Berkshire Hathaway

Though I am working on a few posts with some more substantial valuations and thoughts of my own, I haven’t managed to get them done yet so I’ve decided to give a quick recap of what I think is one of the most undervalued and safest large-cap opportunities out there at the moment, Berkshire Hathaway (BRK).

For those of you who don’t know, Berkshire Hathaway is the conglomerate controlled by the legendary investor Warren Buffett.  In the past, Berkshire traded with what was known as a ‘Buffett’ premium. This meant that Berkshire was generally valued by the market at a higher multiple than would be given to a similar business under different management to account for the asset allocation abilities of Buffett.  However, in recent years this Buffett premium has disappeared and currently the gap between Berkshire’s share price and intrinsic value is arguably as large as it has been any time in the last decade.

A nice (though slightly out-of-date) valuation of Berkshire has been written up by T2 Investment Funds and can be viewed here.  As outlined in Tilson’s presentation, even using very conservative estimates for Berkshire’s intrinsic value places the value of Berkshire’s ‘B-class’ shares at over $100 per share as of the end of the 2010 fiscal year.  As they’re trading at around $77 currently, just trading up to this conservative intrinsic value would result in a 33% gain from the current price.  Accounting for Berkshire’s 2011 earnings, it’s not hard to project an intrinsic value of almost 50% higher than the current share price (~$115).  Berkshire is also trading at a price to book ratio of approximately 1.1 which is at the very low end of its historical range (between 1.1 & 1.7).  Given the quality of Berkshire’s businesses, it’s hard to argue that Berkshire doesn’t deserve some premium above book value which can be thought of as providing downside protection for the investment.

A number of things have conspired to drive the share price down including the standard fears that Buffett may pass away (as he’s now into his 80’s), the catastrophic losses incurred by Berkshire’s insurance divisions due to the Japanese earthquake and other disasters, and the David Sokol scandal.  Berkshire’s insurance division will actually report its first combined loss in a decade this year due to losses incurred from the events in early 2011.  However, the flip side is that these losses will also cause insurance and reinsurance rates to rise in the future which bodes well for future returns.

In any case, I think it’s hard to argue that Berkshire is over-valued when compared to any of the major North American stock indicies and I personally think that it’s one of the best large-cap values out there.  Combined with the high quality business, initiating a long-term position at these levels should result in acceptable returns into the future.

Until next time,
Nathan @ EngineeringIncome.com

Disclaimer:

The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question.  The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past.  This is generally not true.  It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation.  For more information, please see my disclaimer.

Full Disclosure:  Long BRK.B as of the time of this writing.

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Solitron Devices

As one of the highest quality net-net investments in the US market, I was going to write an analysis of Solitron as part of my due diligence prior to initiating a position.  As it would have it, someone else beat me to it!  Oddball Stocks recently posted a good series on Solitron that I think covers the investment prospect well.

Introducing Solitron Devices
Solitron:  The Assets and Liabilities
Solitron:  Wrapping things up

Anyone who’s interested in net-net investing should definitely take a look as Solitron represents a potentially interesting opportunity.

Until next time,
Nathan @ EngineeringIncome.com

Disclaimer:

The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question.  The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past.  This is generally not true.  It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation.  For more information, please see my disclaimer.

Full Disclosure:  No positions as of the time of this writing.

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CSS Industries Analysis

Even though it’s been awhile since my last post, I haven’t forgotten about the blog or investing in general.  For those of you so inclined, my most recent analysis of CSS Industries has been published on Gurufocus as an entry in their June Value Ideas Contest.  Hope you enjoy and I’ll be back with more value investing ideas shortly!

Until next time,
Nathan @ EngineeringIncome.com

 

Full Disclosure:
Long CSS

Disclaimer:
The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question. The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past. This is generally not true. It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation. For more information, please see my disclaimer.

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Micro-Cap Investing is for Me!

A few posts ago, I put up an analysis of Crystal Rock Holdings where I mentioned that it is a micro-cap stock.  What this means is that the total market value of all of the outstanding common shares at the current share price is less than $100 million.  Some people like to define micro-caps as having a market cap of less than $25 million, but that’s really just splitting hairs.  The important thing is that companies of this size are small enough that they are essentially out of the reach of professional investors.  This makes investing in micro-caps perfect for amateur investors as mispriced bargains are generally easier to find if professionals aren’t looking for them.

Micro-Caps – Ignored by the Big Guns

Most institutional investors, hedge funds, and mutual funds can’t invest in micro-caps as they are illiquid stocks.  Depending on the company and the amount of money to be invested, it can take weeks to establish or get out of positions without drastically affecting the share price.  For most funds, not being able to trade in and out of positions when required disqualifies these stocks immediately.  Funds are also generally looking to invest in opportunities where they can accumulate a significant position in relation to their total assets under management so that if the underlying stock does well, it is reflected in the fund’s performance.  However, with micro-caps, a large fund may run up against ownership limits while establishing even a relatively modest position.

Examples of a Micro-Cap ‘Mispriced Bargain’

Recently while browsing through a list of Canadian micro-caps I found a stock that for a good portion of last year traded at a price that was below its net current asset value (current assets minus total liabilities).  This basically means that at the price the stock was trading at, for every $0.90 you put in, you ‘bought’ $1.00 in cash, receivables, and inventory with the rest of the assets and earning power of the business thrown in for free.  This was also an established company that had turned a profit in 9 of the last 10 years.  The company’s board of directors, being at least somewhat insightful, authorized an unlimited share repurchase plan that would remain in effect as long as the stock was trading below its net current asset value.  In doing so, the company was able to repurchase a relatively significant number of shares on the open market to enhance the return to continuing shareholders at the expense of those who were silly enough to sell out.

If you’re wondering, as far as I know the only time in the last 100 years that profitable large-cap companies sold for less than their net current asset value was at the end of the Great Depression.  In general, securities analysts know exactly the asset backing that their companies have on their balance sheets and what their underlying businesses are approximately worth.  Because of this, highly covered stocks rarely trade far from their fair value, and will almost always trade far above their net current asset value (NCAV).  However, for stocks with no analyst coverage (like all micro-caps), investors actually have to look up, read through, and understand the company’s financial statements to determine a company’s financial position.  By just referring to the earnings per share and other ‘standard’ data aggregated by the financial sites such as Morningstar, Yahoo, or Google, investors that sold out of the abovementioned stock at a price less than the net current asset value got hosed as it is unlikely that they could have found a cheaper, higher quality company to invest in at the time.  (Note that the stock in question has run up over 50% since this time and while it is still trading at a discount to what I would consider fair value, it is no longer the screaming buy it once was).

Here’s the Catch
Now, the biggest advantage of investing in micro-caps is also its largest drawback.  As analyst coverage of micro-caps is virtually non-existent, the only way to find suitable investment candidates is to research them by going through exchange listings, one by one, and reading through company’s annual reports and financial statements.  Most of the time, companies can be eliminated from further consideration after looking at their most recent annual report.  However, some of the time, you’ll find the hidden gems like the stock mentioned above.  Then you just have to make sure that you invest with a big enough margin of safety, be patient, and wait for the market to recognize the value you’ve uncovered.

Until next time,
Nathan @ EngineeringIncome.com

Full Disclosure:
No Positions

Disclaimer:
The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question. The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past. This is generally not true. It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation. For more information, please see my disclaimer.

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Show Me the Money

In almost every stock analysis, the reported (or projected) earnings per share is referenced as a proxy for how well the company is performing or is expected to perform.  However, after reading through a number of company’s annual reports and various investing blogs, I’ve come to think earnings aren’t all they’re cracked up to be.

The Earnings Illusion
When it comes right down to it, companies required cold hard cash to function.  Whether it be paying their employees, paying interest on debts, or replacing old equipment, every transaction worth noting is really a cash transaction.  That’s why I’ve become much more interested free cash flows when analyzing a business.  In the income statement, earnings are calculated by taking sales, subtracting the cost of sales and other expenses, accounting for some depreciation and amortization, one time costs, interest, taxes, and voila, net income for the year.  The unfortunate thing is, some of these ‘expenses’, especially depreciation and amortization, may have no relationship to the actual replacement cost (or useful life) of the asset that they’re accumulating on.

An easy way to illustrate this concept is by looking at the financial statements of a railway, say Canadian Pacific.  If you pull up the current income statement and statement of cash flows, you’ll see that the depreciation expense ($489.6) is significantly less than the expenditures for property, plant and equipment ($726.1).  This is because railways are a capital intensive industry that relies on long-lived assets.  When a railway replaces a section of track, they account for this expense by ‘depreciating’ (spreading out) the expense on the income statement (to calculate earnings) over the assumed useful life of that segment (say 25 years).  Now, when it comes time to replace this section of track in 25 years, inflation (assumed at 3% per year) will cause the same piece of track to cost more than double what it had the last time it was replaced.  What all this ends up meaning is that the actual cash spent on replacing these types of long-lived assets will almost always be greater than the depreciation allowance that can be ‘claimed’ due to the effects of inflation.  Therefore, if you’re interested in investing in railways (or similar types of capital intensive companies such as utilities), make sure to take a good hard look at their free cash flow numbers (operating cash flow minus purchases of property, plant, and equipment or maintenance capital) in relation to reported earnings to get a more accurate picture of the stocks ‘true’ profitability.

The Bottom Line
One of the reasons that earnings are all of the rage, is that up until relatively recently (late 80’s), there was no way to get an accurate picture of the cash generated by a company as the statement of cash flows was not included in the reporting requirements.  I’m almost certain though that had cash flow information been easily available back in Graham’s day that he would have used it instead of earnings when evaluating potential stocks.  Warren Buffett certainly does, as free cash flow is very similar to his concept of Owner’s Earnings.

By evaluating potential investments based on their free cash flow instead of earnings, investors have the potential to discover some mispriced bargains.  As free cash flow is rarely tracked or reported, most investors don’t pay attention to it.  And if people don’t pay attention to something, it isn’t likely to factor into the stock price.  All it takes then is a little research and patience when investing in these scenarios to eventually be rewarded with stock buybacks, dividends, internal growth, and accretive acquisitions as free cash flow is (hopefully) used to enhance shareholder returns into the future.

At the end of the day, it does still pay to remember that cash really is king.

Until next time,
Nathan @ EngineeringIncome.com

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Stock Valuation – Crystal Rock

In researching stocks that are trading at a discount to their intrinsic value, I read a fair number of blogs and investing forums from time to time.  One of the stocks that was briefly discussed on a forum I frequent caught my attention for a number of reasons, so I decided to write up the stock to get a thorough understanding of the company and its future prospects.  After discussing my critique with another blogger, I’ve decided to reproduce it here.

In going through this valuation, the first thing that should be noted is this is not an investment recommendation of any kind, but just a research article on a particular company and their stock.  As the company discussed in this article is a micro-cap and thinly traded (illiquid), anyone considering a position after performing their own due diligence should make sure that they are comfortable entering into these types of positions.  Also, I haven’t discussed a lot of the terms used in this analysis before on this blog, so stay tuned over the next number of posts where I’ll try to make sense of the numbers and what they mean.

Now on with the show!

Crystal Rock Holdings Inc:

Crystal Rock Holdings Inc (CRVP – AMEX), is engaged primarily in the production and distribution of bottled water, coffee, and other ancillary products.  The company is controlled by the Baker family who together own the majority stake of the common stock.  A quick look at some of the stock’s vital signs are as follows:

  • Z-Score:  1.3
  • F-Score:  4
  • FCF Margin Coefficient of Variation:  0.21
  • Ave. 10-year real FCF yield: 19.2% (based on market cap) / 8.7% (based on enterprise value)

Note that in calculating the average 10-year real FCF yield, I adjusted the reported free cash flow in 2010 & 2009 to exclude one time legal settlements of $3.5 million and $3 million respectively (including income tax provisions).

Looking at these numbers, a few things stand out right away; the Z-score is terrible and the company has a lot of debt.  Looking at the balance sheet, due to past acquisitions there is no tangible equity in the business.  The current ratio is okay at a little over 2, but overall, the stock is nowhere near an asset play.

Looking at the cash flow numbers, the FCF margin CoV is very good at 0.21 and they have had over 10 years of positive free cash flows.  Using just the market cap value, the company would seem to be trading at an 19% FCF yield to its average real 10 year free cash flow, but due to the large debt load, this number is misleading.  Using the enterprise value instead of market cap leads to a 9% 10-year average FCF yield which is still somewhat intriguing.  So from a cash flow perspective, the company seems to be worth at least another look assuming that they’re not going to go bankrupt in the near future.

Examining the notes to the financial statements, the debt on the balance sheet is from two sources, a term debt note (and revolving credit facility), and subordinated debt due to the Baker family (from a buyout of Crystal Rock Spring Water Company shareholders in 2000).  Looking at the debt maturities, the company has approximately $2.2 million of debt due in each of the next 4 years.  As the company’s average FCF over the last 10 years is $4.1 million, the debt retirement is covered approximately 2 times.  Out of the last 10 years, the company only failed to generate this amount of real FCF in 2001.  However, given recent acquisitions and the relative stability of the business, the company should be able to continue to retire debt as planned as I would expect FCF generation to at least remain at its historic average.  Furthermore, to help stabilize the interest payments on the debt, the company has entered into a number of interest rate swaps.  Though the first swap actually resulted in a net loss (due to the very low rates experienced from 2008/9 to the present), insuring against the possibility of significantly rising rates is prudent for the company as a rapidly rising interest expense could result in default.  Though there is a large subordinated debt maturation (13 million) in 2015, by that point, the company will have paid off over $9 million in term debt which should let them refinance if needed.  The company has also been paying down debt ahead of schedule from time to time to lessen their debt load ($500,000 in both 2009 & 2010).  After looking at the debt maturities, FCF generation, and interest rate swaps, I am more or less convinced that they shouldn’t go bankrupt in the near future barring extraordinary circumstances.

Given that debt retirement accounts will account for 50% or more of the available FCF over the foreseeable future, and given the financial covenants in place, no dividends can be paid on the common stock.  Other than debt repayment, FCF has been used for small share repurchases from 2006 onwards and for acquisitions.  Looking at the past history of acquisitions, the company has primarily targeted water producers and distributors to grow their geographical area and expand their business. In addition, their coffee distribution business is a compliment to the existing water business as the demand for the two beverages tend to be somewhat counter-cyclical.  Future acquisitions to expand these sides of the business would seem to be the most appropriate investments.  However, the most recent acquisition was an office supply company in order to ‘diversify’ their business.  Though their existing customer relationships with businesses may make it easier to make sales to their existing water and coffee customers, this purchase would seem to move the company out of their area of expertise.  I would rather have seen this cash (essentially from their legal settlement) been used for additional debt repayment or held to fortify the balance sheet.

As the Baker family owns the controlling interest in the company, they should be motivated to ensure that the company remains in compliance with its debt covenants.  Though the Bakers would recover most of their subordinated debt ($13 million) in the event of a bankruptcy, they would lose an equal amount of equity in the company.  They would also lose their income as employees and directors of the company ($320,000 annually) and the operating leases of properties that the company rents from them would be terminated (an additional $700,000).  Furthermore, they have options on 300,000 shares outstanding with a minimum strike price of $1.80.  Based on the above, the Baker family would seem to have incentive to ensure that the company survives and that the stock price increases such that their vested options are in-the-money.

Having gone through the financials, using the average real 10-year real FCF of $0.19 per share and assigning a FCF multiple of 15 while subtracting the net debt position leads to an estimated intrinsic value of the company of somewhere in the $1.50 to $1.75 range.  Given that the stock is trading around $0.86 (and has hovered around $0.70 for much of the last year) it is trading relatively close to a 50% discount to my calculated intrinsic value.  As recently as 2008, the stock traded in the range of the above estimated intrinsic value.

Based on the above, CRVP seems like an interesting earnings value play.  However, other than the obvious difficulties in carrying a large debt load (which seems manageable based on the above discussion), the decision to branch out into office supplies somewhat muddies the future.  Though the company is trading in an attractive range, as the potential profitability of their entry into the office supply business is not known, it is difficult to determine how much of the available free cash flow outside of debt repayments will be required for this venture, and what the returns may be.  If instead, the cash available had been redeployed into their water / coffee businesses, returned to shareholders through buybacks, or used for additional debt repayments, I think the investment case would be a lot stronger.  That being said, if everything works out according to plan, an intrinsic value of between $2.50 to $3.00 (valued only on market cap after significant debt repayment) for this stock within 5 – 10 years seems to be within the range of possibility.

Until next time,
Nathan @ EngineeringIncome.com

Full Disclosure:
No Positions

Disclaimer:
The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question. The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past. This is generally not true. It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation. For more information, please see my disclaimer.

Posted in Investing, Valuation | Leave a comment

Investing

As a relative newcomer to the incredibly diverse field of investing, the sheer amount of information available can be overwhelming at times.  With no formal training in investing or finance, it has taken me awhile to gain exposure to many of the investing strategies employed by speculators and investors alike.  During this time, one of the struggles has been defining the type of investing approach that fits my personality.  To outline my investing journey so far, I’m going to spend a few posts talking about various investing strategies I’ve looked into, and how I think I’ve finally found the one that ‘fits’.

Let’s Go Old School

If you walked up to someone on the street and asked them if they knew who Warren Buffett was, I would bet that the majority of them would answer yes.  Likely they would also be able to identify him as a great investor and then may mumble things about wishing they had invested with him earlier, and so on and so forth.  Because Buffett is one of the richest men in the world, he has a certain degree of notoriety.  How did he become one of the richest men in the world?  By exploiting inefficiencies in the stock market to generate investment returns well in excess of the market averages over very long periods of time.

Fewer people (outside of the investing world) may recognize the name of Buffett’s mentor, Benjamin Graham, who is largely credited with formalizing the field of value investing and who also delivered market beating returns to those invested in his fund over a 20-year plus time span.  As I have been gradually working my way through a number of investing books, I recently decided to read through Graham’s highly regarded book, The Intelligent Investor, to try to glean some wisdom from the master.

The Intelligent Investor was originally written in 1949 after the Great Depression and was periodically updated and re-released throughout Graham’s life.  After a trip to the local bookstore, I ended up with a revised release of the 1972 edition of The Intelligent Investor which had been updated in 2003 with commentary after each chapter related to changes and happenings in the capital markets from 1972 to the end of the tech boom & bust.  After reading the reflections of Graham and others on the past fluctuations in the market, the first thing that I was struck by is how the behaviour of the markets seems to repeat itself over long periods of time.  There are times of irrational exuberance and times of panic and fear, long bull markets and deep bear markets, interest rate increases and decreases, wars and major global events.  The constant through all of these events is the knowledge that “this too shall pass”.  Excesses are eventually removed and fears are eventually allayed.

Types of Do-It-Yourself Investors

The Intelligent Investor separates investors into two types:  defensive and enterprising.  Defensive investors are defined as people who wish to have a hand in their own finances, but do not wish to devote a significant amount of time to this activity.  Today’s defensive investors would typically be called passive or index investors.  Enterprising investors on the other hand, are people who are willing and able to devote time to the task of securities analysis to determine the suitability and merits of individual securities.  As the styles and strategies employed by these two types of investors is very different, I’m going to examine each of them in turn, starting with the defensive investor.

Defensive (Passive) Investors

For people who aren’t inclined to spend a lot of time on investment research, Graham recommends simply adopting an indexed approach to investing.  In plain language, this means that investors who don’t want to think about their investments should be happy to receive market returns less a small percentage for investment fees.  To accomplish this, Graham recommends placing a portion of your portfolio (from 25 – 75%) in a diversified stock fund, with the remainder placed in high quality bonds (or bond funds).  As stocks and bonds tend to perform well at different times, by placing money in both markets and rebalancing annually (which will be described later on), the total volatility (change in value) of the combined portfolio from year to year should be less than an all-stock portfolio.

Though standard advice is to maintain a 60% / 40% split between the equity and fixed income (bond) portions of a portfolio (which is good advice for many to adopt), Graham suggests altering this mix depending on the relative attractiveness of the equity markets and bond markets.  With interest rates currently at or near historic lows, I feel that the potential for achieving significant real returns in the bond markets (after inflation) over the next few years is low.  Therefore, I would currently contend that maintaining a slightly underweight fixed income holding (25% of the total portfolio) may be prudent.

As there is risk in losing purchasing power in the fixed income portfolio over time due to inflation and rising interest rates, adopting a slightly higher weighting (75%) in equities seems appropriate.  As the available field of index funds has exploded in recent years, it is now possible to own a piece of the entire global equity market in a single fund with a relatively low expense ratio.  By going this route, passive investors can be assured of catching the ‘next big thing’ as they own a bit of everything!

To ensure that the entire portfolio isn’t invested just as the equity (or bond) markets peak, investors should also look to invest (approximately) equal dollar amounts in the portfolio each month.  This strategy is known as dollar-cost averaging and it helps to smooth fluctuations in the portfolio as more shares (or units) are purchased when prices are low, and relatively fewer when prices are high.

Similarly, to help enforce the ‘buy low, sell high’ mantra, each year investors should perform a portfolio review to determine whether the portfolio as a whole is still at the target bond and equity allocations.  If the bond and equity portions of your portfolio are significantly different than their target percentages (due to market fluctuations during the year), a portion of the overweight component should be sold and reinvested in the underweight component to bring the target allocations in line.  This is known as ‘rebalancing’.  During this portfolio review and rebalancing act, investors should also determine if the target percentages for the bond and equity portions of the portfolio assigned at the beginning of the year are still appropriate based on current events (here’s where sticking with the less complicated constant 60% equity, 40% fixed income portfolio simplifies things).  Depending on the current market and interest rate conditions, increasing or decreasing exposure to either the bond or equity markets may be prudent (though remember to always maintain a 25% minimum or 75% maximum allocation to each).

Summary

In this first post about investing strategies, we’ve looked at what Benjamin Graham referred to as defensive investors, or those investors who would like to have a hand in their own finances, but who don’t have the time or the inclination to do their own market research.  In this case, I agree that adopting a passive or indexing strategy with both bonds and equity funds in a portfolio is the most prudent path forward.  In this way, the investor can be assured that they make a satisfactory return (based on the market performance) without being on the hook for significant investment fees.

In the next post, I’ll start to look at different types of enterprising (or active) investors and compare and contrast a few different investing styles.  As always, feel free to leave any questions or comments below or send me an e-mail and I’ll get back to you as soon as I can.

Until next time,
Nathan @ EngineeringIncome.com

Disclaimer:
The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question. The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past. This is generally not true. It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation. For more information, please see my disclaimer.

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Options Trading: Writing Cash-Secured Puts

Cash-secured put options are similar to ‘limit buy’ orders in that they potentially allow you to acquire a stock at a later date at a price below the current market value.  The main advantage of writing cash-secured puts instead of using limit buy orders comes from the income (options premium) received from the options contract.  By writing a cash-secured put, you are essentially being paid to wait until your order is filled or expires.  As a bonus, if the contract is exercised and you receive your shares, the options premium received acts like a rebate on your purchase price, lowering your adjusted cost base! (See Note 1)

Prerequisites:
When writing a put option, the strike price of the options contract represents the buy price of the security if the contract is exercised.  To ‘cash-secure’ the put, a cash amount equal to the total buy price of the option (strike price multiplied by 100 shares for each contract) must be ‘set aside’ in your trading account until either the options contract is exercised and you buy the shares, or it expires and you keep the premium.  By setting aside the total purchase price of the options, it ensures that no undue leverage is employed and helps to avoid any unnecessary margin calls.

In addition to having enough cash in your portfolio to cover the buy price of the shares should the put option be exercised, your brokerage account must also be approved for put options trading.  Unfortunately only non-registered investment accounts are currently eligible for writing puts in Canada.

Determining an Appropriate Options Series:
Determining an appropriate options series is largely subjective.  By writing short-term in-the-money cash-secured puts, an investor can be relatively confident of receiving their shares at a slight discount to the current market price sometime in the near future (within one month).  By writing longer duration out-of-the-money puts, the options writer can potentially acquire the stock at a larger discount to the current market price and may also potentially receive a larger options premium.  However, the chance that the options contract may never be exercised also increases.

Rate of Return:
When writing medium to long term cash-secured puts, it is important to look at both the annualized options yield if the contract expires out-of-the-money, and the adjusted cost base (adjusted buy price) if the contract is exercised at expiry.

In order to make writing put options worthwhile, I want to receive at least an 8% annualized options yield net of commissions.  This ensures that even if none of my options are exercised, I generate an acceptable return on my cash position.  Similarly, if the put options are exercised, I want my adjusted buy price to be at a suitable discount to the current price.

Example – Abbott Laboratories (ABT):
To outline the process of selecting an appropriate strike price when writing cash-secured put options, I have replicated part of the February 2011 put option chain for Abbott Laboratories (ABT) as Table 1 below.  In addition to the strike and bid prices, I have added columns representing the annualized put option yield based on the bid price and corresponding strike price and the adjusted cost base of the stock should the option be exercised at expiry.  Note that neither column reflects the impact of trading commissions.

Table 1:  Partial ABT ‘Put’ Option Chain for Feb/12

Option

Strike Price

Bid Price

Annualized
Yield

Adj. Cost Base

ABT_110219P00044000

44.00

0.73

6.6%

43.27

ABT_110219P00045000

45.00

1.00

8.9%

44.00

ABT_110219P00046000

46.00

1.35

11.7%

44.65

ABT_110219P00047000

47.00

1.81

15.4%

45.19

ABT_110219P00048000

48.00

2.39

19.9%

45.61

ABT_110219P00049000

49.00

3.05

24.9%

45.95

Before discussing which strike price seems most suitable, note that one of two things happens at the expiry date:

a.       The option expires out-of-the-money:  You do not buy the shares, but keep the option premium.  The return on the cash securing the put option is equal to the annualized yield.
b.      The option expires in-the-money:  You buy the underlying shares at the strike price.  The options premium is applied against the purchase price which results in the stated adjusted cost base for the shares.

Based on the information in Table 1, writing a put option with a strike price of $45.00 or higher would result in an annualized yield of greater than 8%.  Therefore, to differentiate between the various strike prices, it is important to look at the adjusted cost base of the acquired shares if the option is exercised at expiry.

As ABT has a 52-week low of $44.59 and a current market price of $46.92, it would be nice to both acquire the shares at a discount to the current market price, and to acquire the shares near the 52-week low.  Table 2 presents an overview of the discount to market price that would be realized if the various options were to expire in-the-money. Note that for this to happen, the market price would have to fall below the strike price of the relevant option at expiry which may or may not happen.

Table 2:  Discount to Market Price if Exercised at Expiry

Strike Price

Adj. Cost Base
(if exercised)

Discount to Market Price

44.00

43.27

7.8%

45.00

44.00

6.2%

46.00

44.65

4.8%

47.00

45.19

3.7%

48.00

45.61

2.8%

49.00

45.95

2.1%

Given that ABT is trading near its 52-week low and has strong business fundamentals (full analysis to come), if I were interested in acquiring shares, I would consider writing cash-secured puts with a $47.00 strike price.  If the share price remains below the $47.00 at expiry, I would receive the shares with an adjusted cost base of $45.19 which is 3.7% below the current market price and within 1.3% of the 52-week low.  Alternatively, if the share price rises above $47.00 at expiry, I would have generated an options premium of $181 per contract which is equivalent to an annualized yield on the securing cash of 15.4%.

Summary:
Writing cash-secured puts can be a good way to acquire shares at a discount to current market prices or to generate additional income for your portfolio.  However, as with all options trades, it is important to make sure that you fully understand the potential risk & reward and have the necessary collateral (cash reserve) to cover the position.  Writing ‘naked’ options (without having a covering position or appropriate cash reserve) is a highly speculative activity that can quickly result in significant losses far exceeding any initial investment returns.

Happy Investing,
Nathan @ EngineeringIncome.com

Note 1: Taxation on options transactions can be complex.  Records of all transactions must be maintained and should include the date the contract was initiated, total commissions paid, options premiums received, and the outcome of the options trade on the expiry date (expired vs. exercised).  It is strongly recommended that investors trading options in taxable accounts consult their tax or investment advisor to ensure that their taxable income from investments and adjusted cost base are both reported correctly.  An overview of the current Canadian taxation regime with respect to options trading is available from the TMX Montreal Derivatives Exchange for those who are interested.

Disclaimer:
The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question.  The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past.  This is generally not true.  It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation.  For more information, please see my disclaimer.

Full Disclosure: As of the publication date, the author had no positions in any securities mentioned in this article.

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Options Trading: Writing Covered Calls

One of the reasons I like investing in dividend stocks is that I feel that they are inherently less risky than non-dividend paying stocks.  Each time a dividend is received, a small gain on your invested capital is ‘locked in’.  However, in volatile markets, price fluctuations can be significantly greater (in percentage terms) than any dividends received.  To help combat drastic swings in valuation, and to augment the income received from dividends, I’ve adopted a strategy of writing covered calls on suitable long positions.

Writing Covered Calls:
Writing covered call options can be thought of as getting paid for writing a limit sell order.  As with a limit-sell order, a sell price is specified when the options order is entered which limits the maximum achievable capital gain when the contract is in force.  If this sell price is not met when the option expires, you keep the options premium received (free money!) and the stock.  The difficulty in implementing a covered call writing strategy is determining a personally acceptable maximum potential rate of return over the duration of the contract in relation to the options premium received.

Prerequisites:
As each call option represents 100 shares of the underlying security, a covered call writing strategy can only be adopted on long positions involving at least 100 shares.  In addition, your brokerage account must also be approved for options trading.  In Canada, both registered (RRSP, TFSA, etc.) and non-registered investment accounts are eligible for trading covered calls.

Determining an Appropriate Options Series:
Determining what options series to open is highly subjective and is based on a number of factors unique to each investor such as the commission required to write options, the desired annualized yield from options premiums, and the minimum annualized capital appreciation.  To determine the options series that I write for each of my positions, I use the following guidelines:

1.)  Expiry Month
The expiry month of the options series determines how long the options contract will be in force.  As an options’ time value decreases as it approaches expiry, writing contracts with an expiry far in the future will increase the options premium received for each contract.  However, as the time value of options decays more rapidly the closer you are to expiry, the annualized options yield (premiums received per year) can be greater by writing options with expiries in near months (up to three months out).

My rule of thumb for most stocks is that using an expiry date three months into the future tends to provide a balance in terms of capital appreciation potential, options premium received, and trading commissions.

2.)  Strike Price
The strike price of the option series sets the maximum price that you can ‘sell’ the stock for as long as the options contract is in force.  In choosing a strike price, I look at the worst-case total return (capital gains over the life of the contract plus options premium received less commission) of the stock over the two to three month period to expiry.

In general, I tend to write out-of-the-money options with strike prices that allow a total return (not including dividends) of between 7-8% over the length of the options contract.

3.)  Options Premium
As compensation for limiting the potential for capital gains over the length of the options contract, I want to receive at least a 5% annualized options yield (net of commission) on each position I write covered calls on.  Ideally this yield would be higher, but with small positions (writing 1-2 calls at a time) commissions significantly reduce the options yield.

After examining a stock’s call option chain, if I cannot identify an expiry month and strike price that will provide an the annualized options yield greater than 5%, and a worst case total return (less dividends) of greater than 7%, I will not write the contract.  Instead, I will wait until a more volatile market (options pricing increases with market volatility) and then enter into the position.  Otherwise I do not feel adequately compensated over the duration of the options contract for the potential of lower capital gains.

Performance of Options Strategies:
Writing covered calls on open long positions will generally underperform the market in strong uptrends, but outperform the market in downtrends, flat markets, and provide equivalent returns during modest uptrends.  By underperforming during strong uptrends and outperforming in downtrends or flat markets, the overall year-to-year highs and lows in the portfolio will be closer together resulting in lower portfolio volatility.

Over a number of market cycles, the total long-term return of covered call writing should at least equal that of straight buy-and-hold investing.  However, the income generated by a portfolio active in writing covered calls will be significantly greater than that of the buy-and-hold investor.  This can allow for more frequent reinvestment of dividends and options premiums which can help to increase the overall compound growth of a portfolio.

Example:  Microsoft
The following outlines the steps that I would go through in writing a covered call on Microsoft (MSFT) stock.  Note that this analysis is based on a closing price of $25.26 on November 30, 2010.

1.)  Determine a strike price:
Writing a covered call with a strike price of $27.00 would result in a sale price (if called) 6.8% over the day’s close.  A strike price of $28.00 would result in a sale price (if called) of 10.8% over the day’s close.

Based on the above, a strike price of $27.00 would seem to be appropriate as the total return (if called) including the options premium should be between 7-8% over the duration of the contact.

2.)  Determine an expiration month:
In order to receive a decent options premium, February 2011 is chosen as the expiration month.  The options chain for February 2011 calls is as follows for MSFT:

Table 1:  Partial MSFT ‘Call’ Option Chain for Feb/11

Option

Strike

Bid

Ask

MSFT_110219C00025000

25.00

1.33

1.35

MSFT_110219C00026000

26.00

0.85

0.87

MSFT_110219C00027000

27.00

0.51

0.53

MSFT_110219C00028000

28.00

0.29

0.31

As can be seen from Table 1, the bid price for the options with a $27.00 strike price is $0.51.  Thus, for each option written, you would receive $51.  Based on a closing price of $25.26, this is a yield of approximately 2%.  Assuming a $10 options trading commission, the options yield net of commissions would be approximately 1.6%.  Annualized over four quarters, this would result in an options yield (after commissions) of ~6.5%.

Summary:
With an annualized options yield net of commissions of 6.5% and a total return of approximately 8% (plus dividends) over two and a half months (if called), writing covered calls of MSFT for Feb11 with a strike price of $27.00 fulfill my covered call criteria.

Until next time,
Nathan @ EngineeringIncome.com

Disclaimer:
The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question.  The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past.  This is generally not true.  It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation.  For more information, please see my disclaimer.

Full Disclosure: Author is short MSFT calls and long MSFT stock at the time of this writing.

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Stock Options Overview

Options trading is regarded by many as a high-risk, high-reward investing strategy that can make or break fortunes almost overnight.  However, in my opinion, options are one of the most useful, misunderstood investment instruments for long-term buy-and-hold investors.  By adopting a conservative options writing strategy, a long-term investor can significantly reduce volatility in their portfolio, increase their portfolio’s yield, all without negatively impacting potential long-term returns.

Over the next few weeks, I’ll be producing a few articles on a number of useful options strategies for long-term buy-and-hold type investors.  However, before I get started on explaining actual options strategies, I will first spend some time giving background on options themselves.

Options Trading Overview:
Before diving into options trading, it is useful to gain an understanding of options trading terminology to simplify the process.  First and foremost, an options contract is a derivative instrument.  Though derivatives have got a bad rap from the financial meltdown, this simply means that an options contract has no value in and of itself, but rather derives its value from the price of the its underlying security.  Options can be traded on most established stocks, ETF’s, ETN’s, CEF’s and other security types listed on major exchanges.  However, as a point of caution, options are traded sparsely on many securities which can lead to wide bid-ask spreads.  A careful examination of the risk-reward profile in these situations coupled with the use of limit orders is recommended.

To simplify the discussion of options terminology, I have reproduced part of the option ‘chain’ for Microsoft Corp (MSFT) in Table 1 below.  This table was assembled November 22, 2010 when MSFT was trading at $25.57.

Table 1:  Partial MSFT ‘Call’ Option Chain as of November 22, 2010

Option

Strike

Bid

Ask

MSFT_101218C00025000

25.00

0.89

0.90

MSFT_101218C00026000

26.00

0.33

0.34

The first column in Table 1 contains the option identification string.  This string contains most of the important information on the option contract itself and breaks down as follows:

  • MSFT_101218C00026000:  The first letters in the identification string refers to the stock (or security) that this option contract refers to.  In this case, this option derives its value from the stock of Microsoft Corp. (MSFT)
  • MSFT_101218C00026000:  The second set of numbers refers to the expiry date of the contract.  In this particular example, the contract expires on December 18, 2010.
    • Options are available with expiries from months to years in the future.  In each case the option contract will be associated with an expiration month.  Options expiry effectively occurs at the close of the markets on the 3rd Friday of each month (December 17th in this case) as Saturday is not a trading day.
  • MSFT_101218C00026000:  The letter identifier after the expiration date identifies the options contract as either a call option (C) or a put option (P).  Calls and puts are the two types of options contracts that can be traded and will be discussed in more detail below.
  • MSFT_101218C00026000:  The last set of numbers is the strike price of the contract.  In this case, it is $26.00 (the identifier carries three decimal places).
    • The strike price is the agreed upon price at which the stock will be bought or sold if the contract is exercised before it expires.  It also is the price that determines whether or not a contract can be exercised.

In dissecting the options identification string, the concepts of expiry, exercising options, strike price, and call and put options were raised.  I’ll come back to address these in a moment after finishing with Table 1.

The last two columns of the table provide the ‘bid’ and ‘ask’ prices.  This is the premium to either buy the contract (ask price) or sell the contract (bid price).  However, as each options contract represents 100 shares of the underlying security, the amount of money required to buy one contract at the $26.00 strike price is actually $0.34 (ask) x 100 = $34.

From the above example, it can be seen that buying options allows individuals to control a significant number of shares with minimal cash outlay ($34 vs. $2557).  This leverage allows options traders to generate massive gains (or losses) very quickly as price movements in the underlying security are amplified and reflected in the options price.  This serves as a warning to investors:  Make sure you completely understand any options trade that you enter into as the potential for permanent capital loss can be greater than investing in the equities themselves.

Options Terminology:
In the above section, the concepts of options expiry, exercising options, strike price, and call and put options, and an options premium were raised.  A lot of the discussion on these topics is linked, so I will address the various points throughout this section, though not necessarily in order.

1.)  Call Options
Calls options are one of the two types of options contracts available.  A call option gives the holder the right (not the obligation) to buy the underlying security (100 shares per contract) from the issuer at the strike price.  This right is granted for a fixed-period of time (until the expiration date is reached) and can only be exercised if the underlying security is trading above the strike price.

In Table 1, it can be seen that with MSFT trading at $25.57, the $25.00 calls could be exercised forcing the issuer to sell the buyer 100 shares of MSFT at $25.00 (which could then be sold at market for a profit of $0.57 per share).  As the strike price is below the stock price, this call option is said to be in-the-money.  Conversely, the $26.00 calls are considered out-of-the-money and cannot be exercised as the stock price is below the strike price.  However, as the expiry date is not for another few weeks (Dec. 17th), the contract still has value in that MSFT may appreciate over that time to over $26.00 which would then cause the $26.00 calls to be in-the-money.

2.)  Put Options
Puts are the second type of option and function opposite to calls.  A put option gives the holder the right (not the obligation) to sell the underlying security (100 shares per contract) to the issuer at the strike price.  This right is also granted for a fixed period of time (until the expiration date) and can only be exercised if the underlying security is trading below the strike price.

Though I haven’t reproduced a put option table, puts are considered to be in-the-money if the strike price is above the stock price (as you can force the issuer to buy your shares at above the market price) and are considered out-of-the-money if the strike price is below the stock price.  Thus, for the MSFT example above, a $25.00 put would be out-of-the-money and could not be exercised whereas a $26.00 put would be in-the-money and could be exercised at the discretion of the holder.

3.)  Options Valuation
Based on the above discussion of calls and puts, it can be seen that the strike price of the option in relation to the underlying stock price is very important.  Additionally, the length of time before an option expires is important as the farther away the option is from expiry, the more likely that the underlying security can appreciate (or depreciate) adding value to the option.  These two concepts are linked and relate to the value of the option or its premium.

3a.)  Intrinsic Value
The intrinsic value of an option reflects the difference between the strike price and the current stock price.  It also represents the value of the option on the expiry date as options at expiry have no time value left.  Only options that are classified as in-the-money have intrinsic value.  Therefore, calls have intrinsic value only if the stock is trading above the strike price.  Similarly, puts have intrinsic value only if the stock is trading below the strike price.  By definition, if the stock price is equal to the strike price, the intrinsic value is zero.

The intrinsic value of a stock option is easy to calculate.  For calls, it is the greater of either zero or the stock price minus the strike price.  Correspondingly, for puts, the intrinsic value is the greater of either zero or the strike price minus the stock price.

3b.)  Time Value
The time value of an option is based on the remaining length of time before option expiry and the distance between the strike price and the stock price.  As the formula to calculate the time value for a given option is complex, it is most easily calculated by determining the intrinsic value of an option and subtracting that from the premium.  From Table 1 for Microsoft Calls, the time value of the $25.00 calls is calculated to be (0.89 – 0.57) = $0.32 whereas for the $26.00 calls it is $0.33 (as there is no intrinsic value).  Note that options right around the strike price tend to have the highest time value.  If I expanded the MSFT ‘call’ option Table, an in-the-money option at a $23.00 strike price would have a time value of only $0.06.  Similarly, an out-of-the-money option with a $28.00 strike price would have a time value of only $0.04.

One of the important things about time value is that it decreases as the option approaches the expiry date.  By definition, there is zero time value at expiry.  It is also important to note that the decay in time value is non-linear and speeds up as the option gets closer to expiry.  Due to this decay acceleration, options lose over 50% of their time value within the last two months before the expiry date.

Summary:
In the above sections, I outlined the two basic types of options as well as terminology commonly associated with options trading.  Building on this knowledge base, in the next few posts I will use the ideas presented above to outline a few relatively simple options strategies that can be successfully employed by long-term investors.  As options trading can be complex, any questions about the above terminology or options types can be left in the comments and I’ll try to provide clarification where needed.

Until next time,
Nathan @ EngineeringIncome.com

Disclaimer:
The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question.  The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past.  This is generally not true.  It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation.  For more information, please see my disclaimer.

Full Disclosure: Author is short MSFT calls and long MSFT stock at the time of this writing.

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