Hedging 5 Stocks Rated "Substantially Outperform"
In an article last fall ("After Enron: Hedging 6 Stocks with High AGR Equity Risk Factors") we looked at stocks rated "substantially underperform market" by GovernanceMetrics International (GMI), which uses a proprietary quantitative approach to analyze the financial reports and governance practices of public companies. We mentioned then that the best-known indicator GMI uses is its Accounting and Governance Risk (AGR) ratings, which range from "Very Aggressive" to "Conservative." In that post, we also mentioned that GMI uses its AGR ratings to derive its AGR Equity Risk Factor, which it considers to be a leading indicator of share performance.
Using Fidelity's screener, on Thursday I screened for optionable stocks with the best AGR Equity Risk Factor rating, "substantially outperform market." In the table below are 5 stocks rated "substantially outperform market," along with the costs, as of Thursday's close, of hedging them against greater than 20% declines over the next several months, using optimal puts.
For comparison purposes, I've added the iShares Russell Midcap Index ETF (IWR). 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, IWR.
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.
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 each of the securities below.
The Optimal Puts to IWR
Below is a screen capture showing the optimal put option contract to hedge 100 shares of the iShares Russell Midcap Index ETF against a greater than 20% decline as of Thursday's close. 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 Thursday's Close
Aside from the ETF IWR, listed at the bottom for comparison purposes, all of the stocks below had AGR Equity Risk Factor ratings of "Substantially Outperform Market." The hedging costs are presented as percentages of position value. Given the high cost of hedging some of these names, if you own them 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 might consider buying optimal puts on an index-tracking ETF (such as IWR) instead, as a way to hedge your market risk.
|CNQ||Canadian Natural Resources||5.62%**|
Western Digital Corporation
Level 3 Communications
|RRD||R.R. Donnelley & Sons||18.2%**|
|IWR||iShares Russell Midcap Index||1.84%*|
*Based on optimal puts expiring in August
**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.