than the price movement of the stock itself. Or, said another way, the lower the cost basis of your original investment, the higher the rate of return each dollar increase in the share price represents.

Here’s a table that may illustrate better:

This table represents the power of compounding returns and is exponentially more important than the simple idea of buy low, sell high. You truly must grasp the significance of this: The lower your cost basis, the higher your rates of return will be. Even to the point where modest gains in the future will still represent outsized gains.

An Illustration

Early investors in Wal-Mart, Microsoft, and Dell did so well because, due to the incredible growth of these companies and those companies’ practice of splitting their shares, those early investors saw their cost basis shrinking and shrinking. Or, looked at another way, their cost basis, relatively speaking, was so much smaller than later investors’ that the continuing growth of their investments enriched them at exponentially higher rates.

[For more details, see related articles, "Adjusted Cost Basis with Options" and "Buy and Hold and Cheat."]

Options and Value Investing

OPTIONS ENABLE THE LONG TERM INVESTOR TO CONTINUALLY LOWER THE COST BASIS OF HIS OR HER INVESTMENTS.

Unlike the traditional value investor who must diligently ensure a low cost basis by purchasing shares as cheaply as possible, the Leveraged Investor who employs strategic option trading techniques has the luxury of a continually shrinking cost basis—before, during, and after purchasing the shares.

Finally, it's crucial to really appreciate the profound significance of what Leveraged Investing attempts to do. The great advantages that investing has over trading is the effect of compounding rates of return and the fact that a successful investment’s returns are largely automatic and require little effort on your part.

Leveraged Investing takes it one step further and speeds up the compounding effect. Even the most successful value investors have to accept the limit of a static cost basis. Leveraged Investors, however, are continually lowering their cost basis which, as we have seen above, has exponential, compounding effects. And that produces life-altering results.

[If you haven't done so already, please read my original essay, Leveraged Investing or No Substitute for Planting a Tree for a definitive explanation of Leveraged Investing.]