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If You Are Long Consider Going Longer
Posted by: Chandan Dubey (IP Logged)
Date: May 25, 2012 05:14PM

The Problem: Think of a good stock that you want to invest in and are juggling the idea of buying shares of at current prices. A good example for me is the Swiss industrial juggernaut ABB (ABB).

The company has averaged a RoIC of around 17% in the last six years, a dividend yield of near 4%, debt/equity of 0.3 and trades at P/E of 11.8 and P/FCF of 14.8. The company has also grown revenue at 9% (five-year average). Given the recent acquisitions, the company will grow at a higher rate in the near future. Comparing it to Siemens (SI), we find that ABB is priced a bit on the expensive side. In fact, on an absolute basis ABB is fairly valued and is one of the stocks which can be classified as growth at reasonable price.

I already have started a small position of 100 shares of ABB at $17 and am planning to add to this when the stock declines further. The stock is trading at a multi-year low and might not decline further if the economic climate in Europe does not deteriorate a lot. The company is cheap to fairly valued in my opinion and I will be quite sad if the stock jumps and I end up not buying it. But again, making a big position at current prices goes against my determination of buying stocks at a significant margin of safety.

So, Mr. Reader, you understand my predicament. You might have found yourself in a similar position a few times. You like a company, are quite confident about its future, but hesitate in making a large position because of the price. A second situation might be that you have started a small position and want to dollar cost average to a lower price.

A Solution

Here is something I tried in my case. Given that I will not hesitate adding a further chunk at prices below $15, I sold one put option at strike price $15 with expiration Dec. 22, 2012 and collected $1.1 in cash.

The Result

The result is regret minimization. If the prices do not fall down until Dec. 22, 2012, I keep the $1.1 cash per share. What this does is to lower the purchase price of my already-bought position to $16.9 (17-1.1). If on the other hand I am assigned the shares at $15, my average price of the whole position is $(1500+1700-110)/200 = $15.45. I like the situation in either case.

The Catch

There is no free lunch. So, what can go wrong here? It might happen that a) there is overall market crash, or b) there is a major problem specific to ABB. These two are quite different issues and I will discuss them separately.

a) If there is a general market crash what would any investor do? You might wait for the market to fall a bit and then buy. No one knows the bottom, and you will have to pull the trigger at some point. It is possible that there is a big crash and ABB starts trading around $10 and does so for a while before recovering. In case you had not sold the put, you would not have been assigned the stock at $15 and would have bought at a much cheaper price of $10.

But if you think for a while, no one stops you from buying the stock again at $10. I sold the put only because I thought that getting the stock at $14 was cheap. No one knows when Mr. Market will price something ridiculously high or low. Getting to buy ABB at $10 may or may not happen. Even after buying at $10, the stock may drop to $5 and you will regret buying at $10. So, this is not a valid reason to not sell the put. Obviously, if you sold too many puts and now your portfolio is overweight in ABB at $15, you might not want to buy even if the stock sells for $10 because then your whole portfolio will be dependent on ABB. This probably is not a good idea because of the lack of diversification. From this discussion comes our first lesson.
Quote:
Lesson 1: Do not try to make a full position in the stock by selling too many puts.

b) There is a problem with the specific stock we sold puts for. It may happen that the fundamentals of the company deteriorate and the only correct thing to do is sell our initial small position at a loss and move on.

This is the real downside. If we had not sold the put, we would sell out our previous position at a loss and get out. But given that we have the put, the downside has increased. We will be forced to buy something which we do not really want to own now and we will have to liquidate the bigger position at a larger loss.

If we have played our cards right and have used puts in the way which honors Lesson 1, we will be spared from significant losses. Because we sold a small amount of puts for bringing down the average price of our initial small position, we are saved from losses which might impair our portfolio. But the fact still remains that we have a larger loss now for which the culprit is the put option we sold. So, now comes another lesson.
Quote:
Lesson 2: Only sell puts for which the risk of significant long-term damage to the business/company is very small. In fact, what were you doing investing in a business for which there was a large risk of significant permanent damage?

The Byproduct

In fact, I will argue to do a thought experiment to see how confident you are in the stock. Before buying the stock think if you will be willing to sell a put some 10 to 20% down the current price of the stock for an expiration date which is around one to two years in the future. This will let you think if you are confident in the future of the stock.

For example, let us look at another stock Total SA (TOT). The stock is currently selling for $43.8 and has a dividend yield 6.89% and P/E of 6.6. It is cheap on several other metrics. Let us say you want to buy the stock at current prices and will regret if you do not buy and prices recover. Well, let us invert the picture. Do the thought experiment I described. If we look at the option chain of Total, you can sell a $45 put with expiration January 2014 for $9 a piece. This will mean that you may be forced to buy the stock at an average cost of $36 at any time between today and January 2014 ($45 minus the $9 premium). Does this deal look attractive to you?

Given this situation, you will start thinking what may go wrong. What if there is a BP-like oil leak which goes out of hand? Total just tackled the Elkin oil leak, and it is not very unlikely that this may happen again. January 2014 is quite far away! What if the price of oil drops and the profitability of Total is severely affected? I mean, are you sure that this is a good deal?

For a reasonable investor, this is exactly what he needs to think before investing in a stock. When you think of selling puts with expiration dates which are far away in the future, you automatically start thinking what may go wrong. You start demanding a better margin of safety, and in general you start worrying about the downside.

Conclusion

Selling puts carefully (read the article) is a very good tool for the value investor. The downside is that a significant deterioration in the fundamentals of the company may lead to larger losses. Even when you do not want to sell the put, thinking about selling one is a very good exercise for an investor who wants to find sound investments. Thinking about selling puts with expiration dates far in the future leads one to think about things that can go wrong with the investment. Hence, this is a useful exercise even when you do not want to have anything to do with options.


Stocks Discussed: ABB, TOT,
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Re If You Are Long Consider Going Longer
Posted by: marcolanaro (IP Logged)
Date: May 26, 2012 01:30AM

Good article Chandan. I apply the same method that you do. I do it in particular with stocks I like a lot. Take Berkshire Hathaway, for example, you can sell puts strike 75 jan 2014 @ $7.50 per contract, with the added insurance that Mr. Buffett should by berkshire stock at 1.1 book value. At $75 BRK.b is well under 1.1 book value.


Stocks Discussed: ABB, TOT,
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Re If You Are Long Consider Going Longer
Posted by: cdubey (IP Logged)
Date: May 26, 2012 01:36AM

Thank you ... I was not thinking about BRK.B ... So stupid of me !

I will sell a BRK.B put on Monday. $68.5 is a good deal for BRK.B.


Stocks Discussed: ABB, TOT,
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Re If You Are Long Consider Going Longer
Posted by: marcolanaro (IP Logged)
Date: May 26, 2012 02:18AM

Sure it is! It is a good deal even if you buy the stock at current prices!


Stocks Discussed: ABB, TOT,
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Re If You Are Long Consider Going Longer
Posted by: batbeer2 (IP Logged)
Date: May 27, 2012 05:53AM

If you like ABB, have a look at Investor AB. A conservative swedish holding company.
If memory serves, they own a chunk of ABB, just cheaper.


Stocks Discussed: ABB, TOT,
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Re If You Are Long Consider Going Longer
Posted by: cdubey (IP Logged)
Date: May 27, 2012 01:07PM

@Batbeer2: I have already bought shares ... you recommended the stock to me a few articles back. Thanks for that !



Stocks Discussed: ABB, TOT,
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Rating: 2.0/5 (1 vote)



Re If You Are Long Consider Going Longer
Posted by: batbeer2 (IP Logged)
Date: May 27, 2012 01:23PM

>> you recommended the stock to me a few articles back.

I don't recommend stocks :o)
Just sharing my thoughts.

Thanks for an interesting article.


Stocks Discussed: ABB, TOT,
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Re If You Are Long Consider Going Longer
Posted by: cdubey (IP Logged)
Date: May 27, 2012 01:31PM

You are welcome ... I did not buy it without looking at it myself. The best things I like about the stock is the more than 30% ownership of the Wallenberg family.


Stocks Discussed: ABB, TOT,
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Re If You Are Long Consider Going Longer
Posted by: Cornelius Chan (IP Logged)
Date: May 28, 2012 10:57PM

I don't see the point of choosing a holding company (however cheap) over shares of a blue chip stock.. With ABB you get dividends, good management, quality assets and business growth. Also, it just seems a lot simpler to invest directly in shares of a productive business rather than indirectly through another entity, no matter what % is owned by XYZ Germanic family.

Can someone point out a few advantages please? Thanks.


Stocks Discussed: ABB, TOT,
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Re If You Are Long Consider Going Longer
Posted by: batbeer2 (IP Logged)
Date: May 29, 2012 12:22AM

>> Can someone point out a few advantages please? Thanks.

Assuming the the guy in charge of the conglomerate is a better capital allocator than yourself (say Berkshire) you have a tax advantage. Cash generated by one subsidiary is re-invested at a high IRR. You don't want to see a lot of overhead though. Berkshire, Leucadia and Loews are nice examples.

- Excess cash is not returned to you through (taxed) dividends but reinvested at high IRR.
- You get to sit back and watch the guy do the work for you (select investments).

You personally might not view these things as an advantage. That's fine. Some do.

As an aside, I think most of the blue-chips you would like (PG, JNJ, BDX, PEP....) have multiple subsidiaries that are managed relatively independently. You own the productive businesses indirectly.


Stocks Discussed: ABB, TOT,
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