An Interview with Jay Buster on "Protected Stocks" and Potential Nikkei 225 Plays vs. ETFs and CEFs

Today we have something new from Seeking Alpha's coverage of Japan -- our first interview. Novice and experienced investors alike should be able to learn something from this interview and broaden their knowledge of the different types of investments that exist. I admit this was a new one for me. Let’s begin with a question:

Is there an investment that would satisfy both the conservative nature of a CPA tax accountant and the wild side of an option and futures floor trader?

Yes! In fact, Jay Buster, a former CPA, option and futures floor trader, has a blog, Protected Stocks, devoted to a unique investing strategy known only to a few. Today he shares his "secret" low risk investing strategy as it relates to Japanese stocks.

ST: First, can you explain to our readers what a "Protected Stock" is?

JB: "Protected Stocks" is our user-friendly name for a class of securities that Wall Street calls "structured products" (aka “index linked notes").

A Protected Stock is created by financial institutions, like Citigroup (CIT), Morgan Stanley (MWD) and Merrill Lynch (MER). Protected Stocks are hand crafted by financial engineers to create unique low risk/high reward investments. These firms, called underwriters, "brand" the Protected Stocks they create. For example, Merrill Lynch, which is the largest creator of Protected Stocks, labels their Protected Stocks "MITTS".

We may describe, in general, the characteristics of a typical Protected Stock:

• Like a bond, it has a maturity date, usually three to seven years.

• At the stock’s maturity, the underwriter promises to pay a guaranteed minimum amount, usually $10, even if the index, that the stock is tracking, has plummeted in value. Price risk is therefore greatly reduced or eliminated.

• The underwriter also promises to pay you an additional amount above the minimum when the index increases in value.

• Tracks a stock index like the Nikkei 225 or the S&P 500.

• Trades like any other stock. Most commonly traded on the American Stock Exchange or NASDAQ.

• Some Protected Stocks are "turbo charged" to provide up to 200% of the index's return, in exchange for some loss of downside protection.

• Is the obligation or debt of the underwriter (e.g. Merrill Lynch).

• The exact terms of the Protected Stock are contained in a prospectus filed with the SEC. This is required reading to understand what you're buying.

• Every Protected Stock is different from every other Protected Stock.

ST: Are there any Protected Stocks related to Japan?

JB: Yes. The Japanese Protected Stocks I cover are MTNK, MNNY, NML and MNK. These all track the Nikkei 225. There are other Japanese Protected Stocks, but they’re so far above the guaranteed $10 minimum, it’s like buying an unProtected Stock. I’ll cover additional Japanese Protected Stocks when they’re issued.

Because of the tremendous rally in the Nikkei 225 this year, all of the Japanese Protected Stocks I cover have soared in value. They’re all trading above the guaranteed minimum ($10) maturity payment. Therefore, there is some price risk. However, when these Protected Stocks are compared to the leading Japanese ETF, EWJ, the Protected Stocks still have a better risk/reward profile.

ST: There is a lot of excitement whenever there is an IPO. For instance, Wachovia plans to sell a "Protected Stock" that tracks Berkshire Hathaway's B-shares. However, the IPO may not be the best time to get in. Why? And what is a good entry strategy?

JB: I would never buy a Protected Stock at its IPO. 100% of the underwriter’s overhead, management fees, commissions and profits are embedded into the IPO issuance price ($10). In most cases after the stock is traded on the secondary markets after the IPO, the stock drops to reflect all of the overhead built into the IPO price. This price behavior is very similar to closed-end funds when they’re issued in an IPO.

It’s unfortunate for the dentist in Dayton Ohio who buys these securities at the IPO. But then again, these unsophisticated buyers become the sellers that we buy from at attractive prices on the secondary markets. Without them, we wouldn’t have these great opportunities.

Entry Strategy: The stock’s prospectus contains the maturity payment formula, which calculates the amount of cash you’ll receive at the stock’s maturity. You can plug the current value of the stock index into the formula and determine what the stock would be worth if maturity occurred today. We call this calculated value “Net Asset Value (NAV)�?.

The NAV provides a guide as to the attractiveness of a Protected Stock. For example, our website is currently tracking a Protected Stock which is trading 21% below its NAV. Of course you can’t sell the Protected Stock today at its NAV. You can only realize the NAV at its maturity. The NAV serves as a guide as to what’s hot and what’s not.

ST: Can you give us a comparison of "Protected Stocks" versus opened and closed-end mutual funds and ETFs?

JB: Yes, there are several important differences.

Capital Protection: In a mutual fund, ETF or closed-end fund, 100% of your investment is at risk. Does anybody remember when the NASDAQ lost 78% of its value? Or when the Nikkei 225 took a little dip from 38,915 to 7,604 (80% loss)? When you buy a Protected Stock below its guaranteed minimum maturity payment level ($10) you have eliminated a lot of risk!

Annual Management Fees: Unlike mutual funds, ETFs and closed-end funds, Protected Stocks have no annual management fees.

Lack of Dividends: Protected Stocks are tracking stock indices, which in most cases do not reflect the payment of dividends. Protected Stocks do not pay dividends. However, this loss of dividends can often be completely offset by buying a Protected Stock at a discount to its NAV.

Taxation: Because of the manner in which they’re created, the owners of Protected Stocks are required in most cases to recognize a certain amount of imputed interest income every year. In addition, any gain or loss recognized at maturity is characterized as ordinary, rather than capital, gain or loss. This drawback can be avoided by holding Protected Stocks in a non-taxable account like an IRA.

ST: I read about the 5-steps to success in investing in "protected stocks" on your website. Can you summarize these for us?

JB: Step 1: Buy when it's Cheap and Safe
Avoid buying the stock at its IPO. Wait until the stock is trading on a stock exchange. Buy the stock when it's trading at a discount to its NAV. The larger the discount the better it is. My web site tracks the NAVs on a weekly basis.

Just as important, buy the stock when there is minimal downside price risk. In other words, limit your price risk by buying the stock when it's below or slightly above the minimum maturity payment amount ($10).

Step 2: Ladder Your Purchases
When buying bonds, investment advisors recommend buying a series of bonds with differing maturity dates. This minimizes the risk of having to reinvest all of your maturing bond proceeds during a period of low interest rates (“reinvestment risk�?). In other words, don't put all of your eggs in one basket.

The same wisdom may be applied to the purchase of Protected Stocks. Spread your investment over a number of stocks that have different maturity dates. For example, if you have $40,000 to invest, divide your investment into four $10,000 stock purchases with maturities of three, four, five and six years.

Step 3: Patience
Due to the "ingredients" of Protected Stocks, your stock during the early years of its life, will not react with the same vigor as the stock index that it's tracking. But don't worry. The stock isn't "broken". It will catch up with the index later in its life. By the stock's maturity date, it will fully appreciate "as advertised".

Step 4: Hold Until Maturity
Benjamin Franklin was quoted as saying, "In this world, nothing is certain but death, taxes and realizing the Protected Stock's NAV is only promised at its maturity date."

Before the maturity date, the stock will fluctuate above and below its NAV. The good news is that this allows you the opportunity to purchase the stock at a discount to its NAV. The bad news is that in order to fully realize the rewards of your investment, you'll need to hold your stock until its maturity date. Only on the maturity date is there a promise by the underwriter to pay you the guaranteed amount.

Step 5: Repeat
After the maturity of your stock, take the proceeds and start over at Step 1.

ST: What is "counterparty risk" and how can it be avoided?

JB: All Protected Stocks are issued by international investment firms like Merrill Lynch. Merrill Lynch promises to pay you cash at maturity. If Merrill Lynch is in bankruptcy at your stock’s maturity date, they won’t be able to follow through on their promise to pay you (“counterparty risk�?). You would become a creditor of Merrill Lynch.

Fortunately, all of the companies issuing Protected Stocks have excellent investment grade credit ratings. Is it possible that Merrill Lynch or Morgan Stanley could go bankrupt? It’s possible, but highly unlikely. It’s the same risk you face when you purchase any type of insurance, annuity or bond.

It is possible to avoid this very remote risk by constructing your own Protected Stocks. You only need two ingredients: exchange traded options and bank CDs. Both of these instruments are backed by the highest credit rating of AAA, the same as US government bonds. In my blog I go into detail on how to create your own Protected Stocks.

ST: Thank you for the introduction to Protected Stocks. Can you disclose for our readers any position you currently hold or describe any of your past Protected Stock trades/investments and how those went?

JB: I, or an entity that I control, have long-term positions in most of the stocks covered on my web site. I eat my own cooking and it tastes pretty good! In addition, I’ve constructed my own US large and small cap and energy sector Protected Stocks using exchanged traded options (SPX, SPY, IWM (Russell 2000) and XLE (Energy Sector SPDR ETF).

All of my investments in Protected Stocks have performed “as advertised�?. In other words, at the maturity date, they’ve been “cashed-in�? at the NAV as my analysis had predicted. It’s really just a mechanical, non-subjective exercise. There’s no guessing, wishing or hoping, ideally suited for accountants and engineers.

Last December, in an earlier version of my blog (www.LowRiskStrategies.com) I wrote about and invested in the Nikkei 225 Protected Stocks (MTNK, MNNY and MNK). I was able to buy them below their $10.00 guaranteed maturity level. Currently, they’re trading between $12 and $13, and they’re still 8% to 14% below their NAV! However, because they’re above their $10 minimum maturity payment, they do carry some downside price risk.

ST: Are there any thoughts you’d like to leave us with?

JB: Yes. I believe the greatest benefit of Protected Stocks is that they provide your average investor the ability to invest in the stock market while avoiding undue levels of risk.

Even though I spent most of my life floor trading futures and options at the Chicago Mercantile Exchanges (rent the movie Trading Places to get a taste of what life was like) I’m actually a scared investor. I was in the Chicago Mercantile Exchange trading pits during the 1987 crash. I saw good men whose lives were destroyed. I saw a grown man sobbing as he called his wife and children and tried to explain how everything they owned was gone.

Risk is a four letter word. It’s lurking in the shadows, waiting to destroy your happy family’s life. Protected Stocks can help to minimize this risk while still providing the rewards of the stock market.

ST: Thank you Jay. We look forward to having you back when new Japan-related protected stocks are issued. Readers interested in Protected Stocks and seeking more information should visit Jay's website at:
www.protectedstocks.com.

Comments

[John Heneghan:]

This was a very fascinating and informative article. I had not heard of these products previously. I don't feel I fully understand these securities yet, but the article wet my appetite. I'll spend some more time at Jay's website protectedstocks.com. This is another very innovative tool in the investment management and risk management toolkit, particularly for conservatively managed portfolios. For example, I have two teenage children with college funds earmarked for 2010 and 2011 start dates that these products might fit nicely into their broadly diversified portfolio. Thanks.

2005 Dec 22 09:33 PM

[Steven Towns:]

John,

Thank you for your comment. I am sure Jay will be pleased to hear of your interest in protected stocks. It's amazing how few people know about them. Above and on his blog, Jay has explained that it's even possible to create one's own protected stock/s using longer-term options and CDs. Unfortunately longer-term options don't exist yet for the Nikkei-225.

2005 Dec 22 11:10 PM

[Steven Towns:]

CC, see the comment by Jay (himself) above the one you left. He is has discontinued the blog. Hopefully the interview content that's on Seeking Alpha is helpful to you.

2006 Apr 21 09:10 AM