Inventory Creation

After a weekend of great weather and great baseball I sat down at the computer this morning and began to check on the world. I had a laugh out loud moment when I read the early headlines. It seems stock futures were up this morning because G8 leaders said they want to keep Greece in the Euro. To me this is like saying you want Uncle Harold to stay at Sunday dinner after he’s borrowed money from everyone and vomited your 20 year old scotch into the mashed potatoes. The other bullish news is that global governments want to favor growth over austerity. I think that’s very nice of them but question if that is practical. I favor an Orioles-Cubs World Series every year too but we do not always get what we want.

The stock market has been in a steady downtrend these past few weeks and we have approached the 10% level that indicates the possibility of an inventory creation event in progress. My approach to the markets, and especially my time frame, allow me the comfort of viewing market declines a positive  event. Although my account may experience quotational losses for a period of time I view these time periods a chance to buy more assets and decent businesses at a cheap price.

As long as I am confident that what I own is safe and cheap I don’t really care too much what the market does over the 5 to ten years I intend to own them. If things get too richly priced I will sell them. If they decline and become cheap, I will buy them. In the interim I read a lot of books, watch a lot of baseball and search for other stocks that fit my criteria or offer a longshot opportunity with a high risk reward. Oddly enough this approach of buying low and selling high seems to work as well, if not better, than most of the complex trading strategies I have run across over the years.

When I checked for new inventory this morning I ran one of my basic market decline screens. I looked for stocks that had dropped more than the market in the past few months, were in the S&P 500 and had fallen below tangible book value. The name that really stood out on the list was Leucadia National (LUK). The shares have declined are back to just under tangible book value. This is a stock that I have owned and followed for years and I am excited about the opportunity to buy it on the cheap once again.

This is an incredible collection of businesses. The company is involved in natural gas, coal gasification, Liquid natural gas, beef processing, wine, real estate, casinos, biotech, plastics and timber. They also own large stakes in several public companies includiung Jeffries (JEF) and Mueller Industries (MLI). Since 1978 the mangers of the company, Ian Cumming and Joseph Steinberg, have grown book value by 18.5% annually. They are distressed and vulture investors who attempt to buy out of favor companies and hold them until they improve. If you understand why they bought the Biloxi Hard Rock casino after Katrina and partnered with Berkshire Hathaway in a mortgage servicing and commercial mortgage origination company in 2009 you start to understand how these guys approach business.

I can give you a lot of reason to own this stock. You have a collection of businesses bought on the cheap with brilliant management. You also have a collection of businesses that will respond positively if all the global money printing does lead to a high inflation rate in the future as some fear may happen.  At 90% of tangible book the stock is not only a solid buy on its own merits, it may proof to be an inflation hedge for your portfolio.

I do not have the room here to break down all the business they own and their corporate strategy. Go to the bare bones website at http://www.leucadia.com/ for a better overview of the company. While you are the read the past thirty years of annual reports and shareholder letter for an MBA in opportunistic, patient vulture investing.

Most of this was orginally published on Real Money.com

Ponies, Markets and Living Well

We are well into the Triple Crown season with just one race left to go. It’s been fun for me so far as based purely on the name I liked I’ll Have Another early on in both Derby Futures as well as Santa Anita. Now we have a decent shot at a real Triple Crown winner as the horse is one of the better closers we have seen in a few years and the length of the Belmont Stakes should favor the him. We have been disappointed several times since Affirmed in 1978 so we shall see what happens in two Saturdays.

I have always been a huge fan of horse racing, racetracks and all the associated depravity. Some of my fondest memories of the past decade are the trips we used to take to Keeneland in Lexington Kentucky every year for the Bluegrass Stakes. Lexington is a town founded by Irish gamblers and is made to order for me. A diverse group of traders, investors, professors and other assorted ner’ do wells used to assemble for a long weekend of horse racing and bourbon drinking with the expected adventurous and occasionally disastrous results.  I guess we all outgrew the trip or just got to busy but they will be telling some of those stories at my funeral in fifty years or so!

I don’t hit the races or even the poker table the way I did in the past. A combination of marriage, kids, getting older, and the end result of the earlier explained IRR have kept me from wagering and whiskey in the quantities of days past. I still follow the ponies however and am always cognizant of the lessons learned at many racetracks and card tables over the years. A day at the track contains lessons in statistics, psychology, marketing, and a host of other scientific disciplines. Many of these I have found to be directly applicable to the markets and to life its own self.

The track contains many of the elements of the financial markets. You have the touters and system developers who look for the answer and failing to find it sell their services to others. It was Tom Ainslie who pointed out how these systems develop in his book on handicapping. “ A longshot wins a race. A disappointed bettor consults his Form and discovers that the longshot had been timed at 36 seconds in a breezing three-furlong workout a couple of days ago. No other horse in the race had worked so rapidly so recently. Powie! A new system is born!” How many of these have you seen in the stock market. Someone curves fit data to show that the winning stocks of the past had a particular characteristic or price pattern and a brand new newsletter and web site is offered to investors as the answer to all their problems and a sure fire path to short term wealth. In truth none of it works any better on Wall Street than it does at the track but selling easy answers to greedy people has always been a source of profits for stock market and horse racing system developers.

 Then there are the people you meet at the track. You have the bleary eyed beer soaked despondent souls who pick up discarded racing forms to search for a long shot winner to just get them back to even so they can start over again. They won once and hit some exacta or trifecta bets, usually by luck and have been chasing that short term success for a lifetime of almost and faded in the stretch. There are those who offer an informed opinion on each and every race with all the certainty of the Delhi Oracle. They bet each and every race and brag of their fantastic winnings before hopping in their classic car (a 1988 Buick Riviera with balding tires and cracked windshield) to head off to their luxury furnished studio apartment with a spectacular view of the railroad tracks and oil refinery. The stock market is full of these folks as well. The oracle of the last market cycle and the expert who never loses are everywhere on Wall Street and I am never sure if their hearts desire is to get to the winners circle or just drag as many others into their pool of disgrace and desperation as possible. Whichever the case, they are to be avoided in life, at the stock exchange and along the rail.

At every track I have been into in my life you can always find a few gentleman, usually older who sit through the race scribbling notes in their racing form each and every race. With the exception of perhaps a close friend or two they do not talk to anyone else or engage in the tip sharing and” who da ya like?” camaraderie of their fellow rail birds. They watch, take notes and perhaps sip a cold beer, or more likely a coffee.  They wander off to the paddock before each and every race and the vast majority of the time they return to their seat to scribble some notes without bothering to place a bet. On rare occasions they get up, go the window and make a bet. These are the ones who have figured out the game. They only bet when they see an advantage and are more likely to fly over the grandstand than tell you how they derived their advantage. This is similar to investors who don’t see the need to trade every day and only pull out their wallets when they have an edge and prices are favorable enough to offer a high probability of long term investment success.

One such astute gambler was among the best of them all. Pittsburgh Phil had a distinguished and successful career as a horse bettor. He once said “Playing the races appears to be the one business in which men believe they can succeed without special study, special talent, or special exertion." This is the case in the markets as well. So many people sit down and read a book or look at a chart and think that they, of all the speculators, traders and investors who came before them, have figured out the answer to market success. They do not study, research, or test and care little for other opinions. The worst thing that can happen to these people is initial short term success that makes them even more confident in their flawed opinions. Eventually the all go spectacularly bust. If this was easy everybody would be rich.

Phil, whose real name was George Smith also once said “Know when to put a good bet down and when not to.” This is not only the best advice for horse gamblers but stock investors. Just because the window is open does not mean you have to get in the action. Patience pays at the racetrack and in the stock market. Just because they open the casino down at Wall and Broad does not mean you have to trade. Once a year or so you will get a steep decline in stock prices that carry 10 to 15% lower. Every few years you will get a gullywhumper of a selloff and prices will fall 20% or more from the highs. That’s when you want to invest your cash. Keep in mind the excellent advice not only of Pittsburgh Phil but Henry Clews in his investing classic, 28 Years on Wall Street as well. “But few gain sufficient experience in Wall Street to command success until they reach that period of life in which they have one foot in the grave. When this time comes these old veterans of the Street usually spend long intervals of repose at their comfortable homes, and in times of panic, which recur sometimes oftener than once a year, these old fellow will be seen in Wall Street, hobbling down on their canes to their brokers' offices. Then they always buy good stocks to the extent of their bank balances, which have been permitted to accumulate for just such an emergency.”

When I was a more frequent visitor to the track I used to look for horses that were stepping down in class in a race. I looked for a horse that had run middle of the pack races in higher dollar stakes race and are now stepping down a bit. If I could find a horse in a $50,000 stakes race that had run a few $100,000 races and had placed third or fourth I was interested. Racing against lesser competition the horse had a strong chance of running well and the past performance figures against better horses usually gave longer odds than should have been the case. The biggest ticket I ever cashed came from finding two of them in one race and hitting a badly underpriced exacta. It also provided a pretty steady diet of simple win tickets over the years. To me this is a lot like buying fallen angel stocks. Former blue chips that have had a reversal of fortune and fall into single digits have provided a fertile shopping ground for winning stocks over my career. It also applies to people. I am more comfortable being associated with someone who has fallen or failed and gotten back up to run again that I am with someone who has yet to taste defeat and disappointment. These temporarily blessed souls usually think it is their brilliance rather than circumstance that has so blessed them. When the fecal matter hits the the fan as it always does they are apt to become unreliable partners or friends in my experience.

If I was betting on a rainy day I always wanted to look for the mudder in the race. Some horses like Storm Cat just love the mud and run very well thought the slop.  I have seen horses that need a taxi to reach the finish line on a dry day win by 10 lengths when the rain is falling and the mud is thick. This plays out in the stock market as well.  Even in a crappy market and economy like 2008 there were some companies that will benefit from current conditions. In 2008 as the world and portfolio values sank like a well-ventilated submarine companies that catered to low end bad credit consumers did very well. AaronRents, Dollar Tree, Wal Mart, Family Dollar and others that catered to the broken consumer saw their stock prices do very well. Last year it was energy stocks and companies that sold to a resurgent upscale consumer that ran to victory in a flat market. In every economy and market condition there is a group of companies that will benefit and buck the trend.

There a lot of comparisons found at the track that apply to markets and to life. That sleek looking thoroughbred that goes off at short odds may win a good percentage of the time but if you bet him every race he will take your wallet for a ride. He will do well for his owners but gamblers will go broke betting short odds. The same can be said of buying high growth issues at very high multiples and trophy wives.  The feisty little colt at long odds that has run well in the past but is under bet can make you a fortune. So can stocks that are experiencing temporary difficulties or just ignored by the investing public. The stunning high maintenance slut queen at the bar may attract all the attention but it is the good looking smart quite woman in the corner that will make you happy man for decades of life. Flash and short odds does not reward in any endeavor as does substance with a high payout.

I love the race track. Not only is it enjoyable and some of the best people watching you will ever experience but you can gain an MBA in Investing and Life $2 at a time.

Bet the Debt

After my column on stocks that are leading the market lower, I got the usual round of "but what about?" queries from readers and associates. The biggest one was: "What about coal stocks?" Cola stocks have been what can only be called a disaster so far this year and indeed, they have been a month the biggest losers in the past month. Depending on your current position the declines have either been impressive or depressing. Alpha Natural Resources (ANR) shares have slipped by 28% so in the past month. Arch Coal(ACI) has declined by 24%. Cliffs Natural Resources (CLF) has dropped 28%. Patriot Coal (PCX) has seen a gut-wrenching drop of 40% while James River Coal (JRCC) is down a mere 30% in the last month of trading. It has been brutal, and trying to pick a bottom has been a disaster for some contrarian investors.

Coal's problems are pretty well known. New regulations have cast a dark shadow over the industry's future prospects. The Environmental Protection Agency (EPA) hasn't exactly outlawed coal, but they have done the next best thing. You simply cannot build new power generation plants that burn coal and be EPA compliant. To make matters worse, natural gas prices have declined to the point that gas-fired generation plants are as cheap to run as coal-fired plants. Fellow Real Money contributor Glenn Williams has discussed this in greater detail and I will be talking to him about coal's future usage in the U.S. sometime in the next few days. Coal stocks have been declining and, given the earnings shortfalls and possible asset write-downs, they will probably continue to go lower this year.

My "aha" moment came when I was looking at James River Coal at the request of a reader. Coal companies are being traded as if they are going to go out of existence. Some just might, but the industry will survive. Even with the stricter regulations they face, coal is still used to provide more than 40% of our electricity in the U.S. Although emerging markets may pay lip service to the environment their chief concern is cheap sources of power, and outside the U.S., that still means coal. Coal will survive and that makes the industry a distressed debt story right now.

I use a very simple rule for distressed debt investing that I got from Marty Whitman of Third Avenue. I use his criteria of looking for performing credits that are priced in such a way that if the company files bankruptcy, I can still make money by holding the debt. Asset-rich situations, such as coal companies, are fantastic candidates for high recovery rates and most of them are still making their debt payments in a timely manner.

I have mentioned the James River debt before. James River owns 25 underground coal mines, 12 surface mines and 14 preparation facilities. They have reserves of about 370 million tons of coal. The company is struggling and it has a substantial debt load of $582 million, but it also has a lot of assets. In fact, it has enough assets that Standard and Poor's gives the senior unsecured notes a recovery rating of 2, indicating a 70%-90% recovery rate in the event of a bankruptcy workout. The senior unsecured 7.875% notes due in 2018 are trading at 66 with a yield to maturity of 16.27%. At the low end of anticipated recovery, I should still make money even if the company files bankruptcy because the company is still paying the interest.

Debt issued by Patriot Coal is not quite as attractive, but it's getting there in the current market. The company owns 14 mining complexes and has reserves of 1.9 billion tons of coal. The debt-laden company has a recovery rating of 3, indicating a 50%-70% recovery in the event of a bankruptcy. Right now, the 8.25% notes of 2012 senior unsecured bonds are trading at 63 with a yield to maturity a little above that level. At the current price, you need to collect interest on the notes for a year and a half to be break-even at the lower end of the predicted recovery range. That would seem to be a reasonable speculation, given that recovery could be closer to the high end of the range if coal markets improve.

Coal equities will eventually be a decent opportunity. Right now, I find the debt much more attractive.

Originally published on Real Money 

Political and Societal Rantings

I have put this off as long as possible but the closer we get to this damn election the more pure shit I hear every day. It is on the Television, on Facebook and twitter. I cannot even watch a damn ballgame without listening to all the rhetoric and asinine pronunciations spewing about the election and what’s right for America and what’s right for me. I have been silent long enough and just literally cannot stand it anymore.

First let’s start with the assumption that both parties are fucking insane and have agendas that do not involve making my life or this country any better. These idiots are mad on their own ideas and power. They actually think that they and they alone know what’s best for every damn one of us and that the government should dictate our behavior and control our choices. The only difference between the parties is how they go about exercising their power and what they want to control.

One party thinks that they know how to spend my money better than I do. They want to redistribute my money to make things fairer. They tell us that the government can fix poverty and ignorance if they just have more money. Now they have been taking large sums of our money to fix these problems since the Great Society of the 1960s and as a nation we just dumber and poorer so the evidence is not on their side.  According to their platform they should take your money and give it to others and if you are dumb enough to have long term success in your life you should give up more of your money because it is not fair that you are wealthy and others are not.

Okay stop for a second. Go get your birth certificate. Look it over very carefully. Do you see anything on that fucking document that says life will be fair?  It is not fair. It never has been and it never will be. Some people will be born to rich parents and others to poor. Some people will be born as geniuses and being solving fractal equations and playing Bach on a harpsichord while waiting for the kindergarten bus. Some will struggle with Dick, Jane and tying their shoes until high school. Some guys will be born with a full head of hair and never lose a strand while others will be bald before Prom. Some girls will grow up to be Barbie-esque tits on sticks while others will have muffin tops on their diapers that never go away. Some people will succeed and some people will fail. Life is not fair. It never has been and it never will be. Punishing others for their success is simply envy and your desire to enjoy others achievements while doing nothing of your own.

The wild idea that the wealthy and successful need to pay more in taxes is the dumbest fucking thing I have ever heard. They pay most of them now. But they can afford to pay more to help us all cries the liberal. Perhaps they can but here’s the issue. IT IS NOT YOUR FUCKING MONEY AND YOU HAVE NO RIGHT TO INSIST THEY GIVE IT TO YOU. Fair would be all of us paying the exact same percentage of taxes. Fair does not discriminate by income level. We all pay our share and move on. To the  wealthys credit they have paid the bulk of the nation’s tax burden for decades without too many complaints. Try to keep in mind that the wealthy generally own the companies that make the products you use, provide your jobs and support the hospitals, libraries and other social institutions of your community.

This applies to the whole evil corporation business as well. Corporations are not inherently evil. The profit motive of American business has given us a very high standard of living. They provide our food, our clothes and all the other things that make life possible and enjoyable. But get this straight. They exist to make money. Although many have been very generous in giving to charitable cause their purpose is to make money. They are not philanthropic institutions.If labor is cheaper somewhere else then the capital is going to flow there. They will always search for ways to cut cost and improve margins. If taxes are too high in location A they will move to location B. They are not evil in and of themselves. There are problems with the current system but I will get to those when I get to pissing off my republican friends.

The Democrats believe that the answer to our energy problems is to throw money at technologies that are not yet mature enough to provide a significant portion of our needs. Until we achieve energy independence the world has us by the balls. The scary part is that much of the oil supply is located in the homeland of those who would very much like to fry and eat our collective balls. We have a shit ton of natural gas and coal and we need to use it to build a bridge to the greener future. It simply is not here yet and no matter how much of our money you throw at solar and wind companies they simply cannot do the job at this point in time. We will get there but we need to use what we have for the next 30 years or so. We have abundant energy sources. We can develop technology that makes it cleaner. For God’s sake use it and quit wasting my time and energy on this green energy and green jobs bullshit. It is lovely rhetoric but lousy policy.

The Democrats are currently approaching the level of socialists. They think government has the answer to everything and that redistribution of wealth is a fair and wonderful thing. There is no historical evidence that this is the case and a lot that it is a really stupid fucking idea but it does garner a lot of votes based on greed and envy so they stick with it. On energy and jobs they trot out the same ideas that have been failing for decades and expect us to swallow this hogwash once again. It is straight forward "vote for me and I will give you the others guy money" politics.

Enough with those assholes let’s move onto the other assholes. I’ll take the corporate issues first. Corporations are not people you fucktards.  They should not be allowed to throw unlimited amounts of money in the political process and buy elected officials. At this point congressmen and women should be like NASCAR driver and have logos on their clothing so we can all know who paid for them. Corporations do not belong in the political process in way shape or form. Lobbying is a fucking criminal activity. Its influencing elected officials to act in a company or industry’s interest. How the fresh fuck is this a good idea?

 While I am on the subject does anyone think that a caretaker CEO making hundreds of times the wage of the average worker is sound capitalism? If a founder like Jobs or Gates makes tens of billion creating and building a company I celebrate his success. When some random MBA who owns 200 share of stock gets hundreds of million to run a  company and  is laying off thousands to make his quarterly number and kick up his stock option value I think we have to question the sanity of that. Corporations are not gods and CEOs are not fucking rock stars.  Capitalism at his finest rewards capital, labor and management but non ownership management should not be paid 350 times what the average worker earns. That’s not capitalism it is feudalism.

Now let’s move onto the big one and your stand on so called social issues. Your moral standards may not be mine and you have no right to force them on me. You do not know God, you do not talk to him and I suspect he does not like you very much. Don’t stand there and tell me you are the party of freedom and smaller government while drawing up regulations on what I should and should not do with my life. It is not your role in the world to tell me who to love or how to love. You do not have the right to tell me who to fuck, where to fuck, when to fuck or how to fuck.  You can’t tell me who to love or who to marry. You do not have that right or that type of moral superiority. Even if you did it is not the role of government to tell me how to live and to love. Stop that ignorant backward shit.

Now for the Libertarians. I support much of what they do and they have some solid ideas. However the party is full  of nut jobs and anarchists who are clueless about the world. Most importantly they have no plan for getting from where are to where we should be. It’s not like we can just end all entitlement programs, shut down the military and go on the gold standard overnight. In fact no matter how much you screech about the gold standard that ship has sailed. We cannot go back on the gold standard at all.  In the 70s the French used price arbitrage to raid the US treasury. Today our nation would get arbed out of existence if we tried to go on the gold standard. I support personal freedom, Liberty and smaller government with sound fiscal policies. Please show me the bridge from here to there or just admit you are a bunch of loony tunes who like to rant, rave and grumble while smoking pot and banging each other’s girlfriends when ComicCom is not in town.

Enough grumbling, lets now spend some time on what we need to do going forward. We as a nation are deeply fucked up right up right now. We are falling behind in many key areas. As opposed as I may to be to government spending we have to spend some cash to get to a place where we have a healthy economy and society. Then we can afford smaller government and great freedoms.

Let start with some key cuts we have to make. First bring all the troops home. All of them. No more worlds beat cop. We can’t fix our own problems. How they hell do we think we can fix every little hot spot in the world? The US military is to provide for the defense of our nation as well as our national security. They are not there to bleed and die for your political agenda be it feeding starving Somalians or preventing the spread of some competing political ideology. If and when we as a nation are threatened turn them loose with full fury. Until them they belong in the US and our territories only.

Along with this all foreign aid needs to cease. We can barely pay our own bills. Why are we giving money to other nations including many who would love nothing more than to see us all die? When there is a disaster in the world we will encourage our citizens to be as generous as they have been historically but not one dime of taxpayer dollars can be given. Same for the United Nations. Withdraw and kick them the fuck out of New York. That building would make awesome condos. Why do we give money and support to an organization that hates us and works to harm our nations while sending our young people to die in their ridiculous fucking police actions? We cannot afford them.

There are a lot of areas we can cut in government budgets. Leave me alone with carte blanche and the federal budget and I guarantee you I will find the money to fix our problems without a single tax increase. I will piss off a lot of people but the money to address our real concerns will be found.

Now for building that bridge. We have to start with education. We keep hearing talk of education and how much the federal government is going to to do to help us educate our children. They have not done dick except create new layers of bureaucracy. It is not a hell of a lot better on the local level. I have yet to find a department of education in any city town state or county in the United States that was not a nightmare of waste and bureaucracy.  Kids do not have books or pencil but there are three people for every job that needs doing back at the Board of Ed building. It’s a fucking mess. We need to cut the layers of people between the money and the classroom.

Included in the layer is the teachers union. They have assumed powers that are not theirs and play a role in curriculum and other classroom matters. The oppose merit based pay and limit the ability of a municipality to eliminate a bad teacher. They do not help the educational process and I am not convinced they do a fuck of a lot for individual teachers either. Get rid of the bureaucracy and the unions and get the money to the teachers and the kids. We need books, computers, supplies and libraries far more than we need a union official or a deputy assistant to the undersecretary of social studies. We are falling behind and teachers are underpaid while bureaucrats and union officials cash six figure paychecks while our kids can’t read or write.

 We need to fix the classroom situation. First we need to make them safer. Not this sissified "safe" where we have hall monitors and cops drive by the school. Put cops in the schools in high risk locations. Education is a privilege of living in our society and no kid has the right to fuck up another’s education. Get the drugs and the violence out of the building and force the kids to focus and learn. It sounds harsh but educations the only way to break the chains of poverty and ignorance that have gripped parts of our nations for decades now. Give kids a chance to learn and they will.

Quit teaching to the lowest common denominator in the classroom Let education lift up the lowest rather than slowing down the best. If we need more teachers to do this then let’s fire a few more bureaucrats and get them in the classroom. Quit teaching to the test and let kids discover the joy of knowledge. Quit fucking with the curriculum. History is not politically correct so stop teaching it that way. Knock off the teaching of Women’s history, African American history, corrupt white people history and all the other brands that have popped up. Teach fucking history with all the blood, piss, shit, mistakes and achievements that have gotten us to where we are today. It may not be pretty but it is fucking beautiful. Teach the kids math for fucks sake. Math is the secret to the whole goddamned universe and underlies most significant human achievement but we are not even in the top 20 globally anymore. Teach them science so they have some basic understanding of how the world, the planet and life itself actually functions. Knock off the politically correct crap and teach them not to just to read literature but to love literature. There is no world literature or hyphenated American literature, there is just literature. To learn to read and explore is to learn to think. I could ramble on here but you get the point. To fix the nation we must fix the education system and not just teach our children but instill them with a love of learning.

One of the chief jobs of the federal government is to enable and encourage commerce. To do this we need an infrastructure upgrade in this country. Our current infrastructure is not horrific yet but to take out place in the world and have the standard of living we need it must be the best in the world. We need to fix our roads, highways and bridges so products can get to market, children can get to school and people can get to work with relative ease. We need an efficient electrical grid to power our homes and industry in a cheaper more efficient manner. We need a safe updated water system. We need broadband to every school at a minimum and every home possible. This will not be achieved by filtering the money though the state and local bureaucracy. We need a methodology for getting the contracts into the hands of private contractors and let them have a profit motive for fixing this stuff. Take the politics and cronyism out of the process and get the damn work done. We have the technology, the industry, the ability and the people to do this. Quit fucking around playing politics and get to work.

Now let’s get to the real problem today. I am here addressing you 300 million plus apathetic cocksuckers who make up this nation. It’s your country, your government and your world. Quit relying on some mythical government to fix your lives, raise your kids and solve your problems. It doesn’t work that way.

First lose the entitlement attitude. Your presence on the earth creates no obligation on my part nor does mine on you. I do not feel an obligation to provide you a house, feed your kids or pay for Grandmas hip replacement. I do not wish to you to do any of that for me. Your problems are not mine and mine are not yours. Beyond the purposes of commerce and defense there is no fucking social contract unless we agree to such.  I do not owe you shit and you owe me exactly the same. Using the government to take mine and give it to you at gunpoint is not leveling the playing filed. Its armed fucking robbery.

Be responsible for your own life and your own decisions. If you want to practice a certain religion please do so. Don’t insist I believe the same. If you do not like the idea of anal sex with Huggy Bear don’t do it. If the idea of tennis shoes made overseas in low labor cost factories bothers you do not buy them. If you do not like gay marriage then by all means feel free to not marry a gay. If you do not like getting high, do not smoke pot. If you want to help the homeless take them a sandwich and build them a house. If something on TV offends you turn it off. If you find a book offensive stop reading it. If you don’t like immigrants don’t socialize with them (your loss). Live your own goddamn life and quit insisting the government pass rules and regulations to enforce your preferences. It doesn’t work that way. Quit worrying about what others have and concentrate on how to get what you need and want.

So there you have it. Both political parties are fucked up beyond salvage. Vote all these idiots out and replace them with people who have real jobs and run real companies. Elect those who have sweated a mortgage or a payroll and send the professional  politicians home. I want a congressman who has tried to fix her MVA problems while holding a sick child on her hip and a President who made payroll by eating ramen noodles for a month while building a company. Give me a Senator who was late with his taxes because the choice was pay the bill or feed the kids. Of the people, by the people,for the people not professional hack job lobbyist sluts for those of us too apathetic to force change.

It is up to us. Educate our children to the highest degree and standards possible. Provide the infrastructure and atmosphere for fair commerce. Practice capitalism that is fair to both capital and labor. Live our lives as we wish and mind our own fucking business. Problem solved.

The 3 W's.

The birthday has passed and is now behind us by almost two weeks. The number was 51 this time so I am well into my second half century of life, a shocking accomplishment by most accounts. I suppose I could do one of these reviews of the year that was, but given all that happened this past year why in the fresh fuck would I choose to do that. Let’s just call it the year of the IRS rectal reaming (IRR), insert a hypothetical tampon and move the fuck on. There are many things of more interest and entertainment on which to focus and concentrate.

 There is one aspect of the past year that needs some discussion as it has been on my mind of late.

In the aftermath of the IRR I fear I turned into something of a shitty friend. I am usually a pretty social guy but I have also always had a highly developed hermit gene. If the joint is stocked with enough wine, cigarettes and books I can go days or even weeks without seeing the need to leave the house. In the past year I find that this gene has moved to the forefront and I’m pretty content to just not do a damn thing but read and watch baseball.  I have not reached out to friends the way I used to in the past (although to be fair to myself there is a shitload of folks who lost my number when the proverbial fecal matter hit the fan). Over the years I have developed a great circle of friends and I need to do a better job of staying in touch during my 52^nd year of life. With all the social media means of communication, ever present cell phones email and texting there really is no excuse even for a curmudgeonly hermit in training.

The other significant discovery of the year is that I have the greatest family in the history of the civilized world. One bonus of living near the city (oaky that’s a grandiose term for Baltimore but it will have to do for now) is that both kids are within a few minutes and I see more of them than I would if I still lived on the shore. My wife has been a rock and a true best friend and partner. We have spent a fair amount of time running around the Burn finding new places to go and things to do. She has kept me from becoming the crazy old man the neighborhood kids that kids fear and parents use to strike fear into their offspring. I will probably get to that eventually anyway but she has delayed the process by some manner of years. How she puts up with my grumpy lazy old ass I ll never know but I am eternally grateful that she is be able to do so.  Erin really is my plus one and the only woman on the planet who could put up with me without seriously contemplating murderous nocturnal projects.

When I sit down to write these meaningless epistles I prefer not to dwell too much on the past. My friend James Altucher is an expert at tearing down every past mistakes and misadventures  with horrifying and entertaining detail at times. Given the long list of stupid endeavors and the fact that I am not up to snuff on the various statues of limitations on all of them I prefer to keep most of those stories where they belong- in the past. I may from time to time drag one or two of the more ridiculous or hilarious takes of Tim up during a good session  of drunken story telling but I will be damned if I will commit most of them to paper for the world to see and reference at will.

I prefer to focus on the here, the now and the future. Life is still a grand adventure and something of a romantic comedy in my view. Like any good adventure story there will always be plot twists that put out hero in danger but without slings, arrows, rolling boulders and evil bureaucrats it’s not much of an adventure is it? It would be easy to sit around and bitch about all the problems and difficulties life brings our way but I find that neither productive nor fun. I would rather ruminate about the cool little bar the wife and I discovered with the cement floors, lopsided pool tables and a killer little beach out back. Life has enough bullshit, traffic jams, shitty bosses, stubbed toes and taxes. I would rather focus on books still to be read, music I haven’t heard yet, soft kisses with morning coffee, road trips that need to be taken, the smiles of my wife and kids, good report cards, wine at sunset on the patio, and other things I find far more important and interesting.

Speaking of interesting let’s talk a little baseball shall we? So far the Orioles have surprised everyone including yours truly. Dan Duquette’s pitching experiment is working better than anticipated so far. We have at least three pitchers, Wen, Arietta and Hammel have been dependable so far although Jake has struggled a bit of late. The bullpen does not entirely suck and Jim Johnson has turned into an honest to god closer. Up the middle with Weiters, Hardy and Jones we are one of the best teams in baseball right now. Markakis needs to start hitting but is still an outstanding outfielder.

However there are some weak spots. Chris Davis show occasional signs of brilliance. He also shows signs of being young and inexperienced. Setting aside his pitching spectacular in the Boston marathon he is error and strikeout prone and exactly the wrong moment in games. As much as I liked Mark Reynolds last year tis may be an experiment that need to end. He is not hitting the way he needs to and the poor defense is a huge liability. Andino is respectable but we need more form the second base position that he can give the team. Left field is a science project so far. Odds are we fade down the stretch but for now the Orioles are in first place and I will just enjoy that for as long as I can.

So far this year we have some cool stories around major league baseball. Josh Hamilton is on a tear and he’s just fun to watch right now. Bryce Harper is as advertised and has the tools and temperament to be the next really, really big thing in the game. Albert Pujols is the highest paid sub 200 hitter in the game to the joy of St. Louis and its surrounding suburbs. Dylan Bundy is yet to give up an earned run in Single A. The scum sucking rat bastard Red Sox are struggling. Crossman’s Indians are in first place. Matt Kemp is playing like he is pissed about last year’s MVP award. Jeff Samardzija is pitching well for the Cubs. Derek Jeter apparently discovered the fountain of youth. I have MLB TV on the phone so I am now a mobile baseball fan. Live baseball on a cell phone goes down as one of the great technology achievements in the history of mankind. It is shaping up to be an entertaining fun season of baseball.

Now let’s move onto that bitch queen whore of a stock market. The market is in one of those dead zones where it lingers much of the time. There is not a ton of cheap stuff around to buy but it’s not really time to sell everything or get short either. There is a lot that can wrong with a mess in Europe, instability among the large banks in the US, a continued better nut not good economy that is struggling to gain traction and continued high level of short term trading dominating the stock market. However politicians around the globe are determined to hold off the day of reckoning and do whatever they can to prop up equity markets and kick the can all the way down the road.

The most disturbing thing I have noticed so far is that both Seth Klarman and Kyle Bass sold enormous amounts of stock during the first quarter. I am still in the early stage of 13HF reviews but these two really stood out so far. These are two very smart guys with strong records so when they exit the stock market in a meaningful way it is food for thought. If I still had the same asset level I had prior to IRR I would probably be trimming. As it is I am focusing on owning the best of the cheapest and building my position in community banks at substantial discounts to book value. I am holding these along with my British and Japanese banks as well as shopping center and hotel REITs no matter what the market does over the next five years or so. I am considering hedging against disaster arising out of Europe or the US banking system with deep OTM puts but have done nothing yet. I also sold puts on a vol spike in Radio Shack (RSH) and SuperValu SVU) and expect to get put the stock if we do not rally between now and the third week of June.

The other thing I have noticed is the level of smart money, including Messrs Bass and Klarman , who are devoting a larger percentage of their assets to mortgage securities. Bass recently told the SALT conference he expects real estate price to stop going down over the next year and if that’s the case mortgage securities at a discount could offer meaningful returns. If we get some bond market gyration that gives us a lower entry it will make sense to add to mortgage REITs like Invesco (IVR) , Ellington (EFG) and Annaly (NLY).

It is a good time to be alive. I am blessed with a n incredible wife, great children and many loyal friends who tolerate my grumpy ass. No idea why the do but I am happy about it!  The old adage of life being a journey is very true and like any journey it is what you make of it. The bumps and turns in the road are part of it and I prefer to ride them out with a one arm around my wife, a drink in my hand and the radio blaring. Over the past few years I have swapped books, broads and booze for wife, words and wine and it was the best decision I have made so far in a half a century of eccentric living.

Onward…..

A Value Guy Goes Macro

 Every once in a while I like to take a peek out of the office and see what is going on in the world around me. My decisions are made on a company company, security by security basis and I try to ignore what I consider the white noise of short term market movements. I keep the financial networks on in my office but for the most part I find them more humorous than useful. Making investment decisions based on market gyrations or news flow has always ended badly for me so I eschew that type of behavior most of the time. I am trying to buy decent businesses at very cheap prices and own them for the long term.  Short term events do not factor into my decisions unless they provide better price points and even that is determined by individual company value and stock price evaluations.

 Once or twice a year I do find it helpful to stop for a minute and consider the bigger picture. I am not looking for trends or trying to make predictions as much as I am looking for potential cheap assets and sectors I may have overlooked. I push aside the stack of 10Qs and 10Ks, temporarily return my copies of Security Analysis and the Baseball Prospectus to the bookshelf (or according to my wife the top of the stack on the floor) and focus on charts of the world. I start with global stock markets, currencies and even commodities. I will look at the sector and industry charts from various markets. I even break out the commodity charts to see what physical and financial assets are trading at multiple year lows and may lead to safe and cheap investing opportunities.

I started that process this morning by looking at global stock market performance over the past year. We have seen a global coordinated stimulus program inflate many asset prices and keep some markets from collapsing in the aftermath of the credit crisis. It has worked for the US as markets are up 10% year to date and stock prices have doubled in the past three years. A quick look at global stock prices shows that most indexes are up year to date with Spain and Italy being the most notable exceptions.

However the year to date figures masks a much greater long term weakness in stock prices. When I look at the past 52 weeks most stock markets are still solidly in the red. Over the past three years very few markets have had a price recovery anything close to what we have experienced here in the United States. Many markets including the market many consider key to full recovery, China, are still trading relatively near the 2009 lows. Japan has improved over the past three years but not by anywhere near as much as the United States. Only India has had returns approaching those of the US domestic stock market. I have no interest at all in anything China but the relative weakness of Japan may be worth investigating for potential safe and cheap stock opportunities. I am already long some major Japanese banks (MTU and MFG) and am not opposed to buying more stocks in the Land of the Rising Sun.

It will come as no surprise that Europe is where the real stock pain is located. Most of the major European markets are down over the past 52 weeks. Spain and Italy are two of the major concerns on the continent these days and their markets reflect that fact. Both are down year to date, the past 52 weeks and are showing negative returns over the past three years. Although Spanish and Italian bond yields are rising I do not think we have reached the point of maximum pessimism in those two trouble nations yet. It is worth the time to check out some of the major companies in those nations for stocks like Telefonica SA (TEF) or Telecom Italia (TI) that may become bargains as maximum pessimism moves closer to reality. I am also tracking the major Spanish Banks such as Banco Santander (STD) but they have a ways to fall before reaching that 40% of book value I consider a good entry for distressed banks.

The next part of my search for cheap is flipping through commodity price charts to see which of these markets has collapsed and declined over the past year. When I was a younger man I was fascinated by the idea of trading commodity futures but the markets quickly proved to me that a value bias in futures is not really healthy unless you approached it with a much larger bankroll than I had at the time. In spite of that paying attention to commodity prices makes sense for a fundamental investor. They are the raw ingredient for the products made by many companies and are a huge input into margins and profits. Cheaper steel could mean more profitable cars for Ford (F) and cheaper coffee prices could boost Starbucks (SBUX). I do not trade commodities anymore but I do check the prices from time to time to see if anything unusual or potentially profitable is occurring.

One commodity that leaps off the chart book for me is cotton. Cotton prices on the New York Exchange have plummeted by more than 40% over the past year. Slowing demand, the end of China’s purchasing program and an export ban in India have helped the fluffy stuff declined over the past several months. Demand is expected by many analysts to remain weak and that could keep prices fairly low thought the summer. This could be a boost to the margins of apparel manufacturers like Oxford Industries (OXM) or PVH industries (PVH) for whom cotton ins an important raw material.

Coffee and Cocoa have both declined over the past 52 weeks and that is welcome news around Chez Melvin. I drink coffee like water all day and the wife and daughters are overly fond of cocoas end products as well. These declines are not only helpful to consumers but a company like Starbucks (SBUX) that uses a fair amount of both could benefit as well. Most coffee firms lock in prices well ahead of time so the boost in profits for these companies may not come until the end of 2012 or early 2013. Even if delayed a more than 30% decline in a raw material that is around one sixth of your cost of goods has to help the profit margins eventually. I am not a fan of the coffee stocks like Starbucks as Dunkin Donuts (DNKN) but momentum investors may want to be aware of the potential for positive earnings surprises the next few quarters.

Lower wheat and corn prices could be great news for consumers as well Wheat is down more than 20% over the past year and it looks like there will be a surplus that could put additional pressure on prices. Corn is down a little less than 20% but any decline in these key grain market form shoppers feeling the pinch of food inflation over the past year. The declines in many food commodities could also provide a small boost to margins for some of the beleaguered grocery chains such as SuperValue (SVU).

One of the more interesting commodity developments is in the energy sector. Natural gas has been talked almost to the point of exhaustion. We all know that slowing demand and an enormous amount of new supply has driven the price of NG to decade lows. At the same time increasing regulations and slow demand has pushed the price of domestic thermal coal to low prices as well. Coal is not quite back to the lows of 2002 but it is not far from those levels either. Digging a little deeper I see the uranium Oxide is selling neat five year lows as well.  These are the three major fuel sources for electricity generation in the United States and the prices have been falling for some time. One would think that this would be a boon for electric utility companies.

When I look at the profits for the regulated utility companies in the United Sates I see this is far from the case. Most are struggling to get back to the profit levels of several years ago and the return on equity and capital for much of the industry is still well below pre-recession levels.

When I look at electric utility stocks none of them are cheap in spite of the obstacles and weak profit environment. Yield chasing has pushed them well above tangible book value.  I have never lost money buying a regulated utility below tangible book value and I have never seen much money made purchasing these stocks above that level either. If the costs of fuels such as natural gas, coal and uranium begin to rebound over the next year or so profits for these companies could plunge even further. Reviewing commodity charts makes at least one thing very clear to me. Electric utility stocks as a group are a sell and avoid.

I am not a macro, chart or commodity guy as you well know by now. However spending a little time with charts of various assets and markets around the globe can provide valuable information even for a value guy like me.

As the final step in my annual to semiannual macro review I like to look at sectors and industries in the stock market to see what is way up and what has lagged the market by a large amount. Often I find that some sectors that do not show up in my traditional stock screening methods have performed in a manner that gives valuable economic information and may also provide investable opportunities. When you tend to have your head down in individual company reports you can miss some trends and data that can improve your understanding of the big picture as well as factors that may affect stocks I already own.

Searching don the list of top performing sectors I see some predictable groups like Luxury Goods. Those that have money can spend money. During the early days of the recession this sector dropped off a little as the wealthy curtailed spending for the sake of appearances but they are back with a vengeance. Companies like Coach (COA) and Tiffanys’s (TIF) are doing very well as those who have it, spend it. Barring a deep double dip recession that is not going to change. The stocks are too rich for me to buy but I do not suggest shorting them either and momentum types might want to have these stocks on their radar screen.

One group that is initially a huge surprise is Recreational vehicles. The group has performed extremely well and with high gas prices and a cautious consumer that does not appear to make much sense. When I dig a little deeper I see that it is companies like Artic Cat (ACAT), Polaris (SNO) and Harley Davidson that have done well. Traditional RV companies like Winnebago (WGO) are still struggling and their stock price is languishing. Motorcycles, snow mobiles and Jet Skis all fall under my addictive lifestyle banner and are seeing some pent-up demand emerge as the economy becomes less horrible. These companies may face tough comparisons next year as demand flattens and gas prices remain high.

One group on the non-performers list that is interesting is long term care facilities and providers.  Intellectually this would seem to be a group that would be booming. Demographics are strongly in their favor as the population ages and long term heath care becomes more of a concern. However rate reductions from Medicare and aggressive claim processing to avoid what Medicare officials deem over treatment are hurting most of these firms. Should the Supreme Court throw out Healthcare reform most analysts feel that this would be another negative for the industry. Many of the companies in this industry use a lot of leverage and that’s where my interest lies. I am far more interested in the debt and potential recovery rates of long term care companies than I am in the equity. It is worth investigating potential high yield and distressed opportunities in this group.

Looking at the rest of the nonperforming groups there are not any real surprises. Coal and natural gas related companies are on the list as those two commodities prices have declined. These are two sectors I am watching closely. Most of the stocks are not cheap enough on a price to book value basis yet but I am confident they will get there. So far my two major longs in natural gas are Penn Virginia (PVA) and EXCO (XCO) but I expect to add to that list over the rest of the year. So far I have not bought any coal stocks but I expect that to change by the end of the year as well.

I also note that in spite of the news and trading action in larger regional and money center banks that community bank stocks have not rallied much yet. The Aba Community Bank Index is still down almost 7% on the year and over the past five years has fallen by almost 50%. The Trade of the Decade is still very much viable and I am still selectively buying stocks across the group.

As I conclude my peek at the macro picture I find that it is very much in line with the micro view uncovered by single stock screening and investigation.  When I stick my head up each year and take a macro look I scribble down and my findings and create a mythical macro fund and track it over time. Last year my imaginary macro fund was long the dollar and Japanese banks and that worked out pretty well.. This year it would be long Japanese and British banks, long coal, uranium and natural gas, short electric utilities and recreational vehicles and long high yield debt in long term care facilities. I would also be long community banks and cotton. It will be fun to track how these work out over the  next year but more importantly I have gained some insights and information that will help me select potential safe and cheap stocks that can return in multiples not percentages.

Originally published as a series on Real Money

Options for Value Investors

 In the past I have often mentioned Ben Grahams  maxim that investing works best when it is most businesslike. I view my investing activities as a collection of businesses. My purposes with my portfolio is to attempt to identify a collection of businesses  whose assets sell for less than they are worth and are capable of remaining a going concern. To institute a margin of safety I prefer those companies where the liquidation value under reasonable circumstances will yield as much or more than I paid for the securities. I also want this portfolio to generate cash flows wherever possible in the form of dividends or other cash payments. I want time and price to be on my side to the greatest extent possible at all times.

I use every tool available to me to accomplish my goals. I have no restrictions on the capital structure of the business and will buy common stock, preferred equity and even bonds of a company if the margin of safety exists and they trade for substantially less than my calculation of value. In the last decade I have learned to add options to my tool box to improve my chances of long term investment success. I think that a solid grounding of option knowledge helps me as a value investor and gives me an advantage when dealing in securities with a long term perspective.

In recent weeks I have seen several articles dealing with options trades on undervalued securities. These authors suggesting buying out of the money call options hoping the stock would appreciate and lead to large gains. The theory is that of you buy these options and the company has a strong earnings release or catches a takeover bid you could gain profits of 100% or more. While that’s true it is also true that if the roulette wheel comes up red and you have bet appropriately you can double your money. If you did not you lose your entire bet. That is not how I want to run my business.

None of the articles I ran across in my reading addressed the issues of time or option pricing. They gave no consideration to options prices or the probability of a 20% or more price move in the underlying stock in such a short time frame. The suggested options suggested for purchase all had well less than a year to expiration and in my mind that is not an investment it is just a speculation and a poor one to boot. I love to gamble but prefer race tracks where at least I can have a cocktail or two with friends while I make mathematically unsound wagers. When it comes to the markets I want to stay as business like as possible and run my portfolio like a company.

As a value investor there will be times when buying options makes a measure of sense. The vast majority of the time however it makes far more sense to be a seller of options. Many others have embraced the concept of selling options by implementing a covered call strategy. I confess that I use this approach once in a great while as a hedge but in general I am not a fan. It is not a truly efficient hedge and can lead to premature selling of issues I prefer to hold. If an issue is overvalued I prefer to just sell it rather than sell a call and hope it rises enough to be called.

The real value of options to me as a long term oriented value investor is as a seller of out of the money put options. Selling puts obligates me to buy the underlying shares at a specific price at expiration. If the stock does not fall to my stroke price or below before expiration I get to keep the premiums I collected for the sale. If the stock does fall I have to buy the stock at the strike price but I still get to keep the premium collected. Obviously the way to make this work in an optimum fashion is to make sure I want to own the underlying stock at the current price and even more willing to buy shares lower. I have to have done the research and work on the particular company and feel the stock offers a margin of safety and is sufficiently undervalued to offer a profit opportunity. Many value stocks take a long time to turn around and selling options in this manner can give me a stream of cash flow on an otherwise dormant stock. If I get put the shares I own a stock I like at a lower price than I would have obtained with an outright stock purchase.

Where a lot of people make a mistake with selling options is not going further than the stock analysis. I also want to evaluate the options and sell them for a fair price. Before selling an option take the time to run the trade through an option calculator like the free one at CBOE.Com. You are trading against an army of PHD’s with supercomputers. Don’t be today’s lunch money by selling your options at less than their fair value.

I also want market conditions to be favorable for my trades. I like to sell options when volatility is rising and options premiums are swelling. When I look at the underlying security I want the Implied and Historical Volatility to be well above the average levels of the past few months.  I do not have to trade so I do not until the conditions are favorable.

If you start with underlying stocks that are safe and cheap and use common sense about options pricing they can be a successful part of your endeavors in the markets. 

I have talked extensively with some of my more options oriented friends last night on the subject of using options as part of the value investor’s toolbox and the Orioles recent mastery of their hometown White Sox. My friends made some key points that are worth reviewing before anyone runs out to start selling puts on stocks in which they may have an interest. I think that using options can give me a huge advantage over investors who do not provided I stay true to the principles of deep value and time. The vast majority of the time I use options to create a long position in an undervalued stock at more favorable prices. Should the stock not fall to the price where I am forced to buy shares I keep premiums and add to my cash hoard.  First and foremost you need to keep in mind that options are complex instruments with complex pricing elements and trade much differently than shares of stock. You need to do some basic research and understand the options markets before you start trading. You need to understand that using an options calculator to price options does not give us an edge in the marketplace. There are far more accurate models for option valuations built by folks who design working rocket ships as a hobby. Using the basic pricing theory keeps us form giving away too much of an edge to those rocket scientists and supercomputer we are trading against. Out edge comes from stock selection and valuation.

Never make the mistake of just reaching for fat premiums. Selling puts is very seductive. When prices are rising it seem like easy money. I did a study once that showed that selling options on the market indexes at prices 5% below last months close on a month to month basis was profitable about 85% of all months. That sounds like the closest thing to a free lunch. It would be except the losses in the few losing months exceeded the gains of the profitable ones by a substantial margin. The trap for options sellers is collecting a few premiums on the right stocks and getting enticed by the fat premiums on high flyers like Apple (AAPL) or Chipotle (CMG). You may collect some fat cash for a few months but if there is bad news out of the company or the market corrects you can lose an extraordinary amount of money very fast and end up owning a stock you have no interest in holding long term. The trick to using options to enhance profits as a value investor is to start with stock valuation not options value.

My next point is that you should never post exchange or brokerage minimum margins. Post the entire potential cost of the trade in cash when you are selling outs. If you are selling $6 puts on Radio Shack your brokerage firm will probably let you get away with putting up just a couple of grand for ten contracts. Don’t do that. Post the full $6000 needed to pay for the shares.  There is a tendency to think that I have 20 grand in my account to buy Radios Shack so if I just use the exchange margin I can sell  100 contracts and not just 30. I know that sounds silly by I was a broker for 25 years and have seen the seductive allure of what looks like free cash lead some very smart individuals down the primrose path of minimum margins. If the options sell for $.50 you can take in $5000 instead of just $1500. However if the stock goes down you are going to find yourself owing more than three times the amount of stock you wanted. When I sell a put option I want the price to fall and be sold to me at the strike price. The premium is a bonus not the ultimate payoff. Post the full price in cash for every contract you sell.

There are some key difference with options trading you will need to be aware of as well. Often when I see a stock trading right around my calculation of asset or intrinsic value and I want to buy the shares at a discount to the number I will go ahead and enter a good until cancelled order 20% below the market. As long as the fundamentals do not change I can just let the order sit there until it gets filled if I choose. That’s not the case with options.  The measurements used to calculate the value of the option will change daily with movements in the price and overall market direction and volatility. You need to recalculate the value every day and renter the order until you get filled. If you leave a GTC order out there odds are you will once again have the pleasure of paying for market makers lunch that day.

Options are a very powerful tool for value investors in my opinion and experience. However you need to do the homework and learn how options are valued and traded before adding these to your regular investing approach. You will find that it is time well spent and should help add to our fiscal well-being many times over the effort and cost expended.

 The vast majority of the time selling puts is the best options related tool for value types to use. It just makes sense to get paid to buy a stock at an attractive price and can add several percentage points over the year. Most of the time I want to be a seller of options not a buyer. Of course there are always some exceptions to every rule and today I want to talk about those. There are two occasions where I favor buying, rather than selling options.

The first is when I want to short a stock. I have often said I am the world’s biggest chicken short. Outright shorting a stock can tie up a lot of capital and you are subject to margin calls if the position moves against you, as it usually does in my case. Some of my option savvy friends sell calls when they want to bet a stock will go down. Although that is a valid strategy a good percentage of the time I need more than one hand to count my associates who have been blown up by being short calls before a takeover or other significant event. That is just too much risk for me to take with my hard earned money and over the years I have developed my own chicken short style.

When I short a stock I look for egregious over valuation. I want to find those stocks with nosebleed price to earnings and price to sales ratios that are much beloved by Wall Street. I am of the steadfast opinion that in the long run no stock is worth 70 times earning s or 10 times sales not matter how promising the potential. The stock may hold the valuation level for far longer than one would expect, eventually gravity does reassert itself. I try to gain an additional edge by looking for things like slowing earnings momentum or decreasing earnings surprise to attempt to find a high flyer that is preparing to do an Icarus imitation.

When I locate such a stock I will either buy a put, or more likely buy a put spread. I will buy an out of the money put and then sell a lower strike price. I look for at least a 3 to 1 risk reward ratio with these trades. If I am buying a 70-50 put spread on a $75 stock like Lululemon (LULU) I do want to pay more than 6.50 net for the trade. I also want to go out as far as possible to give bad things time to happen. Six months is the absolute minimum. I use no stop loss and hold until it either trades below the lower strike and I can close at the maximum gain or it expires.

This is a tiny part of my investing approach.  The total cost of put spreads is never more than 2% of my total portfolio. Frankly speaking they are bets that I hope have some decent analysis and expectation behind them. If I am really honest about it is akin to going to the racetrack without leaving the office. I win these bets on average about half the time historically so it has added a little to my pile over the years but the rewards have been more intellectual than anything else.

The only other time I am likely to buy options is when a particular stock has been hit hard during a steep market decline. On some few rare occasions I can find long term options that are very cheap. I like to buy in the money leaps that have little or no time premium and allow me to gain cheap low cost leverage on a particular stock that I think will recover over the next year or two. As an example only as the market is hardly suffering steep decline right now the Arch Coal (ACI) January 2014  $5 calls have a last price of $5. With the stock at $9.83 there is very little time premium in the options and I am not paying much for 20 months of leverage in the stock. If the market was down sharply and I could execute the trade at those prices I would be interested. The key is to pay a lot of time and pay very little time premium. It is a rare trade but can be spectacularly profitable when you find an appropriate situation.

I have spent most of this week talking about options during the day and watching the Orioles actually win baseball games most evenings. The more in depth discussion of trading options is a departure from my usual subject matter but I think it is an important one. The combination of options and value stocks is one that has a lot of potential for profits if used correctly. I have long theorized that if a pure value investor and an options expert teamed up they would create an approach that was almost an anomaly.  Most option traders do not even consider the valuation of the underlying. Most value investors do not consider options a serious part of their investment toolbox. Such a combination would, in my opinion, be wildly profitable.

I have given thought at various times to finding a partner and raising money for such an approach. If I ever did then the combination trade would be a large part of my trading activities for such a fund. The combination is one of my favorite trades and I have used it at times in the past with strong results.  I usually use this approach when a stock is bomber out and has fallen sharply. My most successful combinations have been one time blue chips or midcaps that have fallen into single digit midget status.  When I find one I like I buy 1000 shares of stock and simultaneously sell 10 calls well above market and 10 puts below the current price.

As always valuation of the underlying stock is the most important factor in this trade. The stock has to be cheap enough to justify purchase on its own merits before I do the option trades. I also want to go as far out as the option chain will allow me. Right now most of the trades I would consider use January 2014 options to execute the combination. In no case would I go any shorter than January of 2013. The money in this trade is made over time as prices change to reflect fundamentals and premiums decay not in short term fluctuations.

 This trade is as close to a win-win situation as you can find in the markets if you have the valuation correct. If the stock goes above the higher strike price the stock is called away at a profit and you keep the premiums. If the stock falls below the bottom strike you have to double your stock position by buying more shares at the lower strike offset by the premiums received. If the stock flat lines and stays between the strikes you keep the premiums and still own the stock.

To best illustrate how this trade works I will use an example. A stock many of us here on real Money have discussed in the past is SuperValu (SVU), the supermarket chain. The incredibly competitive grocery market and high debt levels have caused the stock to struggle somewhat painfully as it has fallen form near $50 in 2008 to just around $6 today. Many believe that the company will finally fight its way back to profit this year and the company will begin to see a solid turnaround. If that happens the stock price could finally stage a rally. Management gave optimistic profit assumptions and the company has attracted some attention. It is worth mentioning that in the risk section of the latest federal filing that a dividend cut was unlikely but possible. It is the first time that language has been used by Supervalu.

Top create this trade I want to use January 2014 options. I will buy the stock right here at $6.20. I am then going to sell the $10 call for $.70 or better and the $5 put for $1.3 or better. If the stock goes up over $10 in the next 20 months I will sell my shares for $10 and I keep the $2 premium for a total profit of $5.80. That work out to roughly a 55% annualized profit. If the stock says the between $5 and $10 I keep the $2 and still own the stock which is almost 20% on annual basis. If the shares fall I have to buy another $1000 shares and now own 2000 shares of Supervalu at $5.60 but I also kept the $2000 in premiums so my adjusted cost is now $4.60. Should the company continue to pay the divided I add 5.6% to my annualized returns.

The worst case scenario is that I buy a decent company at less than the all-time low price. The best case is almost doubling my money in less than two years.  In my mind that is pretty close to a win-win trade.

Options and value stocks do not appear to go together at first glance. A deeper look however shows that they can combine for powerful profit opportunities.

Originally published as a series of real Money articles