Is A Correction At Hand?
In a recent article ("Is A Correction Beginning? Stock Index Futures Analysis Shows Speculators Fear No Evil"), Seeking Alpha contributor DoctorRx surveyed a number of factors ranging from copper and stock index futures action to fiscal policy, and noted, "We now have many of the standard ingredients for a correction". DoctorRx suggested that investors ought to be wary of broad stock market ETFs and that stock pickers may have an advantage in this environment. Along the same lines, if a correction is indeed at hand, investors may want to be particularly wary of stocks that could decline significantly more than the broader market.
Predicting Market Underperformance
Last month, we noted that the quantitative forensic accounting analysis firm GovernanceMetrics International (GMI) had given the large cap pharmaceutical company Pfizer, Inc. (PFE) the worst of the five possible ratings on GMI's AGR (Accounting And Governance Risk) Equity Risk Factor, indicating that the company was liable to "substantially underperform" the market. According to GMI, companies given its worst-possible Equity Risk Factor ranking have, as a group, substantially underperformed the market. At the time, Pfizer stood out as a rare large cap stock to which GMI had given its worst-possible Equity Risk Factor ranking. As of Wednesday though, GMI had given this ranking to more than 60 mid cap stocks. In this article we'll look at 5 of the most actively-traded of those mid caps predicted to "substantially underperform" the market.
High Accounting And Governance Risk
Of the 60+ mid caps predicted by GMI to substantially underperform the market, these five were among the most-actively traded: BlackBerry (BBRY), First Solar (FSLR), Western Union (WU), SAIC, Inc. (SAI), and Halcon Resources Corp. (HK). Knowing that the AGR Equity Risk Factor is derived from another GMI Metric, the Accounting And Governance Risk Rating, I reviewed GMI's Accounting And Governance Risk Review report on these five stocks (via Fidelity), and saw that GMI gave its worst possible ranking, "Very Aggressive", to four of the five stocks, indicating that they had higher accounting and governance risk than more than 90% of the stocks GMI covers. According to GMI, companies rated "Very Aggressive" are 10 times more likely to face SEC enforcement actions than those rated "Conservative" (the best of its four possible Accounting And Governance Risk ratings). The fifth stock, Halcon Resources Corp., was merely ranked "Aggressive", indicating that it had higher accounting and governance risk than 83% of the stocks in GMI's universe.
Ameliorating The Risk Of Owning These Mid Caps
In his article where he noted the ingredients were in place for a correction, DoctorRx suggested that holding higher levels of cash was one way of ameliorating that risk. That's certainly a possible course of action for owners of the mid caps mentioned above: if investors feel we may be due for a correction and are concerned that these stocks may substantially underperform the market in the face of one, reducing their positions and raising cash may be a prudent move. For those investors who are wary of the risks, but would rather not sell their shares at this point, we'll look at a couple of different ways they can hedge against significant declines over the next several months. To illustrate, we'll use one of these mid caps, First Solar, as an example. Then we'll show the costs of hedging the other mid caps we've discussed here in the same manner.
Two Ways Of Hedging FSLR
Below are two ways for a First Solar shareholder to hedge 1000 shares against a greater-than-20% drop between now and late September.
1) The first way uses optimal puts*; this way allows uncapped upside, but is quite expensive. These were the optimal puts, as of Wednesday's close, for an investor looking to hedge 1000 shares of FSLR against a greater-than-20% drop between now and September 20th:
As you can see at the bottom of the screen capture above, the cost of this protection, as a percentage of position value, was quite steep at 12.67%.
2) An FSLR investor interested in hedging against the same, greater-than-20% decline between now and late September, but also willing to cap his potential upside at 20% over that time frame, could have used the optimal collar** below to hedge instead.
As you can see at the bottom of the screen capture above, the net cost of this collar, as a percentage of position value, was negative, meaning an FSLR investor would have gotten paid to hedge with this collar.
Note that, to be conservative, the cost of both hedges was calculated using the ask price for the optimal puts and the put leg of the optimal collar, and the bid price of the call leg of the optimal collar; in practice, an investor can often buy puts for some price less than the ask price (i.e., some price between the bid and ask) and sell calls for some price higher than the bid price (i.e., some price between the bid and the ask).
Hedging Costs For All Of the Mid Caps Mentioned Above
The table below shows the costs, as of Wednesday's close, of hedging all of the mid caps mentioned above in a similar manner as FSLR above: first, with optimal puts against a >20% drop over the next several months; then, with optimal collars against the same percentage drop over the same time frame, while capping the potential upside at 20%. The SPDR S&P 500 ETF (SPY) was added to the table for comparison purposes. There was no optimal collar available for Western Union given these parameters as of Wednesday's close.
Optimal Put Hedging Cost
Optimal Collar Hedging Cost
SPDR S&P 500
*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance Ph.D to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones.
**Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University. The screen captures above come from the Portfolio Armor iOS app.