In my March issue I discussed reasons one should be optimistic and extending my perspective beyond the current events to think more about the future. One reason I believe we should be optimistic is our ability to adapt and evolve. Adaptability is an important trait in all aspects of our life, including investing. In this issue I want to discuss an investment I made in the portfolio highlighting me adapting my style to take advantage of the recent volatility in the market.
This is a lightly edited excerpt from an email sent to partners following the trade:
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The basket of Preferred Stocks represents a slight departure from our typical equity holdings. However, the current climate provided an opportunity to invest with a very attractive risk/reward. The recent market volatility caused Preferred Equity Funds/ETFs to experience a dramatic sell-off. Evidence of the volatility can be seen in the chart below with average trading volumes in March running at 3.5-5.5x the prior five years.
These "passive" strategies are forced to sell into a market irregardless of the price. This created an imbalance in the market causing the price for these securities to fall dramatically. The chart below provides the pertinent details about these investments. Essentially, I believe these investments can provide an equity like returns without taking on the risk of owning an equity. Each of these securities has a Par value of $25, which allows the company to repurchase the Preferreds from us at $25 per share. As you can see, we purchased our basket for $0.80 for every $1.00 of Par value. Additionally, the blended yield on this basket is ~7.25%. If this basket trades at $25.00 by 3/31/20, then our expected return is ~33% (~7.25% dividends + 26% in Capital appreciation). The ability to purchase them at such a large discount to Par is what creates the potential for equity like returns.
I was selective in which securities I purchased. Excluding Preferred A, each of these companies has investment grade debt. Additionally each of these businesses operate in areas unlikely to be affected by Coronavirus.
The largest and most straightforward risk with these securities is the underlying businesses not performing well causing the company to default on their dividend payments. I view this as an extremely low probability. The other big risk I can think of is if the pending stimulus package passed by the US government creates an environment driving higher inflation. This is a really complex question. I don't think the answer to this will be knowable until the economic impact is more quantifiable. And if something like that occurs, it will impact the pricing of all financial instruments.
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Fast forward five weeks and here is an updated version of the chart.
As you can see I sold two of the investments because they reached Par Value. The return on this basket has been competitive to the recent appreciation in the S&P 500 AND we moved up the capital stack. Taking advantage of a short-term dislocation in the market is not something I anticipate happening too often with my strategy. However, this represented a unique opportunity with a very attractive risk/reward. Just as humans adapt over time, so do markets. In addition to the attractive risk/reward, the investment allowed me to harvest some tax losses and create a cash position that I can now re-deploy.
I know this letter was a more technical than usual. So if you made it this far, I appreciate the effort. I’m going to have a second newsletter next weekend covering another key aspect of adapting when investing.
If the events in the past couple months have caused you to question your finances, then please reach out. I’m happy to chat with you and hopefully answer some of your questions.