Insurance For Intuitive Surgical

| About: Intuitive Surgical, (ISRG)


The closest thing to a bearish Seeking Alpha article on Intuitive Surgical recently highlighted the stock's P/E. We discuss why the company's current valuation shouldn't be a concern.

Nevertheless, some shareholders may be interested in limiting their risk in the event of a market correction or a negative surprise from the company.

We present two ways of doing so.

Screen capture via Intuitive Surgical

Intuitive Surgical And Its Valuation

There was an interesting discussion about valuation in the comments of Seeking Alpha contributor Dividend Investor's article on Intuitive Surgical (NASDAQ:ISRG) last month ("Intuitive Surgical: Future Bright, But Shares Overvalued"). Dividend Investor had cited Intuitive Surgical's P/E ratio in refering to its shares as overvalued; reader and self-described surgeon "RoboticUrology" commented in response:

There may be a lot of good reasons not to buy shares in a particular company, but for a rapidly growing company with a monopoly, a high PE is not one of those good reasons.

RoboticUrology's comment is worth reading in full for a sense of the utility of Intuitive Surgical's Da Vinci robots, but he makes a good point there about the limits of looking at a P/E ratio when evaluating a growth company (particularly across different industries). A PEG ratio can be more informative, since it takes into account the company's estimated growth rate. Although ISRG's PEG Ratio isn't low on an absolute basis (PEG ratios higher than 2 are often considered high), it is lower than average for its industry (data via Fidelity):

Screen capture via Fidelity. Click to enlarge

So current valuation shouldn't be a concern for ISRG longs. Aside from any negative earnings surprises, the biggest downside risk for ISRG longs would likely be from a broader market correction. And crowd-sourced research platform Estimize is more bullish than Wall Street on Intuitive Surgical's upcoming earnings.

Screen capture from Estimize. Click to enlarge

Downside Protection For ISRG Longs

For Intuitive Surgical shareholders who want to add some downside protection here, to protect against market or stock-specific risk, we'll present a couple of hedges for the stock. If you'd like a refresher on hedging terms first, please see the section titled "Refresher On Hedging Terms" in this previous article of ours, Locking In Gold Gains.

Hedging ISRG With Optimal Puts

We'll use Portfolio Armor's iOS app to find optimal puts and an optimal collar to hedge ISRG, but you don't need the app for this. You can find optimal puts and collars yourself by using the process we outlined in this article if you're willing to do the work. Either way, you'll need to determine your "threshold," which is the maximum decline you are willing to risk. This will vary depending on your risk tolerance. For the purpose of the examples below, we've used a threshold of 15%. If you are more risk-averse, you could use a smaller threshold. And if you are less risk-averse, you could use a larger one. All else equal, though, the higher the threshold, the cheaper it will be to hedge.

Here are the optimal puts as of Thursday's close to hedge 200 shares of ISRG against a greater-than-15% drop by late April.

As you can see at the bottom of the screen capture above, the cost of this protection was $3,580 or 2.49% of position value. A few points about this hedge:

  1. To be conservative, the cost was based on the ask price of the puts. In practice, you can often buy puts for less (at some price between the bid and ask).
  2. The 15% threshold includes this cost, i.e., in the worst-case scenario, your ISRG position would be down 12.51%, not including the hedging cost.
  3. The threshold is based on the intrinsic value of the puts, so they may provide more protection than promised if the underlying security declines in the near term, when the puts may still have significant time value.

Hedging ISRG With An Optimal Collar

When scanning for an optimal collar, you'll need one more figure in addition to your threshold, your "cap," which refers to the maximum upside you are willing to limit yourself to if the underlying security appreciates significantly. You don't think the security is going to do better than that anyway, so you're willing to sell someone else the right to call it away if it does better than that.

The potential return over the next 6 months implied by the consensus 12-month Wall Street price target for Intuitive Surgical is less than 3% (based on the data from Nasdaq below).

Screen capture via Nasdaq

We checked Portfolio Armor's website to get its potential return for the stock too (for an explanation of its process, see the section titled "Calculating A Potential Return For Amazon (NASDAQ:AMZN)" in this article). Our site was more bullish than Wall Street, estimating a potential return of 12% over the next several months. But lowering the cap to 11% reduced the hedging cost considerably, so we used tha 11% as a cap.

This was the optimal collar, as of Friday's close, to hedge 200 shares of ISRG against a >15% drop by late April while not capping an investor's upside at less than 11% by then.

As you can see in the first part of the collar above, the cost of the put leg was $3,180, or 2.22% of position value. But as you can see in the second part of the collar below, the income generated from the call leg was a bit more, $3,560, or 2.49% of position value.

So the net cost of this collar was negative, meaning an investor would collect an amount equal to $380, or 0.27% of position value when opening this hedge. A couple of points about this collar:

  • Similar to the situation with the optimal puts, to be conservative, 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 collected more than $380 when opening this collar.
  • This hedge may provide more protection than promised if ISRG declines in the near future due to time value (for an example of this, see this article on hedging Apple (NASDAQ:AAPL)). However, if Intel 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, Facebook (NASDAQ:FB) 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.