By Scott at Sabrient and Ilene
Stand up and be counted!
For what you are about to receive
We are the (primary) dealers
We'll give you everything you need (free money!)
Hail, Hail to the good times
'Cause rock has got the right of way
We ain't no legend, aint no cause
We're just livin for today (the Fed)
(Apologies to AC/DC.)
With February and the most of earnings season passing, we decided to "stand up and be counted" with a summary article on our Virtual Dark Horse Traders' Hedge (DHH) portfolio. Our mission has been to generate absolute returns through the use of a tilted Long/Short strategy that remains market neutral, but with a partial bias towards momentum (as defined by measuring the S&P 500 relative to its 50- and 200-day Moving Averages). We have been tilted to the long side since October 2010.
Over the long term, reasons for using such a strategy include being positioned to take advantage of both bull and bear runs. As evidenced by the near zero returns of the market over the last 10 years, buy-and-hold strategies are majorly flawed. The market also teaches hard lessons to those who attempt to predict direction, and has forced many retail investors to reconsider their strategies after being pounded in 2001 and 2008.
Alpha is a measure of a return over and above a benchmark index's return, and Beta is a measure of the portfolio's performance as it is correlated to movements of the market. With DHH, we strive to optimize Alpha while minimizing Beta to protect our portfolio in up and down markets. Beta is reduced by holding both Long and Short positions and using a rules-based approach to determine which stocks have the best chacteristics to benefit when the market is rising, and conversely to determine which stocks are most apt to perform poorly when the market is falling. In other words, we want to be long stocks of the best companies and short stocks of the worst companies -- we want to identify the "tails" of a market, index, sector or basket of stocks.
Once a portfolio of Long and Short stocks is established, then it is a matter of gaining the desired exposure using the available tools, such as Sabrient's ratings for publically traded companies. DHH also uses option strategies in an attempt to leverage our capital, acquire stocks at discounts to current prices, and create income yield on positions that don't pay dividends. Phil's buy/write strategies are ideal methods for achieving these goals.
Since March 2009, the market has resembled a "hail, hail to the good times," with periods of irrational exhuberance fueled by QE1 and QE2 and a mindset of "living for today." (Stock World Weekly presents the case that the current round of QE2 is inflating prices in everything from oil to food to stocks.) Dissociated from the "wealth effect" of higher stock prices, most Americans are not feeling the recovery, even though for the past two years, the bulls have mostly "got the right of way."
Currently, the DHH virtual portfolio is tilted 70% Long and 30% short. In the past few weeks, the market has tested the 50-day Moving Average several times without giving way. A move below the 50-day MA would prompt us to go back to 50/50 market neutral.
So let's get to DHH's virtual positions and start by reviewing the 12 stocks DHH is holding long.
Arrow Electronics, Inc. (ARW) is a provider of products, services and solutions to industrial and commercial users of electronic components and enterprise computing solutions. Arrow made Fortune's World's Most Admired Company list again last week. Several analysts raised price targets on ARW in the last 30 days, as well as raising 2012 earnings. Currently ARW is trading at a p/e of 8 and a forward 12-month p/e of 7. The 5-year projected growth rate is 14.5%, double the forward p/e and the industry trades at an average p/e of 17.5. This profile fits in our Growth at a Reasonable Price (also known as GARP) category. ARW options are not very liquid, but a buy/write strategy might be a good way to establish a new position nonetheless.
Entering ARW with a buy/write strategy, and thereby reducing our cost basis, we could buy 100 shares of ARW (half our position) for approximately $39.20, sell 1 ARW June 2011 40 Call (ARW110618C00040000) for approximately $2.50 and sell 1 ARW Jun 2011 40 Put (ARW110618P00040000) for approximately $3.20. This would lower our cost basis by $5.70.
Axis Capital Holdings (AXS), through its subsidiaries, provides various insurance and reinsurance products to insureds and reinsureds worldwide. It operates in two segments, Insurance and Reinsurance. AXS beat the street expectations of $1.41 vs. $1.21 in its last earnings report and analysts have been raising earnings estimates for 2011 and 2012. It has a yearly growth rate of 15.5% and a forward p/e of only 8.5. AXS also pays a 2.6% dividend. We originally bought AXS in our virtual DHH portfolio on Sept. 9, 2010 for $31.86. AXS is currently trading at approximately $35.74. Its optons are very illiquid so we are not devising a buy/write strategy for this position. Gannett Communications Inc. (GCI) operates as a media and marketing solutions company in the United States and internationally. As a value stock (p/e of 7), it is a solid addition on the Long side, using Phil's buy/write strategy. GCI is not a high growth company. We first added GCI to the virtual DHH portfolio on July 26, 2010 when the stock was at $14.52. This stock gives a good example to how to use the buy/write strategy on a value stock that has little risk of a big move in either direction. DHH bought 1/2 of the exposure desired by buying the stock, and then sold a Jan. $15 call for $2.25 and Jan. $15 put for $1.75 (the put gives potential exposure to the other 1/2 position if the stock is under $15 at the time the put expires). At expiration time, GCI had moved very little and the Jan. $15 put was trading at $0.49.
The Jan. $15 call expired worthless (as approximately 65-70% of option contracts do). We bought back the $0.49 put rather than buying more stock for $15. With a realized gain or reduction to our cost basis of $3.51 ($2.25 + $1.75 - $0.49), we effectively bought our shares of GCI for $11.01 ($14.52 - $3.51 = $11.01), a 24% discount.
Holding onto our core virtual position, we sold an April $15 Call for $1.35 and sold an April $15 Put $0.95 on Jan. 21, 2011. Now that GCI has moved up to $16.26, if we were to enter GCI as a new position, we might buy 100 shares of GCI and sell 1 GCI July 2011 16 Call for approximately $1.75 (GCI110716C00016000) and sell 1 GCI July 2011 Put for approximately $1.50 (GCI110716P00016000).
Ingram Mcro (IM) distributes information technology (IT) products and supply chain solutions worldwide. The company offers various IT products, including peripherals, systems, software, networking, and more. It makes our list of Longs as a GARP stock. The 5-year expected growth rate for IM is 15% and the stock is trading at a p/e of 9 in an industry that trades at an average of 15. Analysts have been busy upping their estimates of quarterly and annual earnings for 2011 and 2012.
We bought IM in the virtual DHH portfolio on July 26, 2010 at $16.81 along with GCI, and we used the buy/write strategy to enter the position. IM is currently trading at approximately 19.94. For those who don't already have a position in IM, a current buy/write strategy would be to buy 100 shares of IM, and then sell 1 IM June 2011 20 Call for $1.10 (IM110618C00020000) and sell 1 IM June 2011 Put for $1.10 (IM110618C00020000).
Come back for part 2 later this week.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.