Hedging 10 High 'Relative Value' Stocks

by: David Pinsen

Relative Value

In a recent articles, we looked at the 10 stocks ranked highly according to "Relative Safety" and "Relative Timing" by VectorVest. In this one will look at 10 stocks ranked highly according to "Relative Value." VectorVest calculates Relative Value based on:

... forecasted earnings per share, forecasted earnings growth, profitability, interest, and inflation rates. Value increases when earnings, earnings growth rate and profitability increase, and when interest and inflation rates decrease.

VectorVest uses its own forecasts of earnings per share and earnings growth for those calculations. Then it ranks the stocks in terms of Relative Value in the same way it ranks them in terms of Relative Timing and Relative Safety: on a scale from 0 to 2, with 2 being the highest (best) possible score. The stocks listed in the table below had Relative Timing scores ranging from 1.49 to 1.62 on Thursday.

Hedging costs of high Relative Value stocks

I also looked at the hedging costs for these stocks using optimal puts, and found them to be quite high -- 7 were too expensive to hedge using 20% decline thresholds, and for the other three, the cost of that level of protection was over 11% of position value. You can see those costs in the table below. First, a reminder about what optimal puts are, and why I've used 20% as a decline threshold; then, a screen capture shows the current optimal puts to hedge one of the stocks listed below, Cummins, Inc. (CMI).

About Optimal Puts

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 position, scanning for the optimal ones.

Decline Thresholds

In this context, "threshold" refers to the maximum decline you are willing to risk in the value of your position in a security. You can enter any percentage you like for a decline threshold when scanning for optimal puts (the higher the percentage though, the greater the chance you will find optimal puts for your position). I have used 20% thresholds for each of the securities below. Essentially, 20% is a large enough threshold that it reduces the cost of hedging, but not so large that it precludes a recovery.

The Optimal Puts For CMI

Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of CMI against a greater-than-20% drop between now and March 16, 2012. A note about these optimal put options and their cost: to be conservative, Portfolio Armor calculated the cost based on the ask price of the optimal puts. In practice an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask. In any case, the hedging cost is quite expensive. CMI longs concerned about downside risk may simply want to reduce their position sizes and raise cash instead.

(Click to enlarge)

Why There Were no Optimal Contracts for 7 of these stocks

In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with most of the stocks on this list. As of Thursday, the cost of protecting them against a greater-than-20% declines over the next several months was itself greater than 20%. Because of that, Portfolio Armor indicated that no optimal contracts were found for them.

Hedging Costs as of Thursday

The data in the table below are as of Thursday. The stocks are listed in order of Relative Value, ranging from an RV of 1.62 for RES to an RV of 1.49 for DAR. Other than HollyFrontier Corp. (HFC), and Cummins, Inc. ((CMI)), which are rated "hold", and Jazz Pharmaceutical, Inc. (JAZZ), which is rated "buy", the rest of these stocks are rated "sell" by VectorVest (VectorVest bases its "buy", "sell", and "hold" ratings on a weighted average of RT, RV, and RS, overweighting RT and underweighting RV).



Cost of Protection (as % of position value)


RPS, Inc.

No Optimal Contracts

(IVR) Investco Mortgage Capital, Inc. No Optimal Contracts


Paterson-UTI Energy, Inc.

No Optimal Contracts

(HFC) HollyFrontier Corp. 17.1%*
(LXU) LSB Industries, Inc. No Optimal Contracts
(AG) First Majestic Silver Corp. No Optimal Contracts
(JAZZ) Jazz Pharmaceutical, Inc. 17.8%*
(SVN) 7 Days Group Holdings Ltd. No Optimal Contracts
(CMI) Cummins Inc. 11.6%*
(DAR) Darling International Inc. No Optimal Contracts

*Based on optimal puts expiring in March, 2012

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.