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In a recent article ("7 Large-Cap Dividend Stocks Undervalued By Levered Free Cash Flow"), Seeking Alpha contributor Kapitall analyzed a diverse group of seven dividend-paying stocks, with market capitalizations greater than $10 billion, that were undervalued by levered free cash flow. In this post, we'll look at the hedging costs of them. Of these seven stocks, one in particular, Enersis SA (NYSE:ENI), was extremely expensive to hedge using optimal puts. Recall that we have observed examples of high optimal hedging costs presaging poor performance. The table below shows the costs, as of Tuesday's close, of hedging Enersis SA, and the six other names Kapitall presented, against greater-than-26% declines over the next several months, using optimal puts.

Comparisons

For comparison purposes, I've added the iShares MSCI ACWI Index ETF (NASDAQ:ACWI) and the PowerShares QQQ Trust ETF (NASDAQ:QQQ) to the table. First, a reminder about what optimal puts are, and a note about the 28% decline threshold; then, a screen capture showing the optimal puts to hedge the comparison ETF QQQ.

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). Often, I use 20% thresholds when hedging equities, but one of these stocks, Enersis SA, was too expensive to hedge using a 20% threshold (i.e., the cost of hedging it against a greater-than-20% drop was itself greater than 20%, so the app indicated that no optimal contracts were found for it). The smallest decline threshold for which there were optimal puts for Enersis SA was 26%, so that's the threshold I've used for all of the names here.

The Optimal Puts for QQQ

Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of QQQ against a greater-than-26% drop between now and September 21st. 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 (the same is true of the other names in the table below).

Hedging Costs as of Tuesday's Close

The hedging costs below are as of Tuesday's close, and are presented as percentages of position values.

Symbol

Name

Hedging Cost

AZN Astrazeneca, PLC 0.89%*
ENI Enersis, SA 25.7%*
AMAT Applied Materials 1.97%*
NTT Nippon Telegraph and Telephone 5.69%***
TWX Time Warner, Inc. 1.30%*
ACN Accenture, Plc 1.63%**
XRX Xerox Corporation 3.30%*
ACWI iShares MSCI ACWI Index 3.13%*

QQQ

PowerShares QQQ Trust

1.41%***

*Based on optimal puts expiring in July

**Based on optimal puts expiring in August

***Based on optimal puts expiring in September

Source: Hedging 7 Large Caps Undervalued By Levered Free Cash Flow