Performance review for FY2010 Part 2 – Stocks and equity ETFs

bigstock_Hand_Measures_Plant_Growth_smallAustralian Stocks

We started the year with no stock positions in the Australian market. We decided to do off market transfers of some stocks that were held in Kingsley’s personal name to the SMSF so he could use the capital losses from these stocks to offset other capital gains. This turned out to be a very good decision as the price of one of the stocks doubled in 2009 and capital gains are taxed at a much lower rate in the super fund compared with Kingsley’s marginal tax rate.

We continued our strategy of selling puts to get into stock positions at a discount and selling covered calls to generate additional income on top of dividends. We started using this strategy in FY2009 and we were happy with the results and it continues to meet our expectation last year as well. We set aside about AUD100K in our CommSec high interest account to buy stocks that we would be happy to own long term. As we did not have very bullish expectations of the stock market, we decided to stick with fundamentally sound stocks in defensive sectors like consumer staples and healthcare, that held up well in the last stock market downturn. As we planned to sell options over these stocks, another of our requirements was that the stocks have to be optionable, and there has to be sufficient liquidity in the options for those stocks. As the options market on the ASX is pretty small, we were limited to ASX 20 stocks like Telstra, CSL and Woolworth which have reasonably liquid options.

We used some of the money to buy Telstra shares which we used as collateral for selling put options. It was a lot less troublesome than using cash as CommSec calculates margin required on a daily basis and this generates a lot of meaningless transactions in our bank account which confused our accountants in the previous year. We generated an additional income of $10,060 from selling options on top of the $2,106 of dividend income from these shares, giving us a total income of $12,166. The cost of our shares was AUD90K and even after we deduct the unrealised capital loss of $3669 on our stocks, we still get an annual return of 9.4 percent from this strategy. While waiting to buy stocks at the price that we wanted, we also received interest income from the cash which was reserved for paying for the stocks should any of our put options get assigned. If we include this interest income and franking credits from dividend income, we would have an even higher rate of return from this strategy.

We also bought an XJO put in as a partial hedge for our Australian portfolio but did not find it to be a very effective hedge for our portfolio as our stocks did not have a high correlation to the ASX 200 which comprise of mainly mining and finance stocks. Because we hold defensive stocks, they held up well when the market corrected 15 percent in April 2010, so we do not see any need to buy protective puts in future.

US Stocks / Exchange Traded Funds

We started the year with only one long positions in XLF, a financial ETF. This position was showing an unrealised loss as it was purchased in 2008 when I thought banks were oversold after the Lehman Brothers collapse. XLF recovered most of the losses during the 2009 stock market rally. Because we believed the rally was only a bear market rally which would end sooner or later, I decided to sell our positions at the end of July 2009 after a big rally in financial stocks that month. In hindsight I probably sold too early as the rally continued until April 2010 and I could have recovered all our losses and even make a small profit if I waited to sell. The lesson learned here is that it normally takes time for market tops to form after a strong rally so there is no need to rush into selling at the first sign of market weakness. As I still saw lots of uncertainties ahead in the banking sector, XLF was not an investment I wanted to keep for the long term so I was happy to sell it even at a loss.

As our outlook for the US economy is deflationary, we expect prices of assets including stocks not to do well in the next few years so I avoided buying any more stocks. Many years ago I read an amusing book about dealing with change called “Who moved my cheese?”. In the book there were two mice (Sniff and Scurry) and two Littlepeople (Hem and Haw) who used to get their cheese from a place called Cheese Station C. For a long time there was plenty of cheese to meet their daily needs but one day they found that there was no longer any cheese at Cheese Station C. The mice quickly moved on to find new cheese but the Littlepeople kept going back to the Cheese Station C to look for their old cheese and complained when they could not find any. Like many thought leaders, we believe that we are living in a period of significant change where old beliefs like “the stock market will outperform in the long term” may no longer hold true in the future. The Japanese stock market has been declining in the past 20 years and the US stock market seems to be headed the same way as well. Good stock pickers and market timers can probably still make money in the stock market, but it will be increasingly harder to get a good return on stock investments.

As we recognise that we are not particularly good at picking stocks, we decided to be like Sniff and Scurry and go out to look for new cheese. We decided to put some of our capital into new investments like treasury bonds which we believe would do better in a deflationary environment. We also used some of our capital to try some new bear market strategies using products that were only available in the US market such as inverse ETFs and complex option strategies. I will discuss the performance of theses new investments / strategies in other posts in the coming weeks so stay tuned…

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Posted by on Aug 4th, 2010 and filed under Performance. You can follow any responses to this entry through the RSS 2.0. Both comments and pings are currently closed.
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