Trojan Investing Newsletter

November 13, 2008 Issue 2 - Volume 2

Welcome Trojan Investors! Inside This Issue

We would like to thank our contributors and those
who have invested their time and effort to make the Trojan Trend Analysis
Investing Newsletter all that it can be. If you are interested Aerospace and Defense, Defensive Play?...p.2
in contributing or editing, please contact us at
trojan.investing.newsletter@gmail.com. For those of
you who are new to the TIN, read on to find out how you Investment Analysis
can benefit from joining our readership. GS - An Uncertain Future....................... p.4
Through issues distributed at the beginning of
each month, the Trojan Investing Newsletter hopes to
bring ideas together that stimulate new ways of thinking Learning Center
to benefit you as an investor. Through critically analyzing Naked Puts As Limit Orders.................... p.6
economic and sector/industry trends as well as individual
securities, we hope to provide you with new insight into
how to view the world as a place to invest.
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“When you’re in a pit, the first thing to do is stop dig-

ging.” Contributors:
-James Ellman Joshua Inouye, Richard Graham, Alexander Muhr

Co-Editor-In-Chiefs:
-Trojan Investing Newsletter Staff
Alexander Muhr
Jordan Ohama

Disclaimer: Views expressed in this newsletter are not those of the University of Southern Cali-
fornia or any of TIN’s affiliated groups, but the author’s own. Recommendations are made by
students, not financial professionals. Readers should not rely on information from the following
articles or the recommendations therein for trading or investing. The purpose of this newsletter is
to facilitate discussion and broaden students’ awareness of current market issues.

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does it guarantee the accuracy or completeness of any information presented therein.
A “Defensive” Play?
By Alexander Muhr Price volatility has also been a major factor in decision-mak-
Written on: Oct. 20, 2008 ing at aerospace and defense firms – where we have only seen
3-month historical volatility like now since early 2003 (~65%)
In general, aerospace companies – especially the largest ones – and right now we are seeing the same measure spiking to new
need immense amounts of capital in order to develop, design highs above 60%.
and manufacture their systems or vehicles. Beyond the need
for capital, they are also vulnerable to the governments they
service, commodity prices, their manufacturing employees,
and subcontractors. These dependancies force companies in
the aerospace industry to have a diverse set of customers as
well as scale in production. There has been a lot of consoli-
dation over the years due to these dilemmas, and many of the
remaining players in the industry are large and diverse

Products from this industry segment include:

• Commercial and passenger aircraft
• Military aircraft
• Weapons and intelligence systems
• Satellites
Light Sweet Crude Contiunous Contracts, Nov. ‘05-Current
Aerospace is a highly cyclical industry. In a strong economy, Source: Stockcharts.com
more people travel and exchange goods; requiring the trans-
portation services provided by this industry to get business One of the biggest impacts of the oil price spike is the
done. During these periods, governments reap the benefits pwnage of the airlines industry. The recent price spike has
of increased tax revenues and are able to spend more on de- caused many airlines to second-guess expansion plans and
fense products or other capital-intensive projects contractedcancel orders for planes from stalwarts such as Boeing (Tick-
to these companies. er: BA) or EADS. Boeing reported that past quarter plane
deliveries are down 23% (25 planes) and over the same period
Here are a few themes that investors should focus on in this from last year they are down 33% (42 planes) in its recetly
industry segment: released quarterly (SEC 10-Q) report.

1. Fuel prices – recent and anticipated Government Clientele

2. Government – US and international defense spending In 2008 and for the past decade, the US stands out as the
3. Air Traffic – this includes for commerce and travel unchallenged global leader in terms of the dollar amount.
spent on aerospace defense. According to GlobalSecurity.
Fuel Prices org, which has updated the defense budgets of many differ-
Crude oil prices are obviously one of the main factors that ent countries, the world spending in aerospace defense totals
influence how airlines and commercial shipping compa- at least $1.2 trillion dollars.
nies operate and expand. Without a stable price or a price
at which the firms are profitable, investments in new air- According to the CIA World Factbook, the United States
planes or related services decrease. In recent months, is ranked 28th in the world in terms of military spending
both extremely high fuel prices and volatility have caused as a percent of GDP – 4.06% (2005 estimate). This is only
many companies and governments to decrease spending. including the base budget for the Department of Defense,
while other spending may happen under other departments,
Currently, crude oil prices stand at $63 per barrel, and for depending on the purpose. From the 2005 budget if the US
December 2009 that markets are forecasting $69 oil, while Government we can see that in reality, the comparison to
for December 2016 the market expects $85 per barrel of oil. GDP is quite small, even though the amounts might seem
huge, but that doesn’t preclude the funds from being taken. and efficiently transfer them.

For 2009 the Department of Defense has requested $515
billion for its base budget (74% over the 2001 level) and $70
billion in emergency allowances to fight the Global War on
Terror.
DoD Funding that affects the industry:
• $17.3B to modernize aircraft fleets
• $7.5B for tactical vehicles/armor
• $12.7B to build warships
• $1.8B for unmanned aerial vehicles
• $10.7B to “maintain leadership in
space”
• $10.4B to enhance “missile defense”
systems
These are just some of the major parts of the budget for
the DoD, and does show that firms doing business in Aero-
space and Defense have a strong tailwind. The one caveat is
that military spending in dollar terms is very high, and with a the US and Europe because of the convergence of the world
regime change we could see these number decline. The likeli-
hood of that though, looks to be small due to the potential
political backlash – fear of terrorist attacks are still widespread
and was found to be among the top fears of Americans ac- Near-Term Troubles
cording to the exit polls during the recent election.
According to the Bureau of Transportation Statistics, since
1981 (to 2007) “Over-all available ton-miles” for air transpor-
tation grew from 61.24 billion to 204.33 billion, an annualized
growth rate of 4.55% (BTS). Although the growth rate has
slowed to 3.03% per year since 2001, the ability for airplane
sales growth still exists due to the aging fleet of airplanes.
Another factor in airplane sales growth comes from devel-
oping nations, which have much less capital assets and in-
frastructure than countries like the US. In the United States
and Europe there are 65% of the passenger jets in the whole
world, while the population is only 17%. India and China
have 37% of the population but only 20% of the passen-
ger jet fleet (Page 7, S&P Industry Survey). As the popula-
tions of developing countries grow wealthier, there will be
an increased propensity to consume and travel – in turn that
will mean buying planes to feed the appetite of the country’s
citizens. Regions such as Asia, the Middle East, Africa and
Latin America will all grow faster than mature markets like
economy and the marginal ability for developed economies
to expand rapidly – although that is not out of the question.
In the near future, due to the major contraction in credit,
business will not be good for many aerospace and defense
firms. Budgets will need to be trimmed by both the consumer
and the government. Some interesting points come out of
the shipping and trucking industry to illustrate the amount
of business contraction.

On October 24th, the Wall Street Journal ran an article de-

scribing the ordeal that many trucking companies are going
through currently. According to the WSJ, 1,908 trucking con-
cerns have gone bankrupt already through the first half of
US Drone Unmanned Aircraft 2008 and are expecting over 2,000 more will go belly-up by
Source: News.bbc.co.uk the end of the year – that’s out of 200,000 companies. UPS
also said they have seen “precipitous declines” in their next-
In the longer term, there are still many threats in the world day delivery options, which are where they make most of
and defense spending will be a prime mechanism for protec- their money. And this is all happening at a time when nor-
tion. Military spending in China is increasing, while Iran con- mally shipping volumes would be up in anticipation of the
tinues to clamor for nuclear power (and possibly weapons), holiday season. These kinds of anecdotes reveal what is really
and Islamic extremism has not really decreased, so the US going on in the economy, and it’s not pretty.
and other countries will continue to budget billions of dollars
for aerospace and defense firms to compete for. Overall the industry can considered a “defensive” play dur-
ing a downturn due to the outstanding contracts the firms
Air Traffic currently hold and their ties with government. Economic
When we talk about “air traffic” there are two segments. First downturns hurt virtually every business, but some are able
there is the passenger who is paying to travel. Second, there to maintain their competitive advantage, and Aerospace &
are firms such as UPS and FedEx that buy planes in order to Defense industry certainly has that quality.
transport goods throughout the world and need to quickly
An Uncertain Future - GS
By Richard Graham activities, and asset management and securities services. Its
Recommendation: Sell primary operations occur in the United States, accounting for
71% of its revenues in 2007. In spite of the financial down-
Snapshot turn, Goldman posted a profit of $1.89 per share in their
Company Name: Goldman Sachs Group, Inc. most recent quarter, ending August. This number however, is
Ticker Symbol: GS significantly less than the $6.54 per share Goldman posted a
Closing Price (Nov 13): $67.31 year earlier. Its primary source of revenue came from trading
Market Cap: $26 Billion and investments, which accounted for almost 50% of overall
P/E (ttm) 4.04x revenue last year. The other two segments, investment bank-
Source: www.finance.yahoo.com ing and asset management and securities services each made
up about 25% of Goldman’s overall revenue.
It seems that every week a new wave of financial institutions
are hit with cataclysmic losses and either have to accept a gov- Challenges
ernment bailout or are forced to merge with a more financially Now that Goldman is a CIB, in order to be considered well
sound company. Until recently, Goldman Sachs Group, Inc. capitalized it will be required to keep a Tier 1 capital ratio of
appeared unscathed by the collapsing markets and was one 6% and a Leverage Ratio of 5%. Its current Tier 1 capital ra-
of the last standalone investment banks. By late September, tio of 4.6% and Leverage Ratio of 3.7% is unsustainable and
2008 though, it had succumbed to market pressure and was Goldman will be forced to deleverage itself to meet Leverage
reorganized as a bank holding company. It further offered $5 Ratio requirements. Goldman’s trading and investments ac-
billion in preferred stock to Berkshire Hathaway, Inc., held tivities, which accounted for 50% of its revenue, will bring in
a public offering less revenue
for $5.75 billion in the fu-
and accepted a ture due to
$10 billion capi- the decrease
tal injection from in invest-
the US Treasury. able capital.
Collapsing
The financial commodity
landscape may prices and
be volatile and equity mar-
unpredictable, kets pose
but there is still further risks
value and poten- for this op-
tial to create val- erating divi-
ue within these sion. These
large institutions. market con-
By researching ditions re-
Goldman Sach’s quire Gold-
current financial man to rely
Source: Finance.yahoo.com
situation, its future prospects and the likelihood more heav-
of those prospects, it is possible to determine whether or ily on investment banking and asset management activities to
not this company still has any value and whether the current maintain and grow its profits. Unfortunately for Goldman’s
market price clearly reflects this value. investment banking arm, companies are less willing to go
public or merge/acquire due to poor market sentiment and
Most Recent Quarter (MRQ) lack of availability of credit. According to the Wall Street
After being reorganized as a bank holding company, a com- Journal, there has been 25 straight weeks without an Ameri-
mercial investment bank (CIB), Goldman is involved in in- can IPO. This streak represents the longest period without an
vestment banking activities, trading and principal investment IPO in the last 28 years. The weak IPO market doesn’t only
mean fewer IPOs, it also means lower willingness to pay high credit crisis. Moreover, Goldman has taken the necessary
fees, lowering the margin on any potential future deals. steps to increase its liquidity by participating in the Treasury’s
market rescue program by issuing $10 billion in senior un-
Balance Sheet Trouble secured debt to the Treasury. Furthermore, while there have
Goldman Sachs is also currently facing problems related to been rumors of a merger with Citigroup, Goldman has taken
its assets. According to its most recent 10-Q filing, Goldman no real steps to merge with other financial institutions, a sign
still holds roughly $30 billion dollars in collateralized debt ob- of its strength to remain independant.
ligations (CDOs) and mortgage-backed securities. Of these,
$18 billion are Level 3 assets. In order to be classified as a Final Analysis
Level 3 asset, it “requires inputs that are both significant to Until the current market turmoil passes, it is unclear whether
the fair value measurement and unobservable.” This means or not Goldman will suffer more losses from the market col-
that Goldman values these assets themselves and does not lapse. Goldman’s inability to more heavily trade as a result of
value them at market price. Because Goldman is valuing two- becoming a CIB and decreasing investment-banking fees due
thirds of its CDO and MBS portfolio as Level 3 assets, the to current macro-economic uncertainty also could prevent
mark down which should accompany the decrease in market future profit growth. However, Goldman’s superior business
prices for CDOs and MBS has not occurred. Even though strategy and leadership leave it poised to succeed in the cur-
Goldman posted a $1.5 billion gain on Level 3 Assets in its rent market. While Goldman has a powerful leadership factor
most recent quarter, the potential for future write-downs ex- working to grow the company the aforementioned analysis
ist. As it unwinds its trades and deleverages itself, Goldman of Goldman’s financial troubles trumps and creates uncer-
may be forced to revalue its Level 3 Assets, particularly its tainty for future profit growth and the potential for more
CDO and MBS portfolio, at a potentially significant loss. losses and a smaller share price. For that reason I am recom-
mending Goldman Sachs Group, Inc. as a SELL.

Source: Lewrockwell.com

Opportunities for Success

Before the financial crisis began, Goldman Sachs was consid-
ered to be the premier investment bank due to strong leader-
ship from Lloyd Blankfein and David Viniar. Even though the Goldman Sachs Tower
crisis has shaken the books of Goldman Sachs, its leadership Source: Flikr.com
and talent has largely remained intact. Goldman’s employees
and leadership has so far proven that it has the foresight and
financial ability to squeeze a profit even in the midst of the
Naked Puts As Limit Orders
By Joshua Inouye
Suppose that you want to purchase shares at $50. You could
watch the stock every day to see if it drops to around $50 or
you could submit a limit order of $50. With the limit order,
if it does drop down there, you will have saved yourself 4.39
(the price of WMT at the time of this writing, 11-9-08, was
54.39). However, if the stock never gets to that level, you save
nothing and you make nothing.
One interesting way to play this is to sell a naked put with a
strike price of $50, December expiration (the price of this
put on 11-9-08 was $2.31). One of two things will occur at
the expiration of this put:
1. The stock is below $50 at expiration, and you will
have the stock put to you at a price of $50 (you will be forced
to buy the stock at $50 from the person who bought the op-
tion). That’s what you originally wanted, right? Obviously it is
now below 50 (maybe much lower) if you were put the stock,
but you are confident that WMT is a good stock to own, and
are convinced that it will rise in the future. Now, you’ve saved
yourself $4.39 plus the premium you brought in from selling
the put: $2.31. So you now own the stock at a net cost of
$47.69! The put has made your buying price $2.31 less than
the strike price (and your original target price).
2. The stock is above $50 at expiration, and you will not
have the stock put to you. Perhaps the stock has rallied, never
again to touch the $50 mark. However, you now have made
$231 from each contract you sold. That’s a lot better than the
nothing you would have made if you didn’t sell the put!
As a sidenote to situation 2, the margin requirement for set-
ting up (one) naked call is about $880, so your return on this
over the one-and-a-half month period would be 26%, and
you didn’t even have to own WMT. This is a nice situation
to be in, but will only ideally happen if WMT doesn’t drop
much, otherwise you will have to put up more margin to
maintain the position (naked option margin requirements are
marked to the market), and your percentage return would go
down somewhat. But it is still certainly better than 0%. You
can even use stocks or bonds you own as collateral for the
margin requirements so you don’t have to invest cash for this
strategy.
There are certainly some strings attached (come on, it’s just
simple economics). One is that your risk is leveraged greatly
on the downside, so can be wiped out if you’re not careful
and you write too many puts. Also, if you don’t wait until
expiration and decide to buy the put back because you got
nervous about owning the stock, any downside move will
have made the put increase in value, and therefore you will be
faced with a loss when buying it back if not much time has
passed and the implied volatility is approximately the same.
Furthermore, if implied volatility goes up, the option price
will rise and you will lose if you decide to buy it back. Again,
it depends on how much time has passed. The figure below
helps explain this graphically.
Profit/Loss Graph of Selling Naked Dec. 50 Puts on WMT
You originally establish the position at the gold star when the
price of the stock is 54.39. Your profit/loss is shown on the
vertical axis, and you can see that your initial position has a
P/L of $0. That is because you could immediately buy the op-
tion back for no profit or loss (less transaction costs, assum-
ing the stock price and implied volatility remain the same).
However, if WMT moves up or down, your profit/loss will
be determined by movements along the curved black line. If
implied volatility rises, the entire black line will shift down,
away from the kinked blue line. If implied volatility falls, the
entire line will get closer to the kinked blue line. Also, as time
passes, the black curved line will get closer and closer to the
kinked line until is exactly on top of it at expiration. There
are many good things and bad things that can happen when
you sell a put, and you should be aware of all of them before
you go trying to make 26% returns every month-and-a-half.
Note also that since implied volatility is high (it is very high
for the market as a whole right now, and it is about 59% for
the December 50 WMT put right now), the price of the op-
tion is very high and hence the returns from successfully sell-
ing options are much higher.