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Thursday, August 23, 2012

Hedging and Shopping

Two months while expressing some concern about the markets I played around with ways to hedge the risk of news driven volatility in a portfolio. I formed some portfolios that were hedged dollar for dollar short position in the index. I looked at using the biggest 52 week losers among index components, those  yielding at least 3% and trading at new lows and the ones trading below book value. I also had one using F scores but that failed almost out of the box and was discarded. The results are informative and I want to review them and share some other observations about the portfolios. I am also going to rebalance and continue testing this approach.

The portfolio of stocks at new lows didn’t work that well. Overall the mix had a two month return of (1.76)%. As the market rose 10% the long positions gained just 6.59%. Although 16 of the 20 stocks went higher the four losers averaged more than 11% with GameStop (GME) and Lexmark (LXK) leading the way on the downside. I am going to keep tracking this one to see how it performs when we finally have a down cycle in the market. As a long biased portfolio the short term results are disappointing. If you were leaning short two months ago as many were this approach saved you a ton of cash.

The portfolio of stocks trading below stated book value did well in the rally. Overall the fully hedged portfolio gained 4.53%. 9 of the 11 stocks went higher for an unhedged gain of 19%. Unfortunately since we used stated and not tangible book Alpha Natural Resources (ANR) was in the mix and the shares declined more than 34%. Stocks like First Solar (FSLR) Phillips 66 (PSX) and NRG Energy (NRG) led the way higher with huge gains in the tow month period. If you were long biased but nervous this approach has worked okay for you so far.

The star so far is stocks with the largest 52 weeks losses. This was a portfolio that was long stocks down more than 50% in the last year hedged dollar for dollar with a short index position. The portfolio gained 6.28% over the two month period. The unhedged portfolio of losers would have shown a gain of 22.67%. Although 6 of the 15 stocks continued to move lower those that rebounded flew. Sprint (S) more than doubled. First Solar (FSLR) was up nearly 80%. Metro PCS  (PCS) stock price is up more than 60% higher than it was just 8 weeks ago. This seems to be a method that may have value for nervous investors looking for hedged exposure to an uncertain market. It’s early in the test but I will be watching developments with this portfolio carefully.

It is also instructive to look at the stocks without a hedge. Traders may want to start focusing more on stock in the index that are falling knives with large 52 week losses instead of the momentum darlings. These issues have rebounded sharply rising far more than the broad market. In today’s low volume short term trading dominated market once the fundamental sellers such as mutual funds and institutional asset managers are done exiting the stock there are few natural sellers left. When the index buyers and traders move into the long side of the market the buying pressure in the absence of sellers causes short covering and spectacular rallies. With no fundamental selling taking place these issues should track the market or even outperform slightly on the downside.   With a reduction in the number of natural sellers and absence of retail investors it appears that losing stocks may revert to the man much faster than years past. At least that’s the theory and I plan to continue tracking the results of these portfolios.

Hedged mechanical portfolios are not part of my regular activities but is a fascinating subject. In addition I suspect there is valuable information to be garnered by tracking and testing these ideas.When I was reviewing the hedging strategies yesterday I was impressed by the returns some of the individual stocks posted during a two month period. The list definitely provides traders with a solid source of ideas but I was curious to see if the current selection provided long term investment opportunities as well. I decided this morning to sit down and use them as a shopping list to see if there were any true bargains. I have written in the past about the strong returns available by investing in S&P 500 stocks trading below book as well as catching the falling knife stocks that had declined more than 50. I have not tested the higher yielding stocks at new lows but it is an interesting idea and may provide an opportunity or two for investors.

The largest stock on the list is McDonalds (MCD), a company I love to hate. This is a great company and one of the great American success stories. They dominate their industry and have one of the widest moats in the history of the world. Much like Coca Cola (KO) you could not recreate the brand with any amount of capital investment.  As the parent of a 9 year old I hate the place. The dividend yield is over 3% and the payout has grown by more than tenfold in the past decade. It is reasonable to assume that the dividend will continue to grow in the future. However the stock is not cheap on any reasonable metric for a long term value investor. The shares trade at 6 time book value. The EV/Ebitda ratio is ten and the price to sales is a healthy 3. Even at close to 52 week lows the stock trades at twice my estimate of intrinsic value. This is a stock that should be on your buy in a crash blue chip list but it is far from a bargain today.

One stock that does have some bargain appeal is Safeway (SWY). Having owned both Winn Dixie and SuperValu (SVU) over the past few years I am well aware of just how bad the grocery business is today. Wal-Mart has endeavored to crush the competition and for the most part succeeded. To complicate matters the weak economy has made it very difficult to pass along higher food costs to consumers. Safeway is one of the bigger chains and better known company’s in the industry and should be among the survivors of the industry. While the shares are not cheap on a book value basis the shares trade at an EV/Ebitda ratio of less than 5 and a price to sales ratio of less than $.10 on the dollar. Safeway also trades at a healthy 30% discount to my estimate of intrinsic value. The stock yields 4.6% right now and management has better than tripled the payout since 2005. Safeway is a solid company in a tough business and the stock should reward patient investors.

Shares of office supplies retailer Staples (SPLS) fell sharply recently as a result of weak revenues and lowered guidance. The stock now trades blow the 2009 lows. In addition to weakness in Europe US sales slumped in the quarter as businesses become more cautious about spending. The release of Windows 8 is expected to give some support to top and bottom line in the last quarter of the year. I suspect that we still see some continued weakness however as many businesses are delaying spending until after the election when the regulatory and tax picture is clearer. Staples in the largest office supply company in the world with sales of $25 billion so they should be able to weather the storm. They also have exposure to emerging markets that could drive long term revenue growth so there are some positives in the picture. The company has done a lot of acquisitions over the years and is not cheap on tangible book bases but the EV/Ebitda ratio is just 4.4 and the shares fetch just 70% of my intrinsic value calculation. At today’s price the shares yield more than 3% so you do get to paid for an economic turnaround to life the profits and share price.

Using the list of dividend paying stocks in the S&P 500 near new lows seems to be a useful approach for finding stock ideas. Not all of them are cheap but some are cheap enough to consider for long term investors. I would probably wait for a solid market pullback to buy any of them .

1 comment:

Jeff Watson said...

If I'm doing anything more than a day trade, I hedge my grains. You know, the only speculators who ever had longevity in the pits were the locals who spread all their positions. The "scalpers" all ended up getting ground down.