From Bust to Boom: How to Profit From Bankruptcy
Investors deal with volatility in different ways. But the net impact of most of these strategies has investors underperforming the S&P 500. That extends to mutual funds as well. A 2022 report concluded that over a 10-year period, only 18% of all mutual funds outperformed the S&P 500.
There are two reasons for this underperformance: No exit strategy, and poor exit strategies.
Having no exit strategy means you buy and sell based on emotion. You buy a stock because it’s hot, and you sell it because it suddenly cools. But people who invest like this will buy after a rise and sell after the decline has begun. They clip returns on both ends, and hence underperform the market.
A poor strategy is one that has you exiting your position after a loss, and from normal volatility. Setting tight stop-losses on your positions is a good way to lose money, because normal volatility will usually take you out of your position after a decline.
It seems like everyone has a system that they hope will beat the market, but few do. However, there is one system with a track record of beating the market. It’s one that I use.
I diversify across all of the major sectors of the S&P 500, and then sell covered calls on my positions. That strategy has been shown to outperform the S&P 500 most of the time at lower risk. The only time it historically underperforms is during a strong advance of the S&P 500.
The way I deal with volatility is by keeping positions small, and then riding out whatever volatility may come. For example, if every position in my portfolio only represents 3% of the total, then a complete loss in that position only impacts my portfolio by 3%.
At times, that strategy has led to a wild ride. I have had positions decline by 50%, and then go on to gain 1,000%. But until last week I had never had a position go all the way to zero.
Bed Bath, and Bankrupt
I added Bed Bath, and Beyond to my portfolio in 2018. At the time, the company seemed to be solid, and was favored by analysts. But it wasn’t long before it ran into serious financial challenges.
I entered my position at $19.85 a share in 2018. Ultimately, my original Bed Bath, and Beyond shares declined and declined until reaching zero last week. A total and complete loss, which would have negatively impacted my portfolio by about 2%. Except for one thing.
Since 2018 I have sold calls on my position totaling $22.35 a share. In addition, before the company eliminated its dividend in 2020, I collected $1.16 in dividends. So, on my original $19.85 a share, I earned $23.51 in dividends and call premiums. Since shares went to zero, I netted ($23.51 – $19.85) = $3.66 a share on a company that went bankrupt.
That’s a total return of only ($3.66/$19.85) = 18.4% for a position I held for nearly five years. That’s not the kind of return you would brag about, except without the covered call strategy all I would have are the dividend payments, and a total loss of 94%.
I must confess that if the company had fallen much faster than this, I would have never had time to recoup the loss. The key here is holding for a period of time measured in years and chipping away at the cost basis over time with dividends and call premiums so that even in the worst-case scenario, you don’t take a total loss.
People have predicted bankruptcy for Bed Bath, and Beyond for more than a year, so you may wonder then why I would ride the company all the way to bankruptcy. Honestly, when it became clear that the company was headed to zero — and in the last few months of its life it was pretty clear — then there is no reason for a buy and hold investor to remain in the position.
Except in the case of a covered call seller like me, the calls I had sold were more valuable than the share price. Thus, I needed them to expire worthless in the future, which is why I couldn’t sell shares before bankruptcy. And every time the stock had a little bounce, I would typically sell a new call to capture a bit more profit from my shares.
That, ladies and gentlemen, is how a covered call strategy can win — even on a losing stock.
Editor’s Note: Robert Rapier just explained how to turn a bust into a boom. There’s money to be made in distressed companies and market imbalances. That’s why we offer a trading service called Mayhem Trader.
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