Many investors (AKA value investors) like to buy great companies at a bargain. Investors such as Warren Buffett are famous for sitting on a pile of cash and waiting for a great company’s stock price to drop. When the mentioned event happens, value investors tend to jump into thinking they are buying a great company at a discount. This strategy is fine. It works. Heck, we all know Buffett has gotten stupidly rich with this plan of attack. However, this strategy is not for me.
I think there is one thing all good investors agree on -- none of us has a clue what the market is going to be like over the next 12 months. If you asked me 18 months ago, I would have guessed the market would have been flat or down and the last 18 months have shown some of the biggest gains ever seen. If I had stayed on the sidelines waiting for a pullback so I could pick up some companies at good prices, I would have missed out on a big gain. That is not to mention all the dividend payments I would have missed as well.
Considering the market over the last 18 months is up over 15%, it is very unlikely that our next pullback will be over 15% (granted it has happened in the past). There is a pretty good chance if I waited on the sidelines for a deal, I missed price levels we will never see again.
To combat this problem, many investors turn to dollar cost averaging -- investing a little bit every month and hoping you average out on a good basis. While this is a good idea, and I do this at times, it is not my favorite approach. At least, I like to dollar cost average with a twist.
Using Options To Lower Your Basis
If you are like me and unwilling to sit around waiting for a discount on your favorite great company you seek out ways to lower your basis in other ways. Take Amazon for example. If you are a traditional value investor you have never had a chance to own this company. The stock price has never dropped enough to own this company at a discount and the stock price has grown like a weed over the last 20 years!
I own Amazon and I think I have a pretty good “synthetic” basis. What I call a synthetic basis is the act of generating a profit on a short-term trade and using that profit to buy stock in a great company.
Let's say I want to own $20,000 worth of Amazon, but I want to originate my investment at a discounted price. One thing I might do is to buy a leap call option on Amazon for $1,000 leaving the other $19,000 in a saving account. With a leap call option, if the stock goes up in value, you are likely to have a big outsized return. If the stock goes down, you are likely to lose the entire $1,000. Of course, if the stock stays flat, you're likely to lose the $1,000 as well.
Since leaps are over a year out to expiration, the $19,000 in the savings account most likely gained some interest to help offset the $1,000 in the case of a complete loss of the $1,000. Also, if the leap expired and became worthless, you avoided a loss in the stock had you invested the entire $20,000 at the start.
In case the stock goes up in value, the leap likely had many times over again. Let’s say the leap is now worth $4,000. If you were to close out that leap, you would have $23,000 + the interest you earned on the $19,000 in savings (let's say $150). Now you have $23,150 to invest in Amazon. I know what your thinking. If the leap went up in value the stock price of Amazon also did. Maybe it is a wash. This is true. But odds are it is not a wash as leaps have the power of leverage (since one option contract controls 100 shares).
Let’s assume it was a wash. Fine no big deal. Just wait for a pullback in Amazon. Now you're sitting on $23,150 waiting for a good price to enter the trade at. If the stock keeps going you made $3,150 on $20,000 -- not a bad trade anyway.
Walking away with the $3,150 is an option but what I would do at this point typically is dollar cost average into the stock. Maybe 10% of the $23,150 every week or month (depending on the market).
If this all plays out well I will own Amazon on a reduced basis. I did not have to wait until some pullback. I did not sit on the sidelines waiting for a discount.
Another Way to Reduce Basis
My leap buying strategy above was nothing more than one of many tools in my basis reducing toolbox. One strategy I use rather often I refer to as the overflow approach. Since I have mentioned it in other blog posts I will not go into too much detail here. But the basic concept is to take the profits from short-term trades and use them to buy long-term buy and hold positions. I would call this reducing my “synthetic” basis.
Back to Amazon…….but this time let’s say all I have is $10,000 to invest in Amazon but I really want a $20,000 position. I might use the $10,000 and start trading put credit spreads on the SPY. I might continue to trade put credit spreads until I have $20,000 in total. Now I can go buy $20,000 on Amazon. As long as the duration of time it took me to get $20,000 was not too long (say a year) I would consider my basis in Amazon to be $10,000, not $20,000. In a way, I am buying Amazon at a 50% discount (a discount value investors would salivate for). At that discount, I don't really care what the price of Amazon stock is. I just care that I still think Amazon is a great company and will grow for years to come.
The Best Way To Get Rich Is To Lower Basis
Yes, I am the first to admit there are tons of flaws in the examples I listed above. There is an additional risk as well. But I would also submit there is the opportunity cost of sitting on the sidelines with cash waiting for a discount in the market that may or may not come. I would also point out I have an entire portfolio strategy. In the case of the leaps, or put credit spreads there is a chance I could lose a fair amount of money and get into Amazon after losing some of the money effectively increasing my basis. My overall portfolio strategy assumes some of these trades will not work and losses are built into the plan. As a whole my play to lower basis before entering any buy and hold strategy tends to work.
The lesson I am trying to convey here is when I put on my long-term investing hat the number one thing I am concerned with is reducing basis. I truly think it is the best way for retail investors to get ahead. Waiting for a discount in a stock or using margin to buy more stock are strategies for slower overall portfolio growth.
If I was a rap artist I most certainly would have a single called “Reduce Reduce Reduce Your Basis” :).