Second Quarter 2017 Letter to Investors

Dear Investors,

Burr Capital LLC has released its Second Quarter 2017 letter to investors. In addition to the usual review, the letter explores a role for machine learning in Charlie Munger's latticework of mental models for business and investments.

Please do not hesitate to reach out if you have any questions.

Sincerely,

Rahul Ray
Principal

 

Covered calls in a low-volatility, low-yield, arguably over-valued equity market

Please refer to Important Disclosure Information at the end of this research note.

Covered call writing is a low risk strategy to enhance yield and lower cost basis. The latter benefit may be appealing in today’s arguably overvalued equity market.

It’s perhaps easiest to understand the mechanics using a real example. Say you own shares of Discover Financial (DFS), a company with a relatively deep and liquid options market.  The shares are trading at around $58 with a 2.1% dividend yield.  You can sell one covered call for every 100 shares you own.  If you sell the $65 strike price, 10/21/2016 expiration, you can collect around $5 for a 0.1% yield. You can repeat the process 6 times in a year for a 0.5% annualized yield.  

If your options expired out of the money, you would’ve realized an overall yield on DFS of 2.6% versus a straight 2.1% dividend yield. To increase the yield further, you could pick a lower strike price or a longer expiration.

If DFS shares rise above $65, to say $100, by 10/21 then the options will be exercised against you and you will have to sell your shares at $65, capping your gains. So by selling a covered call you’re trading off capital appreciation potential for a modest current yield.

Here's a list of pros and cons.

Pros

  • Covered calls are an easy to implement, low risk way to enhance current income. 
  • They can be implemented in most retirement accounts and many brokerage firms even provide easy drop down menu options so that one could sell covered calls without a deep knowledge of option Greeks (Delta, Gamma, Theta, etc.) and chains.
  • When volatility is elevated and the markets are heading lower, the strategy can act as a speed breaker. 
  • If you believe the underlying shares are fairly valued but you’re not quite ready to sell the position then selling covered calls can be a better alternative to holding cash.

Cons

  • It’s worth noting that the call option market is very efficient and there’s rarely, if ever, a free lunch.  So while in theory covered calls are more appealing in today’s low yield market, in practice, the low volatility and rising market make covered calls less attractive. This can be easily seen from the above example where we created a low 0.5% yield on DFS using covered calls. In contrast, we could’ve created a 3.5% annualized yield earlier in the year when volatility was much higher.
  • Covered call writing can tie up more capital for longer than one would like.  If the underlying shares rise then the mark-to-market losses on the call option will offset the gains on the shares so if you close the position before the expiration date, when the call option is underwater, you may risk losing the premium you collected when you initially sold the covered call.

 

Important Disclosure Information

At the time this report was submitted for publication, the principals and clients of Burr Capital LLC owned securities issued by Discover Financial (Ticker: DFS). 

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Burr Capital LLC), or any non-investment related content, made reference to directly or indirectly in this research will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this research serves as the receipt of, or as a substitute for, personalized investment advice from Burr Capital LLC.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Burr Capital LLC is neither a law firm nor a certified public accounting firm and no portion of the research content should be construed as legal or accounting advice.  A copy of Burr Capital LLC’s current written disclosure statement discussing our advisory services and fees is available for review upon request.

 

Our Stock Idea at VALUEx Vail 2016 Investor Conference

Please refer to Important Disclosure Information at the end of this research note.

Britain’s vote to leave the EU triggered a 3.6% drop in the S&P 500 and an almost 50% spike in volatility.  Perhaps more surprising than the result was how little risk of Brexit seemed priced into stocks, heading into the vote.  Which reminded me of Thaler’s work on Homo Economicus vs. Homo Sapiens, that people don't always make rational choices based on rational expectations.

While the financial world was glued to the situation in Britain, I spent the week in beautiful Vail with some wickedly smart investors at the VALUEx 2016 Investor Conference hosted by Vitaliy Katsenelson.  Past presentations at this amazing conference can be found here.

I had the privilege of presenting a stock we like and own - CABO.  Here is the presentation. 

 

Important Disclosure Information

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Burr Capital LLC), or any non-investment related content, made reference to directly or indirectly in this research will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this research serves as the receipt of, or as a substitute for, personalized investment advice from Burr Capital LLC.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Burr Capital LLC is neither a law firm nor a certified public accounting firm and no portion of the research content should be construed as legal or accounting advice.  A copy of Burr Capital LLC’s current written disclosure statement discussing our advisory services and fees is available for review upon request.