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Nicholas Cavallaro
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Investment professional with experience in equity, credit, and global-macro strategies. Previous roles include working for a mutual fund, hedge fund, and investment advisor.
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  • An Intriguing Long Silver Wheaton Transaction

    As Fed Chairman Ben Bernanke testified to the US Senate today that economic uncertainty had grown, I decided to make an intriguing play on silver. The transaction is eyebrow raising in two regards: first, that I made a long investment in silver, and second, in that I employed a three-legged derivative transaction.

    Silver is a real asset that can be used for the manufacturing of goods or as an exchange of value (money). However, its primary use and valuation depends on production, or more broadly, economic demand. Although a global slowdown is probable, industrial production in the US has been chugging along, and China's growth rate is still around 7%.

    Silver Wheaton SLW

    Silver Wheaton is a silver streaming company. That is, it makes upfront, preproduction payments (investments) for the right to purchase a fixed percentage of future silver production from a mine. To date, the company has entered into 14 long-term silver purchase agreements and two long-term precious metal purchase agreements, relating to 19 different mining assets, whereby Silver Wheaton acquires silver and gold production from the counterparties for a per ounce cash payment at or below the prevailing market price.

    For example, last year, Silver Wheaton's average silver cash cost per ounce sold was $3.99, whereas its average realized silver price per ounce sold was $34.60. Likewise, the company's average gold cash cost per ounce was $300 while realized gold price per ounce sold was $1,609 per ounce.

    Management plays a huge role in this business. Although silver volume and price influence Silver Wheaton's future, the company is still well positioned. Many of the company's investments have already been made, and the company has a respectable operating record. Furthermore, its mine investments are located in politically stable parts of the world and are aligned with major industry players, such as Barrick ABX and Goldcorp GG. Teaming with gold miners makes sense since 70% of worldwide silver production comes from copper, lead, zinc, and gold mines. Reasonably Thinking, Silver Wheaton can take delivery of other miners' unwanted silver inventory and redistribute it.

    A handful of smaller items serve as positives for shareholders:

    • Management continues to search for future opportunities as the company has a few small equity stakes in publicly listed mining companies for strategic purposes
    • Silver Wheaton maintains a healthy cash position and overly sufficient liquidity ratios
    • Shareholders receive a dividend that is linked to operating cash flows, which protects long-term shareholders
    • The company is incorporated in the Cayman Islands & Barbados and therefore subject to minimal income tax

    Risks to investing in Silver Wheaton center around macroeconomic activity. If a global slowdown intensifies, demand for silver could wane, bringing down silver prices. Such a scenario would adversely affect Silver Wheaton.

    Derivative Transaction

    Today's transaction consisted of three option legs, all of which expire in January 2014. I sold 2 puts at $20, bought 1 call at $33, and sold 1 call at $50. This custom trade enables me to get paid while bearing downside risk and provides upside potential. This can be thought of in two ways:

    • A synthetic long, strike prices of $20 and $33, funded by a cap at $50 and selling an additional put at $20
    • A $50/$33 call spread funded by selling two put options at $20

    Looking at the chart below, at expiration, I will make $350 if SLW is between $20 and $33. My gains are positively correlated with SLW, in a linear fashion, up to a share price of $50. On the downside, my breakeven point is $18.25 per share, at which point I would owe $2 per penny movement below $18.25.

    (click to enlarge)

    (chart and above analysis account for $45 worth of transaction costs incurred to initiate the three legs)

    SLW Jan14 20 Putshort23.17$ 618.98
    SLW Jan14 33 Calllong13.27$ (341.97)
    SLW Jan14 50 Callshort10.88$ 73.02

    Initial intake = $350.03

    This article can also be viewed at

    Jul 17 9:47 PM | Link | Comment!
  • The Case For Gold Miners

    Gold miners GDX has been falling the past two months and seems to represent some nice value. Meanwhile the price of gold has remained relatively flat since the beginning of the year. This dichotomy is unlikely to persist. Let's examine.

    (Image from Marketwatch)

    Reasonably thinking, I am bullish on gold for three reasons. First, gold is a safe haven asset, and investors can flock to it in times of turmoil. Europe anyone? Second, US real interest rates are negative. That is, a ten year investment yields an investor only 1.88% per year, whereas inflation will be more than this. A ten year investment in a US Treasury Bond will lose real purchasing power in ten years. With fixed income securities and stocks offering unattractive returns (think 1970s), gold has historically appreciated as an alternative. Third, gold price increases over the past decade have been driven by buyers in emerging asia. Buyers in India and China represent permanent demand as investors suffer from capital outflow controls (financial repression), which I view as unlikely to abate in the upcoming years.

    Gold miners extract gold from the ground and sell it at market prices. So, if gold rises, then the revenue for gold miners increases. To ensure that the increased revenue is captured by shareholders (and not employees' wages or governments' taxes), we can examine companies gross margins. The top three companies have margins that are either stable or increasing. Thus, increased gold prices should be flowing through the income statement as increased earnings to shareholders.

    (click to enlarge)

    With a solid thesis for gold, and some assurance from gold miners income statements, a divergence of the metal and stocks seems illogical. One area of blame is that analysts are forecasting gold prices at $1600 an ounce or lower. If this is the case, then long gold miners and short gold would be a prudent position. However, given my arguments, I'm happy to be a gold owner, even if the price fluctuates downward in the interim.

    I am already long gold miners in the form of GDX, GDXJ, NEM, GOLD, GORO, and FNV. On Monday (5/7/12), I initiated a synthetic long position, by selling a GDX Dec12 $39 Put and buying a GDX Dec12 $44 Call. See the options-basic page for the derivation of this strategy. The trade cost me $200.00. I am on the hook if GDX falls below $39 and have unlimited upside if GDX advances beyond $44.

    Top Five is updated to reflect my increased GDX exposure.

    Disclosure: I am long GDX, GDXJ, NEM, GOLD, GORO, FNV.

    May 17 10:51 AM | Link | 1 Comment
  • Risk Factors, Fama-French 4 Factor Model

    Risk Factors, Fama-French 4 Factor Model

    The Fama-French factor model is rooted in the idea that risk factors, such as fundamental macroeconomic factors, can outperform the market.  When such factors or anomalies persist, markets lack perfect efficiency, and investment opportunities exist outside of the market portfolio.


    The Capital Asset Pricing Model is a financial model, which calculates expected returns as a function of the risk-free rate, market risk, and market returns.  Central to this model is the idea that returns are solely dictated by systematic risk.  That is, if all market participants hold similar beliefs about expected returns and the dispersion of returns, then only increases or decreases in market risk will change portfolio returns.

    While the idea behind the CAPM seems generally okay, I have some issues with it.  Deep down, the CAPM relies on a static beta, which is a correlation measure between stocks and the market.  Unfortunately, historical measures of individual stocks’ market correlation are fluid, so the robustness of the model is suspect.  Furthermore, market participants hold a variety of risk tolerances, time horizons, and investment constraints.  This assortment of characteristics differs from the CAPM’s primary tenet.

    Fama-French 3 Factor Model

    In 1993, Fama and French challenged the CAPM idea that market risk was the only determinant of returns.  Instead, Fama and French argued that risk factors, such as style and size of companies, could be used to enhance portfolio returns for a given level of risk.  Style, which can be measured as a company’s book-to-market ratio, historically favors value stocks (low book-to-market) over growth stocks (high book-to-market).  For example, over many years, a group of cash cow, well known companies will have better stock returns than trendy start-up companies with high expectations.  Size, which is measured by market capitalization, historically favors smaller companies over large companies.  For example, over many years, smaller, niche player companies will have better stock returns than larger, established companies.

    Fama and French took the CAPM market factor and added style and size to create the Fama-French 3 Factor Model.  Here, the style factor is calculated as high value stocks minus low value stocks, and the size factor is calculated as small stocks minus big stocks.  In other words, the style factor buys value stocks while shorting growth stocks, and the size factor buys small cap stocks while shorting large cap stocks.

    Using data from Ken French’s website, one can replicate empirical data behind the conclusion.  Since 1927, the Fama-French 3 Factor Model (blue line) has outperformed the market portfolio (red bars).  Look at the gap between the blue line and red bars.

    In the graph, three particular time periods show noteworthy outperformance.  In 1943-45, both style and size contributed significant outsized gains.  From 1963-68, style (value) outperformed for a few years, then size (small stocks) outperformed in the later years.  Lastly, small cap stocks dominated large cap stocks from 1975-83 while value stocks beat growth stocks from 1981-84.  Among these three time periods, no attribute singlehandedly dominated.  The risk factors are successful in combination and over a series of years.

    Value seems to persist because of investor behaviors.  Investors tend to over-extrapolate past growth rates into the future and bid up prices to the point of excessive optimism; this optimism does not always materialize, and prices retreat.  Thus, returns of growth stocks tend to be less than returns of value stocks.  This anomaly persists because a multi-year time horizon is generally necessary to capture the value opportunity.  Since fund managers are evaluated on monthly, quarterly, and annual bases, the euphoric competition for short term excessive returns creates a structural opportunity for value investing.

    Style persists because of the amount of information needed to be processed.  Thousands of small, publicly traded stocks exist, and finding winners among the group requires a herculean effort.  Here too, fund managers play a role by tending to guard their reputation.  If a fund manager does poorly by investing in well known companies like Apple, Exxon Mobil, and Wal-Mart, his misfortune may be excused as just a market downturn.  Yet, if the manager unsuccessfully invests in smaller companies that few people have heard of, he will be considered aloof for investing in such losers.  Thus, feasibility and reputation risk are likely to favor the style attribute going forward.

    Fama-French 4 Factor Model

    Also in 1993, Jegadeesh and Titman found that adding a fourth factor, momentum, to the market-style-size model also enhanced portfolio returns for a given level of risk.  Momentum is calculated by investing in firms that have increased in price while selling firms that previously decreased in price (winners minus losers).  Today, the four factors of market, style, size, and momentum, constitute the Fama-French 4 Factor Model.

    Jan 11 8:30 AM | Link | Comment!
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