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Concentrated Stock
Quarterly Update

Q2 2023

Highlights

NCAM Amish Dalal_CSQuarterly
Amish Dalal, CFA
Senior Vice President
Portfolio Management

Market Exposure Model

Major equity indexes ended June higher: the S&P 500 and technology-heavy Nasdaq rallied 6.6% and 6.7% respectively, while the Dow advanced 4.7% for the month. We attribute stock performance year-to-date primarily to the expansion of multiples, as reflected in the P/E ratio expanding by approximately 17%. While the economy has displayed resilience recently, we believe the full impact of the monetary tightening is yet to be experienced. We anticipate a more challenging macro environment in the equity markets due to uncertainties in monetary policy, weakening consumer trends, and heightened recession risks. Against this backdrop, we have maintained a cautious stance in equities, with our U.S. equity exposure remaining at 45%.
 

Stock Scoring Model

Technology stocks, specifically within the semiconductor sector, have performed very well this year. Of the mega cap companies, NVIDIA (NVDA) is up 189% followed by Advanced Micro Devices (AMD) which is up 76%. While last quarter’s tech earnings largely beat estimates, another reason for the strong rally is the enthusiasm behind artificial intelligence, or AI. As more firms invest in generative AI, analysts believe that firms that develop these technologies or manufacture cutting-edge graphics processors for AI are positioned to benefit greatly. 

We are currently underweight tech for several reasons. The sector’s recent price action appears to be highly speculative, therefore, valuation ratios seem lofty. Other considerations supporting our conservative posture are the current interest rate environment, the possibility of mean-reversion given recent momentum, and consumer confidence lingering well below its baseline level.
 

Options Pricing Model

The Volatility Index (VIX) continued its downward trend, ending the second quarter near pre-pandemic levels. Premiums are lower (see last quarter’s article, “What is Volatility and Why Should it Matter?”) but we are incorporating more upside through higher option strike prices to better manage risk. A dramatic run-up in price can be challenging for covered call strategies because an in-the-money option is at greater risk of being exercised, potentially leading to the underlying shares getting called away. An in-depth summary of this topic is featured in the Portfolio Insights section.
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What Happens to Covered Call Strategies in an Up Market and What Can We Do About It?

US equities are experiencing one of the longest bear market rallies in history. Nasdaq is up 38.7% for the year, while the S&P 500 and Dow are up 15.9% and 3.8%, respectively. Just a handful of technology firms are contributing much of those returns. Overall, 8 out of 11 S&P 500 sectors are positive for the year. 

When market action is strong, it’s critical that your portfolio manager is ready to respond if necessary. Our investment team uses proprietary tools and models which we believe deliver a competitive advantage in managing concentrated stock portfolios. The market exposure and stock selection models use current and historical data to help us gauge future performance. Accordingly, we select strike prices and expiration dates based on those models’ outputs, as well as risk assessment and upside potential. 

Active management is key. If risk levels exceed internal guideposts, the team may strategically roll options prior to expiration to mitigate risk. Options are more likely to go in-the-money (ITM) in an up market, and those that are deep ITM with less time to expiration have a higher likelihood of being exercised. In these situations, the team may preemptively take these steps:

  • Close existing options
  • Gain/loss neutrally sell shares if the client is interested in partially liquidating the position
  • Adjust contract durations based upon market conditions
  • Reset strike prices higher
  • Generate premiums from new covered calls

Conversely, if risk levels are within an acceptable range, we may hold off.

Even with daily monitoring of positions, options may still be exercised. Here is what happens following a covered call options exercise:

  • Shares are “called away” or “assigned”
  • Client receives proceeds equal to the number of shares called-away multiplied by the strike price
  • Client usually realizes a gain on the called-away shares
Occasionally, news of share assignment is an unwelcome surprise to clients. But there are steps we may take immediately afterwards to “undo” the assignment. We call it the No-Call-Away provision. Please read below to learn more.

Portfolio Insights: The No-Call-Away Provision for Concentrated Stock Positions

There is always some risk that covered call options are exercised with shares called away. Risk increases when a position is deep in-the-money and close to expiration. However, options can theoretically be exercised at any time, and sometimes irrationally, i.e., when it doesn’t make financial sense to do so.

Under certain circumstances, NorthCoast may have contingency measures available to protect our clients’ shares. Upon receiving notice of share assignment, and after confirming with the advisor or client, we may buy back shares at market open the next business day at the prevailing price. Next, the custodian delivers the newly purchased shares to the option holder. In this process, the client keeps their shares with the original cost basis, and they should not realize stock gains because of the exercise1. 

Here is an example using a concentrated stock position in Chevron (CVX). On January 26, 2022, we wrote June 2022 covered calls with a $150 strike price which allowed for 19% upside. The next month, Russia invaded Ukraine. Markets expected a downside shock to global oil supplies, and crude oil futures prices jumped in response. Oil company stock prices followed suit.

ChevronPrice2


What happened? After an initial spike, volatility started to retreat in March 2022 and CVX’s price leveled off. But one month before expiration, a holder of the June 2022 $150 calls exercised the options and the shares were assigned. The next day, we bought back the quantity of assigned shares, which were delivered to the option holder. The shares with the original cost basis remained in place. Finally, we wrote new November 2022 covered calls with a higher $220 strike price which allowed for 27% further upside and generated additional option premium.

Sources: NorthCoast Asset Management, Bloomberg
 

 

Note:
1 The Covered Call Strategy is not a tax avoidance strategy. Any tax impact from selling shares simply gets deferred. It is important to consult your own tax and accounting advisors for specific recommendations or comments regarding tax rates that apply to your situation as individual circumstances may vary.
 

Interested in how Concentrated Stock Triple Play may help your portfolio?

Contact your NorthCoast advisor or email us at info@northcoastam.com.