A Bulletproof Portfolio Containing Activision Blizzard

Activision Blizzard, the subject of a recent article by GuruFocus contributor Bram de Haas, currently has the second highest potential return in Portfolio Armor's universe.

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Oct 20, 2015
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In a recent article ("ATVI: Pricey Stock But Highly Attractive Portfolio of Games Headed by an Owner Operator"), value investor and GuruFocus contributor Bram de Haas commented on the attractiveness of Activision Blizzard (ATVI, Financial), though he noted the stock was pricey, by his standards and would remain on his watchlist for now.

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De Haas' article caught my eye because, as of Monday's close, Activision Blizzard had the second-highest potential return of any security in Portfolio Armor's universe. Potential return, in our terminology, is a high-end, bullish estimate of how a security will perform over the next six months. In the hedged portfolio method, we look to include securities that have the highest potential returns net of hedging costs.

What's interesting about ATVI appearing so high on our current screens at the same time it attracted the attention of a value investor is that our method of calculating potential returns doesn't take into account any fundamental analysis. Instead, it looks at price history and option market sentiment, which provides a forward-looking element. Essentially, Portfolio Armor starts with the assumption that a security's return over the next six months will be part of a process of reversion to its long term mean six month return. It then tests that assumption by gauging option market sentiment around contracts set to expire approximately six months out. What this suggests is that much of what makes Activision Blizzard attractive from a fundamental standpoint is reflected in the stock's price action and option market sentiment.

The risks of stock investing

With any style of stock investing, you face two kinds of risks: idiosyncratic risk, the risk of something bad happening to one of the companies you own, and market risk, the risk of your investments suffering due to a decline of the market as a whole. Bram de Haas pointed out some stock-specific risks of ATVI in his article, such as the challenge presented by the decline of the company's World Of Warcraft franchise.

Two ways of limiting stock-specific risk

One way to limit stock-specific risk is via hedging; another way is via diversification. In a previous article ("How to Limit a Bear Market's Bite"), we discussed how to limit market risk for a diversified portfolio. In this post, though, we'll look at a concentrated, "bulletproof" portfolio including ATVI that was created using the hedged portfolio method. In that method, you limit both stock-specific and market risk via hedging. This portfolio was designed for an investor with $60,000 to invest who is unwilling to risk a drawdown of more than 20%. First, let's address the issue of risk tolerance, and how it affects potential return.

Risk tolerance and potential return

All else equal, with a hedged portfolio, the greater an investor's risk tolerance – the greater the maximum drawdown he is willing to risk (his "threshold", in our terminology) – the higher his potential return will be. So, we should expect that an investor who is willing to risk a 25% decline will have a chance at higher potential returns than one who is only willing to risk a 15% drawdown. In our example, we'll be splitting the difference and using a 20% threshold.

Constructing a hedged portfolio

We'll outline the process here briefly and then show an example using the automated hedged portfolio construction tool at Portfolio Armor. The process, in broad strokes, is this:

  1. Find securities with promising potential returns (we define potential return as a high-end, bullish estimate of how the security will perform).
  2. Find securities that are relatively inexpensive to hedge.
  3. Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high potential returns net of their hedging costs (or, ones with high net potential returns).
  4. Hedge them.

The potential benefits of this approach are twofold:

  • If you are successful at the first step (finding securities with high potential returns), and you hold a concentrated portfolio of them, your portfolios should generate decent returns over time.
  • If you are hedged, and your return estimates are completely wrong, on occasion –Â or the market moves against you –Â your downside will be strictly limited.

How to implement this approach

Finding securities with high potential returns

For this, you can use GuruFocus screeners, among other sources. To get potential return estimates, you can use your own or look at analysts' price targets for each security and calculate potential returns in percentage terms from them. But you'll need to use the same time frame for each of your expected return calculations to facilitate comparisons of expected returns, hedging costs and net expected returns. Our method starts with calculations of six-month potential returns.

Finding securities that are relatively inexpensive to hedge

For this step, you'll need to find hedges for the securities with high potential returns and then calculate the hedging cost as a percentage of position value for each security. Whatever hedging method you use, for this example, you'd want to make sure that each security is hedged against a greater-than-20% decline over the time frame covered by your potential return calculations. Our method attempts to find optimal static hedges using collars as well as protective puts.

Buying securities that score well on the first two criteria

To determine which securities these are, you may need to first adjust your potential return calculations by the time frame of your hedges. For example, although our method initially calculates six-month potential returns and aims to find hedges with six months to expiration, in some cases the closest hedge expiration may be five months out. In those cases, we will adjust our potential return calculation accordingly because we expect an investor will exit the position shortly before the hedge expires (in general, our method and calculations are based on the assumption that an investor will hold his shares for six months, until shortly before the hedges expire or until they are called away, whichever comes first).

Next, you'll need to subtract the hedging costs you calculated in the previous step from the potential returns you calculated for each position, and sort the securities by their potential returns net of hedging costs, or net potential returns. The securities that come to the top of that sort are the ones you'll want to consider for your portfolio.

Fine-tuning portfolio construction

You'll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs. Another fine-tuning step is to minimize cash that's left over after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won't need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash, you can potentially boost returns. In this step, our method searches for what we call a "cash substitute": that's a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better-than-cash return while keeping the investor's downside limited according to his specifications. You could use a similar approach, or you could simply allocate leftover cash to one of the securities you selected in the previous step.

Calculating an expected return

While net potential returns are bullish estimates of how well securities will perform, net of their hedging costs, expected returns, in our terminology, are the more likely returns net of hedging costs. In a series of 25,412 backtests over an 11-year time period, we determined two things about our method of calculating potential returns: it generates alpha, and it overstates actual returns. The average actual return over the next six months in those 25,412 tests was 0.3x the average potential return calculated ahead of time. So, we use that empirically derived relationship to calculate our expected returns.

An automated approach

Here, we'll show an example of creating a "bulletproof," or hedged, portfolio using the general process described above, facilitated by the automated hedged portfolio construction tool at Portfolio Armor. In the first field below, we're given the choice of entering our own ticker symbols. Instead, in this case, we'll leave that field blank and let the site pick its own securities for us. In the second field, we enter the dollar amount of our investor's portfolio ($60,000), and in the third field, the maximum decline he's willing to risk in percentage terms (20%).

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Next, we clicked the "create" button. A couple of minutes later, we were presented with the hedged portfolio below. The data here is as of Monday's close:

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Why these particular securities?

The primary securities included in this portfolio – Activision Blizzard, Expedia (EXPE, Financial) and Global Payments (GPN, Financial) – had some of the highest net potential returns in Portfolio Armor's universe on Monday. We mentioned above that Activision Blizzard had the second-highest potential return in our universe on Monday. It also had the second-highest net potential return, and it appears in the portfolio above. The security with the highest potential return, Amazon (AMZN, Financial) doesn't appear in this portfolio because its share price is too high relative to the size of the portfolio. The site first attempted to allocate equal dollar amounts to Activision Blizzard, Ex[edia and Global Payments, rounding down the dollar amounts as it went in order to get round lots of each stock. In its fine-tuning step, Portfolio Armor replaced most of the cash from the rounding down process with Salesforce.com (CRM, Financial). Let's turn our attention now to the portfolio level summary.

Worst-case scenario

The "Max Drawdown" column in the portfolio level summary shows the worst-case scenario for this hedged portfolio. If every underlying security in it went to zero before the hedges expired, the portfolio would decline 18.49%.

Negative hedging cost

Note that, in this case, the total hedging cost for the portfolio was negative, -0.03%, meaning the investor would receive more income in total from selling the call legs of the collars on his positions than he spent buying the puts.

Best-case scenario

At the portfolio level, the net potential return is 15.81%. This represents the best-case scenario if each underlying security in the portfolio meets or exceeds its potential return.

A more likely scenario

The portfolio level expected return of 6.06% represents a more conservative estimate, based on the historical relationship between our calculated potential returns and actual returns.

Each security is hedged

Note that in the portfolio above, each underlying security is hedged. Activision Blizzard, Expedia and Global Payments are hedged with optimal collars with their caps set at each security's potential return. Salesforce.com, the cash substitute, is hedged with an optimal collar with its cap set at 1%. Hedging each security according to the investor's risk tolerance obviates the need for broad diversification, and lets him concentrate his assets in a handful of securities with high potential returns net of their hedging costs. Here's a closer look at the hedge for Activision Blizzard, using a screen shot from our iOS app:

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As you can see in first part of the image above, Activision Blizzard is hedged with an optimal collar with its cap set at 28.76%, which was the potential return Portfolio Armor calculated for the stock: the idea is to capture the potential return while offsetting the cost of hedging by selling other investors the right to buy Activision Blizzard if it appreciates beyond that over the next six months. The cost of the put leg of this collar was $420, or 3.11% of position value, but, as you can see in the second part of the image below, the income from the short call leg was $120, or 0.89% as percentage of position value.

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Since the income from the call leg offset some of the cost of the put leg, the net cost of the optimal collar on Activision Blizzard was $300, or 2.22% of position value.[i] Note that, although the cost of the hedge on this position was positive, the hedging cost of this portfolio as a whole was negative.

Possibly more protection than promised

In some cases, hedges such as the ones in the portfolio above can provide more protection than promised. For an example of that, see this post on hedging Tesla (TSLA, Financial).

Hedged portfolios for more risk-averse investors

The hedged portfolio shown above was designed for an investor who could tolerate a decline of as much as 20% over the next six months, but the same process can be used for investors who are even more risk averse, willing to risk drawdowns of as little as 2%.

Notes:

[i] To be conservative, the net cost of the collar was calculated using the bid price of the calls and the ask price of the puts. In practice, an investor can often sell the calls for a higher price (some price between the bid and ask), and he can often buy the puts for less than the ask price (again, at some price between the bid and ask). So, in practice, the cost of this collar would likely have been lower. The same is true of the other hedges in this portfolio, the costs of which were also calculated conservatively.