Hedging 5 Industrials Facing A Slowdown In China - And 1 That Isn't

by: David Pinsen

Western Industrials and China Slowdowns

In an article in Monday's Financial Times ("Western Industrials feel a Chinese Burn"), Chris Bryant and Ed Crooks reported that China's efforts to cool its economy have led to slowdowns in some markets in that country, and lowered demand for capital goods. Crooks and Bryant noted that a handful of major Western industrial companies had reported lower sales in China recently and issued cautious guidance for the first half of this year. The article mentioned one exception: Honeywell International, Inc. (NYSE:HON), which posted an 18% increase in its China sales in 2011

According to Honeywell's CFO, Dave Anderson, who was quoted in the article, growth in sales of his company's aircraft and truck components was offsetting declines in sales of products tied to real estate, such as air-conditioning equipment. The table below shows the costs, as of Tuesday's close, of hedging Honeywell and the five Western industrials that haven't faired as well in China recently against greater-than-20% declines over the next several months, using optimal puts.


For comparison purposes, I've also added the costs of hedging the Industrial Select Sector SPDR ETF (NYSEARCA:XLI) and the iShares MSCI EAFE Index ETF (NYSEARCA:EFA). First, a reminder about what optimal puts are, and a note about decline thresholds; then, a screen capture showing the optimal puts to hedge one of these stocks, 3M Corporation (NYSE:MMM).

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.

Decline Thresholds

In this context, "threshold" is the maximum decline you are willing to risk. 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've used 20% decline thresholds for all of the names below.

The Optimal Puts For MMM

Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of 3M Corporation against a greater-than-20% drop between now and July 20. A note about these optimal put options and their cost: To be conservative, Portfolio Armor calculated the cost based on the ask price of the optimal puts. In practice, an investor can often purchase puts for a slightly 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 Tuesday's Close

The hedging costs below are as of Tuesday's close and are presented as percentages of position value.



Hedging Cost

MMM 3M Company 1.87%**
ABB ABB Ltd. 4.08%*
SI Siemens AG 3.50%**
HON Honeywell International Inc. 1.90%*
DD DuPont 2.36%**
ETN Eaton Corporation 5.30%**


Industrial Select SPDR


EFA iShares MSCI EAFE Index 1.80%*

*Based on optimal puts expiring in June

**Based on optimal puts expiring in July

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.