Prashanth Krish | Portfolio Yoga

Managing risk using Put Options

One of the ways to manage risk of a portfolio it is said is by buying Out of the Money puts so that in the event of a market meltdown, one’s portfolio (assuming total correlation to Nifty) will be protected from the point where Put option gets in the money.

Since options are expensive, there is no point buying a At the Money option but if you were to buy a Out of the Money Option, it comes pretty cheap (more like a Term Insurance Policy). If market drops catastrophically as ZeroHedge predicts day in and day out, the option can save the distress by ensuing that losses aren’t as huge as one would experience if one is unhedged.

But is it a worthwhile strategy is the bigger question and for that we really need to test based on some real data.Testing option based strategies can be a real nightmare given the amount of data we have and unless one has some good programming skills, it can be tough.

But we have CBOE to thank here since it runs a Index called CBOE S&P 500 5% Put Protection Index (PPUT). Following is the description of the said index from the CBOE site

The CBOE S&P 500 5% Put Protection Index is designed to track the performance of a hypothetical strategy that holds a long position indexed to the S&P 500 Index and buys a monthly 5% out-of-the-money S&P 500 Index (SPX) put option as a hedge.

The PPUT Index rolls on a monthly basis, typically every third Friday (OTM)y of the month.

In other words, this Index replicates what you would stand to gain by having a long S&P 500 hedged by puts (at 5%). So first lets see the historical chart for the said index. Remember, the chart is one of Gains / Losses accrued through being long S&P minus the cost of Options bought.

While not shown in the chart above, the draw-down in 2008 / 09 was to the tune of 41% vs 53% suffered by S&P 500. Lets now move on to a chart that compares this with the S&P 500.

In other words, lets compare this performance with that of S&P 500 and see if the cost we are paying has benefits.

What one observes here is that some one who held this index was almost all the time under-performing one who had just bought and held onto the S&P and the only time the twain did meet was in Feb 2009 when for a brief moment of time, he actually held a upper hand.

The under-performance is guaranteed given the fact that the investor of the Put strategy needs to keep buying puts which got way way expensive as markets cratered in 2008 / 09. But is the whole thing worth the trouble?

You may say that he will get a slightly better benefit if he compensated for the cost of puts by selling out of the money (5%) calls. But as we very well know, Put options (due to a variety of reasons) are always more expensive than Call Options. Just to give you a idea, lets take the case of Nifty 50.

Nifty current month futures closed at 7568 and if you had to hedge at 5%, that would mean buying 7200 puts (rounding off from 7189) and selling (to compensate for the Buy Call options of strike 7950 (rounding off from 7946). On Friday, the 7200 Puts closed the day at 35.50 while the 7950 CE closed at 11.40 (nearly 3x the price of Puts).

There is no simple way to avoid market crashes and the only way to ensure one has lesser pain is either by trading some kind of timing system or having a higher cash component / lower leverage. Buying puts while sounds like a nice theory will only end up enriching the seller of the option for most of the time.

Investor Education

One of the pet peeves of Mutual Fund advisers and Fund managers is that the lay investor needs to be educated about the benefits of equity. If only more people knew the riches that could be obtained by investing long term in equity, much of their problems will be solved.

While its one thing to educate the public on options when it comes to the asset classes available to invest, its quite another to take them for fools who don’t know the difference between a stone and a diamond. The common investor is much more educated and knowledgeable than many are willing to accept.

Investing in Gold / Real Estate as much as they may be hated asset classes has done a world of good. While there is always the question as to whether the next 20 – 30 – 50 years will be as good as the previous, one really cannot just ignore the stark reality that the bulk of the returns generated by vast majority of folks has been via their investments in real estate.

Recency Bias affects everyone of us and that is the reason why money flows into asset classes which are showing momentum (even when it comes to Mutual funds as I showcased the growth in Mid and Small Cap funds as the market started hotting up). When the tide turns, money flows out to destinations which otherwise would have been over looked.

Investing in Equity (Direct or via Mutual Funds / PMS / Hedge Funds) is not the only solution. Every person has his own reasons which make him invest the way he does. With Interest rates pretty high and being risk free, it will take a long time before investors appreciate the advantages of equity. No point trying to push them when they aren’t mentally or financially ready to take the risks that come associated with investing in the stock markets.

Benchmarking it right

Wikipedia defines Benchmarking as the process of comparing one’s business processes and performance metrics to industry bests or best practices from other companies. Unless one compares and contrasts, one never knows where one is placed relatively speaking.

But the key point to note is that Benchmark works only if done correctly. As a joke / moral goes (Cartoon below), if you were to select a bunch of animals and benchmark them against a single target, you aren’t benchmarking it right.

When it comes to investing, Benchmarking is important since it enables you to get a much better perspective on whether you are getting it right or wrong. If your returns on investments over a period of time cannot even match returns generated by the Index, does it really make sense to keep trying by spending valuable time or whether will you be better off by just buying a cheap ETF that tracks the Index and be done with that?

Mutual Fund managers / PMS fund managers and even Robo Advisors love to tell you how good their picks were and how they have beaten the Index by a comfortable margin. But given the fact that there is plenty of evidence on the other side of the Atlantic about how very few fund managers are able to beat the Index, it makes one question what is missing out here.

The question we need to ask is, Are our fund managers way better in ability to invest than their counterparts in say the United States? After all, if fund manager after fund manager cannot beat the Index on a sustained and continuous basis (heck, even Warren Buffett changed how he measured performance of BRK vs the S&P 500), how is that our fund managers are able to do with such ease.

One reason could be that our Indices are still evolving and hence a lot of quality stuff are left out while including a lot of low quality stocks which end up ensuing that if you replace all the bad apples in the Index and add a few good apples, probability of your returns exceeding the Index is pretty high.

Lets take the broadest index out there, the Nifty 500 and review its list of stocks. Here is a list of 10 of them,

GTL Infrastructure Ltd.
Alok Industries Ltd.
Gammon Infrastructure Projects Ltd.
Unitech Ltd.
Jaiprakash Power Ventures Ltd.
Lanco Infratech Ltd.
GVK Power & Infrastructures Ltd.
IVRCL Ltd.
Usha Martin Ltd.
Jaiprakash Associates Ltd.

What is common in every one of them? Other than that they are all embroiled in debt of the nature that they cannot possibly repay in full, literally everyone has gone through Corporate Debt Restructuring and unless one has been under a rock, the probability is that they shall all fail. Yet, these gems form part of the largest index, stocks that theoretically are penny stocks and have no business getting traded, let alone being part of a index.

Of course, the weight of these are small, but do note that if you can identify stocks that like above and make no allocation, you will beat if you buy the rest in the proportion they are weighted. Its as simple as that. You don’t even have to go out and try and identify stocks out side that are way better than these junks and you shall still be a winner.

A secondary way to beat / or showcase beating the Index is by comparing with the wrong set. Literally everyone loves to compare himself with Nifty 50, but is Nifty 50 really the correct benchmark if you are investing in all kinds of small cap and have a large turnover ratio?

The thing with static indices is that they are always Long – no matter what and even if you can reduce exposure a bit and if those days are bad, you can turn out to be a winner. You will argue of course that how the hell does one know about bad days in advance and for that, I shall post this tweet from a twitter friend who posted it recently.

80% of the worst daily return days happened when Nifty was < 200 MA..same if we exclude 2008 pic.twitter.com/kfGSrpT6mv

— karanb (@karanb_k) January 26, 2016

80% of those bad days had a single independent factor that is known before the bad day has taken place. Now, lets go back the question, How difficult to reduce allocation when Nifty is below the 200 day average? We aren’t talking about shorts or even selling in full. All I am talking about is reducing exposure of equity to 80% and keeping the 20% in cash. What probability do you think you have when it comes to beating Nifty. Remember, we are not even adding stocks from outside, its all a question of allocation.

I am not sure how many are aware of a Index NSE has (and in recent past, NSE has started way more indices than your fingers can count) that goes by the name Nifty Alpha 50. To read more about that Index, please do download this document (Nifty Alpha 50).

To me, the biggest disappointment is that while NSE keeps introducing Index after Index, we really have no way to invest / trade in the same. One hopes that someone with the powers that be shall take notice of this and do something to remove the anomaly. But first, lets compare the performance of the Index vs our Nifty 50

In all years when Nifty was +ve, save for 2013, Nifty Alpha 50 has beaten it. While 2008 showcased how wrong thing can go, 2015 was a case of Alpha trumping even as Nifty closed the year with -ve returns.

If you feel that I am comparing wrong and should be comparing against the Nifty 500, let me show you those numbers as well

Not too different, ain’t it? So, how many funds / advisers have you found bechmarking themselves to the Alpha Index?

Another way to beat benchmarks is to select the period that works best to showcase better returns. A famous fund manager plastered the town with 100% returns over the period of 1 year. But this wasn’t a financial year, it was just from the date he accomplished that number to 1 year prior. The financial year number was 35% (IIRC) below the 100% mark, but he had achieved infamy by then and why bother with these small details.

Advisers (who just provide advise for a fee) who beat the Indices generally do no even bother with small things such as slippage / market limits (as to how many stocks you could have possibly bought at that price) among others. Why let data interfere with the selling they would say.

Benchmarking is a important process and regardless of how others do, its important that you understand the biases and fallacies that can accompany one. After all, its your money everyone is after.

Coattail investing

The world has become a smaller place thanks to technology which these day enables everyone access to quality information nearly at real time, something which in the older days played a great part in returns generated by professional investors / fund managers. In other words, it has become a great equalizer of sorts.

Twitter / Facebook / Whatsapp / Slack among other tools have become tools of collaboration and discussion resulting in better disbursal of knowledge and ideas. But what is also brings to the table is blind belief’s in some one elses ideas / trades and trying to follow them in the hope of easy money (easy give the fact that one doesn’t need to spend a lot of time doing the leg work himself).

When markets are good, these trading strategies / ideas are lauded as the next best thing, but markets being cycles are prone to excesses on either side and when things go wrong, its amazing how fast everyone is quick to blame the one guy who propogated the idea and hence is the person to blame for all the misery.

Following big investors / traders seems a nice idea if your intention is to pick up on the thesis behind their picks, but if its just the picks you are more concerned about, its just a matter of time before you will be sorely disappointed and will have parted with more money than you bargained for.

2015 seemed one such year when a strongly recommended and fancied stock (which manufactures pressure cookers) took a severe beating. Every one, whether he had a position or not, decided that the blame was to be laid at the door of the guy who felt it was a good pick with even suggestions that he was actually selling himself quitely while suggesting that other stay on.

2016 has started with a fancied textile company which is facing a rout similar to one the previous company faced. Unless the company turns out to be a complete fraud, the stock will stop falling and normalcy will return. But those who picked up the stock at much higher levels may need to wait for months or even years before they can get back to their high water mark.

At the beginning of last year, a famous analyst came up with a prediction for Nifty that suggested that 2015 will be the big year (in terms of returns) and while that call came nowhere close to being true, the said Analyst is still very much renowned and continues to be one of the talking heads at business channel. So much for accuracy of forecasts.

Profits and Losses are part and parcel of trading / investing. But if you are investing based on some one’s (paid or free) view, the risk quotient goes up even higher since you have no clue regardless of what happens and taking action is tougher especially when its not going the way one would have wished it would.

I see advisers regularly advising investors to invest only what they are willing to lose while at the same time claiming that only investing in equity can provide one with above inflation returns and its not prudent to invest into other asset classes for history has shown (not in India) that Equities beat others by a long yard.

The very term of being willing to lose means that you cannot risk enough to make a difference to your lifestyle should your selections work great. But if you risk more than what you are willing and do end up on the losing side, you will be faulted for risking too much. Heads I win, Tail you lose.

Warren Buffett has in the past talked about distinguishing between temporary draw-down and permanent loss of capital. When you invest in a ETF / Mutual fund, the risk is generally of the temporary draw-down nature. No matter how worse it looks, the probability is that it shall eventually recover (unless the country goes to dogs, but if that happens, you will have a lot more to worry than the value of your investments) while investing in stocks can result in serious and permanent loss of capital if you aren’t able to exit even as the stock continues to slide down on the slope of hope.

When you follow other people’s trades, you are in affect hoping that the other guy (the guy you are following) is not actually lost but knows the way. But it still doesn’t allow you to risk the kind of capital that will make a big win, a win worthy enough to retire upon. In one of my past blogs, I have written about my 1000 bagger – a kind of return that is very rare and yet, the fact that I risked so little has meant that even that amount I stand to gain should I sell now is too negligible. Forget about retiring, I cannot even go on a dream holiday and yet I have a 1000 bagger.

This year is my 20th year in markets and yet as far as I can remember, I know more people in markets whose biggest wins have come from Business / Real Estate than their wins in market. In fact for many of whom I know, what they risk even today is a small percentage of their total net-worth and this alone ensures that even if everything they touch goes to dust, they can still lead a comfortable life.

Coattail-ing is a interesting strategy only if you have complete knowledge of the guy you are trying to copy. Else, where he will be risking 0.01% of his money, you could end up risking 25% or more of yours. A loss won’t affect him anyways while a loss for you will wipe out a significant amount of your capital.

Social Media provides a interesting platform to learn from but if you were to try and use it as a short cut, you run the risk of getting caught in the middle of a forest with no clue as to where to go next as the light dims away.

What will you do, What will you do

The toughest thing in markets is to action when things aren’t going the way one hoped it will be. When markets are going up, the biggest worry for most investors and traders is that they haven’t loaded up enough to benefit from the rise and when it starts to fall, and when it starts to fall – man, most of them are caught up in the “Deer in the Headlights” syndrome – fixed feet unable to decide whether I should even move a damm muscle.

When markets plummeted 600 points (Nifty) in a matter of days, anyone caught on the wrong foot would have had it tougher by the day to take corrective action. Much of this can be ascribed to the “Sunk Cost Bias” that affects every one of us. After seeing a 400 point loss, would you consider cutting the position or sitting tight or worse, adding in the hope that a small recovery shall make good all the losses suffered till then?

The advantage for guys who use charts is that they provide you with clues on what may happen if a support or resistance gets broken (can be a many a time a major inflection point). When a stock or a Index breaks below what is known as a major support zone, you know that the probability of a rise now looks even dimmer and the best way to handle the situation is to either take a hedge or better, exit the position and wait for a new Signal.

Its much tougher for fundamental investors who have piled into a share to take evasive action since their signals aren’t like the one of technicians. You don’t get the company to make a announcement every time their stock tanks nor can you expect earnings reports to be updated after a major rise in the company’s share price.

Lets use a real life example – Kitex. This is a stock, that is as far as I know, that most value / fundamental investors have fallen in love with. Great business, nice earnings and hopefully a great future. The stock for a long time did not disappoint them either as it surged from trading in single and low double digits to something that was traded in 4 digit numbers.

All that changed when the company came out with its first quarter results for 2015 on 21st July. The company’s results were not what analysts had expected and given the premium valuations, it was natural to see a slump in the price of the stock. For a trader who uses charts, this would have been a clear exit signal as it broke through several support zones without as much as pausing.

When a stock price pierces several Resistance / Support zones, one indication is that the buying / selling is too strong and hence all the selling / buying that would have happened at those zones were not enough to change the situation.

The stock then continued to decline as it gutted away the gains that were accumulated in the previous months before it stopped at 575. But why 575 and the reason is that this was the place from where it had taken off in April. To add to that, this was also the breakout zone (once failed) which made the level even more of a worthwhile candidate to risk buying at.

Either way, it did work as the stock through much of the fall – but did it reverse course completely – of course, not. The price did not even catch up to the price at which it opened after the bad results. The slide that has taken place from there was not as sharp as earlier though we did fall and this time, even the old support wasn’t good enough.

But unless a stock moves into All time Low zones, there will be areas of support and for Kitex, there is a glimmer of hope at the levels between 422 and 437. That tiny gap which wasn’t filled is the next best hope. When I started writing this, was inside that very area. I even tweeted the chart showcasing the gap (Chart below).

As of now, the stock has bounced off from that zone, but will that hold? I don’t know and I honestly won’t care. But the fact is that for some one who looks at charts to trade, this is a area which provides a good risk reward opportunity. If it works, well and good, else one takes a small loss and exits in the hope that there will be another potential trade somewhere ahead.

Technicals is not about catching those bottoms or selling at the tops. Its all about listening to markets and going with the flow – no one has survived by trying to swim against the tide, not even John Paulson who if reports have to be believed has been forced to pledge his personal properties to ensure that he can remain in the trade (that for the time is wrong). He got it right in 2007 / 08, but will he be second time lucky?

What will you do, What will you do if your stock breaks that major support

Sell Sell Sell

What will you do, What will you do if your stock cruises past that major resistance

Buy Buy Buy.

What will you do, What will you do if your stock doesn’t behave as you expected

Run Run Run

for there is always another trade around the corner waiting for you.

New age Gold Diggers

In the mid 18th Century, California experienced what is now known as the California Gold Rush. People converged from near and far to try and get rich quick. While the initial diggers made some money, the late arrivals barely eked out a living, let alone get rich. A allegory that is used to describe those who made money says that those who sold Shovels made more money that those who actually dug for the Gold.

While the stock markets aren’t a place for the easy money kind, it does attract investors who hope to make a killing buying stocks that are peddled by advisers with the promise of it being the next big thing. Investors subscribe to websites that claim to tell you what big investors are Buying / Selling and how by just following them, you too can make a fortune.

When mid and small caps were booming, we had big fund managers come on TV claiming to have bought what they claimed was stocks which were very under valued and were ripe for a revaluation. Momentum sellers showcased how their portfolio’s were able to buy only the best of the lot and profit from the rally we were seeing.

Its amusing (though having fallen myself more than once into such traps) as to how we believe that the experts who come on TV are there to educate the public rather than trying to ensure growth of their own services. Fund mangers have found TV to be the best medium to broadcast their views and become popular and more the popularity, higher their assets under management.

Advisers come on TV in the hope that you not just hear their views, but visit their website and subscribe to their products – products designed to make you a better investor / trader / Macro Analyst or whomever you want to be. The idea is that all you need to do is pay a few shillings and glorious days are here.

Of course given the fact that failure rate in markets are so high, most experience disappointment about losing more money than they bargained for and try to exit as quickly as possible. But the world being a large place, that place is occupied by the next sucker hoping to not do the wrongs did by the one who lost. But guess what, probability is that he too ends up in the same place as the earlier – maybe in a different way.

I have had the good fortune of being able to meet / interact / learn from quite a number of guys and guess what, none of these have anytime to run subscription services, let alone spend majority of the time shuttling between various television channels giving gyan to one and all.

These days, everything is for sale but none come without any assurance of profit. Tip sellers want you to risk real money first to pay them and next to invest on those stocks that they recommend. But ask about reversing the process and they want some sort of guarantee that you shall pay if it works.

At least in the Mutual fund space this seems to be changing with the arrival of new age distributors who provide you with the ability invest directly and who are willing to get paid for their advise only if they beat predetermined benchmarks. While we still do not have websites like Collective2, I do hope that we shall see something of that nature in a matter of time as investors and traders want more than just assurances of the stock picker really knowing his stuff.

But till that time happens, you are better off taking every claim with a bag of Salt and spend your hard earned money on things that are worthwhile (Books for instance) than fall prey to buying the latest shovels from the friendly guy next door.

Promoters and Lifestyles

While Indian stock markets are said to be on the largest (in terms of listed securities) exchanges of the world, when it comes to Mergers & Acquisitions, especially of publicly listed firms, we really pale to a non significant ranking. And if you were to search for hostile acquisitions, there is very little of that happening on Indian markets. The last famous hostile battle was to try and takeover GT Offshore.

“Taking over a company (in India) has become even more difficult … every time if one has to waste years in court, it’s not worth it (a take-over bid),” said Lord Paul who attempted some high profile takeovers in 1982. While he exited in profit, the fact that he had to take the companies to court to get his shares registered says a lot about the pain quotient in taking over publicly listed firms.

The fact that its tough to acquire companies has made promoters to worry less about the risk of being thrown out even if they run the company to ground trying to boost their ego even if they don’t own 51% of the company. And if you own 51% or 74%, you can treat the company as your own piggy bank with none to bother.

Motor Cars are a depreciating asset and hence when you buy them personally, you suffer the depreciation. But what if the same could be routed out via your company. You get the same car while the company pays off the cost of acquiring and sets if off against its balance sheet.

Now, companies are free to spend the money the way they want but when promoters start to use them for their personal needs, one really wonders where the line ends between the company’s real needs and the promoters own needs.

If I own 100% of my company, I can do as I please since end of the day, its my own money at stake. But what if I run a publicly listed firm where at least 25% (SEBI minimum) of shareholding is held by the public. Treat them with the contempt they deserve to have trusted me in the first place?

A long time ago, a flashy promoter bought a private jet for his personal use using funds from a US listed (where he owned a majority stake I believe) firm. All hell got raised and he was forced to act. The promoter therefore simply sold off the plane to his Indian firm (where again, being listed was not 100% his own) and that matter died a natural death.

Media tags promoters with tags like Visionary or frauds / charlatans. Most of the time, its based on outcomes rather than the process itself. If a promoter takes enormous risks and succeeds, he is a Visionary, if he fails, it was because he was either stupid or there is more to it than visible to the eye.

The idea for this particular post came from friend Anand Mohan who runs equitybulls.com. (A disclaimer though, he also holds a stake in the company and hence can be treated as being interested). He posted a pic of the depreciation table of a small listed company. The company as on date has a market cap of 6.65 Crores and a Enterprise Value of 8.16 Crores. Promoters hold 74.43% of the company shares.

In the Financial Year 2014 – 15, they had a Profit after Interest but before Depreciation of 1.13 Crores. But then there is the depreciation which came to 94 Lakhs which literally ate away all that the company made that year. So, the question is, what kind of assets does the company hold that ensures that all it earns is literally wasted away in depreciation.

Here is the Fixed Assets statement. Apologies for the low quality of the pic, but it seems that the company has in order to save money, stitched up pictures taken from what seems like a low end camera.

The biggest number out here is for Plants and Machinery which is acceptable given that Plants and Machinery constitute the very basis for the company’s existence. Second biggest item though is Motor Car. The total amount invested into Motor Cars before this year was 2.16 Crores and this year they seems to have added 38.46 Lakhs worth more.

In other words, 23.50% of the company’s depreciation is due to Motor Cars which most likely are for personal usage rather than being for running the business of the firm. While 38 Lakhs in itself may not appear big, do consider that the Net Profit of the firm comes to just 8.89 Lakhs for the whole financial year. In other words, they spend around 4x what the company made.

Of course, this is one such company and I am sure that there are dime a dozen companies where the promoters milk the company in every way possible.

A famous quote of Warren Buffet is

“When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.”

Most investors unfortunately get sidelined by the management even in outstanding business as promoters lifestyle requirements takes a more prominent place. Since hostile take overs cannot even be effected, there is no exit route other than to give up on the company’s shares since its rare as they say “A leopard can’t change its spots”.

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