In this post, we'll look at six small cap stocks trading within 25% of their 52 week highs that are rated "sell" by a leading independent research firm, Ned Davis Research: MEMC Electronic Materials, Inc. (WFR), RF Micro Devices, Inc. (RFMD), Exco Resources Inc. (XCO), CIENA Corp. (CIEN), PMC-Sierra (PMCS), and Polycom, Inc. (PLCM). The reason I limited this post to sell-rated stocks trading within 25% of their 52-week highs was so that it might offer a useful warning to shareholders: there are many more sell-rated small caps trading further below their 52-week highs, but investors in those stocks are more likely to have already suffered significant declines. As the chart below shows, two of the small caps listed above, CIENA Corp., and Polycom, are down slightly year-to-date, but the other four are up on the year.
First, though, let's be clear about what separates an independent research firm the sell-side research that often dominates investment headlines.
Independent Research Versus Sell-Side Research
Investopedia offers a good elaboration of the differences between sell-side research, buy-side research, and independent research, but, in a nutshell, sell-side analysts work for investment banks, buy-side analysts work for fund companies, and independent analysts work for neither. The ratings that often get the most attention come from sell-side analysts, but, unfortunately for investors looking for warnings that their stocks may be headed for trouble, these firms have inherent conflicts of interest. If an investment bank's analyst has a sell rating on a particular company, that can be problematic for the investment bank if it hopes to win investment banking or advisory business from the company. Investment banks would counter that their analysts are objective and separated from their investment bankers by a Chinese wall; readers can draw their own conclusions. Since independent research firms don't do investment banking business with the publicly-traded firms they analyze, they don't have that inherent conflict of interest.
How Ned Davis Comes Up With Its Sell Rankings
Analysts at Ned Davis employ a quantitative screening process with both fundamental and technical components to rank 1,400 stocks on a scale of 0 (worst) to 100 (OTCQB:BEST). The fundamental component of the rating is 50% based on valuation, and 50% based on profitability. Ned Davis Analysts drill down on several key criteria when looking at valuation and profitability:
Free Cash Flow/Enterprise Value
Operating Cash Flow Yield
Return on assets
Standardized Unexpected EPS
Stocks scoring below 10 on this methodology are rated "sell," stocks scoring between 10 and 90 are rated "neutral" and stocks scoring above 90 are rated "buy."
Profitability And Valuation Ranks
Although all six small caps mentioned above were rated "sell" by Ned Davis, they were given different profitability and valuation ranks, each on a scale of 0-100, with 0 being the worst possible rank.
RF Micro Device
Polycom is an interesting outlier here, in that it scored highly in terms of valuation, but was nevertheless rated a sell to due to profitability rank and other factors.
Rating Stocks A "Sell" Before They Go South
One of the criticisms of buy-side analysts is that, when they do give a sell rating to a stock, it's often not before the stock drops significantly. Hedge fund manager Tim Knight offered an example of this a couple of years ago, noting that only 8 of 25 analysts had given an "underperform" or "sell" rating to Netflix, Inc. (NFLX) before its shares plummeted from over $300 to under $200. As we noted above though, four of these small cap stocks are up on the year, and the two that aren't are only down slightly. Given the sell-ratings on these stocks, shareholders may want to consider reducing their risk. We'll look at a few ways they can do that below.
Ameliorating The Risk Of Owning These Small Caps
The simplest way to reduce risk, if you take Ned Davis Research's sell ratings to heart, would be to sell your shares of these stocks. For those investors who are wary of the risks, but would rather not sell their shares now, 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 small caps, CIENA Corp, as an example. Then we'll show the costs of hedging the other small caps we've discussed here in the same manner.
Two Ways Of Hedging CIEN
Below are two ways for a CIENA Corp. shareholder to hedge 1000 shares against a greater-than-20% drop between now and mid October.
1) The first way uses optimal puts*; this way allows uncapped upside, but is quite expensive. These were the optimal puts, as of Tuesday's close, for an investor looking to hedge 1000 shares of CIEN against a greater-than-20% drop between now and October 18th:
As you can see at the bottom of the screen capture above, the cost of this protection, as a percentage of position value, was fairly steep at 8.00%.
2) A CIEN investor interested in hedging against the same, greater-than-20% decline between now and mid October, 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, 0.83%.
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 Small Caps Mentioned Above
The table below shows the costs, as of Tuesday's close, of hedging all of the small caps mentioned above in a similar manner as CIENA Corp. 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 iShares Russell 2000 ETF (IWR) was added to the table for comparison purposes. There was no optimal collar available for MEMC Electronic Devices given these parameters as of Tuesday's close.
Note that the cost of hedging the small cap index-tracking ETF IWM with optimal puts was considerably lower than the cost of hedging the six sell-rated small caps. Investors who own those six small caps as part of a diversified portfolio, and are content to let diversification ameliorate their stock-specific risk, might consider buying optimal puts on an index ETF to ameliorate market risk. We elaborated on this method of ameliorating risk in a previous Seeking Alpha article.
Optimal Put Hedging Cost
Optimal Collar Hedging Cost
RF Micro Device
*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.