Analog Devices identifies with the bobsledding precision (Credit: Twitter)
Most Analysts Are Bullish On Analog Devices
After Analog Devices' (NASDAQ:ADI) beat-and-raise earnings last month, a number of analysts raised their price targets for the stock. What if the bulls end up wrong though? We present a couple of ways ADI shareholders can limit their risk in that case. First, let's look at the bullish case for ADI and our site's take on it.
The Bull Case For Analog Devices
As the screen capture below from Nasdaq shows, ADI bulls are ascendant among sell-side analysts, with 15 out of 19 rating the stock a "buy" or "strong buy."
The bullishness isn't limited to the sell side. Brian Hamilton, Growth & Income editor at Zacks, is a bull as well, as you can see in the interview below posted last week.
On the income side, Hamilton liked the recent 7% increase in ADI's dividend, and on the growth side, he liked the consistency of 14 consecutive earnings beats, and the recently raised estimates for the company. Hamilton was also bullish on the macro picture for ADI, saying "we're still in the upswing of the semiconductor cycle."
Our Site's Take On ADI
Analog Devices currently passes Portfolio Armor's two screens to avoid bad investments, but the site's potential return estimate for it over the next several months is fairly modest. Net of hedging cost, ADI's potential return ranks it #516 in our system, between Berkshire Hathaway (BRK.A) (BRK.B) and Ryanair Holdings (RYAAY), as you can see in the screen capture from the site's admin panel below.
Given that our site isn't bearish on ADI, and most analysts are bullish on it, why consider hedging it? One reason is that the analysts could end up being wrong, due to stock-specific reasons. Another is the prospect of a market correction that could knock down ADI's share price. Let's look at a couple of ways you can limit your risk while staying long the stock.
Adding Downside Protection To Analog Devices
Let's assume you own 500 shares of ADI and can tolerate a 14% drawdown, but not one larger than that. Here are two examples of hedging it against a >14% decline over the next several months (screen captures below via the not-yet-released version 3.0 of Portfolio Armor's iPhone app).
Uncapped Upside, Positive Cost
These were the optimal puts, as of Monday's close, to protect 500 shares of ADI against a >14% decline by late September.
The cost was $1,850, or 4.06% of position value (calculated conservatively, using the ask price of the puts). For those like Brian Hamilton at Zacks who like ADI in part for its dividend yield, this is not going to be an attractive hedge, because of its cost. The next hedge may be more to Hamilton's liking.
Capped Upside, Negative Cost
If you were willing to cap your upside at 9%, you could have used the optimal collar below to protect against the same >14% decline over the same time frame.
After an iterative sorting process taking into account the net cost of the collar, the hedging algorithm was able to select a less expensive strike for the put leg of the collar. This one cost $1,475, or 3.24% of position value (calculated at the ask again, to be conservative). The income from selling the short call leg was slightly higher though: $1,550, or 3.4% of position value (calculated conservatively, at the bid).
So the net cost was negative, meaning you would have collected a net credit of $75 when opening this hedge, assuming you placed both trades at the worst ends of their respective spreads.
Wrapping Up: Safety First, But You Could Aim Higher
The bullish analyst consensus for ADI is encouraging, but it's not one of the top 10 or even the top 500 names in our system now. If you like it as a growth and income stock, you may want to consider a hedge similar to the second one above, which would let you capture upside potential of slightly more than 9% (taking into account the net credit) while strictly limiting your downside risk.