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Last Friday marked the 10th anniversary of Enron's bankruptcy filing, after its extensive accounting fraud was unveiled. One of the forensic accounting firms founded in the wake of Enron's fraud was GovernanceMetrics International (GMI), which uses a proprietary quantitative approach to analyze the financial reports and governance practices of public companies. The best-known indicator GMI uses is its Accounting and Governance Risk (AGR) ratings, which range from "Very Aggressive" to "Conservative." According to GMI, companies rated "Very Aggressive" are 10 times more likely to face SEC enforcement actions than those rated "Conservative," and 4 times more likely to file for bankruptcy.

GMI uses its AGR ratings to derive its AGR Equity Risk Factor, which it considers to be a leading indication of share performance. AGR Equity Risk Factor ratings range from 1 ("Substantially Outperform Market") to 5 ("Substantially Underperform Market").

Hedging 6 Stocks With High AGR Equity Risk Factors

In this post, we'll look at the current hedging costs for six stocks that have the highest (least favorable) AGR Equity Risk Factor rating ("Substantially Underperform Market"). For comparison purposes, we'll also look at the cost of hedging the SPDR S&P 500 Trust ETF (NYSEARCA:SPY). First, a reminder about what optimal puts are, and a note about why I've used 27% as decline threshold. Then, a screen capture showing the optimal puts to hedge one of these six stocks, Mechel OAO (NYSE:MTL).

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" is the maximum decline you are willing to risk. Another way of thinking about it is this: the percentage you can tolerate losing. In this case, since we're using 27% as a decline threshold, we are indicating that we could tolerate a 27% loss, but not a loss greater than that. 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). We used 27% as a decline threshold here because two of these stocks, Jeffries Group, Inc. (JEF) and Mechel OAO, were too expensive to hedge against against smaller declines (i.e., the cost of hedging them against 26% declines was itself greater than 26% of position value, so Portfolio Armor indicated no optimal puts were found for them).

The Optimal Puts to Hedge Mechel OAO

Below is a screen capture showing the optimal put option contract to hedge 100 shares of MTL against a greater than 27% decline as of Monday's close. 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.

Hedging Costs As Of Monday's Close

Aside from the ETF SPY, listed at the bottom for comparison purposes, all of the stocks below had AGR Equity Risk Factor ratings of "Substantially Underperform Market." The hedging costs are presented as percentages of position value.

Symbol

Name

Hedging Cost

JEF Jeffries Group, Inc. 23.4%***
LUK Leucadia National Corp. 7.92%**
RIMM

Research in Motion Limited

13.7%**

MTL

Mechel OAO

25.1%***

GMCR Green Mountain Coffee 16.0%**
NFLX Netflix, Inc. 11.1%**
SPY SPDR S&P 500 Trust 1.98%*

*Based on optimal puts expiring in May, 2012

**Based on optimal puts expiring in June, 2012

***Based on optimal puts expiring in July, 2012

Source: After Enron: Hedging 6 Stocks With High AGR Equity Risk Factors