Deep out of the Money Put Options as Portfolio Insurance
Will the stock market rally continue? Macro forecasts are difficult to make. Instead of timing the "risk-on, risk-off" trade, investors can try to hedge their portfolios with put options. After having published put picks based on fragility, we now turn to selecting puts on overvalued stocks. This strategy assumes that stock valuations eventually regress to typical multiples-- that euphoria and bubbles do not last forever.
The following criteria were used to screen high valuation put candidates:
- The price-to-earnings ratio is higher than 20 (trailing twelve months).
- The price-to-sales ratio is higher than 3 (trailing twelve months).
- The price-to-book ratio is higher than 5.
- There must be an active options market for the stock.
Generating a List of Deep out of the Money Put Candidates
Here is a list of stocks which met the criteria:
Ticker | Company | P/E | P/S | P/B | EPS growth past 5 years | EPS growth next 5 years |
Salesforce.com | 6422 | 8.35 | 11.67 | 14.5% | 25.8% | |
Alexion Pharmaceuticals, Inc. | 104.31 | 21.7 | 14.61 | 87.7% | 34.8% | |
Crown Castle International | 94.83 | 6.9 | 5.22 | 0.0% | 17.9% | |
American Tower Corporation | 93.07 | 10.64 | 7.63 | 59.1% | 21.3% | |
VMware, Inc. | 56.24 | 10.59 | 8.39 | 45.4% | 23.6% | |
Baidu, Inc. | 52.33 | 24.08 | 22.99 | 132.5% | 49.7% | |
Kinder Morgan, Inc. | 45.56 | 2.79 | 7.59 | 0.0% | 26.1% | |
Cerner Corporation | 41.98 | 5.62 | 5.32 | 20.3% | 19.5% | |
FMC Technologies, Inc. | 32.93 | 2.74 | 8.57 | 35.8% | 13.0% | |
Teradata Corporation | 31.34 | 4.64 | 7.42 | 9.1% | 15.5% | |
Companhia Siderurgica Natl | 30.56 | 6.47 | 17.91 | 18.8% | 13.9% | |
Starbucks Corporation | 29.41 | 3.02 | 7.7 | 17.1% | 18.1% | |
Continental Resources Inc. | 28.39 | 8.5 | 5.72 | -4.1% | 12.8% | |
Intuit Inc. | 27.92 | 4.31 | 7.14 | 13.6% | 14.0% | |
Mastercard Incorporated | 26.71 | 7.49 | 8.57 | 109.3% | 18.3% | |
Cognizant Technology Solutions | 25.67 | 3.67 | 5.37 | 33.2% | 19.0% | |
Celgene Corporation | 25.08 | 6.58 | 5.7 | 73.1% | 24.8% | |
Wynn Resorts Ltd. | 23.2 | 2.68 | 5.46 | -4.8% | 32.1% | |
Paychex, Inc. | 21.01 | 5.25 | 7.28 | 3.1% | 10.9% |
Clearly all of these stocks are pricey from a static valuation perspective. We can evaluate them further by using growth estimates and trends to calculate total return for rosy "best case" and a dismal "worst case" scenarios*:
Worst Case | Best Case | |||||
Ticker | Growth | Terminal P/E | Annualized Return | Growth | Terminal P/E | Annualized Return |
CRM | 14.5% | 4278.1 | -84.2% | 25.8% | 3222.7 | -84.3% |
ALXN | 34.8% | 42.6 | -26.4% | 87.7% | 15.8 | -5.1% |
CCI | 0.0% | 94.8 | -43.6% | 17.9% | 57.8 | -41.1% |
AMT | 21.3% | 52.1 | -31.2% | 59.1% | 23.1 | -19.3% |
VMW | 23.6% | 29.8 | -17.1% | 45.4% | 18.3 | -12.2% |
BIDU | 49.7% | 15.6 | 2.9% | 132.5% | 4.2 | 53.2% |
KMI | 0.0% | 45.6 | -27.1% | 26.1% | 22.7 | -17.9% |
CERN | 19.5% | 24.6 | -11.6% | 20.3% | 24.1 | -20.9% |
FTI | 13.0% | 22.8 | -9.4% | 35.8% | 13.1 | -4.9% |
TDC | 9.1% | 24.1 | -11.0% | 15.5% | 20.4 | -17.2% |
SID | 13.9% | 20.7 | -4.5% | 18.8% | 18.2 | -14.5% |
SBUX | 17.1% | 18.3 | -2.0% | 18.1% | 17.9 | -12.9% |
CLR | -4.1% | 32.2 | -19.1% | 12.8% | 19.8 | -17.1% |
INTU | 13.6% | 19.0 | -3.4% | 14.0% | 18.8 | -15.4% |
MA | 18.3% | 16.1 | 1.8% | 109.3% | 2.9 | 59.5% |
CTSH | 19.0% | 15.2 | 3.7% | 33.2% | 10.9 | 3.1% |
CELG | 24.8% | 12.9 | 9.6% | 73.1% | 4.8 | 37.2% |
WYNN | -4.8% | 26.9 | -13.7% | 32.1% | 10.1 | 9.5% |
PAYX | 3.1% | 19.2 | -2.6% | 10.9% | 15.4 | -10.3% |
Inspecting the 3-year total returns under the best case scenario reveals that many of these firms have very rich valuations. In particular, CRM, CCI, CERN, AMT, KMI, CLR, TDC, and INTU would yield annualized losses in excess of 15% to investors who bought at today's high prices. These are good firms with great growth prospects, but their current prices are just too high.
It is prudent to note that there is no way to tell the future, and that many of these stocks have traded at high multiples for many years and will continue to do so in the future. This is a list of put candidates based on rich valuations, and by no means is a divination or a guarantee about future events.
* Total returns were calculated over a three year holding period for each of these stocks. (I use a 3-year holding period since above-average growth estimates are not reliable further out.) In the rosy "best case" scenario, each stock is assumed to be sold at a generous growth stock price-to-earnings multiple of 17 and the maximum of historical and analyst estimate values for earnings growth are assumed. These assumptions are used to project an annualized total return over the next three years and a terminal price to earnings ratios-- that is, price paid today divided by earnings at the end of the holding period for each stock.
The dismal "worst case" scenario 3-year total returns were calcualated using conservative assumptions. A bargain value stock price to earnings multiple of 10 and the lesser of historical and analyst estimates values for earnings growth are assumed.
Please read the article disclaimer.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
