In January, we published a Tear Sheet and ChartBook detailing a “Synthetic Short” investment in Caterpillar. Because there was one valuation scenario above the trading price of the stock at the time, we characterized this investment as a Low Conviction one.
Since publishing that research, a Goldman Sachs upgrade and two solid quarters’ worth of earnings results (1Q, 2Q) have pushed the price up to and beyond the strike price at which we bought an In-the-Money put option on Caterpillar – $115 / share.
Because there are still several months before the January expiration, this contract still has time value on it, but the option no longer has intrinsic value. Were this a classic short position, we would have been “stopped out” at $115. Because it is a synthetic short – a short position created using option contracts – we have not stopped out; the contract still has several dollars’ of value on it.
Choices
Among the hedge fund world, it is said that a short is not a short until it has run against you by 50%, so by that measure, we are still early in the investment. Nonetheless, holding an unrealized loss is not pleasant, and I have been considering what I should do. My choices are:
- Leave it alone
- Roll this synthetic short into another contract
- Close the position and realize a loss.
In the end, I have decided to leave it alone for now for the following reasons.
First, the time value of an option contract decays very slowly until about three months from expiration, so doing something (either closing or rolling) might make me feel better psychologically (more about that below), but would have limited impact economically. I can hold the position until late-October or early-November, at which point I can reassess my choices.
Second, rolling the contract would not change the economics to date – the stock has moved against the original position, but rolling to a new position that is “fresh” doesn’t rewrite history or change the outcome of the original investment. When a position is moving against me, I am careful not to take action in a way that will simply make me feel better. Making a decision that is psychologically soothing is an example of the X-System winning over the C-System, in my opinion.
Third, closing the position and realizing a loss would be contradictory to my valuation of the firm. I spent a good bit of time to reassess my model assumptions and to play devil’s advocate to my own bearish position. I believe that the valuation is accurate, so closing the position would contradict the conclusions of my C-System processes. This is, by the way, one reason why I am philosophically opposed to “stop-loss” orders. If you are focused on value and the price moves against your position, that should make the position more rather than less attractive. A stop-loss order acts contrary to that principle.
There are two advantages to using options for a synthetic short position like this one. First, the investment remains in place even when the price breeches the strike price (which would otherwise serve as the stop-loss). Second, when the stock price does reach the strike price, it serves as a reminder that it is time to take a hard look at one’s valuation assumptions again. This does not happen for a “normal” position without stop losses established.
It Only Takes One Bullet
At the Spring Grant’s Conference, Water Capital’s Gilchrest Berg made an interesting observation: “When you’re long a stock, you want multiple sources of ‘optionality.’ When you’re short a stock, you just need one bullet to kill it.”
There are multiple sources of optionality for a long investor in Caterpillar, but even accounting for those, it is simply difficult to see value in the shares at this price. My analysis of the company showed how resilient its profitability is, thanks to a disciplined, intelligent management, and I would be happy to own Caterpillar if the stock was trading $55 lower right now.
Right now, I am waiting for a bullet to knock the share price down. That bullet might come from:
- President Trump’s promised steel tariffs (which would hurt Caterpillar and other users of steel by raising input costs).
- The collapse of President Trump’s infrastructure proposals (or, in fact, of any major political issues related to the dysfunctional Trump administration).
- A crisis in China related to the very high levels of financial leverage in the economy.
- Write downs on some portion of the Bucyrus acquisition that would force Caterpillar to cut dividends (this might occur in conjunction with another “bullet”).
- Armed conflict breaking out in Asia (N. Korea / S. Korea or Japan) or Europe (Russia / Baltics).
Any of these factors are possible, though their probability and the market’s reaction to them if they do occur, is uncertain.
While unpleasant to hold a position suffering an unrealized loss, I have decided to suck it up and wait for a few months, at which point, I will reassess.