Hedging 4 Stocks Overvalued On A PEG Basis

by: David Pinsen

A PEG (price/earnings/growth) ratio of over 2 suggests a company is overvalued relative to its projected earnings growth. Stocks with high valuations could be vulnerable when market multiples contract. In screening for the best performing stocks over the last 52 weeks -- the ones whose price performance placed them in the top quintile of the market -- I found 165 with PEG ratios of 2 or higher. To narrow down that list to a handful of stocks that might be particularly worth watching, I also looked at short term price performance. Specifically, I screened for optionable stocks with market capitalizations over $500 million that met these three additional criteria:

  • PEG ratio of 2.0 or higher
  • 52-week price performance in top 20% of market
  • 5-day price performance in the bottom 20% of the market

Adding that last criterion dropped the list of stocks from 165 to 4. The table below shows the PEG ratios, 52-week price performances, 5-day price performances, and the costs, as of Monday's close, of hedging these 4 stocks against greater-than-20% declines over the next several months, using optimal puts.

A Comparison

For comparison purposes, I've also added the costs of hedging the ProShares QQQ Trust ETF (NASDAQ:QQQ) against the same decline, using optimal puts. First, a reminder about what optimal puts are, and a note about decline thresholds; then, a screen capture showing the optimal puts to hedge one of 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" is the maximum decline you are willing to risk. 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% decline thresholds for each of the names below.

The Optimal Puts For QQQ

Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of the PowerShares QQQ Trust ETF 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 slightly 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 Monday's Close

The hedging costs below are as of Monday's close and are presented as percentages of position value. Stocks are ranked in descending order of their PEG ratios. Note that the cost of hedging one of these stocks, Mellanox Technologies, Ltd. (NASDAQ:MLNX), was particularly high. Recall that we've observed examples of high optimal hedging costs presaging poor performance. If you own an expensive to hedge stock 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 hedging your market risk by buying optimal puts on an index-tracking ETF such as QQQ.



52-Week Price Perf. 5-Day Price Performance PEG Ratio

Hedging Cost

NUAN Nuance Com. 50.6% -4.19% 10.8 7.62%***
MLNX Mellanox 39.0% -5.26% 6.55 16.0%**
FTNT Fortinet, Inc. 23.0% -3.45% 3.55 10.8%**
VPHM Viropharma 54.1% -9.22% 2.22 12.4%*
QQQ PowerShares QQQ 14.9% 0.20% NA 1.94%**

*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.