Trade in Groups

Trade in Groups header image 1

Absolute Returns for Individual Investors: Covered Calls

January 28th, 2009 · Hot Stocks, Options 101

An area of opportunity for individual investors that we’ve only touched briefly on so far is traditional options. This article assumes you have a basic understanding of call options – if not, a few quick primers can get you up to speed – see here for a basic long call, and here for covered calls.

 

There can be different reasons to employ a covered call strategy, but a few general reasons for doing so:

 

-Implied volatility is high, translating to rich call premiums one wishes to capture. See more on how volatility translates to option values.

-A long-term bullish outlook, but a near-term belief the stock has little upside.

-Improve returns should the market trade lower.

 

One widely-followed stock that has earnings coming up is credit card processor Visa (V), which reports on February 4th. Visa is currently trading just above its IPO price at $44.15/share, and with earnings in one week the implied volatilities of the front month (February) calls are high. Below is a chart comparing Feb. IVs with March IVs.

 

 

One of Visa’s competitors, American Express (AXP), rallied almost 10% today following its earnings announcement. But Visa and American Express have very different business models, because AmEx retains its card members’ loans and Visa does not. This exposes AmEx to credit risk, whereas Visa is simply a payment processor that earns a fee from transactions.

 

The unique business model (similar only to MasterCard, ticker: MA) and strong competitive advantage makes Visa’s 20x trailing EPS multiple seem less overpriced than the rest of the credit-sensitive financial sector to which it is traditionally compared. Indeed, when most of the finance industry is going through a period of massive losses and liquidity concerns, analysts are debating how much money Visa will earn. Below is TradeKing’s Earnings Center analysis for Visa; showing current estimates and how Visa has traditionally beat expectations.

 

 

Visa’s huge competitive advantage is sustainable for the long-term, but with the market driven by short-term sentiments (especially around earnings time), Visa could go either way. Let’s say you own 100 shares of Visa and are confident in its long-term success, but want to reduce uncertainty going into earnings. You can sell one call option and collect the premium up front, and as an example we will use the $47.50 strike. This gives upside of 7.6% from the most recent close before the short call option begins to offset profits from the long stock position.

 

The $47.50 strike for the February Visa calls currently trades at a $1.35 bid/$1.45 ask. Taking the mid-point of that range implies a contract premium of $140, or 3.2% of a 100 share position in Visa stock. The graph below shows the payoff from initiating a covered call on Visa stock.

 

 

Two important points to note: first, the breakeven on the trade is lowered to $42.75 because of the option premium. This means that Visa stock could decline somewhat, and this strategy will still show a profit – whereas not selling the call and simply owning the stock would result in losses from any decline in share price. Second, the strategy begins to underperform simply owning Visa stock above $48.90, which is the strike price plus the option premium. Even though the chart shows flat profits above $47.50, the addition of the call premium to the comparison is crucial.

 

The premium to be collected from writing covered calls on long-term stock positions can add substantially to performance, especially in down markets or when volatility is high.

 

For more on covered calls, see the Options Industry Council explanation or the TradeKing Options Playbook.

Did you like this? Share it:

→ No CommentsTags:

How ETFs Can Minimize Risks You Didn’t Know Existed

January 24th, 2009 · Random

The financial world has seen many innovative products in the last several years – but unlike many of the structured finance acronyms we’ve come to know for their ability to destroy wealth, ETFs (exchange-traded funds) are of great service to investors. They allow rapid diversification into a defined type of stocks, commodities, or currencies, and their constant trading means they are valuable not only to long-term investors seeking diversification, but for traders to make short-term profits on themed bets.

One takeaway from the great selloff of 2008 is that bad news in a stock can quickly result in huge losses. In a bull market, stocks can often bounce back quickly – not so in a bear market, and that is why ETFs can be a better way to express industry or sector views than one stock from the group. More troublesome, hidden risks (or, more accurately, overlooked risks) can be lurking where least expected. An example of this lies in the consumer staples sector:

As one might guess, consumer staples have been the best relative performer of the S&P sectors over the last 52 weeks. ETFs tracking this group include iShares Global Staples (ticker: KXI) and SPDR Consumer Staples Select (ticker: XLP), both of which include names like Pepsi (ticker: PEP) and Procter Gamble (ticker: PG) among their top holdings. But sometimes, unexpected events arise that change a company’s fortunes – even in relatively stable businesses.

 

For the last week, the U.S. government has been warning against products made with peanut butter or peanut paste, such as peanut butter cookie mix, peanut dog treats, and peanut butter ice cream, etc. As of now, jars of peanut butter sold at the grocer’s have not been declared a salmonella risk. Still, it is widely agreed that consumers should exercise extreme caution when purchasing any peanut butter or peanut paste product.

The contamination has been traced to a Georgia plant owned by privately-held Peanut Corp of America (PCA going forward). Both ConAgra Foods (ticker: CAG), producer of Peter Pan brand peanut butter, and J.M. Smucker (ticker: SJM), producer of Jif brand peanut butter, have stated that their products are not at risk, because the companies did not purchase from PCA. However, this highlights the often unpredictable world that drives financial markets.

The largest consumer staples companies have the size that they can likely ride out a negative product event like the one that happened to PCA, but shareholders would likely see big losses if something similar happened to an individual stock they owned. As examples, contact maker Bausch & Lomb suffered a 50% drop in their stock price after one brand was linked to a rare eye infection; the company was later taken private at a discount to the pre-recall price. Some companies are not so lucky – in November 2007, Topps Meat Company (with more than 60 years of business) was forced into bankruptcy by a product recall. In tight credit markets like those at present, companies have less of a margin of error, and one large unexpected loss can be all it takes to sink a company otherwise thought of as solid.

 

This risk from unexpected events – “black swan risk,” as Nassim Taleb would refer to it – is a strong argument in favor of diversification, especially within sectors via ETFs. Although Taleb’s idea of the “black swan” is now widely cited, it is often misunderstood, and an explanation of it will soon be featured along with a continuation of the “Absolute Returns for Individual Investors” series.

Did you like this? Share it:

→ No CommentsTags:

Trading Financials: Managing Risk a Must

January 19th, 2009 · Hot Stocks, The Markets

One thing we have focused on heavily in the last month is presenting strategies used to create absolute returns – that is, manage risk and turn trading profits regardless of the general market’s direction. It’s a difficult market, and the days where simply owning a handful of hot tech or commodity stocks could result in good returns is gone. What are you going to do about it?

 

The solution I’ll offer is to show some humility. The market is volatile, and it’s easy to lose money quickly if you don’t manage risk. This is why stockpicking now is about relative value, unless you have a very long time frame and don’t mind seeing potentially large paper losses in the interim. At the heart of a relative value strategy is trading pairs long and short against each other. Trading long/short is about identifying the relatively overpriced and underpriced securities and taking the appropriate action, eventually taking profits when the pricing discrepancy narrows. Long/short is at the heart of many absolute return strategies, because it can help manage the risk of a sharp market move.

 

For over a month, we’ve been suspicious as to the sustainability of market rallies led by financials. But outright shorting (or buying puts on) financials is a risky strategy; the SPDR Financial Sector ETF (ticker: XLF) rallied over 40% in a very short time. That could have meant serious losses for getting in at the wrong time. One way to play financials while managing risk that was suggested here involves a long/short play on capital structure. Specifically, convertible arbitrage using Bank of America convertible stock was analyzed. Although we concluded that the specific security was not underpriced, turning this trade into a long/short play by owning the convertible and shorting the number of common shares one has a call option on (20) has proved a superior strategy to owning either outright.

 

 

Important to note above is that simply owning the convertible security would have outperformed simply owning the common essentially all the time. How do the numbers work?

 

The convertible stock (ticker: BAC-L) is down 23%, and the common (ticker: BAC) is down 48%. Keep in mind, all of this has occurred over about one month. Even if volatility indices (like the VIX) are down off their highs, there is still substantial volatility in the marketplace. So, using the numbers from Friday’s close:

 

Shorting 20 shares of BAC common stock = 13.90 * 20 = +278

Covering 20 shares of BAC common stock = 7.18 * 20 = -143.6

Profit/Loss on Short = 278 – 143.6 = +134.4

 

Buying 1 share BAC-L convertible preferred = -647

Selling 1 share BAC-L convertible preferred = +486

Profit/Loss on Long = -647 + 486 = -161

Net Profit/Loss = -26.6

Net P/L as % = -2.88%

 

S&P 500 % Change = -4.17%

 

Over the last month, this trade has lost a slight amount of money (ed. note: it would have been in the green using Friday’s open prices), although some small battle can be claimed as won by outperforming the S&P with less risk. Where to on this trade from here?

 

There is incremental value added to the convertible preferred because of the limitations placed on Bank of America’s dividend policy; per the government, common stockholders are entitled to no more than 1 cent per share per quarter in dividend payments. No such change was dictated to the convertible preferred, so there is now a large income spread between the two securities. Further, with government policy showing little regard for shareholders (as it should) and more senior securities trading at large discounts, the best way to gain exposure to financials will continue to involve managing risk through relative value bets. Remember that value can be added both through earning excess profits, as well as eliminating losses, and trade accordingly.

Did you like this? Share it:

→ 1 CommentTags:

Does Steve Jobs’ Departure Make Apple (AAPL) Too Risky To Own?

January 16th, 2009 · Hot Stocks

A recent email from Steve Jobs to Apple (ticker: AAPL) employees announcing his medical leave of absence has left some investors in a bit of a tizzy. While the email promises a summer return, some have been hesitant to immediately accept the pledge. The concern and even distrust over Jobs’s departure most likely stems from the company’s handling of his 2004 bout with pancreatic cancer. The public was alerted only after Jobs had the successful surgery to remove the tumor from his pancreas.

 

For everyone’s sake, a speedy recovery and return would be ideal. But what if Jobs doesn’t come back? The possibility of a very pre-mature retirement has no doubt crossed the minds of most investors. So far, Jobs has been reluctant to give up the reins to Apple and will still remain in charge during his recovery period; Tim Cook will just oversee the day-to-day operations.

 

But Apple can, and will, survive without Steve Jobs. That isn’t to discount any of the incredible things that he has done for the company, and any transition will be naturally bumpy. But now that Apple’s innovative products have given it such a strong position in its markets, it will only be a matter of time before people once again recognize this company’s potential. Consider its recent history of topping expectations for earnings growth, as well as the relative strength with which profitability is expected to hold up in 2009.

 

 

As a rule, a product will go through a general life cycle; it is up to the creative minds at the company to rejuvenate the environment. Traditionally, Apple has had a pre-emptive response for so many problems that consumers may not have even known that they had. Music moving from a clumsy collection of CDs to purely digital? Fine, introduce the iPod, build one of the strongest product brands around, and revolutionize the mp3 player. Laptops are too heavy? That’s ok, develop the MacBook Air and bill it as the thinnest notebook computer ever.

 

Apple has developed such a strong and consistent brand for itself- young, hip, cutting-edge, that any new CEO would be foolish to deviate from Jobs’s current model. And any replacement would be well-aware of that. For right now at least, in spite of a dire economy, Apple has the opportunity to pause for a moment with the success of its iPhone. However, there is a good chance that, even post-Jobs, there will be no pausing at Apple. Apple is the innovator, and everyone else is a “suit,” just a sheep in a large flock. Steve Jobs has placed an enormous emphasis on creative advertising in marketing the technology. He has created brand positioning for the company that is unmatched throughout the industry. While many things have changed at Apple since the “1984” computer ads that aired during the Super Bowl that year, the link to the recent advertising campaign pitting a young, laid-back, creative-type with long hair against a stuffy, balding, four-eyed “suit” is still quite clear. Apple is always looking towards the next thing, always fighting against the bane of conformity. If Steve Jobs were to leave Apple, whether tomorrow or in twenty years (eventually, the day will come), investors needn’t seriously worry. The CEO left such a deep handprint on the brand that his values are intrinsically woven throughout the company. A successor would be Jobs’s closest ally, and would be smart enough to carry on his legacy.

 

Now, there is a bear argument to be made that between the uncertainty from Jobs’ health, stagnant growth from core products like the iPod, and competitive pricing pressures exacerbated by falling consumer spending, Apple is set up for a dramatic fall. But despite a generally rough market this week and the news about Jobs, AAPL stock has more or less recovered from the initial reaction sell-off and is only down slightly overall. While the shorts may or may not be correct, one thing is certain: Apple will have difficulty replicating its returns to investors in the last five years, with or without Steve Jobs.

 

Did you like this? Share it:

→ 1 CommentTags:

Absolute Returns for Individual Investors: Commodities, Part II

January 15th, 2009 · Hot Stocks, The Markets

In the previous article introducing commodities, one strategy that was mentioned was relative value trading using long positions paired with short positions. A benefit of this strategy is that having both long and short positions can help offset broader market moves; for a more detailed explanation see “Absolute Returns for Individual Investors: Long/Short”.

 

When the topic of investing in commodities comes up, there are two natural approaches that tend to arise – either owning the physical commodity, such as gold or oil, or owning stocks of companies that produce commodities, like Barrick Gold (ticker: ABX) or Goldcorp (GG), or Exxon Mobil (XOM) or Chevron (CVX). While the long/short strategy can be applied to play commodities against each other, as with gold and silver or oil and natural gas, a more direct way is to value the stock of the company on a relative basis compared to the price of the commodity they produce.

 

The first chart here compares the price of the Amex Goldbugs (an index of gold producers) relative to the price of gold. After holding fairly steady for over two years, the relationship – like many others – fell apart in the second half of 2008.

 

 

An easier way to visualize this might be to break down the above chart into its component parts. HUI represents the value of the gold producers index, and GLD is a gold-tracking ETF. The price of gold is essentially flat in the last year, while gold stocks are down 40%.

 

 

 

This should raise questions about whether gold stocks are undervalued relative to the present price of the good they produce, especially because plummeting energy prices will translate to lower costs and higher profits. In a simple long-only portfolio, buying gold stocks might be risky because of the uncertain future price of the metal, but putting on a trade being long gold stocks and short the price of gold (via the GLD ETF) could be a better way to hedge out uncertainty and manage risks. The theory behind this trade is simply a classic hedge play: if the price of gold goes down, gold stocks might fall, but being short the price of gold will ideally offset (and then some) any losses on the long position. If gold prices soar, the gold producers will generate enormous profits and their stock prices will soar – ideally, in excess of the losses on a position being short the price of gold.

 

One thing to be aware of is that oftentimes large commodity companies, while known for one particular product, actually have multiple lines of business. ConocoPhillips (ticker: COP) is known as an oil company, but they also have large natural gas holdings, so trying to use that for a long/short trade might result in an imperfect hedge. Likewise, a company such as Freeport McMoRan (ticker: FCX) is primarily a copper producer, but they also have revenue from gold mining as well as molybdenum production. Not everything can be hedged.

 

Here is a chart of FCX relative to the price of copper; note the potential double bottom that was recently put in.

 

 

A final thought for now: ETFs are a great tool for investors, but make sure your ETF is accurately tracking the index it is supposed to follow. For example, the copper ETF (ticker: JJC) is shown below, relative to the price of copper futures. Although there has been volatility of late, this ETF has followed its benchmark closely.

 

 

This is part of a series. Prior parts:

Long/Short

Capital Structure

Convertible Securities

Volatility, Part I

Volatility, Part II

Commodities, Part I

Did you like this? Share it:

→ 1 CommentTags:

Absolute Returns for Individual Investors: Commodities, Part I

January 14th, 2009 · The Markets

As the established order of the financial system underwent upheaval in 2008, the Federal Reserve responded by greatly expanding its balance sheet, ostensibly to provide liquidity to a number of strained markets. This means that, after holding Federal Reserve credit outstanding just under $900 billion for most of 2008, the Fed’s expansionary policies mean it now has over $2.1 trillion dollars outstanding.

 

 

“Deleveraging” and “deflation” have recently been buzzwords, but the Fed’s policies beg the question: will printing so much new money lead to surging inflation down the road? In an environment with falling commodity prices and rising unemployment, inflation seems to be one of the last economic threats that come to mind. Yet a quote often attributed to Lenin is that the surest way to undermine the capitalist system is to debauch the currency – a road the U.S. Federal Reserve seems to be walking down, hand in hand with other central bankers.

 

The threat of a falling dollar and/or high inflation often drives people to invest in gold or silver, both of which have devoted (and vocal) buyers. But gold in particular has been a disappointing inflation hedge over time, and I believe it to be more effective for a different purpose – we will discuss this later

 

Commodities, though, are a much broader asset class than just gold and silver – there are industrial metals like copper, energy sources such as oil and natural gas, and agricultural products (corn, soybeans, etc.). Owning a wide basket of these “real assets” can provide protection from inflation, and widening the net can include alternate assets like real estate and timber. Still, traditional stocks (particularly consumer staples) have historically offered the best protection from inflation over the long-term. Where does this leave commodities?

 

There are three applications of commodities to be discussed here:

1. Relative value trading through long/short (active)

2. Generating income from commodities (active)

3. Changing the correlation of a portfolio (passive)

 

Before we begin evaluating those, it’s important that individual investors understand how they can gain exposure to commodities. It used to be necessary to have the financial backing to trade futures, but now there are commodity ETFs that make transacting in commodities as simple and easy as buying and selling stocks. As an example of how many ETFs (and ETNs) there are in the commodity universe, one can buy a specific commodity like platinum via the UBS Long Platinum ETN (ticker: PTM), or a basket of precious metals via the Precious Metals ETN (ticker: PMY). For even quicker diversification, one could purchase the Rogers International Commodity ETN (ticker: RJI), which offers weighted exposure to 36 different commodities.

 

Point being, there are plenty of ways to implement the strategies we will discuss. Many online brokers also have ETF centers that can be used for further research into owning commodities and more.

Did you like this? Share it:

→ No CommentsTags:

Absolute Returns for Individual Investors: Volatility, Part II

January 8th, 2009 · It's all Greek to me, Options 101

Last time, we examined how options on index volatility (such as the VIX) could possibly function as an attractive asset class because of its unique nature and diversification benefits. This is supported by a 2007 Goldman Sachs research note, although their particular strategy relied on institutional tools like variance swaps and volatility forwards – individual investors must make do with volatility options.

 

For starters, consider the relationship between the S&P 500 and the VIX volatility index over the last three months: they have moved inversely at almost every point.

 

 

 

The two options on the VIX that will be used in this example are the at-the-money (42.5) Januarys – options tickers VIX AV for the call, and VIX MV for the put. Below are the Greeks for both of those from TradeKing’s options calculator.

 

 

Of particular interest is the volatility for these options – the volatility of volatility, if you will. Exceeding 100% for an expiration date only two weeks in the future, it’s obviously high. While I do not use traditional measures of risk (i.e. standard deviation as a proxy), especially for a highly skewed/fat-tail measurement like volatility, the two tables below show such estimates as a basis for comparison.

 

The first is for the VIX, which has a +/- 3 sigma range of 22.5 to 80.

 

 

The next is from a randomly selected Dow Jones Industrials component – United Technologies (ticker: UTX). The +/- 3 sigma range is 45 to 64.

 

 

 

So the volatility of volatility is high, and volatility itself is elevated relative to historical levels. Because the VIX has been jittery, there have been plenty of chances to make money being net long or short, or to hedge existing positions.

 

Volatility has been declining lately, and if one believed that would continue to occur, purchasing a put option would be one way to express that view. With the volatility of the VIX so high, however, it might be less expensive to create a credit by selling a call of the same strike against the long put, to create a synthetic short. The payoff diagram from such a strategy is below; note how it is exactly equal to the payoff from a simple short stock position.

 

 

 

A caveat: being short volatility can be risky (i.e., it was partially behind the downfall of famed “hedge” fund Long-Term Capital Management). Carefully consider the risks of any strategy before engaging in it.

 

One lesson of 2008 is that volatility is not bounded as originally believed; while a level of 35 to 40 was once considered to be very high, the VIX touched above 80 twice over a one month period – and there is nothing to prevent it from reaching higher levels.

 

In that vain, being long volatility in this environment could serve as a decent hedge against any future sharp declines. Again, while one cannot buy the VIX directly, a synthetic long position can be established by purchasing a call and selling a put at the same strike (the opposite of the strategy outlined above).

 

The final possibility to discuss here is that the VIX stays relatively constant, hovering in the 40s. This would make the best play a butterfly or condor, both of which are options strategies used to express a neutral outlook. The payoff diagram for a 40/45/50 butterfly is depicted below.

 

 

 

For more on options strategies, see this options intro  or this advanced options tutorial.

For more on volatility, the CBOE has an FAQ and a comprehensive white paper. Another source of information is Bill Luby’s excellent VIX and More blog.

 

This is part of a series. Prior parts:

Long/Short

Capital Structure

Convertible Securities

Volatility, Part I

Did you like this? Share it:

→ No CommentsTags:

Absolute Returns for Individual Investors: Volatility, Part I

January 7th, 2009 · It's all Greek to me, Options 101

In late 2007, Goldman Sachs released a research note entitled “Volatility as an Asset Class,” where they argued that the diversified returns from strategies involving equity index volatility made it worthy of an allocation from investors. While I disagreed with their particular approach because of risk management concerns, the underlying point – that strategies involving volatility can generate returns independent of favorable equity markets – is well-presented and should be considered.

 

What is Volatility?

Because all the inputs into options pricing formulas are observable (e.g. strike price, current price, time to expiration, interest rates) except for volatility, it is essentially the “plug” in the formula that brings the option’s market price in line with its theoretical price. The exact definition of volatility is up to debate – some people believe it is expected standard deviation, others believe it is a fictional number showing how expensive or cheap an option is. For argument’s sake, let’s assume that volatility is simply related to demand for options on an index like the S&P 500. Options are most valuable when prices are expected to diverge widely, which is why higher variability of stock market returns coincides with more expensive options (for more, see “Why Options are More Valuable Now Than Ever Before”)

 

However you define volatility, you will keep coming back to the relationship between higher volatility, larger expected stock market moves, and higher options prices. What’s important is that trading volatility lets one bet on options prices without having the same “delta risk” of a regular put or call option on a stock or index. For a typical at-the-money option, delta – the change in an option’s price compared to a change in the stock or index – will represent the majority of the option’s change in price. But dealing directly with volatility (like the VIX) changes things.

 

Trading Volatility

Currently, a volatility index such as the VIX cannot be purchased directly in the same way a stock can. Instead, there are options on the VIX which individual investors can use to get exposure to volatility. Any number of options strategies can be replicated using volatility, including a synthetic long position by being long a call and short a put (or a synthetic short by being short a call and long a put).

 

As eluded to in the discussion of delta above, volatility options require a slightly different framework. The underlying reference is volatility itself – so the delta of a volatility option position equates to changes in volatility. The “volatility” for VIX options is now the volatility of… volatility. It might seem complicated, but is actually more common sense than it might come across.

 

Asset Class Upside

If you believe the Goldman argument that volatility is its own asset class – and I do, given the number and type of products linked to it – the logical follow-up is to see what value that asset class can offer.

 

The long-dated chart below shows the relationship between the S&P 500 and the VIX volatility index. Although not perfect, there is an inverse relationship that could make volatility useful as a portfolio hedge or for speculation. Examples of each will be explored more fully in the next part of this series.

 

This is part of a series. Prior parts:

Long/Short

Capital Structure

Convertible Securities

Did you like this? Share it:

→ 1 CommentTags:

Absolute Returns for Individual Investors: Convertibles

December 22nd, 2008 · Hot Stocks, The Markets

Last time, we discussed how investors willing to analyze opportunities up and down a company’s capital structure open up numerous possibilities to generate absolute returns – in particular, through looking for undervalued embedded options in convertible securities. Reading the last article will be helpful to understanding this one, but an abridged summary is that convertible securities offer superior coupon/dividend payment security, while offering upside through a call option allowing the holder to convert their security into a specified number of shares of common stock.

 

As an example, consider the Bank of America 7.25% Non-Cumulative Convertible Preferred Stock, ticker BAC-L (your online broker or financial website may have its own way of entering preferred stock tickers – such as BAC.L on TradeKing, or BAC-PL on Yahoo Finance). Breaking that down, each share has a par value of $1,000 and pays annual distributions totaling $72.50/share in equal quarterly installments; the caveat is that because this is a non-cumulative security, if Bank of America misses a dividend payment, preferred stock holders see no income for that period and cannot recover the amount at a later date. Companies – especially ones with the stature of Bank of America – do not take the decision to skip a dividend payment lightly, and for that to happen to the preferred stock would mean that common stockholders would see no dividends either. Nonetheless, in these extraordinary financial times anything should be considered in the realm of possibility.

 

Below is a chart of the year-to-date performance of the convertible preferred, relative to Bank of America common stock:

 

As for conversion rights, the holder is allowed to convert their holding into 20 shares of Bank of America common stock (ticker: BAC) at any time. Since BAC recently closed at $14.60, the current conversion value equals

(20 * $14.60 = $292)

which will fluctuate along with the value of the common stock. Now, the convertible preferred stock trades around $641, so how do we determine if this is a good value?

 

Like most financial valuations, this requires some working assumptions. Let’s start by thinking of this as a call option. The difference between the current price of the convertible and the current conversion value is

($641 – $292 = $349)

which is similar to a call premium, because the intrinsic value of this option is $292, and the price in excess of that represents the remaining time value of the option. That works out to almost $17.50/call for the option premium, and that might strike you as pricey without even knowing the theory behind valuing a perpetual call option. You’d be correct, as the two options pricing models used offered values between $3.00 and $3.60 per call.

But there is one important difference between a traditional call option and one embedded in convertible preferred stock: the former offers no cash flow in the meanwhile, whereas the latter does – in this case, an 11.3% yield. What is the value of the preferred stock itself?

 

Since the quarterly distributions are set, the challenge here is ascertaining an approximate discount rate to capture the risk of financials. The yields on Bank of America trust preferreds (a type of subordinated debt mainly used by financial companies) run around 9.5%, and using the capital asset pricing model for BAC common stock suggests 14.5% is a very rough cost of equity estimate. Thinking back to the earlier lesson on capital structure, preferred stock is between subordinated debt and common stock, so the discount rate for that can be assumed to be somewhere in between those two figures – just over 12% is what we’ll use. That 12% discount rate yields a value for the preferred of $630.

 

Now, we need to sum everything up – the $630 value of the preferred, along with an option value in the range of $60 to $70, suggests the total package is worth just under $700. Just before publication, the last quote on BAC-L was $647, so this could be slightly undervalued – but many assumptions were made, and fine-tuning inputs could easily wipe out the difference between current price and initial value estimate. Although this specific convertible might not be the best value, looking through the universe will give investors a chance to find high yields and underpriced call options – in many cases, the perfect combination to create absolute returns, regardless of what the market does.

Did you like this? Share it:

→ No CommentsTags:

Absolute Returns for Individual Investors: Capital Structure

December 19th, 2008 · The Markets

As was discussed last time, all too often investors handicap themselves by defaulting to the long-only equity investment strategy. While equity ownership is the best path to wealth in peaceful and stable capitalist societies, having a portfolio solely comprised of long stock positions is in reality minimal diversification; in cases where the broad markets suffer a broad and deep decline, odds are your portfolio will lose value as well. It might be some comfort that superior stock picking can provide for relative outperformance, (i.e., losing less than the average), you probably aren’t a mutual fund manager and thus can’t eat relative performance. By using risk management strategies to target absolute returns – that is, consistent positive gains – investors have a chance of making money regardless of what the major indices are doing.

 

Most of the financial media’s attention is focused on the equity markets, when the equity holders of a company are the last in line for payments in the capital structure. A quick overview: the capital structure of a company is simply how it is financed – through debt, equity (stock), or some hybrid of those. There are also many variations because debt and equity can have modifiers as to their payment rights – subordinated debt is paid after senior debt, for example, or preferred stock is paid before common stock. Here’s a simple outline of a hypothetical capital structure in order of right to payment, with the amounts of each at book value:

 

7% Senior Debt, $300 million

8.5% Subordinated Debt, $75 million

5% Cumulative Preferred Stock, $100 million

Common Stock, 2% Dividend, $400 million

 

A simple takeaway from this is that, in liquidation, the company would need to have assets valued at

($300mm + $75mm + $100mm = $475mm, not counting possible interest owed)

before the common stock holders would see anything. Another is that the company needs to generate

($300mm * 7% + $75mm * 8.5% + $100mm * 5% = $32.4 million)

in cash annually to pay obligations senior to the dividend on the common stock, only amounts above that may be distributed to regular stock holders. And because of the cumulative provision on the preferred stock, if the company misses a payment to its preferred holders, the amounts accumulate over time and must be repaid in full before the common stock holders can receive a dividend.

 

The most direct way to apply this to investing strategy is to buy the debt or preferred stock of a company. My largest personal position is in high yielding senior debt, and that has held up quite well in the last six months – but this does not mean buying up debt or preferred stock is the always the best choice. There were plenty of holders of preferred stock in Fannie Mae and Freddie Mac, and debt holders of Lehman, who now have investments worth pennies on the dollar.  

But to go a little bit deeper into using capital structure, one popular investment strategy used by many top hedge fund managers is searching for cheap options, often ones hidden (embedded) in a security. We’ve discussed why options are so valuable now – so how and where might they be available for less? Some companies issue convertible preferred stock or bonds, which have a fixed coupon payable before the common stock holders receive any dividend, in addition to having an embedded option that allows the holder of the convertible security to turn their stake into a certain number of shares of common stock.

 

Of course, it’s worth mentioning that convertible arbitrage – the practice of buying a convertible and short selling the underlying common stock – is classified as a “market-neutral” strategy, but it has actually been the worst performing hedge fund strategy of late. It should be emphasized that not every strategy should be used by every investor – you must be able to understand and manage the risks of your investments. Still, with the distress in the convertibles market so high, it that means there could be opportunities to lock in high yields while acquiring undervalued call options on good companies. Next, we’ll give a sample analysis of a convertible security.

Did you like this? Share it:

→ No CommentsTags: