Whether you are a day trader, steelworker, rock star, or sales manager there has and always will be the need to construct a portfolio of longer-term holdings. This portfolio can be made up of mutual funds, ETFs, bonds, individual stocks, or any number of assets really. The fact of the matter is that each holding needs to be purchased smartly, timely, and managed effectively.
This seems like a tall order in today's market. Though volatility has subsided greatly between the crash of 2008 and now, the economy, equity markets, bond prices, and any number of assets will remain in vast fluctuation for quite sometime. In fact, a very famous technical analyst friend of mine just showed me a long-term chart on the Dow Jones Industrial Average, which illustrates how the markets move in 12-year bull cycles followed by 12-year highly volatile periods. We just so happen to be smack-dab in the middle of a 12-year volatile consolidation period, with, at minimum, 5-years before the next secular bull run.
So how are investors to manage their portfolios in this environment, namely how can they take advantage of current volatility to add equity positions to their long-term holdings?
There is a method to the madness and here is how I do it:
1. ‘Old School' Stock-Picking
2. Small Initial Entry Positions
3. Options and Volatility Selling To Enhance Returns
4. Think Long-Term
5. Reinvest Dividends/Premium
‘Old School' Stock Picking: what do I mean by this exactly? This means searching for companies that have high and increasing free cash flow, consistent and growing dividends, proven brand names that warrant premiums compared to competitors, and company's with pricing power. Note that unless you are willing to monitor your positions very closely, you should avoid highly cyclical names.
What companies would qualify as ‘Old School' positions? Well, frankly, just about anything Warren Buffet holds is game, though I cannot recommend Berkshire Hathaway BRK itself for this strategy as it does not pay a dividend. Other names include MetLife Inc. MET, Prudential Financial Inc. PRU, Hershey Co. HSY, Microsoft Corp. MSFT, and General Electric GE to name just a few.
While most of these names are not “sexy” by any stretch of the imagination, remember that we are searching for stable, cash rich companies, who have proven to stand the test of time and proven their ability to deliver cash back to shareholders. This is key, so that cash can be periodically reinvested to amplify compounded interest. I would rather pass along a boring, though large equity portfolio to my kids than stories about how I thought I had the next Google GOOG, when in fact I had the next Washington Mutual.
Small Initial Entry Positions: this is key and, frankly, self-explanatory. While you may believe that a stock is at a bottom, even a generational bottom, this does not mean that that is the case. Unless your name is Ken Heebner, you will probably be wrong, so don't put yourself through the stress of trying to pick ultimate bottoms. This 5-step process will allow your entry position to be smoothed over time anyway, thus negating the necessity to pick a bottom.
First, investors should decide how large a position will ultimately be in the portfolio; I typically do not want a position to be more than 7.5%-10% of my total holdings. Often I keep positions even smaller. The long and short of it is that if you are hit with the next Enron, you will not be materially cratered. Second, your starter position should be 20% of that, will subsequent purchases of 20% every 6-10 months until a full position is reached. Lastly, do not be afraid of holding onto cash, thinking that all of it should be invested is a common mistake by retail investors; while it's a shade hard to watch in a bull market, I am never sad when I am making money—even on 20% of a position. Also, remember that cash outperforms a falling market.
Options and Volatility Selling To Enhance Returns: While you will be collecting a dividend from your holdings, this step is key to magnify the cash coming into your portfolio. You should look to sell a strangle (one upside call and one downside out) at least 6-12 months out, and at least 15% out of the money, as a way to capture time premium and as a way to enter into the next 20% of your position, while connecting a lot of cash to do it.
If the stock moves higher, much higher you still make at least 15% on your holdings, collect a dividend, and collect premium from the options sales. You are always allowed to buy back into the name as well. If the stock moves lower, you buy your next block of stock at, at least, a 15% discount plus the premium taken in.
You will see what to do with the cash generated in two more steps.
Think Long-Term: do not fret the small market movements; these positions are for the long-haul. If you are holding companies with plentiful free cash flow and generous dividend payout rates, you will not have to fret about holding a potential lemon.
Most importantly do not jump ship—follow the plan. Jumping ship just because of near-term market volatility is a sure fire way to sell at the bottom.
Reinvest Dividends/Premium: Premiums generated from selling options against your positions, coupled with the dividend payments you will be receiving from the companies themselves, should be piled together in one lump sum. That sum will then be divided by twelve. Each month at roughly the middle of the month, you will divide the monthly cash among you holdings and purchases as many shares as you can. You are essentially creating your own DRIP, dividend reinvestment program.
Doing this will take advantage of near-term market fluctuations and also keep you from talking yourself into thinking that you are “missing” the action.
Easy as pie—follow the five-steps, beat the S&P 500, and grow your wealth into something sizable that can be passed along to your children.
Trade Well,
Michael J. Zerinskas
Chief Options Strategist
Benzinga.com
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