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by George Rho of 3Dimensional Research
Building and keeping wealth requires diversification, among and within asset classes. Moreover,
active management of the various assets can enhance the investor’s performance. An investor
in rental properties, for example, can’t simply buy buildings and collect rent. Constant vigilance
is necessary to optimize returns on invested capital. All rentable units should be generating
income, and rents need to be raised whenever supported by market conditions. At some point,
the owner may even decide that a different set of properties would be more profitable. The
same principles of active management also apply to stock investments. Most investors buy a
stock, hope for the best, and sell when he or she thinks that “sufficient” gains have been
achieved. We believe there is a life cycle to a stock investment, with different phases requiring
possibly different actions. In this report, which was inspired by questions from several
subscribers, we discuss both the phases and the actions that investors can take to maximize
returns from each investment. In the process, we will also introduce concepts and strategies
that may be foreign to some investors, but will be necessary both to the understanding and
implementation of most Event Driven Special Situation recommendations and to the optimal
use of the 3DR program.
When stocks are advancing consistently, as U.S. equities have been since March, simply buying
and holding may be the best strategy. Most of the easy gains are probably now behind us, so
active management may well be more important in the months ahead. As such, subscribers are
urged to read on….. (Note: In conjunction with discussing different strategies in our Special
Situation reports, we will store the explanations on our “Strategies” page for future reference.)
The Basic Tools
Stocks have been around for hundreds of years and are generally easy to understand and trade.
The trading of options, on the other hand, began less than four decades ago, in 1973. At first
blush, they can seem like very complex instruments, requiring extensive study. The fact of the
matter is, however, that options are relatively easy to understand, and once understood, can be
profitably used in the management of an investment portfolio. Options, for instance, can be
utilized to increase leverage and to generate current income. Moreover, contrary to widely held
belief, they can also be used to reduce risk and provide a cushion against a drop in stock prices.
All in all, our view is that managing a stock portfolio without using options is tantamount to
going into battle without all the weapons and armor at one’s disposal.
The abundance of options‐related terminology can perplex and deter prospective users, but
understanding a few basic points should clear up most of the confusion. First, there are only
two types of options, calls and puts. Second, there are only two things that you can do with
these options, that is to buy or sell them. Third, although there is a plethora of strategies that
can be implemented with options, only a few are truly useful; most of the others serve mostly
to overwhelm potential users and to enrich brokers.
A call gives the holder the right, but not the obligation, to buy the underlying stock at a
specified price (known as the strike price) anytime until a specified date (known as the
expiration date). A put gives the holder the right, but not the obligation, to sell the stock at the
strike price until the expiration. Options are traded as contracts, with each contract
representing 100 shares of a particular stock. A December $125 call on IBM, for example,
would give the holder of this option the right to buy 100 shares of IBM for $125 each by the
expiration date (December 18th); options expire on the third Friday of each month. A January
$125 put on IBM would give the holder the right to sell 100 shares of IBM for $125 each by
January 15th.
For every buyer of an option, there is a seller (or writer) of the call or put. The buyer pays the
seller a premium for assuming the obligation to sell a stock (for calls) at the specified price,
regardless of the market price of the underlying stock. The buyer of a put can sell his stock at
the strike price, while the seller of the put will have to buy the stock at that price if it’s put to
her. For assuming this obligation, the seller receives a premium from the buyer.
The outright selling (or writing) of a call is almost equivalent to shorting a stock and is too risky
for most investors since the loss potential is unlimited. Combining the selling of a call with
owning the underlying stock can make sense, however, because the sale generates income and
the stock protects (or covers) the seller against losses. This combination is called a “covered
call,” and it is probably one of the best strategies employable with options.
Buying a Stock
The buying of a stock sounds easy enough, considering investors have literally thousands of
foreign and domestic equities to choose from and seemingly as many sources of advice. It’s
seldom easy, however, because the investor ultimately has to decide specifically where to
allocate his or her scarce resources, with the goal always being to buy the best stock available.
Even more important, a reasonable price has to be determined; a company may be worth
owning, but only at the right price. Clearly, investors following specific advisory services, such
as ours, can simply buy the stock immediately after the recommendation is issued. The
“buying” decision becomes a little more complicated if the price has risen before the shares
have been purchased. In this case, the investor has three alternative courses of action. 1. First,
he could buy at the higher price, deciding that the stock is still cheap enough to produce above‐
average returns. To help make this determination, the investor can use various guidelines,
including the price/earnings ratio and the appreciation potential implied by the price targets
outlined in an adviser’s report. The P/E is probably the most useful, and can be applied as
follows: When we recommended Boeing Company stock in early September, the price was
$49.15 and the P/E on estimated 2010 earnings ($4.55) was 10.8. The shares are now $52.50,
making the multiple 11.5. Since the historical norm approximates 20, BA stock still looks
attractively priced. This assessment is also supported by three‐to five‐year price targets ($95‐
$105) that allow for worthwhile long‐term returns. That said, it’s important to note that
price/earnings multiples and price targets are more meaningful for some stocks than others.
Medtronic’s earnings are far steadier and more predictable than Boeing’s, making it easier to
chart the likely course of its stock. 2. Second, he could enter a “limit” buy order, hoping that
the price drops back down to the level at which the stock was recommended. 3. The third is
the least commonly used alternative but is certainly worth knowing. The strategy is referred to
as “writing cash covered puts,” whereby an investor sells a put option that obligates him to buy
a set number of shares of a particular stock at a predetermined price, within a certain time
period. So, getting back to the Boeing example, he could sell one contract of a December $50
put for which he would receive $155 (with the bid/ask at $1.55/$1.65). If the price of Boeing
shares were below $50 at the close of trading on December 18th, which is when the option
expires, the investor would be required to buy 100 shares at $50 each. Since he received $1.55
for the option, however, the actual cost would be $48.45 per share. On the other hand, if the
stock closed at $50 or above, the put would expire worthless and the investor would not get
the Boeing shares. He would still pocket the $155 from the sale of the option, though.
Moreover, he could implement the same strategy again selling put options that expired in
January or any other future month. This strategy is referred to as “cash covered” because the
investor maintains in his brokerage account the cash needed to cover the purchase of the 100
shares. It is comparable to the “covered calls” strategy that we reviewed above.
Monitoring and Optimizing Returns
As noted in previous reports, we don’t think it’s particularly useful to watch every gyration of
the stock market and to dissect every single piece of data emanating from government
agencies, industry groups, and corporations. In fact, it’s probably not a good idea to own stocks
that require daily vigilance. All that said, investors should evaluate their holdings regularly to
determine steps that can be taken proactively to optimize portfolio returns. Stryker shares, for
example, have performed superbly since we recommended them in late March (at $33). A
current assessment would suggest that they still look very attractive and require no action.
Despite the nearly 50% increase in price, valuations remain reasonable and the stock offers the
potential of doubling over the next three to five years. On the other hand, Colgate‐Palmolive
stock doesn’t look nearly as compelling now following the nearly 40% advance in price as it did
when recommended on April 20th at $60. The price/earnings multiple has rebounded to near
historical norms, the dividend yield doesn’t stand out anymore, and neither does its long‐term
price appreciation potential.
Given both more attractive investment choices and scarce resources, investors could use
Colgate as a source of funds to purchase the superior alternative(s), Medtronic and/or Oracle
shares, for example. Absent more attractive choices, investors could sell (or write) calls on their
shares, supplementing dividend income with options premium and, hopefully, additional capital
gains. The exact call options written will depend on several variables, including how much
upside potential still seems left in the stock, the investor’s assessment of the overall equity
market, and how averse he or she may be to possibly having the shares called away. On August
13th, with Colgate shares at $72.03 and the market trending upward, we wrote November calls
($80 strike price), which would allow us to participate in a relatively strong performance over
the following three months. The calls generated a premium of only $0.80 per share, but the
strike price allowed us 11.1% upside potential. If we were to write calls now, with the stock at
$84, we would be less aggressive, perhaps selling the $85 strike and receiving a larger premium.
Equity prices and the earnings bases change with the passage of time. So, too, do price targets
and the resulting price appreciation potential. Boeing and Medtronic may not be good
candidates on which to write covered calls now, but they may be in a few months; thus the
need to assess the portfolio on a regular basis.
Exiting a Position
Investors typically have more trouble selling than buying a stock. They will hold their losers
indefinitely, reluctant to lock in losses, while arbitrarily selling those that are moving up in price,
eager to book profits. Wall Street has a tendency to overreact to data, which in a larger, longer‐
term context may be irrelevant. An analyst may downgrade his recommendation on a stock
simply because the company missed earnings expectations by a penny. The price of a stock
could plunge as investors react to a press release announcing a product recall, irrespective of
how small that product’s top‐line contribution. Clearly the reverse also happens, with stocks
surging because earnings were slightly better than expected, or a minor product was approved
by the Food and Drug Administration. These dynamics underscore the importance of knowing
the companies, as represented by their stocks, in your portfolio ‐ explaining our lengthy reports.
The thought process and calculations in deciding whether to sell a stock aren’t that different
from the exercise that led to the initial purchase of the stock. First and foremost, if the
fundamentals of the company, which underpinned your buying decision, have deteriorated,
then it’s a safe bet that the shares should be jettisoned. Beyond this, the key determinant of
the selling decision should be valuations, as measured by a combination of earnings, cash flow,
dividends, and book value. As noted above, Stryker shares should be retained even though
they’ve appreciated some 50% in the past seven months: the company’s fundamentals remain
strong, valuations are reasonable, and its earnings prospects suggest the stock will outperform
most others over the next several years; the decision to sell can also be a function of having
superior investment alternatives.
Conclusion
The stock market’s consistent vigor through much of year 2009 diminished the importance of
supplementing capital appreciation with dividends, options premiums, and participating in
special situations. With the rising valuations cutting into capital appreciation potential and
affording fewer good alternatives, though, the need to embrace a more comprehensive
approach to managing a stock‐based portfolio will become more critical going forward.
Editor and founder of 3Dimensional Research George
Rho is a 20‐year veteran of Wall Street, with
experience as an equity analyst, an assistant research
director, a portfolio manager, and an options
strategist. A generalist in the early years, he followed
the telecommunications sector in the second half of
the 1990s and the healthcare sector through much of
the current decade. Most recently, George Rho was
Executive Editor of Value Line Publishing's Special
Situations and Select products, along with being the Senior Strategist for the company's Options
Survey. "Select" is Value Line's premium ($795/year) research‐based product, which highlights
the company's single best investment idea every month. He has been quoted countless times
in periodicals all around the world, including the Wall Street Journal, New York Times, and
Business Week. He has been described as a "market savvy analyst" who gets his "ducks in
order." Moreover, his work can be found in many financial textbooks. Further references to his
work can be found by googling George Rho, Value Line, Options. On a more personal
level, George was born in Seoul, Korea, spent most of his childhood in Uganda, and earned his
BA (in psychology) and MBA (in international finance) from Rutgers University. He is an avid
tennis player, golfer, and chess player.