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Deep out of the Money Put Options as Portfolio Insurance

Macro forecasts are difficult to make. Instead of timing the "risk-on, risk-off" trade, investors can try to hedge their portfolios with put options on richly valued securities. This strategy assumes that valuations eventually regress to typical multiples; that euphoria and bubbles do not last forever. Oddly, many REITs (real estate investment trusts) seem overvalued, and are worth considering as put candidates.

The following criteria were used to screen high-valuation REIT put candidates:

  1. The price-to-earnings ratio is higher than 20 (trailing twelve months).
  2. The price-to-sales ratio is higher than 3 (trailing twelve months).
  3. The price-to-book ratio is higher than 2.
  4. There must be an active options market.

Generating a List of Deep out of the Money REIT Put Candidates

Here is a list of REITs that met the criteria:

Ticker

Company

REIT Specialization

P/E

P/S

P/B

AVB

Avalonbay Communities

Residential

71.9

14.2

3.2

BXP

Boston Properties

Office

56.7

9.0

3.3

EQR

Equity Residential

Residential

211.4

9.5

3.3

SPG

Simon Property Group

Retail

30.8

10.7

7.8

VNO

Vornado Realty

Diversified

36.0

5.6

2.4

Clearly all of these REITs are pricey from a static valuation perspective. We can evaluate them further by using growth estimates and trends to calculate total return for rosy "best case" and a dismal "worst case" scenarios*:

Worst Case

Best Case

Ticker

Growth

Terminal P/E

Annualized Return

Growth

Terminal P/E

Annualized Return

AVB

-0.3%

72.6

-48.4%

12.8%

50.1

-27.4%

BXP

-23.9%

128.9

-57.4%

7.6%

45.6

-26.3%

EQR

7.6%

169.9

-61.1%

33.4%

89.1

-41.0%

SPG

9.9%

23.2

-24.4%

11.4%

22.2

-5.2%

VNO

-4.4%

41.1

-37.6%

4.9%

31.1

-16.9%

Inspecting the 3-year total returns under the best case scenario reveals that many of these firms have very rich valuations. In particular, AVB, BXP, EQR, SPG, and VNO would yield annualized losses in excess of 5% to investors who bought at today's high prices. These are good firms with great growth prospects expected by analysts, but their current prices are just too high.

It is prudent to note that there is no way to tell the future, and that many of these REITs have traded at high multiples for many years and will continue to do so in the future.** This is a list of put candidates based on rich valuations, and by no means is a divination or a guarantee about future events.

* Total returns were calculated over a three-year holding period for each of these REITs. (I use a 3-year holding period since above-average growth estimates are not reliable further out.) In the rosy "best case" scenario, each stock is assumed to be sold at a generous growth stock price-to-earnings multiple of 17 and the maximum of historical and analyst estimate values for earnings growth are assumed. These assumptions are used to project an annualized total return over the next three years and a terminal price-to-earnings ratios, that is, price paid today divided by earnings at the end of the holding period for each stock.

The dismal "worst case" scenario 3-year total returns were calculated using conservative assumptions. A bargain value stock price to earnings multiple of 10 and the lesser of historical and analyst estimates values for earnings growth are assumed.

**There are many clichés, which relate to how investing manias test patience and funding. From "The market can remain irrational longer than you can remain solvent" to "Hope springs eternal" the human capacity to ignore valuation is a tremendous foe. Using put options instead of shorting shares limits losses and heeds the wisdom behind such concerns.

Please read the article disclaimer.

Source: 5 Rich REITs For Portfolio Insurance