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The market euphoria of January 2012, has provided an opportunity to hedge against a market downturn. Investors can hedge their exposure to financial turmoil by purchasing deep out-of-the-money put options on stocks with weaker balance sheets as a form of portfolio insurance.

Deep out-of-the-money put options have no intrinsic value and will expire worthless unless there is a dramatic price decline in a stock. Thus, they tend to be somewhat inexpensive but are unlikely to provide any return. Put buyers must carefully select stocks that score poorly according to tests of financial health since the vast majority of out-of-the-money puts expire worthless.

In a recent article a screen was used to discover the following put candidates:

Ticker

Company

Altman Z-Score*

P/E

P/B

Insider Transactions

AA

Alcoa, Inc.

1.52

9.74

0.65

-15.8%

AEP

American Electric Power Co., Inc.

0.97

12.51

1.34

-9.4%

CBS

CBS Corporation

0.07

15.79

1.84

-7.1%

CCI

Crown Castle International Corp.

1.02

91.94

4.9

-3.6%

CSC

Computer Sciences Corporation

1.56

0

0.78

-2.8%

CVC

Cablevision Systems Corporation

0.82

14.85

0

-8.2%

EP

El Paso Corp.

0.80

871.33

4.61

-20.6%

EQIX

Equinix, Inc.

1.30

62.83

2.46

-12.0%

F

Ford Motor Co.

1.31

7.05

7.51

-4.2%

IPG

The Interpublic Group of Companies

1.16

12.15

2.01

-4.2%

NEE

NextEra Energy, Inc.

0.99

16.23

1.67

-6.6%

NFX

Newfield Exploration Co.

1.54

10.46

1.34

-3.1%

PPL

PPL Corporation

0.99

10.8

1.52

-10.3%

RCL

Royal Caribbean Cruises Ltd.

1.10

9.11

0.66

-2.2%

SIRI

SIRIUS XM Radio Inc.

-0.73

66.67

13.33

-19.1%

SO

Southern Company

1.39

18.3

2.05

-34.9%

TIN

Temple-Inland Inc.

1.59

51.16

3.6

-3.0%

TWX

Time Warner Inc.

-0.61

13.84

1.19

-3.8%

VMED

Virgin Media, Inc.

0.40

75.62

5.14

-65.5%

WCRX

Warner Chilcott plc

1.23

42.16

106.8

-87.4%

WYN

Wyndham Worldwide Corporation

1.36

14.53

2.4

-4.3%

(It is prudent to note that there is no way to tell the future, and that many of these companies are currently healthy and will remain so in the future. This is a list of put candidates based on a credit scoring model, and by no means is a divination or a guarantee about future events.)

Of the companies on this list, Ford, Virgin Media, and Cablevision have large payments due in the next one or two years that they will have to support with weak balance sheets.

According to its 10-K released in 2011, Ford had $33.4 billion in purchase obligations payable in 2011, and has $41.2 billion in purchase obligations due in 2012 and 2013. This might seem like a relief, but these scheduled payments will continue to put Ford under scrutiny from lenders. Unfortunately, Ford's most recent 10-Q from the third quarter of 2011 features a 26.4 debt-to-equity ratio. Ford might be forced to pay high rates depending on the global economic climate or on underwriter scrutiny for this highly leveraged American icon.

Virgin Media is another company with large payments scheduled for 2012 and rough financials. Its most recent 10-Q from the third quarter of 2011 reveals a 0.75 current ratio, which suggests that the company may seek additional financing for liquidity. Lenders might question its 8.82 debt-to-equity ratio.

The book value of VMED equity dropped from £ 1.98 billion to £ 1.29 billion in the first three fiscal quarters of 2011. During this period VMED was scheduled to make extremely large payments. Based on the last 10-K, it is slated to do so again in 2012:

SABIGTABLE

Virgin Media Scheduled Payments (£ Millions, Based on Fiscal 2010 10-K)

Item

2011

2012

10-K Page Reference

Long Term-Debt Payments

£ 150.30

£ 239.40

F-112

Capital Leases

£ 92.90

£ 64.10

F-20

Operating Leases

£ 70.20

£ 47.60

F-20

Equipment & Services

£ 518.90

£ 251.10

F-51

Sum

£ 832.30

£ 602.20

Cablevision appears to be in much worse shape on the basis of its financial statements. The book value of its equity is negative: the accounting value of its assets total was $5.5 billion less than the accounting value of its liabilities as of the third quarter of 2011. CVC's current ratio was 0.54 as of third quarter in 2011 because its current assets exceeded its current liabilities by almost $900 million.

Cablevision may have to make hard choices in 2012. According to the 10-K released in 2011, CVC and its subsidiary CSS Holdings have $686 million in obligations payable in 2012, up from $476 million payable in 2011. This increase in payments comes at the wrong time for CVC.

My sincere hope is that all these companies meet the financial challenges that confront them. However, it is not prudent to rely on hope. Instead, investors should consider purchasing puts on these three companies as portfolio insurance as they brave challenges in 2012.

*The Altman Z-Score is a measure of bankruptcy risk that is not based on stock price volatility. This score places companies into three groups: "safe" (Z-score > 2.99), "grey" (Z-score between 2.99 and 1.81), and "distressed" (Z-score < 1.81), and is surprisingly useful for identifying bankruptcy risk in the coming year. This method of segmenting companies uses of fundamental (financial statement) data and market capitalization only, not on price volatility. Beyond credit risk prediction, companies with higher Z-scores have historically outperformed companies with lower Z-scores, in aggregate. One sector has not been accurately modeled: Altman's Z-score has not accurately predicted the bankruptcy risk of financial companies.

"Distressed" was a label coined by researchers, and should not be taken to mean that any company is bankrupt or in default on the basis of this calculation alone. Credit scoring is not fate, only prediction based on relative past performance of companies grouped by key variables. Time will tell.

Volatility has be incorporated into a credit scoring to improve accuracy and extend it to financial companies, but this would reduce the value of a fundamentals-only model for indicating attractively-priced put options.

Disclaimer: This article was written to provide investor information and education, and should not be construed as a guarantee or investment advice. I have no idea what your individual risk, time-horizon, and tax circumstances are: please seek the personal advice of a financial planner. This article uses third-party data and may contain approximations and errors. Please check estimates and data for yourself before investing. I repeat: this research does NOT constitute a guarantee.

Source: Put Candidates With Triggers In 2012