RCA - Generating High Returns Without Market Risk: Qurate And Other Ideas

2023-03-31 14:55:06 ET

Summary

• Market risk is the biggest risk in investing as most high-yield investments, regardless of undervaluation, will fall significantly in a bear market.
• This is meant to be an educational article that will discuss our market-neutral investment approach, which has performed extremely well in this bear market.
• I will then present some of our investing/trading ideas, with a focus on an extremely successful pairs trade idea involving Qurate bonds versus the Qurate preferred stock.
• Three of the five investment ideas presented here are still actionable ideas for investors currently.
• I hope you will find this article useful in your investing.

Investment Philosophy

To put it simply, our investment philosophy at Conservative Income Portfolio is to "make money" and in a fairly conservative way; to greatly beat the market benchmarks in a lower-risk manner. And we are open to and recommend many less traditional approaches.

Personally, I do not believe in buy and hold. Buy and hold has been a miserable strategy during this bear market. And what was relatively attractive and undervalued 6 months or 1 year ago may no longer be relatively attractive given the drop in price of so many other investments. Why stay in an investment that may have been relatively attractive some time ago when there are now better investments available? Just look at how different the investment arena is in the banking names from just 1 month ago.

And I don't believe in simply dividend investing. We are total return investors. Although I am generally focused on the high-yield fixed-income sector, in my own investing/trading, I generate about half of my annual income from capital gains.

This article will focus on market-neutral pair trades but also mention some other approaches that reduce or eliminate" market risk". Market risk involves the risk that a bad stock market will pull down your stocks as well. I'm sure many of you have losses on many of your holdings over the last 1.5 years, primarily because the whole market is down and not because of your poor stock selection. With the ideas presented here, you won't care if the market goes up or down. It will make no difference. The ideas can work in an up or a down market, and market risk is generally the greatest risk investors face in investing.

Pair Trades

For those unfamiliar with pairs trading, a pair trade involves going long (buying) one security and shorting a similar security when one is undervalued versus the other. The trade generally is shorter term until the market corrects the mispricing. And sometimes the mispricing is so egregious that a very high return can be generated in a short time.

These trades have a very high probability of success whether the market rallies or sinks. The only question is generally how long it will take for the trade work. Although we have not recommended a large number of pair trades to our subscribers, we have a 100% success rate so far on those recommendations.

Some people talk about SWAN (sleep well at night) recommendations but many who purchased those have not slept well at night. Pair trades are the ultimate sleep well at night investments. In fact, I usually hope the trade goes against me at first so I can add to my position and ultimately earn more profits. But if you are simply long a stock, continually averaging down as it falls can be deadly.

Qurate

For those unfamiliar with Qurate ( QRTEA ), they own the Home Shopping Network and QVC. So the majority of their business is in television retail. They do have some much less significant subsidiaries but they don't amount to much. Currently, they are moving into online retailing and working on streaming agreements for their shows.

Qurate did very well during the pandemic. With so many people stuck at home and afraid to go shopping, Qurate did a great business for some time. They got so confident that they started backing back their stock at $11.00 per share and were paying out huge special dividends. This greatly reduced their big cash hoard that they had.

Fast forward to today and things have become disastrous with increased labor costs, increased shipping costs, a fire at their second-largest fulfillment center, and a drop in sales with people no longer staying at home. Their common stock is now selling for under $1.00. But that doesn't mean there isn't money to be made here. And they still have a fair amount of cash due to the sale and leaseback of some of their properties. So they are like to stay out of bankruptcy for some time and have additional properties that they can sell and leaseback to raise more cash.

Qurate Pairs Trade

One of our recent recommendations to our members was to go long a Qurate bond (CUSIP: 530715AD3) with a maturity date in 2029. This bond is also referred to as a Liberty Media bond as that was what it was once called. And on the other side of the trade we recommended shorting the Qurate preferred stock with the symbol QRTEP . On March 6th, we recommended buying the bond at its then current price of $37.25, and we recommended shorting term preferred stock QRTEP ($100 par) at its then current price of $47.55. So you were getting the bond at 37 cents on the dollar while shorting the riskier preferred stock that surprisingly was selling at 47 cents on the dollar (the preferred stock matures in 2032).

So the upside on the bond was much greater than the upside on the preferred stock. Not only that, but the yield-to-maturity (YTM) on the bond was 32.4% while the YTM on the preferred stock was only 22.45%. And even the current yield on the bond was much higher than the preferred stock with a 22.8% current yield versus a 16.9% current yield on the preferred stock. This was truly a massive mispricing, and if this trade had gone against me at first, I would have eagerly added to the trade. And while you waited for this trade to work, you were collecting almost a 6% yield due to the bond's higher current yield.

Fast forward just 3 days and our short QRTEP position had tumbled to $40.53 for a gain of over $7.00 while the bond was actually up 75 cents at $38 for an $8.00 gain in just 3 days. We exited half of our position in this trade as even still the trade has more room to work.

Here is the current situation.

As you can see, the safer bond still sells at a deeper discount than the preferred stock - around 25 cents on the dollar for the bond and close to 29 cents on the dollar for QRTEP, which last traded at $28.86. The safer bond currently has 44.8%% YTM while QRTEP has only a 35% YTM. And the current yield on the bond is still 5.3% higher than QRTEP. So you have better safety with the bond, a better yield, and more price upside.

Besides the market rectifying this mispricing, a catalyst for further big gains would be a dividend suspension on QRTEP which would again send QRTEP tumbling significantly more than the bond. I believe this is still a good trade for those interested although not as good as it was earlier in March. If I had just discovered this today, I would still make this trade and it could get better as the bond and preferred stock are volatile and the mispricing could get larger before more normal pricing emerges.

Babcock & Wilcox Pair Trade

This was a more unusual pair trade as we went long Babcock & Wilcox ( BW ) preferred stock and shorted the common stock. This is not something I normally do much because the common stock has the potential to make larger percentage moves than the preferred stock. So whereas with the QRTEA pair trade, we had the same amount of dollars short as we had long, in this case, we bought the same number of shares of preferred stock ( BW.A ) as we shorted in BW. We put on this pairs trade on December 16th as the preferred stock had been beaten down mercilessly from tax loss selling, and we expected BW.A to be a big beneficiary of the January effect but we still wanted a partial hedge as BW is not a particularly solid company.

We went long BW.A at $13.39 and shorted BW common stock at $5.06. Our thesis worked out as the beaten-down stocks rallied strongly in January. We exited half of our position just 3 weeks later with BW.A up to $16.92 for a gain of $3.53 while our BW common short went up a much lesser $1.09 to $6.15. We then exited the other half of our trade just another 5 days later with BW.A long position up $4.59 and our BW short up $1.39.

Pairs Trading Agency mREITs

Another actionable pairs trade you might want to consider is going long Dynex Capital ( DX ) and short AGNC ( AGNC ) with the same dollar amount of each. Currently, DX trades at over a 20% discount to its $14.73 NAV while AGNC trades at a slight premium to its $9.84 NAV. That is a huge disconnect, especially when you consider that DX has been the best-performing agency mREIT for some time. Although the NAVs are old, from the beginning of the year, I believe the difference between the AGNC premium to NAV and the large discount to NAV for DX still makes this a good trade.

I feel comfortable with this because I have already recently done 2 pair trades that made large gains in a very short time. Those were long DX and short NLY, and long DX and short CHMI. Once the first quarter NAVs come out for the agency mREITs, we will see if there are some more good pair trades here.

Special Situations

Merger/Call Opportunities

Mergers can also provide market neutral opportunities. The iStar and Safehold ( SAFE ) merger offered an opportunity as iStar preferred stocks were going to be called as part of this merger. For some reason, STAR.PG sold down to $23.22 despite the high likelihood of a call at $25. We added that to our portfolio on November 10th. Unlike most of our ideas, we did actually write this idea up publicly later a few days later. When sanity returned to the market we sold STAR-G at $25.10 on January 28th for a nice gain plus a dividend. The annualized return on that investment/trade was 47%.

Maturity Date Opportunities

Similar to this merger idea is using likely calls or maturity dates to make market-neutral investment trades/investments. One market-neutral investment is a baby bond from Ready Capital ( RC ) that you might want to consider. The symbol on this bond is RCA ( RCA ). It is a very short-term bond that matures in less than 5 months but currently has a YTM of 9.7%. Since it is such a short-term bond, what the market does over the next 5 months doesn't matter. All that matters is that RC doesn't go bankrupt between now and August, which has an extremely low likelihood of happening.

Covered Call Writing

Writing deep in the money covered calls on already undervalued stocks is also a way to generate a high yield while greatly minimizing risk. My partner, Trapping Value, takes care of these ideas so I can't offer any, but it is a good strategy in a risky market and has handily beaten the indexes.

Bottom Line

No investment philosophy or dogma is right for every market. You must look at the current situation and identify how you can best profit from it. Buy and hold has been a train wreck in this market, and in my opinion is a poor strategy in general causing you to opt to hold your current investments when better ones arise.

Deciding when to sell is often the most difficult part of investing for many people but it is actually very simple. You sell when something better comes along. If this concept is the only thing you take away from this article, it will make investing much easier for those who have a difficult time deciding when to sell something. Don't fall in love with your stocks and promise "til death do us part". There is almost certainly something better now than what you bought 1 year ago.

I remember 30 years ago while I was driving home from work I was listening to a radio show by a trader and he said that "trading is safer than investing". At the time I thought he was just "talking his book". But over the years, I have realized that he is absolutely correct if you know what you are doing.

Market-neutral trading/investing and opportunistic investing is a great strategy in all markets if you don't like losing money. Yes, it requires more work, and the more bonds/stocks that you cover the better will be your results, but I actually enjoy that challenge, and the monetary rewards can be great.

I hope that readers found this article educational and useful, especially more novice investors.

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