Shares of Genworth Financial (NYSE:GNW) hit a 52-week high of $18.58 intraday Thursday, on news that the company was set to move forward with an IPO of its Australian mortgage insurance unit. Genworth shares closed at $18.23, within about 8% of the fair value target Seeking Alpha contributor Stephen Simpson, CFA assigned to the stock in a recent Seeking Alpha Pro article ("Can Investors Leverage Skepticism On Genworth To Their Advantage").
In addition to being close to Simpson's fair value target, shares of Genworth Financial are fairly high according to a few key valuation metrics. According to Fidelity's data, Genworth's trailing twelve months Price/Earnings ratio is 15.85, versus an average P/E of 12.13 for the insurance industry as a whole. Similarly, Genworth's Price/Cash Flow is 15.74 on a trailing twelve months basis, versus an industry average of 4.12.
Fidelity doesn't give a Price/Earnings-Growth (PEG) ratio for Genworth, but gives a PEG ratio of 1.37 for the insurance industry on average. Yahoo Finance, drawing on Thomson Reuters data, does give a PEG ratio for Genworth, of 2.53. A PEG ratio over 2 suggests a company may be overvalued relative to its growth prospects.
With shares of Genworth trading approaching Simpson's fair value, and trading at a somewhat elevated valuation according to the three key ratios mentioned above (trailing Price/Earnings, trailing Price/Cash Flow, and forward Price/Earnings-Growth), some GNW investors may want to add downside protection here. One way to do that would be to construct a hedged portfolio around a Genworth position. You could also use a hedged portfolio approach if you don't currently own Genworth but are considering buying it (perhaps because you like it on a technical basis) and want to limit your risk.
Let's review some of the basics of hedged portfolios, and then see how we can go about building one around a Genworth Financial position for an investor with $50,000 to invest, who wants to maximize his potential return given the constraint that he wants to limit his downside risk to a drawdown of no more than 16% in a worst-case scenario.
Risk Tolerance, Hedging Cost, and Potential Return
All else equal, with a hedged portfolio, the greater an investor's risk tolerance - the greater the maximum drawdown he is willing to risk (his "threshold") - the lower his hedging cost will be, and the higher his potential return will be.
Constructing A Hedged Portfolio
In a previous article ("Rethinking Risk Management: A New Approach To Portfolio Construction"), we discussed a process investors could use to construct a hedged portfolio designed to maximize potential return, while limiting risk. We'll recap that process here briefly, and then explain how you can implement it yourself. Finally, we'll present an example of a hedged portfolio that was constructed this way with an automated tool. The process, in broad strokes, is this:
- Find securities with high expected returns.
- Find securities that are relatively inexpensive to hedge.
- Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high expected returns net of their hedging costs (or, ones with high net expected returns).
- Hedge them.
The potential benefits of this approach are two-fold:
- If you are successful at the first step (finding securities with high expected returns), and you hold a concentrated portfolio of them, your portfolio should generate decent returns over time.
- If you are hedged, and your return estimates are completely wrong, on occasion - or the market moves against you - your downside will be strictly limited.
How to Implement This Approach
- Finding securities with high expected returns. Presumably, if you own GNW (or are considering buying it), you expect it to have a decent return from here. To find other securities with high expected returns to complement it, you could, for example, look at the holdings of a top buy & hold stock blogger, as we did with Eddy Elfenbein's 2014 buy list in a recent article ("Investing Alongside The Best Buy & Hold Blogger While Limiting Your Downside Risk"). Or, if you want to have a more financial-focused portfolio, you could look at the top holdings of a leading financial stock ETF, as we did in another recent article ("A Lower-Risk Way To Invest In Financials"), in which we started with the top holdings of the Financial Select Sector SPDR ETF (NYSEARCA:XLF). To quantify expected returns for these securities, you can, for example, use analysts' price targets for them and then convert those to percentage returns from current prices. In general, though, you'll need to use the same time frame for each of your expected return calculations to facilitate comparisons of expected returns, hedging costs, and net expected returns. Our method starts with calculations of six-month expected returns.
- Finding inexpensive ways to hedge these securities. First, you'll need to determine whether each of these are hedgeable. Then, whatever hedging method you use, for this example, you'd want to make sure that each security is hedged against a greater-than-16% decline over the time frame covered by your expected return calculations (our method attempts to find optimal static hedges using collars, as well as married puts going out approximately six months). And you'll need to calculate your cost of hedging as a percentage of position value.
- Buying the securities with the highest net expected returns. In order to determine which securities these are, you'll need to subtract the hedging costs you calculated in the previous step from the expected returns you calculated for each position, and sort the securities by their expected returns net of hedging costs, or net expected returns. If any of the names in your sort have negative net expected returns (that is, the cost of hedging them is more than their expected return over the same time frame), you'll want to exclude them.
- Fine-tuning portfolio construction. You'll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs, so if you're going to include a handful of securities from the sort in the previous step, you'll need to take into account the share prices of the securities. For example, for our hypothetical investor's $50,000 portfolio, stocks such as Priceline.com (NASDAQ:PCLN), trading at more than $1000 per share, would be problematic. Another fine-tuning step is to minimize cash that's left over after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won't need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash, you can potentially boost returns. In this step, our method searches for what we call a "cash substitute": that's a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better-than-cash return, while keeping the investor's downside limited according to his specifications. You could use a similar approach, or you could simply allocate leftover cash to one of the securities you selected in the previous step.
An Automated Approach
Here, we'll show an example of creating a hedged portfolio around a Genworth Financial position using the general process described above, facilitated by the automated portfolio construction tool at Portfolio Armor. In the first step, we'll enter the ticker symbol GNW, the dollar amount of our investor's portfolio (50000), and the maximum decline he's willing to risk, in percentage terms (16). We'll leave the strategy set to the default, "Maximize Potential Return".
In the second step, we're given the option of entering our own expected return for GNW. In this example, we will leave this blank and use the tool's own expected return calculation.
A few minutes after clicking the "Create" button, we were presented with this hedged portfolio. The data in it are as of Thursday's close.
Why These Additional Securities?
In addition to Genworth Financial, the tool added Alcoa (NYSE:AA), Hewlett Packard (NYSE:HPQ), Cheniere Energy (NYSEMKT:LNG), and Monster Beverage (NASDAQ:MNST) to the portfolio in its primary allocation, based on their high net expected returns. Except for Genworth Financial, each of those securities was hedged with an optimal collar with its cap set at the security's expected return. GNW was hedged with an optimal put, because, unlike those other securities, it had a higher net expected return when hedged that way than when hedged with an optimal collar. As part of its fine-tuning step, the tool added Gilead Sciences (NASDAQ:GILD) as a cash substitute, hedged with an optimal collar with its cap set at 1%.
Each Security Is Hedged
Note that in the portfolio above, each of the underlying securities is hedged. Hedging each security according to the investor's risk tolerance obviates the need for broad diversification and lets him concentrate his assets in a handful of securities with high expected returns net of their hedging costs. Here is a closer look at the hedge for Genworth Financial.
As you can see at the bottom of the screen capture, the net cost of this optimal put, as a percentage of position value, was 3.62%.^{[i]}
Negative Hedging Cost
As you can see below in the summary for this hedged portfolio, the hedging cost of the entire portfolio (which includes the hedging cost of the GNW position above) was negative: an investor would have collected about $131 more from selling the call legs of the collars than he would have paid for the put protection.
Downside Risk And Potential Return
The potential return of this portfolio, as you can see in the portfolio summary image above, was 18.1%. That potential return is what the portfolio will return if each of its underlying securities achieves its expected return. Since it's more likely that some of the securities will fall short of their expected returns and some will exceed their expected returns, and since the collared securities have their upsides capped, the actual return of this portfolio may trail its potential return. But in the worst-case scenario - if GNW and every other one of these securities went to zero before their hedges expired - the investor's downside would be strictly limited to a decline of 15.59%.
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[i] To be conservative, the cost of the hedge was calculated using the ask price of the puts. In practice, an investor can often buy the puts for less than the ask price (i.e., at some price between the bid and ask). So, in practice, an investor may have paid less than $264, or 3.62% of his position value, to hedge GNW.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.