Why not bet on a market decline?

A friend asked about my last post commenting that 80% long equity still seems high relative to my bearish views, why not sell everything and buy Puts? This seems like a good topic for today's post.

1. Alpha based investment strategy: my relative strength is finding undervalued investments and I like my portfolio today e.g. E&P companies trading well below replacement value, tobacco stocks yielding double digit free cashflows, companies on low multiples and/or with yet to recover earnings, etc. Most of these positions have significant margins of safety built into their price which makes me confident: a) there is low risk of long term absolute loss, and b) they will likely outperform a market crash. This makes me comfortable with the size of the positions.

Secondly I'm not a macro investor and I don't believe I can time markets. I let the risk/reward profile of individual ideas determine my invested position. This is why my net long exposure had been rising since early March and peaked in November (despite concerns as far back as June). Today I'm finding no obvious buy candidates and plenty of stocks I should trim or sell out completely which naturally reduces my invested position.

Bottom line: I won't trade in my Alpha convictions to make Beta plays.

2. Hedging overlay: I aim to have my 50% of my equity position hedged using Long/Short Puts on the Nasdaq and S&P before mid January 2021 which reduces my effective net long exposure to 40%. This is the most comfortable way for me to express my market reservations as this fat tail hedging strategy costs nothing in an upwards trending market and a maximum of a % points in an oscillating market. In a market crash, the hedge protection may return more than 50% of my equity losses given my portfolio characteristics.

3. Market crash preparations: some of these details were shared in the last post and these preparations means my actual risk exposure is lower than a 40% net long equity position.

• Stop/Limit orders: I've now started putting on layered Stop/Limit orders which will automatically sell out of certain investment positions

• Short list: the preliminary list includes names which have risen 3-6x over the past year. I've put on some tiny individual 'scouting' positions but I expect most of these basket shorts will be put on in lots according to fixed declines in the market

As I said in my last post, my plan isn't to profit from a potential crash but rather to limit the risk and damage. My profits will come from picking up alpha during the event and potential aggressive beta buying in the early recovery.

4. Capital considerations:

• I have no liquidity demands so these portfolio funds are secure

• I can and will gear into attractive market conditions. I'm comfortable with ~1.5x portfolio gearing so a 40% net long equity represents ~26% of a fully geared portfolio

• There is further capital on the sidelines which I can take in if profit conditions are ripe

Final words

Betting on a market decline is expensive and requires you to be right on timing. Although today many valuations and market actions seems crazy and disconnected from reality, I'll be the first to admit I have no idea when things will turn. Smarter, more experienced and resourceful investors than myself have destroyed themselves throughout history trying to bet against market irrationality.

I intend to play to my strengths and: a) stay away from exuberance, b) focus on individual investments, c) being combat ready to execute a set strategy in a market panic.

Additional words of advice to my friend and other investors is:

• Think defense, not offense

• Don't try to optimize/time your exits

• Match investments with your funding sources e.g. long duration cash yielding investments to retirement funds, limit speculative investments to a fixed portion of your excess savings

• Keep some dry powder intact

Today is abnormal, not the new normal.