One of our most conscientious commenters, Shuki, has raised some issues around the ideas of Stockpiling and selling puts to enter positions so I thought I’d try to clarify my point of view here for y’all.
To understand the concept of Stockpiling you only have to remember that Mr. Market doesn’t put things on sale for no reason. There is almost always a reason that a wonderful business is on sale. I call that reason an ‘Event’. Events can be specific to a company or an industry. The Macondo well disaster drove down prices on BP and Noble. Gildan got hammered when cotton prices doubled during the Arab Spring. Cameco saw its stock price get halved after Fukushima. Events are cool because its pretty easy to see why Mr. Market is dumping the stock. If I don’t know why, I usually feel there is something going on I should know but don’t so buying even at what seems to be a really low price usually seems too risky for me simply because I know Mr. Market isn’t stupid. If Mr. Market is getting out of the stock because who knows if the company will recover in a year or maybe 3 years, or because the CEO said he’s going to have a really bad year, or because the industry is going to be down for a couple of years and if my time horizon for the stock to recover is longer than the period Mr. Market fears, then I can be a buyer while really smart guys are selling. The only problem is, I don’t know how long they are going to be selling or how far down this price will go. Which brings us to stockpiling.
I come by Stockpiling honestly. Its in the Rule #1 tradition. Buffett is an inveterate Stockpiler. He has to be now because it’s nearly impossible for him to take a full position in a company all at once. He’s just too big. He started Stockpiling BNI in 2007 and finished in late 2009. He started Stockpiling IBM in 2011 and was still buying in 2013. But he’s always been like that. Here’s a quote from his 1958 partnership letter about Stockpiling (my term for it) into a small bank:
“So that you may better understand our method of operation, I think it would be well to review a specific activity of 1958. Last year I referred to our largest holding which comprised 10% to 20% of the assets of the various partnerships. I pointed out that it was to our interest to have this stock decline or remain relatively steady, so that we could acquire an even larger position.... Over a period of a year or so, we were successful in obtaining about 12% of the bank at a price averaging about $51 per share....” (http://www.rbcpa.com/WEB_letters/1959.02.11.pdf)
Shuki prefers to buy her whole position as soon as the stock reaches an attractive price and there is nothing wrong with that point of view. Small investors can get away with it. But it is also not wrong for a small investor to Stockpile into a position, particularly if the price seems bent on continuing on down. Our most recent experience with this was with CCJ: I began acquiring it at $28 after it dropped from $44 and I continued to Stockpile it down to $18. Which brings me to using puts.
The main reason we sell OTM puts is to either reduce our basis or increase our position or both. I do it because its often free money and I’m often small enough to get away with it. Buffett also does this on occasion when the opportunity arises as he has recently with both Coke and BNI but at his level the options market is small potatoes on most stocks he is trying to acquire.
Even at my level, I can easily move the premium prices on many stocks I want to acquire by taking too large a position on a specific strike price and expiration. In general, though, on large stocks like CF or IBM, I can effectively use options to get another tranche at a great price or lower the basis of the tranche I already own with virtually no extra risk over buying another tranche.
I recently took a position in CF Industries (CF) at about $190 and lowered the basis by selling way out of the money LEAPS puts down into the $160s that I can now buy back cheaply to lock in the reduced basis. I mention this as an example but its not unique. I did the same thing with Gildan, BP, CCJ, Noble, Coke, Walmart, Coach, Western Union and Oaktree in the last couple of years. The main idea here is to take advantage of the increase in Implied Volatility created by the uncertainty of the outcome of the ‘Event’ to increase the premium of puts that have strike prices so low I’d be jumping for joy to own the business at that price.
In effect, the only downside of selling the puts instead of buying another tranche or two is not getting more of the business but done judiciously I can have my cake and eat it, too. I can buy all of the business I want right now with the expectation that I’ll be in position to buy more in a year when the puts expire. Of course, I have to be willing to overload that company in my portfolio if I get it put to me at that great price right away. Like Buffett, I’m willing to be quite overloaded on one company if the probability of a successful outcome is large and the probability of a loss is quite small. If that is difficult for you to determine, just buy 10% of your portfolio into what you think are great companies at attractive prices and be done with it. But you do give up the possibility of being able to drop the basis and thereby reduce your market risk and vastly increase your return on basis. Imagine buying BP at $27 to $41 yet through judicious use of puts have a basis of $20 with dividends of $2 per share after only 3 years. Each year from now on the increasing dividends reduce the basis (say from $20 to $18) and, as BP raises the dividend back to $5 over the next few years the dividend yield on basis goes through the roof. I like to target a dividend yield of 20% cash on basis within 5 to 10 years of ownership with a basis of about 25% of the projected price at that time. This is pretty much nirvana for investors: low market risk combined with double-digit cash on cash yields.
In addition, another beautiful aspect of Stockpiling and selling puts is that we protect our emotions from ERI (the Emotional Rule of Investing which states that if I buy it it will go down and if I sell it it will go up). I love to buy something and hope it goes down. That is so much more fun than buying it and hoping it goes up because no matter what happens its all good. If it goes down, I get to buy more. If it stays the same, I get to reduce basis. If it goes up I get to reduce basis and my ‘marked to market’ profits look lovely for my investors.
Are there problems with this approach? Sure. If I buy too little and it runs up, I should have bought more but my mistakes tend to be not buying enough at some price rather than buying too much at too high a price and feeling later that I should have waited until the stock stopped dropping. Nailing the bottom, of course, requires a crystal ball. Buffett started buying BNI at $80, continued buying down into the $50’s and then wrapped it up at $100. Crystal balls are hard to come by which is why being comfortable about not getting enough of a good thing seems to me to be much preferred emotionally to agonizing about getting too much of a good thing too soon.
But in truth, this discussion is about maximizing profit. We’re all in agreement that we should focus on not losing money by buying wonderful businesses at attractive prices.
(And lest I forget: CONGRATULATIONS TO THE WINNERS OF THE FREE TICKETS TO THE ATLANTA 'TRANSFORMATIONAL INVESTING' WORKSHOP!!!!!! We received so many essays that were wonderful and heartfelt. I'm sorry we couldn't take everyone this time but we'll try to do this again next year. Thank you to every one of you who participated and to everyone who is coming to the Workshop, I'll see you there!)
Now go play.