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  • NFLX shareholders who hedged last month with the hedge shown below were down 6.8% from 2/18 to 3/25, while the stock was down 15.1% over the same period.
  • Hedged NFLX shareholders can exit now with a smaller loss, hold, or use their appreciated hedges to buy more of the stock.
  • Given Carl Icahn's announcement Monday, plus NFLX's still-rich valuation, exiting now may be a prudent choice for hedged NFLX shareholders.

In a post last month ("Investing alongside Carl Icahn while limiting your downside risk"), we presented a hedged portfolio constructed out of the holdings of Carl Icahn's Icahn Enterprises (NASDAQ:IEP), and designed to limit an investor's downside risk to a drawdown of no more than 16%. That portfolio included a hedged position in Netflix (NASDAQ:NFLX). Mr. Icahn made news on Monday, he told CNBC that he may have sold half of his Netflix stake.

Netflix plunged nearly 7% on that news Monday, and then closed down another 2.13% on Tuesday. In this post, we'll look at the courses of action available to a Netflix shareholder who is hedged in the way the NFLX position was hedged in our previous post about investing alongside Carl Icahn. You can see that Netflix hedge in the screen capture of the hedged portfolio in the previous post we linked to above, but below is an expanded view of it.[i]

A Closer Look At The February 18th NFLX Hedge:

How That February 18th Hedge Has Reacted To NFLX's Drop

Here we'll look at how that hedge would have ameliorated a Netflix shareholder's losses so far, and then we'll consider an investor's courses of action going forward. This an updated quote on the put leg of the hedge as of Tuesday's close:

And this is an updated quote on the call leg as of Tuesday's close:

How That Hedge Protected Against Today's Drop

NFLX closed at $436.85 on February 18th. A shareholder who owned 100 shares of it and opened the collar above on February 18th had $43,685 in NFLX stock plus $2,975 in puts, and if he wanted to buy-to-close his short call position, he would have needed to pay $2,275 to do that. So, his net position value for NFLX on February 18th was ($43,685 + $2,975) - $2,275 = $44,385.

NFLX closed at $370.84 on Tuesday, March 25th, down 15.1% from its closing price on February 18th. The investor's shares were worth $37,084 as of 3/25, his put options were worth $5,030 and if he wanted to close out the short call leg of his collar, it would have cost him $728. So: ($37,084 + $5,030) - $728 = $41,368. $41,368 represents a 6.8% drop from $44,385.

More Protection Than Promised

So, although NFLX had dropped by 15.1% at the time of the calculations above, and the investor's hedge was designed to limit him to a loss of no more than 16%, he was actually down only 6.8% on his combined hedge + underlying stock position by Tuesday's close.

Exit Now, Hold, Or Buy More?

The answer to that question depends in part on why you own Netflix shares. If you bought primarily because of Icahn's stake, his announcement that he has reduced that stake may give you pause. You could continue to hold until shortly before your hedge expires in September, knowing that, in the worst case scenario, you won't lose more than 16% from your position value on February 18th. If you're bullish on the stock, you could buy-to-close the call leg of your hedge, to remove your upside cap, and if you're extremely bullish, you could, in addition, sell your appreciated put leg, and use the proceeds to buy more NFLX shares. Even after Netflix's recent 15% drop, the stock still appears somewhat pricey according to a key valuation metric though: its PEG ratio.

Using PEG As A Valuation Metric

The PEG Ratio is derived by dividing a stock's forward Price/Earnings ratio by its expected earnings growth rate over the next 3-5 years. As such, it's a way to judge a stock's forward P/E ratio in the context of its growth rate.

To illustrate the utility of the PEG ratio, consider two stocks, one with a forward P/E ratio of 10, and another with a forward P/E ratio of 30. Based solely on P/E, the first stock would be considered less expensive than the second. But what if the first stock was expected to grow its earnings at a 10% annual rate over the next 5 years, while the second stock was expected to grow its earnings by 30% over the same period? In that case, both stocks would have a PEG ratio of 1, which makes sense, since the second stock's higher P/E ratio is "justified" by its higher growth rate.

How High A PEG Ratio Is Too High?

Generally, a stock is considered inexpensive on a PEG basis if its PEG ratio is less than 1, but opinions differ on what PEG ratio, exactly, indicates that a stock is too expensive and should be sold or avoided. For portfolio manager and Seeking Alpha contributor David Merkel a PEG ratio greater than 1.5 marks a stock as too pricey; for CNBC's Jim Cramer, a PEG ratio of greater than 2 is too high. According to Yahoo Finance's data, as of Tuesday's close, NFLX had a PEG ratio of 1.81. According to Fidelity's data, it had a PEG of 4.07. The difference is likely explained by different groups of analysts' estimates drawn on by each site.

The Risk Of High PEG Stocks

According to Jim Cramer (in the same article we linked to above), since value investors tend to find stocks with PEG ratios below 1 attractive, that creates a "risk floor," i.e., a PEG level where value investors might be expected to start buying. Growth investors, in contrast, may continue buying a stock while its PEG ratio rises up to 2. At times, stocks will trade at higher PEG ratios (as NFLX has), but Cramer's point there is that when these stocks stumble, there can be a lot of air below. In the case of Netflix, that means that if growth investors do abandon it, it may be a while before value investors become buyers. Hedged Netflix shareholders ought to consider whether growth investors have or are abandoning the stock. Fortunately, since they are hedged, they can take some time to consider this carefully, knowing that their downside risk is limited.

[i] The image of the hedge shown here comes from the Portfolio Armor website. It is the expanded view that one would see if one clicked on the "+" sign next to the Netflix position in the hedged portfolio shown in the article about investing alongside Carl Icahn.

Source: Considerations For Hedged Netflix Shareholders