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December 1, 2008
Two Timely Investment Ideas
The Wish List is coming and our list of potential prospects for 2009 is getting fat. However, there are two potential problems with selecting more companies today:
1) The recent run-up in the U.S. dollar makes ‘undervalued’ U.S. stocks potentially less undervalued depending on future currency translations. If you conclude that the U.S. dollar will resume its weak ways when global deleveraging runs its course this can deeply impact how you appraise U.S. stocks.
2) The bulk of the ‘undervaluation’ theories being discussed today are held together by the conclusion that stocks are relatively attractive compared to other assets (i.e. U.S. Treasury yields), and that many valuation matrixes are absolutely attractive compared to the history books. These seem like odd choices to discuss ‘undervaluation’ given that Treasury yields are so low the history books may have to be rewritten, and few of the popular valuation tools may be a good gauge of how share prices will respond to what could be a historic meltdown in corporation earnings.
In other words, show me solid companies trading below tangible book that that can, at the minimum, realistically be expected to produce at least positive earnings (strong enough to counter D&A) in the coming say 5-years. Despite all of the ‘undervaluation’ talk, I have yet to find these types of bargains. Instead there are the Microsofts – which are admittedly very ‘cheap’ on many levels – that trade at 5.2-times book and 9-times tangible book.
These concerns noted, there are strategies the investor can use to maximize returns in the current marketplace; strategies that are akin to long-term buy-and-hold style investing but potentially more lucrative over the short-term. Consider the following two:
Strategy #1 – Using Volatility To Your Advantage
Writing put options, a strategy sometimes used by Warren Buffett, is an excellent way to ease into a new stock position. An excellent example of this is Coke (KO), which currently trades at $45.50/share. By writing say the May 2009 $40 put options you collect $3.20/share (or $300 per every 100 shares written) and are forced to purchase KO shares at $40 should they fall below this level by May 15, 2009. The flipside is that if KO doesn’t fall to this level the puts expire worthless and you keep the premium.
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The potential downfall to writing put options is that it can tie up capital. Also, there is the risk that if your investment thesis changes you could be forced to purchase shares in a company you no longer believe warrants an investment. These concerns noted, given that put premiums have recently increased and that many share prices are near historically important trading levels, the advantages of writing put options as opposed to simply buying and holding are worth considering.
Strategy #2 – Safely Taking Advantage of High Yields & Beaten Down Prices
Cover up potentially risky new positions with put options. Not exactly rocket science, the goal here is to reap the gains that some of today’s most undervalued investments may offer, while at the same time hedging your position from an unexpected train wreck. As a quick example, TCLP units have been punished (perhaps unjustifiably so) and currently trade at $21.80. The yield on TCLP is almost 13% before taxes and the company, which focuses on pipelines, is unlikely to go under in any economic environment. You purchase the units and options (say the $20 May 2009 puts) on the expectation that your total gain will be larger than the premium paid on the puts.
Why purchase puts in something that would seem to be an appropriate covered call candidate (another strategy to maximize returns). Well, it is unclear of the partnerships true balance sheet given that TCLP doesn’t consolidate its equity interests, and it is entirely possible that business returns will be hit in the future and drive the unit price significantly lower. In short, hedging with puts allows you to seriously look at companies that have potentially dangerous short-term problems but whose share prices can be expected to rebound significantly should these problems not manifest.
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Conclusions
The VIX index was still above 50 last week and the yield on the 10-year Treasury bond ended the week below 3% for the first time in my life. Although the above strategies will only work to their full potential if deployed with the right companies, they are worth considering in that they 1) can take advantage of volatility in the marketplace and 2) safely position capital in high yielding instruments at a time when fixed instrument yields are historically low. As for those below tangible book steady income performers, the hunt continues…
Disclosure: No one at FallStreet.com has any investment position in KO or TCLP.
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