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Long/short equity, long only, growth at reasonable price, portfolio strategy
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Gypsy, has eyes that hide the secrets no one sees

Easy, you smile until she brings you to your knees

Stick around 'til you get the truth

Taste blood when you get your proof (oh yeah)

Find that you've never understood

Give it all, but it's meant for good (oh yeah)

And I know this life makes fools of wise men, thieves and kings

When we lose we live our lives like puppets on a string

Close your eyes and you'll lose your soul

Do your time but there's no parole from here

No chance when the end is near

Hear the words that you never thought you'd hear

Life whispers in your ear

It's a long way down, when you fall from the top

KISS

First and foremost, Happy Holidays to all!

While we wait to see if Washington is going to bring us Christmas cheer or Scrooge 2012 (beware of the 3rd visitor which foreshadows the future), it is a good time of year to review the Dark Horse Traders' Hedge portfolio. I have one option trade to recommend and two positions that I would recommend taking gains on in 2012 and replacing with new positions.

Apple Inc. (AAPL) embodies the lyric "It's a long way down, when you fall from the top." My personal opinion is that the Apple sell-off from a high of $705.07 is largely explained by "the words that you never thought you'd hear," FISCAL CLIFF. When "life whispers in your ear," higher capital gains tax rate, and you have 40%+ gains, the end result can be "a long way down." Fortunately, we didn't have any exposure to AAPL, but now we have the opportunity to potentially profit on this uncertainty. Retail investors have a difficult time investing into the upside of AAPL due to the share price of $538.73, but we can use options to gain exposure to the upside and limit our risk. Let me extrapolate first on why I believe we want this exposure in the first place.

Apple Inc. has $29 billion in cash, operating cash flow of $50.86 billion, and NO DEBT. If you "close your eyes and you'll lose your soul, Do your time and there's no parole from here," so don't close your eyes to this part of the equation. This is part of the value argument for AAPL , and there is so much growth to see; however, the "Gypsy, has eyes that hide the secrets no one sees."

To believe the bear argument on AAPL we would have to believe that this giant, with incredible market share in growing markets (just launching in China), has lost the ability to innovate and margins are eroding. I don't buy that argument and therefore believe that China (among many others) and Apple TV will provide the continuation of dominance in growing markets by a brand leader.

The next question is how to get exposure to the upside, while limiting the risk to a manageable amount. A bullish option strategy created by purchasing an in-the-money call and selling an in-the-money put gains the exposure with little to no cash, but, depending on the broker, it can strain margin requirements. The solution for the margin requirement and protection in this uncertain market is to purchase an out-of-the money put. So the trade looks like this:

  • Buy to open AAPL Feb $540 call (approx. $34.50)
  • Sell to open AAPL Feb $540 put (approx. $35.55)
  • Buy to open AAPL Feb $500 put (approx. $18.80)

The net position costs $17.75, and the margin requirement is greatly reduced by the put protection. The Feb $540 call will increase as AAPL trades higher (and of course decrease if it trades lower). There is solid support at $529 which has held five times since last February. The Feb $540 put will decrease in price as AAPL trades higher (again, higher if AAPL trades lower). The Feb $500 put purchased is a safety net in the event we are completely wrong and Washington concedes there is "no chance when the end is near" and sends America flying off the cliff.

Axis Capital Holdings (AXS) was recommended for long exposure on September 9, 2010 at $31.86. Eight dividend payments later we can close our position at the lower capital gains and dividend tax rates for $35.95 (a total return of +20%). Our thesis going into AXS in late 2010 was that we were acquiring growth (expected 2011 EPS of $4.27) at a reasonable price (P/E of 8.09). AXS failed to deliver not only on that estimate but also in 2012 EPS ($3.57) and in the 2013 EPS estimate ($3.91). Now that it's trading for a forward P/E of 9.2, I believe there are better companies to invest in and therefore recommend closing this position in 2012.

Kohlberg, Kravis, Roberts and Co. (KKR) has all the makings of a Dark Horse Traders' Hedge long position. Start with the 40%+ projected growth in EPS over the next 5 years and a forward P/E of only 6.36 on 2013 EPS. Mix in the 6.9% forward yield (albeit at a higher tax rate in 2013), and I see the recipe for success. By rebalancing out of AXS and into KKR we expose ourselves to higher yield and higher growth for less forward P/E. Similar to AXS, I am recommending simply acquiring a full position in KKR without involving options to gain our exposure.

Valassis Communications Inc. (VCI) was recommended on March 19, 2012 at $23.99. The thesis at that time was that 8 of 9 analysts had raised their 2012 EPS guidance to $3.11, and we could enter at a forward P/E of 6.8. We updated our thesis and position June 15, 2012 as the June call premium was recognized, and we accepted the other half position we originally intended to own in March 2012. The culmination of these trades put us into the shares for a cost basis of $22.60, and VCI is now trading at $27.23 today. I recommend closing this position's +21% gain for a couple reasons. The thesis we bought into has played out as VCI will make $3.20 for 2012. The forward P/E has moved up to 7.66, but the short float has increased from 16.7% to 29.1%. For my taste, there are too many people betting this stock doesn't do well, and we can find better, safer investments at this time.

Marathon Petroleum Corp. (MPC) is that company. As always we want to buy growth for the cheapest price. MPC is trading at a forward P/E of 7.03. Year-over-year growth in EPS has been 12.3% and analysts have recently been revising those estimates higher. The forward yield of 2.3% doesn't hurt, and levered free cash flow of $1.26 billion is an eye catcher. My recommendation on MPC is to acquire half the desired shares at $61.47. Sell to open the April $62.5 call (approx. $4.10), and sell to open the April $62.50 put (approx. $5.40). This reduces the original cost of the trade to $51.97, allows us to capture a dividend payment and gain exposure to the other half position if MPC is trading below $62.5 in April 2013.

Have a safe and happy holiday season. Let's hope that Washington agrees to rise above in 2012.

Recommendations:

Source: It's Been A Long Way Down, 1 New Trade And 2 Positions To Open