Hi everyone, as I mentioned in an earlier post, I’m currently on vacation and will resume writing in the middle of September. While I’m away, I leave you with an excerpt of a note I wrote to my partners in Smart Income Partners in September of 2012. Here it is:
As I was flipping thru channels a couple of weeks ago, I saw an interesting segment that Jim Cramer had on his Mad Money Show CNBC. Cramer was building a diversified portfolio using the analogy of a fantasy football league. Fantasy football, for those who don’t know, is a popular game people play in which you build a football team on paper using different players around the NFL. Then, every week you score your fantasy team paper based on the statistics each of your players actually made in real life. You may google the term “fantasy football” for more information. If you are a football fan, fantasy football is highly addictive. In the past, I’ve spent many falls playing fantasy football which was a very good training for portfolio building.
Getting back to our point, we will use the fantasy football analogy to explain our portfolio. Here at SIP we build our portfolio the way a football team owner would build his team. Our portfolio usually has positions in around 30 to 50 markets at any one time. This is like a football team that has 52 players. SIP strives to have balanced exposure to different markets (i.e. underlying vehicles to write options against) and strategies. Like a football team that has offensive and defensive teams, SIP also has two sides: long positions and short positions. We take exposure to both long and short side. This means that long positions that make money if the stocks go up balance out short positions that make money when the stock goes down. Having both long and short positions helps lower the volatility of the fund. Remember that while this is happening the fund is making money from the time decay of the options we sold. I’ll cover more on this in a future commentary. We’ll focus just on the underlying markets in this article and not on the option strategies.
If you look at a fantasy football team there are several positions to fill:
1) Running back – These are the workhorses of a fantasy football team. They provide consistent points all season long. The run with the ball to score.
2) Quarterback – This is the team leader, with a consistent and steady hand. He throws the ball to the wide receivers, tight ends or running backs.
3) Wide Receiver – These guys run quickly up the field to catch touch downs.
4) Tight End – These guys help move the ball downfield by catching short yardage throws. They also protect the quarterback by blocking when needed.
5) Kicker – This is the guy you count on to put points on the board.
6) Defense – These guys don’t allow the other teams to score points against you.
7) Special Teams – These guys return the kicks and block kicks. They provide the team with extra points once in a while.
At SIP you could map the positions to different types of underlying
1) Running backs – are our large cap lower volatility growth stocks
2) Quarter backs – are our large cap lower volatility value stocks
3) Wide receivers – are our higher volatility growth stocks
4) Tight ends – are our medium volatility growth and income stocks
5) Kicker – : are our low volatility income stocks
6) Defense – are indexes we use to hedge and overvalued stocks we short
7) Special Teams – these are special situations we identify, sometimes speculative.
If we select a subset of our current portfolio here’s what a snapshot of the different positions would look like:
1) Running backs: MCD, IBM
2) Quarterback: BRK/B
3) Wide Receivers: APPL, ISRG
4) Tight End: T, TEVA
5) Kicker: KMB
6) Defense: SPX, RUT
7) Special Teams: FB
Our running backs, the consistent performers, are McDonald’s and IBM. We make money consistently selling option spreads against them. They are workhorses of the SIP portfolio. Our quarterback, Berkshire Hathaway, has never lost us money. We’ve been consistently making money every single month from selling premium on Berkshire. Our wide receivers, Apple and Intuitive Surgical, are our growth engines. They are stars in the portfolio, their higher volatility gives us nice payouts on the premium we sell. The tight ends, AT&T and Teva Pharmaceutical, are consistent, stable, low volatility companies. They provide dividends which we always like to get while we also collect premiums when we sell against them. Our kicker, Kimberly-Clark, a low volatile stock with handsome dividend payments, provides us with consistent cash flow. On the defensive side, we use strategies on indexes S&P 500 and Russell 2000 (small cap index) to hedge the entire portfolio. They provide protection against a big drop in the market. And at special teams, we are playing short strategies on Facebook. As Facebook fall we make money.
Our SIP portfolio is balanced. We have the consistency of the running backs and quarterback. We have the speedy receivers and tight ends to give us growth. We have the kicker to provide income day in and day out. We have the defense to protect the portfolio. And, we have the Special Teams to provide that small percentage of speculation and special situations that can turn into a big play. This is our SIP portfolio. It is built to give us a very good chance of making money consistently while having a healthy mix of defensive trades to protect against a large sudden drop in the markets.
Please keep in mind that the stocks mentioned in the article may or may not be in the fund anymore. The article is old and I am not recommending or endorsing any of the stocks mentioned in it. The article was posted for you so you can get an idea on how to think about portfolio diversification.
Please post any questions or comments in the comment section below.
Have an eclectic investing day!
Disclosure: Long MCD, IBM, BRK/B, T, AAPL, FB. Short: SPX, RUT