Five stocks trading below the Peter Lynch earnings line
In a recent article ("Fossil, Gap Among Stocks Trading Below Peter Lynch Earnings Line"), GuruFocus writer Sheila Dang explained one of the valulation tools used by former Fidelity mutual fund manager Peter Lynch (pictured above):
Lynch uses a chart to map the price and earnings per share, aligning $1 in earnings with $15 in stock price. The optimal time to purchase a stock is when price falls below the earnings line.
GuruFocus’ Peter Lynch Screen displays companies that have historically had strong correlations between the price and earnings lines and are currently trading below the earnings line.
Dang went on to list five stocks trading below the earnings line that had business predictability ratings of 3 or higher:
- Fossil Group Inc. (FOSL, Financial)
- Alliance Holdings (AHGP, Financial)
- Waddell & Reed (WDR, Financial)
- Franklin Resources Inc. (BEN, Financial)
- The Gap Inc. (GPS, Financial)
Below, we'll use those stocks as a starting point to construct a "bulletproof," or hedged portfolio using the hedged portfolio method, for an investor who is unwilling to risk a drawdown of more than 20%, and has $200,000 that he wants to invest. First, let's consider why a value investor might want to consider this approach.
The risks of value investing
As with any style of stock investing, with value 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. Even top value investors can suffer large losses on stocks.
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, we'll look at how to "bulletproof" a concentrated portfolio of Peter Lynch earnings line stocks using the hedged portfolio method. In that method, you limit both stock-specific and market risk via hedging. 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 run through an example using the automated hedged portfolio construction tool at Portfolio Armor. The process, in broad strokes, is this:
- Find securities with promising potential returns (we define potential return as a high-end, bullish estimate of how the security will perform).
- Find securities that are relatively inexpensive to hedge.
- 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).
- 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 -- or the market moves against you -- your downside will be strictly limited.
How to implement this approach
Finding promising stocks
In this case, we're going to start with the five Peter Lynch earnigns line stocks mentioned in the Sheila Dang article we linked to above. To quantify potential returns for these stocks, you can, for example, use analysts' consensus price targets for them, to calculate potential returns in percentage terms. For example, via Nasdaq's website, the image below shows the sell-side analysts' consensus 12-month price target for FOSL as of Oct. 12:
Since Fossil closed at $56.26 on Oct. 12, the consensus price target suggests a 17.4% potential return over 12 months. In general, though, you'll need to use the same time frame for each of your potential return calculations to facilitate comparisons of potential returns, hedging costs, and net potential returns. Our method starts with calculations of six-month potential returns.
Finding inexpensive ways to hedge these securities
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 going out approximately six months). And you'll need to calculate your cost of hedging as a percentage of position value.
Select the securities with highest, or at least positive net potential returns
When starting from a large universe of securities, you'd want to select the ones with the highest potential returns, net of hedging costs. In this case, we're starting with just a handful of securities, but we'll at least want to exclude any of them that has a negative potential return net of hedging costs. It doesn't make sense to pay X to hedge a stock if you estimate the stock will return
Calculating Expected Returns
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. To calculate expected returns, you need to have some idea of how your past potential return calculations compared to subsequent actual returns.
An automated approach
Here we'll show an example of creating a hedged portfolio starting with five Peter Lynch earnings line stocks mentioned above, using the general process described above, facilitated by the automated hedged portfolio construction tool at Portfolio Armor. In the first step, we enter the ticker symbols in the "Tickers" field, the dollar amount of our investor's portfolio ($200,000), and in the third field, the maximum decline he's willing to risk in percentage terms (20%).
In the second step, we are given the option of entering our own return potential return estimates for each of these securities, or leaving the fields blank and letting the site supply its own potential returns. For the purposes of this example, we're going to enter potential returns derived from analysts' consensus price targets, as in the Fossil example above (although, since we're using six-month time periods, we'll divide the 12-month potential returns by two, and enter the results below).
A couple of minutes after clicking the "Create" button, we were presented with the hedged portfolio below. The data here is as of Monday's close.
Why these particular securities?
The site calculated the cost of optimally hedging the stocks we entered over the next several months, and then subtracted those hedging costs from the potential returns we entered for the stocks. It included each of the stocks that had a positive potential return net of hedging costs. In this case, that turned out to be all of them (though barely, in the case of Franklin Resources). As it allocated cash to each of the stocks we entered, it rounded down the amounts to get round lots of each stock. In its fine-tuning step, Portfolio Armor added Facebook (FB, Financial) as a cash substitute, to replace most of the cash leftover from the rounding down process. It added FB because it had one of the highest net potential returns of any security in its universe when hedged as a cash substitute.
Position-level potential and expected returns
Note that the net potential returns and expected returns are the same for the five stocks we entered. Had these been securities where Portfolio Armor supplied the potential returns, the expected returns shown would have been 0.3x the net potential returns. That's because, in a series of 25,412 backtests of its potential return calculations over an 11-year time period, the average actual return over the next six months was 0.3x the average potential return calculated ahead of time.
Since the site doesn't have similar empirical data on user-entered potential returns, and we entered the potential return for the five Peter Lynch line stocks, the site has no basis for reducing those potential returns, net of hedging costs, so it presents the net potential returns as the expected returns. For the cash substitute, Facebook, since its capped at 1%, rather than at its potential return, and since most of its net potential return results from negative hedging cost, the site uses that net potential return as the expected return for the FB position. 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 their hedges expired, the portfolio would decline 18.71%.
Negative hedging cost
Note that, in this case, the total hedging cost for the portfolio was negative, -0.76%, 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 7.08% over the next six months. This represents the best-case scenario, if each underlying security in the portfolio meets or exceeds its potential return. By way of comparison, had we let the site pick its own securities, and entered the same portfolio size and threshold (20%), as of Monday's close, Portfolio Armor would have presented us with a portfolio with a net potential return of 16.49%.
A more likely scenario
A more likely scenario is that not all of these stocks will do well, and your actual return will be less than 7.08%. However, since the site doesn't have empirical data on user-entered potential returns, it doesn't have a way of quantifying how much they may be overstating actual returns. So it presents the aggregate net potential return as the portfolio level expected return.
Each security is hedged
Note that each of the above securities is hedged. Facebook, the cash substitute, is hedged with an optimal collar with its cap set at 1%; Alliance Holdings is hedged with an optimal put, and the remaining securities are hedged with optimal collars with their caps set at each stock's potential return. Here is a closer look at the hedge for Fossil:
Fossil is capped here at 8.7%, because that's the potential return we entered for it over the next several months, based on the consensus analyst price target for it. As you can at the bottom of the image above, the cost of the put protection in this collar is $1,505 or 3.82% of position value. But if you look at the image below, you'll see the income generated from selling the calls is $1,540, or 3.91% of position value.
So, the net cost of this optimal collar is -$35, or -0.09% of position value.[i]
Possibly more protection than promised
In some cases, hedges such as the GoPro (GPRO, Financial) one, or the other ones in the portfolio above can provide more protection than promised. For an example of that, see this instablog post on hedging the iPath S&P 500 VIX ST Futures ETN (VXX).
[i] To be conservative, this optimal collar shows the puts being purchased at their ask price, and the calls being sold at their bid price. In practice, an investor can often buy the puts for less (i.e., at some point between the bid and ask prices) and sell the calls for more (again, at some point between the bid and ask). So the actual cost of opening this collar would have likely been less, meaning the investor would have likely collected more than $35 for opening this hedge. This is true of the other hedges in the portfolio above, as the costs of all of them were calculated in this conservative manner.
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