There are multitudes of value investing strategies advocated by industry legends such as core value long investor Benjamin Graham to situationally diverse Seth Klarman and long / short relative value mathematician Joel Greenblatt. But the “value” strategy advocated by Matthew Peterson, founder of Peterson Capital Management, could be most unique.
Peterson points to pride with the core strategy being adapted from an option put selling method used by Warren Buffett. What makes it unique is the timing on when to initiate the option selling strategy and the resulting long stock selection when the short options get in the money.
More material for investors is the returns history, with significant performance above market beta early in the strategy's history and then a negative change in performance. The hedge fund had three initial years of double-digit gross returns, highlighted in 2012 with 78%. The strategy, however, has experienced a drawdown since 2014, according to a recent investor letter reviewed by ValueWalk. Understanding the strategy and considering past performance, ValueWalk determined returns attribution during both positive and negative, assumptions later confirmed by the manager and raising the question: where did the strategy run into trouble?
Selling put options during a market crisis leads to long stock ownership
As a result of selling put options when the stock continued to fall in price, the option was converted into equity ownership at expiration. Peterson Capital found himself long companies such as HorseHead Holdings Corporation. As a result of this particular long exposure, Peterson Capital now finds itself engaged in an MF Global-like fight for assets in a bankruptcy court.
The HorseHead exposure highlights a long stock selection strategy that is, to a large degree, determined by randomized factors. The stocks Peterson holds in his portfolio are those where the short option position was converted into equity ownership. Peterson sells put options below the current market price and a stock must continue to trend lower for the option to be hit. Thus, struggling companies with real problems whose stock price continues to fall land in the portfolio alongside value plays.
This "buy on a drawdown" strategy might be similar in some respects to Warren Buffett's approach, but Peterson manages the high level concept differently in key respects. Further, examination of the fund's performance attribution leads to very different conclusions as to why and how initial success was generated.
Before entering a position Peterson Capital waits for significant market volatility in an individual stock and then invests by selling put option contracts amid a market “disruption,” known in less polite circles as a “crash.” The market doesn't always need to crash, per say, but a significant value disruption is required for the strategy to sell a put option. This wrinkle on the strategy makes it relatively unique among "value" investors. Further, while the "buy on a drawdown" core concept is in place that certain systematic players use, Peterson's approach has slight wrinkles that make a big difference.
The strategy doesn’t just sell put options without an option hedge
The strategy has similarities and yet differs from a typical mean reversion strategy employed by managed futures CTAs in meaningful respects. Several sub-component components and two key performance drivers with very different outcome correlations have primarily driven performance, but success going forward could be dependent on an odd court battle in which Peterson finds himself immersed. In an interview, the strategy founder outlined his key principles in what he calls a “deep value” investing approach, which sometimes takes multi-year or even decade long positions, a difference with many managed futures strategies.
Once the first strategy component, the short put option, has been “hit” and assigned long exposure to the equity, then the strategy begins to manage its individual name exposure. Using a stock valuation method, the strategy sells call options when valuations have been positively stretched beyond Peterson’s determination of fair value. This premium collection strategy, commonly known as buy-write, limits upside gains and provides income from the option premium collected when selling the put. As a stand-alone strategy it is generally recommended in non-trending market environments and is negatively exposed to the market environment of volatility.
Peterson explains the core concept:
There is a subtle advantage to the put write strategy pertaining to human psychology. Everyone knows to buy low and sell high however it is proven again and again that many do the opposite and consistently do the opposite. In a rational state of mind we determine our entry for a deep value opportunity. The cash secured puts we write are listed for sale at irrationally high prices on the CBOE. They will often sit for months as prices move around often they expire without a buyer. When they are purchased, we have received a very good price for a very cheap security. However, it often comes along with a bit of fear. The might be a flash crash or uncertainty that caused prices to drop. As we sell overpriced puts to purchase underpriced securities it doesn’t always feel psychologically comfortable however, it is buying low and over the long term it is the correct time to buy.
Peterson says the value determination method is based on financial statement analysis. Considerations include high cash flows, high returns on equity, trading below tangible book value, low enterprise value to EBITDA ratios. "We determine our target position through deep fundamental value analysis and use some technical market approaches to sell our puts," he said.
Investment status aside, Peterson provides a behind the scenes look at an aggressive method to integrate traditional value strategies with managed futures mean reversion concepts. For his part, how Peterson’s “value” strategy is executed points to analysis of performance trends and the fund’s involvement in legally sticky bankruptcy business. These are difficult outcomes to model and have a bankruptcy component that appears to be pulling down performance.
Peterson strategy started out primarily selling put options, but as the long exposure grew with time the strategy performance attributes began to change
In evaluating Peterson's strategy, the key is to identify core performance drivers and what is likely to drive future performance.
Peterson said his initial strategy of selling put options was working well. Consider 2012, for instance, the second calendar year of the fund’s operation when the fund generated +78.51% gross performance – delivering 58.58% net to investors. During that period the stock market, measured by the S&P 500 Total Return index, was up 16%.
Peterson said the purpose of the option selling strategy was to establish long exposure, but in the early years the portfolio did not have significant stock exposure. To an independent analyst this indicates that option premium collection was a key factor in the fund's early success. The fact these short option positions were not executed can be viewed as a large component of returns performance and places the stock selection methodology in the spotlight.
In both 2012 and the founding year of 2011, the strategy found significant “alpha” and trounced the stock market. But in 2013 the out-performance trend began to wane as the portfolio garnered long stock exposure. Even though net performance was positive by 26.39%, the net beta out-performance was only near five basis points to the S&P