Hedging 6 Large Caps Undervalued By The Graham Number

 |  Includes: AA, AET, AMP, APA, CI, DFS, DIA
by: David Pinsen

Hedging 6 Large Caps Undervalued By The Graham Number

In a recent article ("6 Large Cap Stocks Undervalued By The Graham Number"), Seeking Alpha contributor Kapitall ran an interesting screen. Kapitall's screen looked for stocks meeting the following three criteria:

  • Market cap of over $10 billion
  • PEG ratio under 1
  • Current share price below Graham Number

As a reminder, this is the formula for the Graham number, named after its originator, the value investing pioneer Benjamin Graham:

\sqrt{22.5\times(\text{earnings per share})\times(\text{book value per share})}

The Graham number is meant to represent a stock's "fair value", so that a stock trading for below that number could be considered undervalued. Kapitall's screen generated 6 names. In this post, we'll look at the costs of hedging them. The table below shows the costs, as of intraday Monday, of hedging them against greater-than-20% declines over the next several months, using optimal puts.

A Comparison

For comparison purposes, I've added the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) to the table below. First, a reminder about what optimal puts are, and a note about decline thresholds. Then, a screen capture showing the optimal puts to hedge the comparison ETF, DIA.

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). I have used 20% thresholds for all of the names below.

The Optimal Puts for DIA

Below is a screen capture showing the optimal put option contract to hedge 100 shares of the Dow-tracking ETF DIA (DIA) against a greater-than-20% 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 for the rest of the names below).

Hedging Costs as of Monday

The hedging data in the table below is as of intraday Monday, and is presented as percentages of position values. If you own these stocks as part of a diversified portfolio, and are content to let that diversification ameliorate your stock-specific risk -- but are still concerned about market risk -- you could consider buying optimal puts on an index-tracking ETF (such as DIA) instead, as a way to hedge your market risk.



Hedging Cost

(NYSE:AA) Alcoa, Inc. 7.47%**
(NYSE:AET) Aetna, Inc. 5.39%**
(NYSE:AMP) Ameriprise Financial, Inc. 5.78%*
(NYSE:APA) Apache Corporation 6.34%**
(NYSE:CI) CIGNA Corporation 4.58%**
(NYSE:DFS) Discover Financial Services 4.95%**
Click to enlarge

*Based on optimal puts expiring in September

**Based on optimal puts expiring in October

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