Like most Apple Inc. (AAPL) investors, we have been waiting (and waiting and waiting) for a positive dividend announcement from the company. Meanwhile, the losses in our position have been piling up. The stock is down almost 40% from its peak and it is certainly in need of a major catalyst to get it back on track. While we definitely think that a dividend hike is imminent (and it will likely send shares much higher), trying to anticipate the moves of Apple's management team seems to be a losing proposition.
Eating Some Humble Pie
First and foremost, we were wrong with regard to the timing of our purchase, and we aren't afraid to admit it. Anytime a stock doesn't perform as expected, something was clearly wrong with your initial investment thesis. So instead of blaming the hedge funds or short-sellers or Tim Cook, we have been forced to look directly in the mirror the past few months to try to figure out where WE went wrong. We try to learn something from every loss, and this is no exception.
So where did we go wrong? In short, we completely underestimated how far the stock would overshoot to the downside when the momentum growth investors realized that they were in fact holding a future dividend growth stock (with slowing earnings). Our initial target Buy Zone was based on a 15-20% pullback and a 12.0x-13.0x forward P/E valuation range (which we felt was conservative). When the stock dipped below $600 for the first time back in October 2012, we started a position, buying our first 10 shares around $595 (which was 15% below its peak). Our strategy was to build our full position in stages, and we made subsequent 10-share purchases at $562, $536, and $522… bringing our cost basis down to $554 (which was 21% below its peak).
Needless to say… the situation has only gotten worse for AAPL. The stock is now through our maximum loss threshold (1% of total portfolio value), and it's time to take action.
Time To Hedge
All investors have losses from time to time; it's part of the game. Knowing that, you should never let a few losses destroy your entire portfolio. What sets the best investors apart from the rest is their ability to identify a problem and deal with it in a timely manner (which typically means taking a loss when you need to). This is why we established a maximum loss threshold (typically 0.5%-1.0% of total portfolio value) for our individual positions. Given that APPL traded below our 1.0% loss threshold a few days ago, we had one of two choices to make today: (1) sell the stock immediately, or (2) hedge the position to limit further losses.
Since we believe that AAPL shares are VERY cheap right now based on future expected earnings and cash flows (its trading at less than 9.0x earnings), we decided to hedge our position instead of exiting the trade completely.
Apple has made the unfortunate transition from "hero" to "zero" over the past 7 months. Back in Sept. 2012, the company could do no wrong… now it can't seem to do anything right! However, we do believe that there is some decent upside to AAPL shares from current levels when the company finally decides to grace the shareholders with a new product or a sizable dividend increase. To maintain part of this upside and to limit future losses, we decided to execute a protective collar strategy for our AAPL position using options (see trade detail below).
Note that the exchanges introduced "mini" options on several high-priced, actively traded stocks (including AAPL) last month. A mini option contract covers 10 shares (as opposed to 100 shares for a standard option contract). Without the benefit of mini options… our only option (no pun intended) to limit future losses on this trade would be to sell our shares outright.
A Protective Collar Strategy is a two-part strategy that consists of purchasing a protective put on your stock and simultaneously selling a covered call on your position. This strategy helps you establish a maximum loss on your position, while maintaining some of your upside potential. Details of our AAPL position are below:
We purchased 4 protective mini puts on AAPL and sold 4 covered mini calls:
- Date: 4/18/12
- Symbol: AAPL
- Put Quantity: 4
- Put Month: Jun13
- Put Strike: $400.00
- Price (Premium): $27.75
- Call Quantity: -4
- Call Month: Jun13
- Call Strike: $450.00
- Price (Premium): $5.75
This protective collar strategy has now set a maximum net loss on our position of $6,700 (which is approximately 1.3% of our total portfolio value). In other words, no matter what happens to the price of AAPL in the future, our net loss on this position will never exceed $6,700 (inclusive of the est. May 2013 dividend). Here's how the math works:
So as the table above highlights, we have capped our maximum loss on the position (which is essentially equivalent to exiting the position). However, we still have upside potential left with the position if the stock rises above our put strike price ($400.00) as we will benefit dollar for dollar if the stock closes above this level. In addition, we get to keep all future dividends since we still own the stock. Note: Our upside is capped at our call strike price ($450.00)… at least until June expiration. When the expiration date of the options approaches, we can reassess the situation and decide what the next steps will be for the position.
This may seem complicated at first. However, once you get more familiar with this strategy, it is a great tool for capping your maximum loss on a position while maintaining some upside potential. The important takeaway from this article, though, is to EXIT a position when your investment strategy says to. If the maximum loss threshold that you have established for yourself is breached, limit your losses IMMEDIATELY by either selling your position or implementing a hedge.
Even though we still strongly believe in the future upside in APPL shares, we would be doing you (and ourselves) a disservice by not sticking to our investment plan. The markets can stay irrational way longer than we think…