Animal Spirits Podcast - Talk Your Book: The Buy-Write Strategy 

Episode Date: November 28, 2022

On today's show, we are joined by Ray Di Bernardo, VP and Portfolio Manager of Madison Investments to discuss writing call options, buying growth at a reasonable price, earnings in 2023, and much more!    Find complete shownotes on our blogs...​ Ben Carlson’s A Wealth of Common Sense​ Michael Batnick’s The Irrelevant Investor​ Like us on Facebook​ And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation.​     (Wealthcast Media, an affiliate of Ritholtz Wealth Management, received compensation from the sponsor of this advertisement. Inclusion of such advertisements does not constitute or imply endorsement, sponsorship or recommendation thereof, or any affiliation therewith, by the Content Creator or by Ritholtz Wealth Management or any of its employees. Investments in securities involve the risk of loss. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. The information provided on this website (including any information that may be accessed through this website) is not directed at any investor or category of investors and is provided solely as general information.)​ Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits Talk Your Book is brought to you by Madison Investments. Go to MadisonInvestments.com to learn more about their covered call strategy we're going to learn about today. And to learn more about the risks involved in any of these strategies. Check out MadisonInvestments.com. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ritt Holtz Wealth Management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritthold's wealth management.

This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Rithold's wealth management may maintain positions in the securities discussed in this podcast. Welcome to Animal Spurs with Michael and Ben. Ben, you know what hasn't been a great strategy or usually doesn't work so well on the bull market? What's that, Michael? It's capping your upside. True. On today's show, we spoke with Ray Di Bernardo.

portfolio manager at Madison Funds, about a covered call strategy. And what the strategy does, simply put, they own a basket of stocks. In this case, I think it's fairly concentrated. I think it's under 40. And they sell calls as to generate income against their holdings. And Ray was, he had a little twinkle in his eye, was pretty happy to say that it's been a good year. He's like the happiest guy in a bear market. He said they're positive on the year. We actually have gotten a lot of questions for people about these types of strategies because they produce regular income. I think a lot of the places that run these kind of funds do like to have distributions for people. Oh, you know what? I had this in my back pocket. I meant to ask about tax efficiency.

But what I was just to say is this is a qualified account type of strategy. That would make sense. But this is the kind of strategy. So you're writing call options and you're capping your upside, but you're receiving a premium that helps a little bit, which makes it so your downside you usually do better and then the upside you lag. it's a defensive strategy. And I think people like the idea of having income, plus you have some upside in there as well, even if it's not as much as the overall markets. We've gotten a lot of questions. This is the kind of thing, though, that as someone who doesn't trade options for a living regularly, I would much rather have a professional doing this for me than trying to figure out which options to write and which time horizons. And I don't know that I'd want to be doing that myself. And should I just buy the stock again after it gets called, if it gets called, or should I

buy another stock? You like the Microsoft January 420s here? I think I've told you this before. I've never bought an option in my life. I would much rather have a professional do this for me. Still can't believe that. And you and I've talked about this before. So Madison Investments is based in Madison, Wisconsin. Started a small, one of the best college towns, by the way. I don't know if you've ever been there before. Easily one of the top college towns in the country. They manage like $20 billion. And for my time in the institutional world, it always shocked me how many places there are like this, that are these niche boutique places that manage money for not only individuals but also large institutions, it managed

billions and billions of dollars. And full disclosure, I should say, my very first investment consulting job out of college, this is probably like 2005, the investment consultant I worked for used Madison investments as an investment advisor to run separately managed accounts on behalf of our clients. So you're trying to say that the active is dead trope is nonsensical? Especially if you look in the institutional world, there is a lot, a lot of money in especially like separately managed accounts that don't have to rely on retail for everything. So here is our conversation with Ray D. Bernardo, where we talk about the Madison covered call and equity income strategy. That is ticker M.E. N. YX.

We are joined today by Ray D. Bernardo. Ray is the vice president and portfolio manager at Madison Investments. Like me, he's a fellow flyover state guy in the Midwest, not a coastal leader like Michael. Ray, welcome to the show. just had to set that out. Ray, for those who aren't familiar with Madison Investments, why don't you just give us a referend down to the firm and what it is you guys do? Sure, Ben and Michael, good to be with you. Madison Investments is an independent, employee-owned investment firm based in Madison, Wisconsin. We were founded in 1974, and we currently manage just over $20 billion in client assets across a number of

investment mandates, including fixed income asset allocation, international equities, and U.S. equities. Our U.S. equity team is primarily based here in Madison. It comprise of large-cap, mid-cap, core. We have a small-cap strategy and an equity income group, which includes a dividend income strategy and the covered-call strategy, which I'm responsible for. All right, so we're going to get into the covered-call strategy. But before we do, maybe let's just take a second to describe the landscape and the year that is 2022 from your seat. How do you think about when you're looking back on this year, what are you going to remember? I'm going to remember an investment environment that has finally been conducive to covered

call writing. We've been doing this for a long time here. We started out with our first covered writing product was back in 2004, a closed end fund, and we started this fund in 2009, so right after the great financial crisis. And for the vast majority of that time, up until this year, we've been in a bull market. Probably the worst environment, you could have for a covered writing fund is a straight up bull market when volatility is low. As the strategy really requires the other side of the cycle to make the case for covered writing over a full investment cycle, we're starting to see that other side now, and we're starting to see the benefits of it. Not only is it a very defensive strategy, but higher volatility that comes

along with bare markets also improves premium income, which makes the fund even more defensive. So this has been, at least from my perspective, a breath of fresh air, even though it's kind of been difficult to handle this for most investors. You're the only happy person I've heard talk about this bear market. I know. Well, fouled the short seller. Our fund is up in a market that's down 15% as of right now, so I'm pretty happy. We get a lot of questions from our listeners about option strategies because they hear about

the income, but I think a lot of people are confused about how they actually work. So why don't we start there from the basics? What exactly is a covered call strategy and how does it work? work. So just lay out the basics for us first. We start out with an underlying asset, and in our case, they're U.S. equities. And essentially, it's a two-part process. You have the underlying asset equities, and then you have an option overlay. In our case, we're using individual call options, equity options, rather than index options. Essentially, what we're just doing is through the option contract, we are agreeing to sell a portion or all of an existing holding at a

predetermined price, which is the option strike price for a predetermined period of time right up until the option expiration date. And for doing that, we're receiving a premium which increases income, but also provides a downside hedge to our existing holding. So we're essentially just pre-selling or agreeing to pre-sell a holding that we already own. So what would be good for this strategy is, I'm using air quotes here, but I don't know what also calls a stock pickers market that goes sideways. I mean, down isn't great, but straight up is certainly not good. You don't want a bull market with a little volatility where your positions are getting called away. Oh, and not only that, to pour salt to the moon, you're also not collecting

a great deal of income because there's no volatility and there's no juice in the options. So the past decade must have been pretty frustrating. It was frustrating, but having said all that, Even though markets were going up 20, in some cases, almost 30% in some years, we were still generating good returns. We just weren't keeping up. So we were participating on the upside. But in bull markets, everybody just wants to make money. In sideways or chopping markets or down markets like we're having now,

people want to preserve capital. So they don't really see the benefit of the strategy until they actually need it. And this year, they've definitely needed it. When you're thinking about, before we get to the strategy, I'm just curious for framing this because people have to have the right expectations for what this can do, both the upside and the downside and the limitations of the strategy. What is the appropriate benchmark? It sounds like it's probably not the S&P, although it feels good to compare yourself to the S&P in a positive year, obviously. But objectively, what is an appropriate benchmark that you

would like to compare yourself to both in good times and bad? Well, it's a good question because the reason that we actually started this strategy back in 2004, at least the first fund that we started, was because a benchmark was finally created. Options and covered writing have been around for hundreds of years, and it wasn't until the 70s when the Chicago Board Options Exchange was created that we had a listed market for options and standardized market for options. People have been writing options on positions and covered calls for a long, long time, but I think generally people understood that it generated income, but there wasn't really another proof statement for the strategy in general.

And that occurred in the early 2000s when the CBOE, the Chicago Board Optus Exchange, contracted with a professor from Duke University. They'd worked with previously to create the volatility index, the VIX index. And they wanted a benchmark created for covered writing. So they created the CBOE S&P BuyW Index, the symbol is BXM. and all that was was the S&P 500 is the underlying asset with a 30-day call option that was just out of the money written and rolled every 30 days just out of the money wherever the market happened to be. And that created a proper benchmark. Now, consultants then went off

and did what consultants do and they studied the benchmark and back-tested and did all that great stuff. And they found that over a full market cycle, The buy-write index had index-like returns, in fact, very, very close to the S&P returns, but it got those returns with roughly two-thirds of volatility. So it underperformed in up markets but outperformed in down markets and essentially got to the same place with less variability. Now, all of a sudden, there was a proof statement and an affirmation for buy-writing in general. And that really was the beginning of kind of a new wave in interest in Colorado writing. You have to obviously have the stocks ahead of time before you start earning the income on them from writing the options.

How do you go through that process? Are you looking for specific types of stocks that can generate specific amounts of income for you based on the options? Or do you have a stock picking strategy to use and then you decide the options after the fact? How does that work? People can do it in both ways. Our specific process and it really is just a matter of identifying where the risk is. in the strategy because ultimately cover writing is a risk reduction strategy. The risk is in the underlying stocks. Like any long equity fund, it's the underlying portfolio. The options reduce

volatility by bringing in premium income. So we focus a lot of our attention on where the risk is, and that's the underlying portfolio. So we want to maintain a very high quality portfolio, not necessarily high dividend earners, but companies that have strong market positions, market leadership, free cash flow generation, business models that will work in various types of markets, high returns on invested capital. We do a lot of work and due diligence on the underlying companies, and then we take what the option market will give us in terms of what kind of premiums are available. To give you an idea why it doesn't work the other way is I look just this morning because essentially you get higher premiums when volatility is the highest.

So if I looked at the Russell 1,000 index and picked out the highest volatility stocks, because I want to get the highest premiums, I would be investing in AMC, GameStop, Coinbase. So what's wrong with that? You kind of get where I'm going with this. So high risk, high beta firms. If you go to the other end of the spectrum, you're getting Johnson & Johnson, Coca-Cola, Pepsi, a lot more high-cap, high-quality companies. So what we try to do is we try to incorporate our stock selection process, which has always been high-quality based, and then add another layer of protection with the option overlay on top of that.

So we get a solid foundation with the equity fund and then add an additional layer of protection with the option overlay. All right. So there's a million follow-up questions. For the equity selection only, do you have strategies that do that with the unhedged version? Let's say somebody just favored your stock selection. Would you offer that, or is that not part of it? Madison Investments has always had a reputation of being kind of a very high-quality

growth at a reasonable price philosophy in terms of investing. So we've always had a very high-quality bias, and we do follow very similar paths in terms of the stocks that we pick for the covered call portfolios. The main difference with us, though, is that there's a lot more turnover because of the option activity. We like to say that we take a long-term strategic view on the underlying stock, which may be three to five years, but the options force us to make some shorter-term tactical decisions based on the 30, 60, 90-day option expirations that we might have. So we're having a lot more turnover. We tend to be investing in a lot of more varied sector

approach. In many cases, our traditional Madison portfolios have very low turnover. And so there's a significant difference in that type of philosophy. But the overriding similarities are high quality, growth in reasonable price, long-term strategic positions. So the turnover would occur what? If a stock gets called away, you're not just going to buy it back? Is that what you're talking about? Yeah, we allow stocks to get called away, partly because when we set these funds up, we set them up to be income generators. So we do historically have a fairly high distribution rate. And part of that distribution rate comes not only from the underlying dividends, which is typically slightly ahead of the market, so maybe two, two and a quarter percent. Option premium is obviously part of that.

So the net option premiums we generate through the year, but we also distribute capital gains that we generate or realize throughout the year. So we're happy to let stocks get called away because essentially when we're agreeing to sell a stock at a certain price, even if the stock goes higher, we're pretty much capped out at that price. So if a stock gets called away, we then decide whether we want to buy it back at whatever the current price is or wait until it comes back to us, or we just take that cash and invest it in some other idea that we've been working on. So you must have to have a pretty big watch list then because it's almost like a catch-22 of it's good that the stock's going up, but then it's also hits that threshold where you can't really hold a long term because you have the call on there.

So you're getting the income, so you have to have another stock waiting the wings, essentially. We do have a large watch list. Very often, more often than not, we are just repurchasing the same position that is getting called away, assuming that the conditions under which we wanted to buy it in the first place still exist, and assuming the price hasn't got overly expensive. One of the things that we do in determining whether we want to sell a stock or not, ultimately, is if valuations get to a point that we think are excessive, we can just write an option closer to the money, bring in a big option premium, and then let the whole thing get called away, and that is essentially the cell discipline that we have built into the system. Along the way, we just collect more option premium. Do the covered call strategy that you employ work the same across every holding, or are you more or less aggressive depending on the underlying security? It's very specific to each underlying security, and that's the benefit of using equity options over index options. We could provide umbrella coverage for the whole fund by selling S&P options and bringing in premium.

Individual equity options typically have a higher premium because volatility is hired for a single company relative to a 500 stock index, and more importantly, we can tailor the option characteristic to our view of the underlying stock. So as you noted, there are holdings that we may not want to write on at all because we want to participate more on the upside. An example of that right now would be Las Vegas Sands, which is one of our biggest holdings. Once COVID is lifted in China, the stock is going to, in our estimation, do very well. So we don't necessarily want to be stopped out of that by having an option written relatively close to the money. In other situations where valuations are a little more excessive, we might write very tight to the money to get more

downside protection in case the market does turn. So it really is specific to our view of each individual holding. But typically, because our overriding strategy is covered writing and income generation, we will typically be 75 to 80% covered virtually all of the time. And if we want to get more defensive, we'll cover more and we'll cover closer to the money. If we want to lay it a little more aggressive, we might cover slightly less. And if volatility as high as it is now, we can write further out of the money and get more upside out of the stock while still generating a good premium. I know that volatility is a big input into figure out options prices. I don't know enough of the relationship in the formula to understand how big a year like this could have. So maybe you could give

us an example of how much different option premiums are this year versus a more normal year like we've had in the past few years. So implied volatility or what the options market is thinking volatility is going to be in the near future is really the driving factor around option premiums. And if we look at a stock like Microsoft, so very high quality, terrific, AAA balance sheet, market leader, all the great things you want to see in a company, is trading at a three-month implied volatility of 32. The S&P 500 is roughly 22. So there's a 10 volatility point difference between the two. And that leads to, I just jotted down a couple of notes here this morning. So if you looked at a 5% out of the money option in Microsoft expiring in January of next year,

you would get roughly a 2.8% premium on that option, 5% out of the money. So you get 5% upside plus 2.8% on top of that. If you did the same thing today with an S&P option, 5% out of the money expiring in January, you would get roughly 1.5%. So almost double the option premium over the same period of time and the same amount out of the money. So that's generally, with a very high-quality underlying holding, you can squeeze out significantly better option premiums because of that increased volatility. Now, not all stocks have that.

Coca-Cola, for example, has lower volatility than the S&P. And historically, it's always been like that. It's just a very low-volatility stock. So in order to get any kind of meaningful premium, you'd have to write very close to the money, which conceptually, even if it was your best long idea out there, you're giving away virtually all of the upside to get a very small premium, it doesn't make as much sense to use Coca-Cola in a covered writing center. Is this why there are no consumer staples, at least as of your most recently filing, there's no consumer staples in the portfolio? We had a couple of them

in there. We let them get called away. We own smuckers and Archer Daniels, and they just recently called away before the last quarter. So the problem we have with consumer staples isn't so much that there's not enough premium. I mean, historically, there hasn't been very much premium. But in this market, everything's got premium for the most part. The problem is valuations. For the longest time, Staples were being chased because everyone was searching for dividend yield, and now everyone's looking for safety. So the valuations for these relatively low-growth companies is a little bit too excessive for us. So we're constantly scouring for good ideas there, but again, we don't want to be buying mediocre growth companies at high valuations,

because, again, that's where the risk is in terms of how you make money in the future. Right. It's funny you mention that because you're right. Consumer Staples for the last, I don't know, call 10 years were bid up because interest rates were at zero, and they were seen as a bond substitute, even though, of course, they're equities. But you get the point with the dividend replacement. So then they went from expensive because of low interest rates to maybe still expensive

because people are like hiding out in these defensive oriented names in the bear market. But Pepsi is trading at like 26 times earnings, which sounds like a lot. We did own Pepsi, and then we sold it because valuations, we felt were just getting too excessive. So it just added too much risk in our mind to continue to own it just because it was a great company and a great name. It also has to be the right price, and we just think it's gotten too expensive. When thinking through valuations on some of these companies, obviously inflation is a big

factor this year. and a lot of people think that a lot of the reason that the market valuation is compressing is just because interest rates are higher and inflation is much higher. How do you think that through going as a long-term investor thinking through, well, of course it makes sense that valuations would compress in that scenario, but now we've got to figure out, does this inflation stay higher for longer, do interest rates higher for longer, and how does that impact valuations, or do they just go back to the trend that they around before and we have just a blip here?

That's like the hard macro thing for me to wrap my head around is how much do you place like a terminal level in that and has it moved? tire versus just ignoring all that and paying attention to the companies? It's a good question because we've certainly seen a major whipsaw in money supply in recent years. I mean, historically high money supply growth post-COVID, and we're still feeling the impacts of that. And that's one of the key reasons that inflation has gotten so high, along with the trade issues and the supply chain issues, etc. Now we're starting to see tightening. And we've seen record declines in money supply back to the longer term

trends. And we're not going to feel the impacts of that until we get a year out. So these things tend to have a lag of a year to 18 months for them to have an impact. So to a large extent, we're still benefiting, even though the markets are lower, we're benefiting from all of that free money that got pumped in. I don't personally think we've seen enough of a reversal in the markets in order to correct what's happened in the past. So I do think inflation is going to come down, not only because that money supply has come down, but I think comps get better, and we tend to feel better when the number is lower, and we're going to be comparing against higher numbers a year ago, so it's all going to feel better. The reality is

that we have the other side of the coin that's going to hit us, which I don't think has hit us yet, and that's earnings. Money supply and inflation have pumped up corporate revenues. Nominal GDP last was 9%. And in order for the Fed to get inflation under control, they have to get nominal GDP to come back down. Let's say they can get it down to 4%. They have to keep Fed funds above that rate for a meaningful period of time in order to squash inflation. Well, nominal GDP is essentially a proxy for corporate revenue. If this is going to happen, then corporate revenue has got to come down generally. And earnings, which are going to get squeezed and have been getting squeezed by higher costs, higher labor costs, higher input costs, are also going to get squeezed as well.

So you have an environment going forward where revenue's got to come down. Earnings are likely going to come down as well, and we're entering a recessionary environment. We have discussions all the time around here about whether this is the beginning of the next bull market or not, or if we're just kind of in another bear market rally, I'm not sure we've actually been in the bear market yet, to be honest. I don't think we've actually been in the bare market yet. You think there's worse to come, huh? I think what we've seen is if you look at a trend from 2009, we just corrected back down to the lower part of that trend.

And we saw this big bubble post-COVID because of that money flowing in, and that's been now corrected back. We haven't seen the recession or the major decline in earnings yet. And I think that's going to happen next year. Your point about earnings is interesting. I always tell Michael, no one ever inflation adjusts earnings levels. So no one thinks the fact that earnings are growing really high. Well, part of the reason is because companies, can increase their prices. So you're saying either the Fed brings stuff down, and even if they have a

soft landing, earnings are going to have to come down. And if we have a recession, then it could be worse. That's kind of your worst case here. I think the Fed has to keep rates above nominal GDP to keep inflation in check for longer than people expect. And that's going to bring revenue down significantly. And I think earnings estimates have to come down. I think right now the estimates for 2023 are still for about 5% earnings growth in the S&P. I've seen more and more strategists out there bringing it down to minus 10, minus 15%. I wouldn't at all be surprised if we have a negative earnings year. So we have an earnings recession along with an economic recession.

So what kind of multiple can you put on that? Right now, if earnings do come down the way I'm thinking, then the market's trading closer to 20 times earnings. And I think in an environment where rates have to stay higher for longer, that's dangerous. I think the market has to adjust lower. So before we start the next bull market, I think we still have to go through some pain. So with this strategy, let's say we do get a washout in 2023, would you ever pivot to more growth-oriented names or as your strategy, your strategy through different economic regimes? We're kind of a go-anywhere strategy. We've been underweight

the traditional high-cap or mega-cap growth stocks, the fang stocks for a long time. And that hurt us. particularly in 2021. Hey, Ray, be honest. How good does this feel? You know what? It doesn't feel bad. Sometimes being early can be painful. We invested a lot of money in energy early,

and we took that money away from technology early. And for a while, it was looking around at the wrong call. But as we went through the end of 2021, and valuations just got ridiculous, we felt better and better about the call. And not that we were seeing our crystal ball, that 2022 was going to happen this way, we certainly didn't foresee the geopolitical issues that we saw that are impacting the commodity space. But we felt much more comfortable with the upward

trend of the commodity and industrial, and particularly the energy space, than we did investing in some of these large-cap growth stocks at these exorbitant multiples. And I've been around long enough to understand that companies can still grow, and you can lose a lot of money. I remember Cisco back in the tech telecom bust. It actually grew from 2000 to 2004, but it lost 70% of its value because the multiple went from 130 down to 30 times. You have to always be aware of valuations and we just think they got too too crazy with mega cap stocks and we're seeing the other side of that. So you think this environment of higher inflation, higher rates makes more sense for higher quality cash flow generating value type stocks than the high-flying growth still for a while?

For now, yeah, I do. And as Michael said, at some point, these stocks get cheap enough that we take a look at them. We tend to be more value-oriented today, but we're not averse to being more growth-oriented in the future, and we're going to just look for the better opportunities as they come along and try and be faithful to our valuation disciplines. Again, growth at a reasonable price means you want growth companies, but you want to pay as reasonable price as you can for them. All right. Last question from me. Maybe I should have love with this. But I'm curious, when you speak to a new prospect or client, how much of the conversation is centered around the option strategy versus the underlying? Where do you begin a conversation?

I always begin with the underlying because, as I said, at the beginning, that's where the risk is. You really have to build that foundation and show that there's an ability to manage a long-term underlying portfolio. That's essentially your first line of defense. And then, understanding the options is important as well, but you really have to understand this is an equity strategy that's defensive, it's conservative, but where you can get into trouble is by buying the wrong stocks, not writing the wrong options. That's really where you have to spend a lot of focus, and that's where we tend to have most of our discussions. Perfect. Where can we send people to learn more, right? Our website, madisonfunds.com. You can see all of our products there. You can

look up the covered call strategy. We have a white paper on there talking about. about the overall strategy and some of the things I've talked about here, that'll be a good starting point. Awesome. Thanks, Ray. Appreciate it. Great. Thanks for having me, guys. Thanks again to Ray. Remember, see all disclosures. Go to Madisonfunds.com or Madisoninvestments.com and then send us an email Animal Spiritspod at gmail.com. Thank you.