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Tom Armistead's  Instablog

Tom Armistead
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I'm a well-informed retail investor and formerly posted on SA in order to expose my thought process to critical examination and comment from readers. It made me a better investor. I'm particularly proud of bullish macro articles posted in 2009 and later, in which I presented ideas that... More
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  • Reacting To Cisco's Guidance: DooDoo Occurs

    Not long after I submitted my article on screening for excess current assets, in which I mention my recently opened position in Cisco (CSCO), the company announced earnings, and more importantly, gave shockingly bad guidance. Shares tanked by about 12%.

    I suppose I could have pulled the article, rewritten it to make the quick hit from the Cisco position less prominent, and resubmitted. For that matter, I could have just sort left it out. But I'm writing about what actually happens, and as we all know, shit happens.

    The position I had was a vertical call spread, long Jul 2014 19 calls and short Jul 2014 23 calls. When the stock tanked, I did what I normally do on these situations, which was to roll the long call down from 19 to 17, at a net debit of $1.60. The effect is to lower the breakeven on the trade by 40 cents, while accepting another $2 downside exposure.

    This Chinese espionage thing is ridiculous. Not that long ago we were periodically catching them spying on us and on our major corporations, electronic espionage, over the internet. Now it turns out we do the same thing, and they become indignant, or fearful, or self-righteous, or some combination of the above.

    The reality is, that for certain applications, any fool knows to use something that was made in his home country, if at all possible. I don't know how this precept works on the cloud, or in the cloud. They'll sort it out, given enough time.

    As for the decline in set-top box revenue, that's not really the kind of business Cisco should be in, I'm pretty sure the market was discounting it anyway.

    Brett Jensen opines that Cisco is always doing this, about once a year they issue some horrendous guidance, or paint some gloomy picture, tanking the whole sector. Then things look up, somehow, and the stock recovers. Meanwhile they've bought back umpteen shares.

    As mentioned in the article, Cisco has excess current assets, which retain their value even if future income decreases. So revenue for the next quarter will be down 8% to 10%, and the shares go down 12%? The cash didn't go down 12%, and there's a lot of it. There is also the question, whether the reduction in revenue is permanent, or just a speed bump.

    Getting back to the vertical call spread: it was in the money when I bought it. The bet was, the stock won't go down more than a certain small amount. Effectively, I sold a put, while maintaining wiggle room and reducing risk.

    I'll hold.

    Disclosure: I am long CSCO.

    Tags: CSCO
    Nov 15 7:22 AM | Link | 3 Comments
  • Sticking To My Knitting

    Thursday last week, early in the trading day, I did a series of adjustments to the Synthetic Dividend Growth Portfolio. It was busy work, rolling various LEAPS up where the stocks had made large upward moves, and reselling calls where I had bought them back on dips, in cases where the stock had since recovered.

    Then Friday I became concerned that I wasn't keeping my spreadsheets on the trades up to date. In point of fact, I hadn't made any. Back in June when I created the portfolio, that wasn't a problem. But after five months of trading and adjusting, it's difficult to track results and plan the next trade without having the history and the position where they can be worked on.

    Using InterActive Brokers, the commissions are very low. However, the mechanics of exporting trades into a spreadsheet aren't as good as Ameritrade or Schwab. I finally took the time to understand what InterActive was offering, it's the same interface you get with a database program, so you can develop queries on trades or positions and pick the fields that will be returned. I was able to replicate what I had been getting from the more expensive brokers.

    So I created the spreadsheets, for example, Exxon Mobil trades would be called XOM TRX. From there, I started analyzing the trades, to see if they were developing according to expectations.

    Managing Diagonal Spreads

    Of course the usual problems were apparent. Briefly, the covered call that has been sold against the LEAPS position can go into the money by quite a bit if the stock makes a large upward move. At that point, seller's remorse sets in, since the buyer of the call has now grabbed a large part of my profits. Also, if the stock continues upward, I have very little exposure to the move.

    First, I roll the underlying LEAPS call up. Often this can be done for something like $4.50 for a $5.00 increase in strike. While this reduces the expected return in dollars if the share prices remain the same, it frees up cash and increases the IRR, all else equal. Plus, if the shares return to the starting point, it can be rolled back down, perhaps for something like $3.50.

    Second, I add a position in another stock that appears either undervalued or fairly valued. During the past week, that was WalMart (WMT). Since the likes of Raytheon (RTN) and Bristol Meyers (BMY) have made large moves, I have very little exposure to price moves, based on low Delta for the positions. I've been going slow on adding positions, since I anticipate a correction.

    Third, I buy back calls when the stock dips enough to make the price attractive. I don't sell calls that are too far out of the money, so why should I leave them out there when I've already earned most of the premium?

    As mentioned earlier, I sold calls where I could do so on terms that made sense to me. Again, I don't think the market can go up indefinitely and would like to be earning premium if it starts to decline.

    An Example

    To illustrate the process, here's my file on Darden (DRI) trades:

    (click to enlarge)

    The position was opened on 7/12. The DUMMY entry is made in order to make the spreadsheet calculate the return on the options position plus the additional funds that would have been required to do a covered call over the actual stock.

    By 9/3 the stock was down enough that I rolled the 40 LEAPS down to 35, and bought back the 55 calls. By 10/14 I was able to resell the calls for a profit. Then on 11/7 I rolled the 35 strike back up to 40, again for a profit. The average cost to roll down was $3.915, the average credit rolling back up was $4.65. The profit was $147, I could take my wife out for dinner at a restaurant, maybe some sea food would be good.

    As the situation has developed, annualized returns are 15.9%. Meanwhile, just buy and hold on the stock itself would be 11.9% annualized.

    Macro Call Not So Good

    When I undertook the LEAPS covered call or diagonal spread strategy for the portfolio, I expected the market to work its way higher, for the usual reasons. I didn't anticipate the power of the move, and the strategy will underperform a strong market.

    On the other hand, if the market should tank, for whatever reason, the options positions are an advantage over owning the stock, and the funds that were not deployed can be used as dry powder.

    What to Do with the Cash

    The strategy as implemented leaves me holding a lot of cash. In the interest of getting a return similar to short-term bonds, I did one options trade, long an in-the-money vertical call spread on Kulicke & Soffa (KLIC).

    (click to enlarge)

    Projecting that shares will be above $11 at expiration, the returns are shown in the second set of trades, with the hypothetical future in gray. As before, a dummy amount has been inserted to reflect my plan to by the shares if the stock is below $11 at expiration. If that occurs, I would plan to sell more covered calls at the 11 strike.

    As explained in my instablog post on the KLIC trade, this company has a lot of extra cash and trades at low multiples. I really don't think if will go below $11 and stay there indefinitely. The implied volatility is high enough to make the premiums for selling calls attractive. The downside risk is greatly reduced by the excess cash.

    So, thinking of the $990.15 expected profit, if that's the return on the $200,000 of cash I've held out of the market by using options instead of buying the shares, it's 1.13% annualized. If I come across some similar ideas, I may do a few more trades of this type.

    A Walk Down Memory Lane

    Speaking of sticking to your knitting, I once worked for an outfit that was run by some foreigners who were characterized by a remarkable insensitivity to political correctness. My bosses boss, on being introduced, remarked that I had the look of a man whose future is behind him. Some of us thought the remark reflected age bias...

    Now my boss had this vision, that if he relocated the business to the right location, and received sufficient inducements from the local authorities, he would make more money. Our location had one big drawback, you couldn't get US citizens to do the work for minimum wage, so you had to resort to illegal immigrants.

    Anyway, he and his colleagues in upper management jetted here and there, playing one state against the other, and paying no attention to the business. I submitted regular monthly reports, detailing rapidly escalating labor costs per unit of production. The reports were ignored.

    Of course it ended badly, in a product recall and severe cash crunch. I had the pleasure, while sitting in my bosses chair, leaning back with my feet on his desk, of informing his boss that all of them should have been sticking to their knitting, and would be well advised to do so, going forward.

    It was kind of sad, I was laid off soon thereafter. To his credit, my boss did remark in letting me go that he should have stuck to his knitting.

    Disclosure: I am long DRI, KLIC.

    Tags: DRI, KLIC
    Nov 09 9:41 AM | Link | Comment!
  • Tranching The S&P 500

    Tranching has lost some respectability in the wake of the blow-up in structured finance. But logically it makes sense: when looking at a stream of income from multiple sources, there is some portion of it that is virtually risk free. And there's an equity tranche, speculative and calling for much higher rate of return.

    Suppose we view the earnings of the S&P 500 in that light. What is the basket of stocks worth, tranching and applying rates of return consistent with risk?

    When last I looked, as reported earnings for the index were projected at $97.83 as of 12/31/2013. Consulting Shiller's irrational exuberance data, inflation adjusted 10 year average earnings for the index stood at $64.06. That's the E in CAPE.

    Consulting history, I find that the largest ten year decrease in inflation adjusted 10 year average earnings was 37%. Reasoning from this fact, I conclude that the risk free portion of S&P 500 10 year average earnings is $64.06 X 63%, or $40.36. Capitalizing that at 2.66% (the ten year treasury rate), it's worth $1,577.

    The remaining portion of the $64.06 is $23.70. Capitalizing at 5.28% (Moody's Baa), it's worth $449.

    As for the final or equity tranche, it amounts to $33.77 ($97.83 - $64.06). Capitalizing that at 15%, on the grounds it's wildly speculative, it's worth $225.

    Adding together the three tranches, the income stream from the S&P 500 is worth $2,191. That is to say, the index would be fully valued at 2,191.

    Supposing currently low interest rates revert to the mean? Using 4.5% for the 10 year and 7.5% for Moody's Baa, the index would be fairly valued at 1,438, according to this line of thinking.

    You can see where I'm heading with this one. It all comes down to the question, how long can the Fed keep interest rates at these levels? Or, on a more fundamental basis, how long will the forces of supply and demand keep the 10 year at current levels?

    There is talk that the Fed will revise the unemployment cutoff point to initiate the taper down to 6%, from 6.5%. The FOMC seems to be doing a delicate dance with fiscal policy as implemented by the dysfunctional band in Washington. The fiscal stimulus that will not be forthcoming, and the fiscal drag that is more probable, will be offset by lax monetary policy well into the future.

    What about profit margins? Forget Corporate Profits as a % of GDP. S&P provides quarterly revenue and earnings data for the index, enabling the computation of margins. Currently the profit margin for the index stands at 8.2% compared to highs of 8.6% in 2007. Margins of S&P 500 companies have room to go higher.

    If this line of thinking is correct, there is considerable room for financial engineering here. With stock prices in the aggregate below the value of the earnings (or cash flow) streams involved, buying back shares with cheap borrowed money makes sense.

    Obviously this can't end well. But it could go on for a very long time.

    Disclosure: I am long SPY.

    Tags: SPY
    Nov 06 7:45 AM | Link | 4 Comments
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