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Monday, April 30, 2012

A Value Guy Goes Macro

 Every once in a while I like to take a peek out of the office and see what is going on in the world around me. My decisions are made on a company company, security by security basis and I try to ignore what I consider the white noise of short term market movements. I keep the financial networks on in my office but for the most part I find them more humorous than useful. Making investment decisions based on market gyrations or news flow has always ended badly for me so I eschew that type of behavior most of the time. I am trying to buy decent businesses at very cheap prices and own them for the long term.  Short term events do not factor into my decisions unless they provide better price points and even that is determined by individual company value and stock price evaluations.

 Once or twice a year I do find it helpful to stop for a minute and consider the bigger picture. I am not looking for trends or trying to make predictions as much as I am looking for potential cheap assets and sectors I may have overlooked. I push aside the stack of 10Qs and 10Ks, temporarily return my copies of Security Analysis and the Baseball Prospectus to the bookshelf (or according to my wife the top of the stack on the floor) and focus on charts of the world. I start with global stock markets, currencies and even commodities. I will look at the sector and industry charts from various markets. I even break out the commodity charts to see what physical and financial assets are trading at multiple year lows and may lead to safe and cheap investing opportunities.

I started that process this morning by looking at global stock market performance over the past year. We have seen a global coordinated stimulus program inflate many asset prices and keep some markets from collapsing in the aftermath of the credit crisis. It has worked for the US as markets are up 10% year to date and stock prices have doubled in the past three years. A quick look at global stock prices shows that most indexes are up year to date with Spain and Italy being the most notable exceptions.

However the year to date figures masks a much greater long term weakness in stock prices. When I look at the past 52 weeks most stock markets are still solidly in the red. Over the past three years very few markets have had a price recovery anything close to what we have experienced here in the United States. Many markets including the market many consider key to full recovery, China, are still trading relatively near the 2009 lows. Japan has improved over the past three years but not by anywhere near as much as the United States. Only India has had returns approaching those of the US domestic stock market. I have no interest at all in anything China but the relative weakness of Japan may be worth investigating for potential safe and cheap stock opportunities. I am already long some major Japanese banks (MTU and MFG) and am not opposed to buying more stocks in the Land of the Rising Sun.

It will come as no surprise that Europe is where the real stock pain is located. Most of the major European markets are down over the past 52 weeks. Spain and Italy are two of the major concerns on the continent these days and their markets reflect that fact. Both are down year to date, the past 52 weeks and are showing negative returns over the past three years. Although Spanish and Italian bond yields are rising I do not think we have reached the point of maximum pessimism in those two trouble nations yet. It is worth the time to check out some of the major companies in those nations for stocks like Telefonica SA (TEF) or Telecom Italia (TI) that may become bargains as maximum pessimism moves closer to reality. I am also tracking the major Spanish Banks such as Banco Santander (STD) but they have a ways to fall before reaching that 40% of book value I consider a good entry for distressed banks.

The next part of my search for cheap is flipping through commodity price charts to see which of these markets has collapsed and declined over the past year. When I was a younger man I was fascinated by the idea of trading commodity futures but the markets quickly proved to me that a value bias in futures is not really healthy unless you approached it with a much larger bankroll than I had at the time. In spite of that paying attention to commodity prices makes sense for a fundamental investor. They are the raw ingredient for the products made by many companies and are a huge input into margins and profits. Cheaper steel could mean more profitable cars for Ford (F) and cheaper coffee prices could boost Starbucks (SBUX). I do not trade commodities anymore but I do check the prices from time to time to see if anything unusual or potentially profitable is occurring.

One commodity that leaps off the chart book for me is cotton. Cotton prices on the New York Exchange have plummeted by more than 40% over the past year. Slowing demand, the end of China’s purchasing program and an export ban in India have helped the fluffy stuff declined over the past several months. Demand is expected by many analysts to remain weak and that could keep prices fairly low thought the summer. This could be a boost to the margins of apparel manufacturers like Oxford Industries (OXM) or PVH industries (PVH) for whom cotton ins an important raw material.

Coffee and Cocoa have both declined over the past 52 weeks and that is welcome news around Chez Melvin. I drink coffee like water all day and the wife and daughters are overly fond of cocoas end products as well. These declines are not only helpful to consumers but a company like Starbucks (SBUX) that uses a fair amount of both could benefit as well. Most coffee firms lock in prices well ahead of time so the boost in profits for these companies may not come until the end of 2012 or early 2013. Even if delayed a more than 30% decline in a raw material that is around one sixth of your cost of goods has to help the profit margins eventually. I am not a fan of the coffee stocks like Starbucks as Dunkin Donuts (DNKN) but momentum investors may want to be aware of the potential for positive earnings surprises the next few quarters.

Lower wheat and corn prices could be great news for consumers as well Wheat is down more than 20% over the past year and it looks like there will be a surplus that could put additional pressure on prices. Corn is down a little less than 20% but any decline in these key grain market form shoppers feeling the pinch of food inflation over the past year. The declines in many food commodities could also provide a small boost to margins for some of the beleaguered grocery chains such as SuperValue (SVU).

One of the more interesting commodity developments is in the energy sector. Natural gas has been talked almost to the point of exhaustion. We all know that slowing demand and an enormous amount of new supply has driven the price of NG to decade lows. At the same time increasing regulations and slow demand has pushed the price of domestic thermal coal to low prices as well. Coal is not quite back to the lows of 2002 but it is not far from those levels either. Digging a little deeper I see the uranium Oxide is selling neat five year lows as well.  These are the three major fuel sources for electricity generation in the United States and the prices have been falling for some time. One would think that this would be a boon for electric utility companies.

When I look at the profits for the regulated utility companies in the United Sates I see this is far from the case. Most are struggling to get back to the profit levels of several years ago and the return on equity and capital for much of the industry is still well below pre-recession levels.

When I look at electric utility stocks none of them are cheap in spite of the obstacles and weak profit environment. Yield chasing has pushed them well above tangible book value.  I have never lost money buying a regulated utility below tangible book value and I have never seen much money made purchasing these stocks above that level either. If the costs of fuels such as natural gas, coal and uranium begin to rebound over the next year or so profits for these companies could plunge even further. Reviewing commodity charts makes at least one thing very clear to me. Electric utility stocks as a group are a sell and avoid.

I am not a macro, chart or commodity guy as you well know by now. However spending a little time with charts of various assets and markets around the globe can provide valuable information even for a value guy like me.

As the final step in my annual to semiannual macro review I like to look at sectors and industries in the stock market to see what is way up and what has lagged the market by a large amount. Often I find that some sectors that do not show up in my traditional stock screening methods have performed in a manner that gives valuable economic information and may also provide investable opportunities. When you tend to have your head down in individual company reports you can miss some trends and data that can improve your understanding of the big picture as well as factors that may affect stocks I already own.

Searching don the list of top performing sectors I see some predictable groups like Luxury Goods. Those that have money can spend money. During the early days of the recession this sector dropped off a little as the wealthy curtailed spending for the sake of appearances but they are back with a vengeance. Companies like Coach (COA) and Tiffanys’s (TIF) are doing very well as those who have it, spend it. Barring a deep double dip recession that is not going to change. The stocks are too rich for me to buy but I do not suggest shorting them either and momentum types might want to have these stocks on their radar screen.

One group that is initially a huge surprise is Recreational vehicles. The group has performed extremely well and with high gas prices and a cautious consumer that does not appear to make much sense. When I dig a little deeper I see that it is companies like Artic Cat (ACAT), Polaris (SNO) and Harley Davidson that have done well. Traditional RV companies like Winnebago (WGO) are still struggling and their stock price is languishing. Motorcycles, snow mobiles and Jet Skis all fall under my addictive lifestyle banner and are seeing some pent-up demand emerge as the economy becomes less horrible. These companies may face tough comparisons next year as demand flattens and gas prices remain high.

One group on the non-performers list that is interesting is long term care facilities and providers.  Intellectually this would seem to be a group that would be booming. Demographics are strongly in their favor as the population ages and long term heath care becomes more of a concern. However rate reductions from Medicare and aggressive claim processing to avoid what Medicare officials deem over treatment are hurting most of these firms. Should the Supreme Court throw out Healthcare reform most analysts feel that this would be another negative for the industry. Many of the companies in this industry use a lot of leverage and that’s where my interest lies. I am far more interested in the debt and potential recovery rates of long term care companies than I am in the equity. It is worth investigating potential high yield and distressed opportunities in this group.

Looking at the rest of the nonperforming groups there are not any real surprises. Coal and natural gas related companies are on the list as those two commodities prices have declined. These are two sectors I am watching closely. Most of the stocks are not cheap enough on a price to book value basis yet but I am confident they will get there. So far my two major longs in natural gas are Penn Virginia (PVA) and EXCO (XCO) but I expect to add to that list over the rest of the year. So far I have not bought any coal stocks but I expect that to change by the end of the year as well.

I also note that in spite of the news and trading action in larger regional and money center banks that community bank stocks have not rallied much yet. The Aba Community Bank Index is still down almost 7% on the year and over the past five years has fallen by almost 50%. The Trade of the Decade is still very much viable and I am still selectively buying stocks across the group.

As I conclude my peek at the macro picture I find that it is very much in line with the micro view uncovered by single stock screening and investigation.  When I stick my head up each year and take a macro look I scribble down and my findings and create a mythical macro fund and track it over time. Last year my imaginary macro fund was long the dollar and Japanese banks and that worked out pretty well.. This year it would be long Japanese and British banks, long coal, uranium and natural gas, short electric utilities and recreational vehicles and long high yield debt in long term care facilities. I would also be long community banks and cotton. It will be fun to track how these work out over the  next year but more importantly I have gained some insights and information that will help me select potential safe and cheap stocks that can return in multiples not percentages.

Originally published as a series on Real Money

Tuesday, April 24, 2012

Options for Value Investors

 In the past I have often mentioned Ben Grahams  maxim that investing works best when it is most businesslike. I view my investing activities as a collection of businesses. My purposes with my portfolio is to attempt to identify a collection of businesses  whose assets sell for less than they are worth and are capable of remaining a going concern. To institute a margin of safety I prefer those companies where the liquidation value under reasonable circumstances will yield as much or more than I paid for the securities. I also want this portfolio to generate cash flows wherever possible in the form of dividends or other cash payments. I want time and price to be on my side to the greatest extent possible at all times.

I use every tool available to me to accomplish my goals. I have no restrictions on the capital structure of the business and will buy common stock, preferred equity and even bonds of a company if the margin of safety exists and they trade for substantially less than my calculation of value. In the last decade I have learned to add options to my tool box to improve my chances of long term investment success. I think that a solid grounding of option knowledge helps me as a value investor and gives me an advantage when dealing in securities with a long term perspective.

In recent weeks I have seen several articles dealing with options trades on undervalued securities. These authors suggesting buying out of the money call options hoping the stock would appreciate and lead to large gains. The theory is that of you buy these options and the company has a strong earnings release or catches a takeover bid you could gain profits of 100% or more. While that’s true it is also true that if the roulette wheel comes up red and you have bet appropriately you can double your money. If you did not you lose your entire bet. That is not how I want to run my business.

None of the articles I ran across in my reading addressed the issues of time or option pricing. They gave no consideration to options prices or the probability of a 20% or more price move in the underlying stock in such a short time frame. The suggested options suggested for purchase all had well less than a year to expiration and in my mind that is not an investment it is just a speculation and a poor one to boot. I love to gamble but prefer race tracks where at least I can have a cocktail or two with friends while I make mathematically unsound wagers. When it comes to the markets I want to stay as business like as possible and run my portfolio like a company.

As a value investor there will be times when buying options makes a measure of sense. The vast majority of the time however it makes far more sense to be a seller of options. Many others have embraced the concept of selling options by implementing a covered call strategy. I confess that I use this approach once in a great while as a hedge but in general I am not a fan. It is not a truly efficient hedge and can lead to premature selling of issues I prefer to hold. If an issue is overvalued I prefer to just sell it rather than sell a call and hope it rises enough to be called.

The real value of options to me as a long term oriented value investor is as a seller of out of the money put options. Selling puts obligates me to buy the underlying shares at a specific price at expiration. If the stock does not fall to my stroke price or below before expiration I get to keep the premiums I collected for the sale. If the stock does fall I have to buy the stock at the strike price but I still get to keep the premium collected. Obviously the way to make this work in an optimum fashion is to make sure I want to own the underlying stock at the current price and even more willing to buy shares lower. I have to have done the research and work on the particular company and feel the stock offers a margin of safety and is sufficiently undervalued to offer a profit opportunity. Many value stocks take a long time to turn around and selling options in this manner can give me a stream of cash flow on an otherwise dormant stock. If I get put the shares I own a stock I like at a lower price than I would have obtained with an outright stock purchase.
Where a lot of people make a mistake with selling options is not going further than the stock analysis. I also want to evaluate the options and sell them for a fair price. Before selling an option take the time to run the trade through an option calculator like the free one at CBOE.Com. You are trading against an army of PHD’s with supercomputers. Don’t be today’s lunch money by selling your options at less than their fair value.

I also want market conditions to be favorable for my trades. I like to sell options when volatility is rising and options premiums are swelling. When I look at the underlying security I want the Implied and Historical Volatility to be well above the average levels of the past few months.  I do not have to trade so I do not until the conditions are favorable.

If you start with underlying stocks that are safe and cheap and use common sense about options pricing they can be a successful part of your endeavors in the markets. 

I have talked extensively with some of my more options oriented friends last night on the subject of using options as part of the value investor’s toolbox and the Orioles recent mastery of their hometown White Sox. My friends made some key points that are worth reviewing before anyone runs out to start selling puts on stocks in which they may have an interest. I think that using options can give me a huge advantage over investors who do not provided I stay true to the principles of deep value and time. The vast majority of the time I use options to create a long position in an undervalued stock at more favorable prices. Should the stock not fall to the price where I am forced to buy shares I keep premiums and add to my cash hoard.  First and foremost you need to keep in mind that options are complex instruments with complex pricing elements and trade much differently than shares of stock. You need to do some basic research and understand the options markets before you start trading. You need to understand that using an options calculator to price options does not give us an edge in the marketplace. There are far more accurate models for option valuations built by folks who design working rocket ships as a hobby. Using the basic pricing theory keeps us form giving away too much of an edge to those rocket scientists and supercomputer we are trading against. Out edge comes from stock selection and valuation.

Never make the mistake of just reaching for fat premiums. Selling puts is very seductive. When prices are rising it seem like easy money. I did a study once that showed that selling options on the market indexes at prices 5% below last months close on a month to month basis was profitable about 85% of all months. That sounds like the closest thing to a free lunch. It would be except the losses in the few losing months exceeded the gains of the profitable ones by a substantial margin. The trap for options sellers is collecting a few premiums on the right stocks and getting enticed by the fat premiums on high flyers like Apple (AAPL) or Chipotle (CMG). You may collect some fat cash for a few months but if there is bad news out of the company or the market corrects you can lose an extraordinary amount of money very fast and end up owning a stock you have no interest in holding long term. The trick to using options to enhance profits as a value investor is to start with stock valuation not options value.

My next point is that you should never post exchange or brokerage minimum margins. Post the entire potential cost of the trade in cash when you are selling outs. If you are selling $6 puts on Radio Shack your brokerage firm will probably let you get away with putting up just a couple of grand for ten contracts. Don’t do that. Post the full $6000 needed to pay for the shares.  There is a tendency to think that I have 20 grand in my account to buy Radios Shack so if I just use the exchange margin I can sell  100 contracts and not just 30. I know that sounds silly by I was a broker for 25 years and have seen the seductive allure of what looks like free cash lead some very smart individuals down the primrose path of minimum margins. If the options sell for $.50 you can take in $5000 instead of just $1500. However if the stock goes down you are going to find yourself owing more than three times the amount of stock you wanted. When I sell a put option I want the price to fall and be sold to me at the strike price. The premium is a bonus not the ultimate payoff. Post the full price in cash for every contract you sell.

There are some key difference with options trading you will need to be aware of as well. Often when I see a stock trading right around my calculation of asset or intrinsic value and I want to buy the shares at a discount to the number I will go ahead and enter a good until cancelled order 20% below the market. As long as the fundamentals do not change I can just let the order sit there until it gets filled if I choose. That’s not the case with options.  The measurements used to calculate the value of the option will change daily with movements in the price and overall market direction and volatility. You need to recalculate the value every day and renter the order until you get filled. If you leave a GTC order out there odds are you will once again have the pleasure of paying for market makers lunch that day.

Options are a very powerful tool for value investors in my opinion and experience. However you need to do the homework and learn how options are valued and traded before adding these to your regular investing approach. You will find that it is time well spent and should help add to our fiscal well-being many times over the effort and cost expended.

 The vast majority of the time selling puts is the best options related tool for value types to use. It just makes sense to get paid to buy a stock at an attractive price and can add several percentage points over the year. Most of the time I want to be a seller of options not a buyer. Of course there are always some exceptions to every rule and today I want to talk about those. There are two occasions where I favor buying, rather than selling options.

The first is when I want to short a stock. I have often said I am the world’s biggest chicken short. Outright shorting a stock can tie up a lot of capital and you are subject to margin calls if the position moves against you, as it usually does in my case. Some of my option savvy friends sell calls when they want to bet a stock will go down. Although that is a valid strategy a good percentage of the time I need more than one hand to count my associates who have been blown up by being short calls before a takeover or other significant event. That is just too much risk for me to take with my hard earned money and over the years I have developed my own chicken short style.

When I short a stock I look for egregious over valuation. I want to find those stocks with nosebleed price to earnings and price to sales ratios that are much beloved by Wall Street. I am of the steadfast opinion that in the long run no stock is worth 70 times earning s or 10 times sales not matter how promising the potential. The stock may hold the valuation level for far longer than one would expect, eventually gravity does reassert itself. I try to gain an additional edge by looking for things like slowing earnings momentum or decreasing earnings surprise to attempt to find a high flyer that is preparing to do an Icarus imitation.

When I locate such a stock I will either buy a put, or more likely buy a put spread. I will buy an out of the money put and then sell a lower strike price. I look for at least a 3 to 1 risk reward ratio with these trades. If I am buying a 70-50 put spread on a $75 stock like Lululemon (LULU) I do want to pay more than 6.50 net for the trade. I also want to go out as far as possible to give bad things time to happen. Six months is the absolute minimum. I use no stop loss and hold until it either trades below the lower strike and I can close at the maximum gain or it expires.

This is a tiny part of my investing approach.  The total cost of put spreads is never more than 2% of my total portfolio. Frankly speaking they are bets that I hope have some decent analysis and expectation behind them. If I am really honest about it is akin to going to the racetrack without leaving the office. I win these bets on average about half the time historically so it has added a little to my pile over the years but the rewards have been more intellectual than anything else.

The only other time I am likely to buy options is when a particular stock has been hit hard during a steep market decline. On some few rare occasions I can find long term options that are very cheap. I like to buy in the money leaps that have little or no time premium and allow me to gain cheap low cost leverage on a particular stock that I think will recover over the next year or two. As an example only as the market is hardly suffering steep decline right now the Arch Coal (ACI) January 2014  $5 calls have a last price of $5. With the stock at $9.83 there is very little time premium in the options and I am not paying much for 20 months of leverage in the stock. If the market was down sharply and I could execute the trade at those prices I would be interested. The key is to pay a lot of time and pay very little time premium. It is a rare trade but can be spectacularly profitable when you find an appropriate situation.

I have spent most of this week talking about options during the day and watching the Orioles actually win baseball games most evenings. The more in depth discussion of trading options is a departure from my usual subject matter but I think it is an important one. The combination of options and value stocks is one that has a lot of potential for profits if used correctly. I have long theorized that if a pure value investor and an options expert teamed up they would create an approach that was almost an anomaly.  Most option traders do not even consider the valuation of the underlying. Most value investors do not consider options a serious part of their investment toolbox. Such a combination would, in my opinion, be wildly profitable.

I have given thought at various times to finding a partner and raising money for such an approach. If I ever did then the combination trade would be a large part of my trading activities for such a fund. The combination is one of my favorite trades and I have used it at times in the past with strong results.  I usually use this approach when a stock is bomber out and has fallen sharply. My most successful combinations have been one time blue chips or midcaps that have fallen into single digit midget status.  When I find one I like I buy 1000 shares of stock and simultaneously sell 10 calls well above market and 10 puts below the current price.

As always valuation of the underlying stock is the most important factor in this trade. The stock has to be cheap enough to justify purchase on its own merits before I do the option trades. I also want to go as far out as the option chain will allow me. Right now most of the trades I would consider use January 2014 options to execute the combination. In no case would I go any shorter than January of 2013. The money in this trade is made over time as prices change to reflect fundamentals and premiums decay not in short term fluctuations.

 This trade is as close to a win-win situation as you can find in the markets if you have the valuation correct. If the stock goes above the higher strike price the stock is called away at a profit and you keep the premiums. If the stock falls below the bottom strike you have to double your stock position by buying more shares at the lower strike offset by the premiums received. If the stock flat lines and stays between the strikes you keep the premiums and still own the stock.

To best illustrate how this trade works I will use an example. A stock many of us here on real Money have discussed in the past is SuperValu (SVU), the supermarket chain. The incredibly competitive grocery market and high debt levels have caused the stock to struggle somewhat painfully as it has fallen form near $50 in 2008 to just around $6 today. Many believe that the company will finally fight its way back to profit this year and the company will begin to see a solid turnaround. If that happens the stock price could finally stage a rally. Management gave optimistic profit assumptions and the company has attracted some attention. It is worth mentioning that in the risk section of the latest federal filing that a dividend cut was unlikely but possible. It is the first time that language has been used by Supervalu.

Top create this trade I want to use January 2014 options. I will buy the stock right here at $6.20. I am then going to sell the $10 call for $.70 or better and the $5 put for $1.3 or better. If the stock goes up over $10 in the next 20 months I will sell my shares for $10 and I keep the $2 premium for a total profit of $5.80. That work out to roughly a 55% annualized profit. If the stock says the between $5 and $10 I keep the $2 and still own the stock which is almost 20% on annual basis. If the shares fall I have to buy another $1000 shares and now own 2000 shares of Supervalu at $5.60 but I also kept the $2000 in premiums so my adjusted cost is now $4.60. Should the company continue to pay the divided I add 5.6% to my annualized returns.

The worst case scenario is that I buy a decent company at less than the all-time low price. The best case is almost doubling my money in less than two years.  In my mind that is pretty close to a win-win trade.
Options and value stocks do not appear to go together at first glance. A deeper look however shows that they can combine for powerful profit opportunities.

Originally published as a series of real Money articles