Investments

Although the use of cash is not really a tactic – and the level of cash often not the result of a deliberate effort – it can be discussed here. A value investor (such as ourselves) does not make bets on market direction or timing. Rather, he buys things when they are good value. If he finds something to buy but has no cash, he sells his least undervalued asset to replace it with the new, more undervalued asset. But he feels no need to be fully invested at all times. So if there are no good values then he does not buy, resulting in a high cash allocation. By default, then, he becomes a market timer, but the high cash position is a result of finding no value, not a goal in and of itself.

As Jean-Marie Eveillard puts it, “cash is a residual.” But that residual can be quite high if there are no values.

Another value investor, Seth Klarman says investors “should choose to hold cash in the absence of compelling opportunity,” again emphasizing that high cash is not a top-down allocation, but the result of the bottom-up search for bargains. He tells his investors who query why they are paying him to hold cash. “You are not. You are paying us to decide when to hold onto cash and when to invest it”, an answer with which we would concur.

At Adrian Day Asset Management, in addition to this approach, we also overlay our assessment of the general market risk profile. If the overall risk appears high, then we will insist on greater and more sure values before buying.

When values are somewhat high, rather than buy outright, we may sell puts on stocks we like, at below market strikes. In this way we can generate additional income, while exposing ourselves to sectors and equities we like. (For more on this, see “Options”, one of the discussions under “Investment Tactics.”) In such cases, we always set aside the cash that would be required were an option put to us; thus not all our cash is necessarily unrestricted, and may be working for you anyway.

When we talk of cash, we are primarily thinking of U.S. cash (or cash equivalents). We may purchase foreign currencies, holding in cash equivalents, as a hedge against the dollar, an investment in and of itself. But again, if we find good values in foreign stock markets, we will generally prefer to hold equities than foreign currencies.

We tend to be incremental buyers and sellers. When we have a new company to buy, we tend not to buy for every client (for whom it meets their investment parameters) all at once at the same time and price. Rather we will tend to buy incrementally, for some clients first (those for whom it is most appropriate, or who are underweight that sector or market, or who have larger cash holdings at that time).
Similarly, we can buy a full position for individual clients, particularly larger accounts, in stages, taking a modest position and buying more if the stock price drops or as developments at the company warrant.

The selling process is similar, selling as the stock moves up, though of course, if we have changed our mind on a company, we will move quickly to sell for all clients.

If we purchased additional shares for a client, we may sell that additional purchase sooner, at a modest profit, while retaining the core holding.

The use of stop losses is one of those issues to which there is no absolute answer; the truth is that using stops can sometimes prevent a small loss from becoming a larger one, while there are definite risks with using stops; each investor must decide for himself when and in what way to employ stops.

Here at A.D.A.M., we tend to be somewhat cynical on the use of stops. First, automatic stops can be employed for the most part only on stocks listed on U.S. exchanges; they cannot be used on Nasdaq, for Canadian stocks, and on most other foreign markets.

Second is the important consideration of being whipsawed, wherein a stock declines to the stop level, takes you out, and then reverses and moves back up. (It is widely thought that some speculators will take stocks down to prices where there are batches of stops.) This is particularly, but not only, true of volatile stocks. Had we employed stops consistently, we would have been taken out early on every single one of our favorite long-term winners.

Further, a stop loss of necessity takes one out of the stock at a low point rather than a high point. This does not mean, of course, that the stock will not go lower, but rather that you are being sold when the stock is down. And once a stop is triggered, it becomes a market order, meaning you may get sold at a price somewhat below your stop level, particularly in thinner markets.

The most fundamental objection to the continual use of stops, however, is this: if one is a long-term value investor and has done one’s homework correctly, then when a stock price declines, it is precisely the time to buy more, not to sell. If one likes ABC at $60 and nothing has changed, one should love it at $40.

Having said all that, we use stops in two different circumstances. First, as discussed above under Shorts, we prefer to use stops when short selling. This is because stocks can move considerably above their true value for extended periods, and in short-selling, one must put up more margin when short sells move against you. As the old saying goes, “markets can remain irrational longer than most investors can remain solvent.”

Secondly, we sometimes use stops when a stock has performed very well, and though we believe the stock is fundamentally overvalued, market conditions make us believe it could go even higher. So instead of selling, we will use a tight trailing stop, moving the stop up as the stock moves up. In such circumstances, a stop is to “protect profits” rather than to “stop losses”.

Sometimes, we have a negative view on the market or a particular sector and want to “make a bet” against the market. This can be done by buying puts or selling short, either indices or specific securities. We may undertake such trades either as a way of profiting from a decline in price, or as a way of hedging an overall account. For example, a client may own a considerable number of European stocks, each of which individually we like. But if we are nervous about the outlook for European stock markets generally, we may hedge that position with an index put or short sale, instead of selling of the stocks.

In theory, buying a put is less risky than selling short, since the maximum loss from a put purchase is the price paid, whereas a short sale has, theoretically, unlimited loss potential. However, puts have two significant drawbacks: they are limited in time; and one pays a premium. In sum, puts are time-wasting assets.

Thus, if one buys a put on, say, Google, expecting the stock to decline, one must be correct, not only on the direction of Google (i.e., down), but right about the timing; the decline must occur during the period when the option is active. And the premiums on puts on some stocks, particularly the most overvalued and volatile ones, can be very high, making it difficult to make money from the purchase of puts. (This is one reason why we prefer to be sellers of options, rather than buyers; see discussion on Options.)

We short typically only in larger accounts. The client must have given us express authorization to sell short. The value of short sales will only ever be a small portion of a total account. Typically, we sell short listed stocks (that is, stocks listed on an exchange), where one can place an automatic buy back, should the stock move up. And we use those stops, which take the emotion out of what can otherwise be a hair-raising experience.

Having said all of that, shorting a stock, in essence, is no more than the reverse of buying it, and, although we do not aim to run a long-short program or hedge fund, shorting indices and individual stocks can be a useful hedge and a profitable exercise.

Options, of course, are but a tool, a tool that can be aggressive or conservative, used or misused. Below we outline the options strategies that we employ most typically. In general, we use such strategies in a conservative manner to enhance performance or to hedge the overall account. However, clients must provide special authorization in order for us to undertake any options trades, and we ask clients to do this only if they are fully comfortable with what we are doing.

• We sell puts on stocks we want to buy. This enables us to buy the stock, net of options premium, at a lower price than we could have done otherwise. If the stock moves up, we do not buy the stock, but pocket the premium.
• We sell calls on stocks we own as a way of selling at an “above-market” price or collecting premiums if the stock does not move up.
• We buy puts from time to time, whether on indices or individual stocks, to profit from a declining market or specific stock; this also acts as a hedge on the overall account.
• We buy calls occasionally in order to increase leverage from short-term moves.

Sometimes, we will undertake strategies that involve a combination of option purchases and sales (such as selling a call and buying a put at the same time, to buy downside protection at no cost).

In order for us to undertake these strategies in an account, the client must sign special paperwork. By doing this, the client is authorizing us to undertake any options purchases and sales for which he has signed. If as a client, you do not want to authorize us to undertake certain transactions, then you should not provide that authorization.

Accounts may be limited as to strategies that can be employed by legal or other reasons. (For example, IRA accounts are restricted by law from certain strategies; trusts may be limited by the trust document or trustees; and brokerage firms must approve clients for certain options activities.) Margin is required for certain options strategies. In order for us to sell puts, for example, we must have margin authorization. We do not sell naked calls or undertake transactions using margin in the sense in which it is commonly understood; that is, your exposure would never be more than 100% of the price paid for the put or call, or the exercise price if a sale. When we sell a put, for example, we put aside the money required should the put be exercised.

As mentioned, typically, we use options to limit risk exposure. In addition, such strategies only ever comprise a small part of an overall portfolio.

Private placements are offerings of stock in new or secondary issues that are not available on the public market. Shares are typically sold at a discount to the market price and with attached warrants, thus providing leverage over a market purchase. Placements frequently have minimum investments, and there are restrictions on the sale of the shares; the “hold” period is typically at least four months and sometimes a year, during which time the shares cannot be sold. Even after that, there are frequently restrictions on sales which limit liquidity.

So though private placement can be a very advantageous investment, they are not without drawbacks and risks, and are clearly not suitable for, nor available to, everyone.

In order to participate in a private placement, you must be an accredited investor (currently, $1 million net worth, excluding primary home, or $200,000 annual income; there are other requirements as well.)

We have dealt with private placements for clients since our inception in 1991. However, not all custodians can accommodate foreign placements. For clients who are interested, we can send a list of requirements and other criteria. Please note: you must be an existing client to participate in a placement.