Accounting And Governance Risk As An Early Warning
In an article published on Wednesday ("Hedging 4 Stocks With The Highest Accounting And Governance Risk Ratings"), we noted that GovernanceMetrics International (GMI) uses a proprietary quantitative approach to analyze the financial reports and governance practices of public companies, and that the best-known indicator GMI uses is its Accounting and Governance Risk (AGR) ratings, which range from "Very Aggressive" to "Conservative". In Wednesday's article we looked at the hedging costs of actively-traded stocks with the best AGR rating ("Conservative"). In this article, we'll look at the hedging costs of stocks with the worst AGR rating, "Very Aggressive".
Using Fidelity's screener, on Wednesday I searched for optionable stocks with the lowest (i.e., worst) AGR rating, "Very Aggressive." Then, I sorted the list according to trading volumes, so that the most actively-traded stocks with "Very Aggressive" AGR ratings rose to the top.
Given the recent controversy surrounding JP Morgan Chase & Co. (JPM), I wasn't surprised to see it come up on this screen. What did surprise me though, was that, except for two quarters when it was rated "Aggressive", JPM has been rated "Very Aggressive" by GMI for the last three years. That surprised me because JP Morgan and its CEO, Jamie Dimon, were, until recently, lauded for the way they handled the financial crisis. See, for example, Roger Lowenstein's profile of Dimon in the New York Times from December, 2010 ("Jamie Dimon -- America's Least Hated Banker"). Granted, some (including President Obama) still consider JP Morgan to be a well-run bank, but I found it interesting that GMI's quantitative approach raised red flags about the company as early as it did.
Hedging Four Stocks With "Very Aggressive" AGR Ratings
JP Morgan was the third most actively-traded stock with a "Very Aggressive" AGR rating on Wednesday. The table below shows the costs, as of Wednesday's close, of hedging JP Morgan and three other of the most actively-traded "Aggressive"-rated stocks against greater-than-20% declines over the next several months, using optimal puts.
For comparison purposes, I've added the SPDR Dow Jones Industrial Average ETF (DIA) to the table. First, a reminder about what optimal puts are, and a note about the 20% decline threshold. Then, a screen capture showing the optimal put option contract to hedge one of the stocks in the table below, Microsoft Corporation (MSFT).
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 Puts to buy to hedge MSFT
Below is a screen capture showing the optimal put option contract to hedge 100 shares of the Microsoft 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 Wednesday's Close
Aside from the ETF DIA, listed at the bottom for comparison purposes, all of the names below had Accounting and Governance ratings of "Very Aggressive". The hedging costs are presented as percentages of position value. Given the high cost of hedging Bank of America (BAC), if you own it 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 DIA) instead, as a way to hedge your market risk.
|BAC||Bank of America||13.2%**|
|GE||General Electric Co.||4.00%***|
JP Morgan Chase & Co.
*Based on optimal puts expiring in October
**Based on optimal puts expiring in November
***Based on optimal puts expiring in December