A slight deviation tonight from the world of stocks and economics…
I’ve been recently pleasantly surprised by how well the Iowa Hawkeyes (my alma mater) basketball team is playing this year. While their conference record of 5-7 is clearly not spectacular, their record perhaps is not indicative of their performance and/or ability.
For those of you who are long time Hawk fans, this has been a pleasant change from the past. Every since Dr. Tom Davis was
forced out retired in 1999, we’ve endured two coaches (Steve Alford and Todd Lickliter) who haven’t lived up to the hype – producing only three NCAA appearances in the last 12 years (and in fairness, one of Alford’s appearances was with a class Coach Davis recruited). Thus, the intensity and performance of the Hawkeyes under Coach Fran McCaffery has been a pleasant surprise to say the least.
In looking at Iowa’s conference losses thus far this season, 5 of the Hawks 7 conference losses have been by 5 points or less (3, 3, 3, 4 and 4 to be precise). This is second only to Indiana (both of their two losses have been <= 5pts) and Wisconsin (3 of their 4 losses have been <=5 pts).
Similarly, the Hawks average loss of 7.7pts (including a 28 point loss at Michigan in their second conference game of the season) is fourth to Indiana’s average loss of 3.5pts, Wisconsin’s average loss of 5.0pts and Minnesota’s average loss of 6.3pts. The similarity of this ranking to the losses <=5pts is perhaps not too surprising given the two statistics (L<=5pts and average loss) are correlated. However, the Hawks ability to be in all but two games in the closing minutes is supportive of my thesis that they are much better than their 5-7 record indicates. Interestingly, if one excludes Iowa’s 28 point loss at Michigan, their average loss is 4.3pts – second only to Indiana and considerably better than Michigan St, Michigan and Ohio State (all three of whom are tied for third place in the conference).
With a home game against Minnesota tomorrow (Feb 17th – a pivotal game to say the least), a home/home with Nebraska, home games against Illinois and Purdue and a tough road game at Indiana in two weeks, the Hawks hold their destiny in their hands heading into the Big Ten tourney and perhaps (??) a NCAA March Madness appearance (its been a LONG time).
Hopefully my exuberance tonight is not a bad omen. GO HAWKS!!!
Invariably, I suspected that as soon as I circulated a name ($GNC) that met my option screen, the trade would work against me. As “luck” would have it, GNC reported favorable earnings vs. consensus estimates – rallying 10% and closing at $39.66.
At today’s (2/14/13) closing price, the $35.00/$37.50 put/call strangle is $2.16 in the money (recall I recommended to “short” the strangle) vs. the $1.65 premium the trade collected. Further, two of my three hypothetical open trades slipped into the red today to add misfortune to bad luck. In short, a less than pleasant day.
Today was a nice reminder of the high volatility implicit in a short strangle strategy. That said, I’m still a believer as my market-to-market gain continues to be ~7% (after fees) over the last four weeks even after taking into account the (4)% decline today. Back to the drawing board to refine the approach. The learning experience today – be highly cautious of entering into strangles on those names with high short interest.
Over the last month I’ve been experimenting with a short strange/straddle option strategy. Via the power of Bloomberg (and their Excel API), I’ve written a Bloomberg Excel function that identifies companies whose stock has exhibit higher volatility vs. the S&P 500 over the prior 90-day period and whose options are highly liquid. From this subset, I then select those with elevated implied volatility in their options in comparison to the realized volatility in the stock.
For those companies that meet both screens, I then consider putting on a short strangle option strategy in advance of their upcoming earnings announcement. It is a rules based function that I am still refining. To date the strategy has been fairly successful rendering a ~15% gross return over the prior four weeks (~12% net return). Of the 20 trades I have consummated, 3 are still outstanding, 2 have rendered negative results and 15 have proven to be profitable. Undoubtedly there is a certain degree of luck in this recent performance but nevertheless I have been very satisfied.
For those unfamiliar with strangles/straddles, both strategies involve buying (or selling) puts and calls with the same expiration date. In the case of a straddle, the exercise price is the same whereas in the case of a strangle, the exercise price is different (there is a delta). When an investor goes long a straddle/strangle, they are betting that the stock price movement will move outside the strike price range (albeit they are uncertain on the directional movement). Thus, if you felt Apple (assume for this purpose it closed at $470 today) will more than likely close the end of the week below $465 or above $475 (assuming a $470 call costs $2.50 and a $470 put costs $2.50), you would go “long” the straddle. If on the other hand you felt it would stay range bound between $465 – $475 over the next two days, you would “short” the straddle. In the long instances, the investor is referred to as “buying” volatility and in short instances they are referred to as “selling” volatility.
The strategy I’m refining revolves around selling elevated volatility ahead of earnings announcements. While this strategy could never be implemented for a $100m portfolio (given limited option activity in individual names), I think it is an interesting strategy for highly sophisticated (and risk tolerant) investors on a smaller scale.
The challenge with short strangles/straddles is one’s maximum gain is limited to the option premium collected. Further in instances where the trade moves against you (outside the strangle/straddle range after capturing the option premium one has collected), the investor is left with a cash outlay but NO investment (or shares) to show for it. While some could consider this more gambling than investing (and I would agree to a certain extent), I do see a significant opportunity for uncorrelated returns for those with a skillful eye for assessing risk-adjusted returns and probabilities (i.e., being selective in the risks you are willing to bear and not taking a bite of every trade available).
One the recent trades the screen suggested was GNC which is set to report tomorrow (Thurs) morning. Given the implied volatility of ~115 in GNC’s Feb-13 options vs. GNC’s rolling 30-day stock volatility of 42, the trade is very inviting given the excess volatility priced into their upcoming earnings announcement. With the stock closing Wednesday at $35.97, I like the short $35.00 put / $37.50 call strangle. Based on the asking price at close, the put garners a premium of $1.00 whereas the call garners a premium of $0.65. Thus, should the stock finish the week between $33.35 ($35.00 less the $1.65 premium collected) and $39.15 ($37.50 plus the premium), the option seller would pocket a gain. Ideally, the option seller desires that the stock’s closing price be between $35.00 – $37.50 which maximizes their gain of $1.65 for each contract sold. Given short straddles/strangles represent naked positions (i.e., selling the right to securities when the investor does not own the underlying security), the trades are subject to margin requirements. As a proxy, ~25% of the underlying stock’s price is a conservative estimate for the cash the seller would have to hold for each option. Thus, in the case of GNC, the option seller would have to hold $9.00 of cash for each contract.
While this is a risky trade, the option seller’s maximum gain could be $1.65 on the $9.00 of cash or 18% – not a bad return for two days exposure (or one day if the seller decides to close the trade on Thursday). Further, for the option seller to begin to lose capital, the stock would have to move -/+ 7.25%. Over the last seven quarters (the only data available to me tonight), GNC has exhibited an average 2.5% stock price movement the day of earnings with 2 of the 7 events registering a movement in excess of 7.25%. Thus, the law of averages are on our side (albeit we have a small data set). While I have not placed this hypothetical trade (given I did not have time to research GNC for potential landmines), it is an interesting example of the opportunities within this strategy.
We will know shortly if this trade is successful.
Disclosure: Given trading limitations at my work, I am unable to place trades of this nature (minimum 30-day holding requirement). Further, the above is made available for educational and entertainment purposes only. You are encouraged to perform your own analysis and due diligence of any idea discussed herein. I undertake no obligation to update or correct any information on this website or update disclosures of my holdings after posts have been published. And lastly, past performance is not indicative of future results.
The latter half of this past week, I was reminded how humbling the markets can be at times.
This week, LeapFrog ($LF), a company that specializes in providing educational entertainment products and is best known for their LeapPad, reported 4Q 2012 earnings. As I expected, LF beat earnings expectations reporting $0.60 per share versus the consensus estimate of $0.49. However, the market was not as impressed with their 4Q beat (or their expectation for 2013) as the stock traded down slightly Thursday and Friday (versus my expectation of a healthy rally and potential short squeeze).
I still continue to be one of LF’s biggest supporters but as I was reminded by Aswath Damodaran, a professor at New York University, recent blog post (here) “the market can stay irrational longer than you can stay solvent” (hat tip to professor Todd Houge for the forward). Thus, for as much as we would like to think we are smarter than the market…even if this is true, the market must agree with our point of view which as Damodaran states in his blog is generally outside of our control.
Also humbling this week was my view on LB Foster’s ($FSTR) 4Q 2012 earnings announcement. $FSTR reported earnings yesterday morning. My expectation was for a modest beat and FSTR to announce 2013 expectations ahead of consensus estimates based on improving market conditions within their Rail Products and Construction divisions (given the Hurricane Sandy rebuilding efforts here in the Northeast). Instead, FSTR missed 4Q consensus estimates and guided 2013 generally in line with consensus. Today, FSTR trades at a ~12.2x FY13 P/E which is generally in line with the market. While the 4Q 2012 EPS announcement was modestly disappointing, the stock has performed very well since my initial post (here) back on October 31, 2012. Since that posting, FSTR is up 30%, even taking into account yesterday’s pullback, versus an increase in the Russell 2000 Index of 12% which is cause for celebration nonetheless.
As I begin to uncover new gems this weekend, I resurrected a “qualitative” checklist list I drafted a few month back that I use when I’m reviewing new investment ideas:
1) Remember cash is king; understand how the company generates cash and be very cautious of those that generate little $$$
2) Seek out unique sources for your ideas & insights – if you’re reading about the idea on Yahoo Finance or Barron’s or hearing about it on CNBC, the idea is likely stale; as a suggestion, observe what you are buying/seeing in your daily life and ask what public company is benefitting from the trends that you are observing
3) Read the most recent 10-K, 10-Q and earnings transcript (if available) to understand the Company’s growth drivers and weaknesses
4) Focus on fundamentals: sales growth, gross margin (hopefully margin expansion), wide moats and cash generation
5) Identify the biggest threats to the company (i.e., replacement products/technologies, declining margins) – handicap appropriately
6) Set a price target before you enter the trade and reassess the stock when it nears the target (What has changed? How does it impact your target?)
7) Review the investor base – is there a large shareholder that controls the company and may influence valuation. Are their activist shareholders that could positively/negatively (when the exit) impact the stock’s valuation
8) If applicable, understand how the company directly/indirectly benefits from government spending and support payments
9) Last but certainly not least, be very cautious of our tendency as individuals to only seek information that confirms our beliefs – do the best to question all of your assumptions (a good exercise is to draft – either mentally or on paper – a “sell” thesis for your idea and then compare its merits to your “buy” thesis)
This list obviously excludes the quantitative analysis (relative value comparison, discounted cash flow model, dividend discount model) that presumably you are doing in tandem. Enjoy and happy investing!
With the pending super snowstorm and blizzard expected for the Northeast Corridor and NYC this weekend, one name that could create a nice trading opportunity today/early next week is Compass Minerals International ($CMP).
CMP is an interesting pureplay in two industries. They are a self-described leader in the production of salt (and other deicing products) and sulfate of potash specialty fertilizer (“SOP”). Per their Form 10-K, highway deicing salt represented 48% of CMP’s 2011 sales while sales for other consumer and industrial salt represented 32% of 2011 sales. The remaining ~20% of sales are related to sulfate of potash. While I’m not knowledgeable with respect to SOP, CMP’s Form 10-K states that “SOP is primarily used as a specialty fertilizer, providing essential potassium to increase the yield and quality of certain crops, which tend to be high-value or chloride-sensitive, such as vegetables, fruits, potatoes, nuts, tobacco and turf grass.”
Earlier this week, CMP reported 4Q 2012 earnings citing “mild winter weather in North America … continued to limit deicing salt sales, partially offset by higher sales of specialty fertilizer products” as a headwind to the FY2012 and 4Q 2012 earnings. For the full year, net earnings excluding special items were $104.4 million, or $3.11 per diluted share, in 2012 compared to $160.4 million, or $4.79 per diluted share, in 2011. Their earnings announcement is here. Consensus earnings for FY13 are $4.18 amid continued strength in CMP’s specialty fertilizer production.
Needless to say, the expected snowstorm this weekend should lead to increased salt orders from municipalities to replenish salt resources they will likely use this weekend.
At a 17.7x FY1 P/E and a 14.3x trailing 12m EBITDA/EV valuation, the stock is a little rich compared to market multiples and comparable Potash peers such as $POT and $MOS. The stock has traded in a relatively flat band YTD - down 1.1% against the backdrop of an increase in the S&P500 of 5.8%. Interestingly, the stock increased 1.5% yesterday rallying into the close suggesting building short-term momentum.
This has been a name I’ve had on my radar for some time – frankly hoping for a significant pullback in price for the right long-term buying opportunity and waiting for the time to build a DCF model.
Possible trading positions include:
Long CMP at $73.86
Long Feb-13 CMP $75 Calls at a $0.25 ask (you profit if the stock trades above $75.25 – a 1.9% increase – before 2/16/13)
Have a great weekend! We’ll be enjoying the snow here in NYC.