A Look At Hedging 4 'Better Than Apple' Stocks

by: David Pinsen

Amid all the excitement Monday about the decision by Apple (NASDAQ:AAPL) to pay a dividend and buy back some of its shares, Bloomberg Television anchor Adam Johnson took to Twitter to offer a list of stocks that were "better than Apple," based on earnings growth and P/E:

"Better than $AAPL" Growing>25% and P/E<14 $AMD $ALL $AIZ $BBT $CAT $DTV $GNW $GS $HIG $JOY $LSI $MS $NBR $LUV $TRV $WDC $$

- Adam Johnson (@AJInsight) March 19, 2012

The title of the list may seem provocative at first - certainly Apple has numerous quantitative and qualitative strengths beyond the two metrics of earnings growth and P/E. But a comment in a recent essay ("Frighteningly Ambitious Startup Ideas") by Y Combinator founder Paul Graham suggested Apple's key advantage in product development may be peaking:

I was talking recently to someone who knew Apple well, and I asked him if people now running the company would be able to keep creating new things the way Apple had under Steve Jobs. His answer was simply "no." I already feared that would be the answer. I asked more to see how he'd qualify it. But he didn't qualify it at all. No, there will be no more great new stuff beyond whatever is currently in the pipeline. Apple's revenues may continue to rise for a long time, but as Microsoft (NASDAQ:MSFT) shows, revenue is a lagging indicator in the technology business.

If Graham is correct, and Apple is likely to go the way of Microsoft, then perhaps Adam Johnson's "Better than Apple" characterization of his list isn't so outrageous. In the table below, we'll look at the costs, as of Tuesday's close, of hedging four of Johnson's "Better than Apple" stocks against greater-than-20% declines over the next several months, using optimal puts.

A comparison

For comparison purposes, I've added the PowerShares QQQ Trust ETF (NASDAQ:QQQ), which tracks the Nasdaq 100 Index, to the table. First, a reminder about what optimal puts are, and a note about the decline threshold I'm using here; then, a screen capture showing the optimal put option contract to hedge 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" 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 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 Nasdaq 100-tracking ETF QQQ against a greater-than-20% drop between now and September 21st. A note about these optimal put options and their cost: To be conservative, the app 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 Tuesday's Close

The hedging costs below are as of Tuesday's close, and are 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 may want to consider buying optimal puts on an index-tracking ETF (such QQQ) instead, as a way to hedge your market risk.



Hedging Cost

ALL Allstate Corporation 2.96%**
BBT BBT Corporation 2.49%*
WDC Western Digital Corp. 6.27%**
LSI-OLD LSI Corporation 7.40%**
QQQ PowerShares QQQ Trust 1.49%*
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.

Additional disclosure: I am long optimal puts on QQQ as a hedge.