A Caution About A Debt-Free, Richly-Valued Company
Last Wednesday's Lex column in the Financial Times raised a note of caution about British chip designer Arm Holdings, plc (ARMH). After mentioning that it had a PEG (price/earnings/growth) ratio of close to 2, which suggests the company is overvalued relative to its projected earnings growth, Lex warned,
The danger is that Arm may have become a haven for investors looking for safety in the equity market. The company has no debt and robust earnings [...]. If it has indeed become a haven stock, it is vulnerable: when markets normalize, Arm's share prices could fall.
After reading that, I decided to screen for stocks that might be in a similar position -- debt free, but also richly-valued on a PEG basis. Using Fidelity's screener, I looked for stocks meeting these criteria:
- PEG ratio of 2.0 or higher
- Debt to capital ratio of 0 (no debt)
- Cash/Price ratio in the top 80%
Arm Holdings didn't come up on that screen, because Fidelity's screener showed it with a PEG ratio of 1.6, but I've included it in the table below anyway, partly because of its mention by Lex, and also because I've also noticed a fairly wide variation in PEG ratios shown by different screeners (presumably, because they are using different estimates of forward earnings).
Given that these richly-valued companies may face multiple compression "when markets normalize", some shareholders may consider hedging them. With that in mind, the table below shows the costs, as of Friday's close, of hedging Arm Holdings, plus the 7 stocks that came up on my screen, against greater-than-20% declines over the next several months, using optimal puts.
For comparison purposes, I've also added the costs of hedging the ProShares QQQ Trust ETF (QQQ) against the same decline, using optimal puts. First, a reminder about what optimal puts are, and a note about why I've used a 24% decline threshold here; then, a screen capture showing the optimal puts to hedge one of these stocks, Ace Limited, (ACE).
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.
In this context, "threshold" is the maximum decline you are willing to risk. 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). Usually, I use 20% decline thresholds when hedging equities, but one of these stocks, Cobalt International Energy, Inc. (CIE), was too expensive to hedge using a 20% threshold (i.e., the cost of hedging it against a 20% decline was itself more than 20% of position value, so Portfolio Armor indicated there were no optimal contracts available for it). There were optimal contracts for CIE against a 24% threshold, so that's the decline threshold I've used for all of the names here.
The Optimal Puts For ACE
Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of ACE Limited against a greater-than-24% drop between now and August 17th. 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 slightly lower price, i.e., some price between the bid and the ask (the same is true of the other names in the table below).
Hedging Costs As Of Friday's Close
The hedging costs below are as of Friday's close and are presented as percentages of position value. Stocks are ranked in descending order of their PEG ratios. Note that the cost of hedging one of these stocks, Cobalt Energy International , was particularly high. Recall that we've observed examples of high optimal hedging costs presaging poor performance.
|PEG Ratio|| |
|RHT||Red Hat, Inc.||5.93||12.3%***|
|CIE||Colbalt Intl. Energy||2.50||19.2%*|
Solar Winds, Inc.
|ARMH||Arm Holdings, Ltd.||1.60||2.87%*|
*Based on optimal puts expiring in June
**Based on optimal puts expiring in July
***Based on optimal puts expiring in August