Novo Nordisk Update

| About: Novo Nordisk (NVO)

Summary

After Novo Nordisk's tumble on Friday, we look back at a hedged portfolio built around a position in the stock last year.

We discuss how we tracked the performance of that portfolio and calculated its return.

For current Novo Nordisk shareholders looking to add downside protection, we present a current hedge for the stock.

Image of Novo Nordisk-sponsored, Novolog-branded race car, via Motorsport.com Click to enlarge

Novo Nordisk Shares Crash; A Look Back, And A Look Forward

With shares of Novo Nordisk (NYSE:NVO) crashing Friday, after releasing mixed earnings and downbeat guidance related to its Novolog insulin pen, we were reminded of the hedged portfolio we built around the stock last October. In this article, we'll update the performance of that hedged portfolio, and we'll also post a current hedge for investors who own NVO now and are considering adding downside protection.

Image of 5-day chart of NVO, via YCharts.

Our October Novo Nordisk Hedged Portfolio

In an article written on October 12th of last year, and published the next day, we presented a hedged portfolio built around a position in Novo Nordisk. The hedged portfolio method is a form of concentrated investing where risk is strictly limited. The process, in broad strokes, is this:

  1. Find securities with promising potential returns (we define potential return as a high-end, bullish estimate of how the security will perform).
  2. Find securities that are relatively inexpensive to hedge.
  3. Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high potential returns net of their hedging costs (or, ones with high net potential returns).
  4. Hedge them.

In our October article, we went into more detail on each step of that process, showing how a reader could construct such a portfolio himself, and why one might want to include Novo Nordisk. Then, we used the automated hedged portfolio construction tool at the Portfolio Armor website to build a hedged portfolio around a position in NVO for an investor with $80,000 who was unwilling to risk a decline of more than 18% over the next six months. This was the portfolio the tool presented us:

Why Those Particular Securities?

For a user-entered security to fit in a hedged portfolio, its potential return, net of hedging costs has to be positive. That was the case there for NVO, so the site included it in the portfolio. Then it looked to add a couple of other securities with some of the highest net potential returns in its universe as additional primary securities. As of Friday, those were Activision Blizzard (NASDAQ:ATVI) and Netflix (NASDAQ:NFLX).

As it attempted to allocate equal amounts of cash to NVO, ATVI, and NFLX, it rounded down the amounts to get round lots of each stock. In its fine-tuning step, Portfolio Armor added Tesla (NASDAQ:TSLA) as a cash substitute, to replace most of the cash left over from the rounding down process. It selected TSLA because it had one of the highest net potential returns of any security in its universe when hedged as a cash substitute.

Tracking Hedged Portfolio Performance

For the interactive backtests of hedged portfolios on the Portfolio Armor website, we used a rather expensive method of tracking performance. We bought historical option price data, which comes in huge files that require software development to sort out. For tracking the performance of the NVO portfolio above, we used a simpler method.

Recall that there are two components to an option's price, intrinsic value and time value. Intrinsic value is based on how far in the money an option is (out of the money options have no intrinsic value). If the price of the option exceeds its intrinsic value, the amount by which it exceeds it is its time value. Time value, as the name suggests, is highest when an option has a lot of time until expiration.

Since the hedged portfolio method involves holding securities for 6 months or until just before their hedges expire (whichever comes first), in most cases, the options in those hedges will have very little time value when the positions are exited. So, in our simplified performance tracking method, we assume that the options have no time value when we exit.

By making the call leg of a collar slightly cheaper to buy back, this will strengthen returns; but by making the put leg worth slightly less when selling it, this will weaken returns. Taking into account the slightly positive effect on the call side and the slightly negative effect on the put side, it should be a wash.

Since the hedged portfolio above was created on October 12th, each position would have been exited on April 12th (after 6 months), or just before the hedges expired. Since the hedge on ATVI expired in May, we exited that one on April 12th; since the hedges on the other 3 stocks expired on March 18th, we exited them then. This was the ending value of that portfolio:

Click to enlarge

The only option here that was in the money when exiting was the call option on TSLA, which had an intrinsic value of $774. The ending value of the portfolio was $80,902, representing a gain of 1.1% over 6 months.

This was lower than the expected portfolio shown in the original hedged portfolio, but it's unlikely any particular portfolio will hit that number. All portfolios will have returns better than their maximum drawdown figures, and over time, the average actual performance of the portfolios ought to track with the average expected return.

A Current NVO Hedge

As of Friday's close, our site estimated a potential return of 10% for NVO over the next several months (historically, actual returns have averaged 0.3x the site's potential return estimates, taking into account securities that ended up having negative returns).

For investors who are long Novo Nordisk and want to limit their downside risk while having a chance of capturing that potential return, here is the optimal collar, as of Friday's close to hedge 500 shares of it against a greater-than-14% decline by mid-March, while not capping your possible upside at less than 10% by then (screen captures via the Portfolio Armor iOS app):

As you can see above, the cost of the put leg here was $1,025, or 4.11% of position value. But as you can see below, selling the call leg would have generated income of $725 or 2.91% of position value.

So the net cost of the hedge would have been $300, or 1.2% of position value. A few notes on this:

  • The cost of the optimal collar was calculated using the ask price of the puts and the bid price of the calls. In practice, an investor can often buy puts for less and sell calls for more (again, at some price between the bid and the ask), so in reality, an investor would likely have paid less than $300 when opening this collar.
  • If you were willing to risk a larger decline, you could have entered a larger number than 14 in the "threshold field" and lowered your hedging cost.
  • This hedge may provide more protection than promised if the underlying security declines in the near future due to time value. However, if the underlying security spikes in the near future, time value can have the opposite effect, making it costly to exit the position early (for an example of this, see this article on hedging Facebook (NASDAQ:FB) - Facebook Rewards Cautious Investors Less).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.