Four Stocks To "Keep Forever"
In an article last week ("Keeping It Simple: 4 Stocks To Keep Forever"), Seeking Alpha contributor Regarded Solutions offered an elegantly simple strategy: buy and hold these four dividend-paying mega cap stocks: Johnson & Johnson (JNJ), Exxon Mobil (XOM), Procter & Gamble (PG) and General Electric (GE). Regarded Solutions wrote that these companies "have been around basically forever and have survived in every environment...". The last part of that statement may be true, but it deserves some qualification in the case of General Electric. As I pointed out in an article last year ("Exxon Mobil: The Anti-GE"), although General Electric was considered one of the bluest of blue chips as recently as six years ago, it required a government bailout to survive the financial crisis. Exxon Mobil didn't require a government bailout then, and neither did Johnson & Johnson or Procter & Gamble.
In this post, we'll look at the current costs of hedging General Electric and the other three stocks in this "Keep Forever" portfolio, but first we'll address the question of why an investor should consider hedging stocks he plans to keep forever.
A Reason To Consider Hedging A "Keep Forever" Portfolio
Although all four stocks in Regarded Solutions' 'keep forever' portfolio survived the market crash of 2008-2009, all suffered significant declines. GE suffered the worst decline of the four, with its shares losing nearly 75% of their value from the first week of September, 2008 to the first week of March, 2009.
An investor who had hedged GE in early September, when it traded near $28 per share, and remained confident in its prospects several months later, when it traded at under $10 per share, could have sold his appreciated hedges and used the proceeds to buy more GE at a steep discount.
This sort of strategy - selling appreciated hedges and using the proceeds to buy beaten-down securities -- is one sophisticated investors sometimes use. An article in Private Wealth Magazine last year ("Growing The Single-Family Fortune") offered an example of this. In it, family office manager David Cohen explained how his firm's hedging enabled it to limit his billionaire client's downside during the 2008 crash and create cash with which he could buy undervalued assets:
The large profits from this trade [buying put options when they were relatively inexpensive, and selling them after the crash] helped to insulate the portfolio from a massive down stroke in 2008, and provide liquidity, which set us up for a big recovery in 2009.
Hedging Regarded Solutions' "Keep Forever" Portfolio
The table below shows the costs, as of Monday's close, of hedging the four stocks in Regarded Solutions' "Keep Forever" portfolio against greater-than-20% declines over the next several months, using optimal puts.
For comparison purposes, and since all four "keep forever" stocks are Dow components, I've added the SPDR S&P Dow Jones Industrial Average ETF (DIA) to the table. First, a reminder about what optimal puts are, and an explanation of the 20% decline threshold. Then, a screen capture showing the optimal put to hedge one of the stocks, Johnson & Johnson.
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% decline thresholds for all of the names here because it's a large enough decline threshold that it lowers hedging costs, but not so large that it precludes a reasonable recovery. A couple of examples may help illustrate this:
- After a 30% decline, it would take almost a 43% gain for an investor to get back to even.
- After a 20% decline it would only take a 25% gain to get back to even.
The Optimal Put to Hedge JNJ
Below is a screen capture of the optimal put option contract to hedge 100 shares of the Johnson & Johnson against a greater than 20% decline between now and October 19th. A note about this optimal put and its cost: To be conservative, the app calculated the cost based on the ask price of the optimal put. 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 Monday's Close
The hedging costs below are presented as percentages of position value.
|JNJ||Johnson & Johnson||0.99%*|
|XOM||Exxon Mobil Corporation||1.64%*|
Procter & Gamble Co.
General Electric Co.
*Based on optimal puts expiring in October
**Based on optimal puts expiring in December
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.