Most Favored Nation Protection For Abbott Laboratories

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About: Abbott Laboratories (ABT), Includes: JNJ, LLY, MRK, PFE, SPY
by: David Pinsen
Summary

On Friday, shares of Abbott Labs and several competitors dipped after President Trump told reporters his administration was working on a plan to reduce drug prices.

That "most favored nation" plan would allow the U.S. to purchase drugs for the lowest price they are offered in other countries.

In the event this plan is enacted and cuts into Abbott Labs' revenues significantly, I present ways bullish shareholders can stay long while limiting their risk.

Abbott Laboratories celebrates millennial blood donors (photo via Abbott's Twitter account).

"Most Favored Nations" Plan Threatens Drug Pricing

One of the frustrations of Americans for years has been the high cost of prescription drugs relative to the prices those drugs sell for in other first world countries, leading some Americans to travel to Canada to purchase drugs there (that's also led to accusations that countries such as Canada are free-riding on drug research subsidized by American consumers). On Friday, though, SA News Editor Liz Kiesche noted that shares of Abbott Laboratories (ABT), along with those of Pfizer (PFE), Eli Lilly (LLY), Johnson & Johnson (JNJ), and Merck (MRK), were down after Bloomberg reported that the Trump administration was working on a plan to allow the U.S. to buy drugs at the lowest price they are offered in other countries.

In the event this plan pans out and cuts into Abbott Labs' revenues in the U.S., below are several ways bullish shareholders can stay long while strictly limiting their risk.

Correction: Darcy Ross of Abbott Labs contacted me making the same point a few readers have:

Abbott does not sell pharmaceutical products in the U.S. (or even in any developed markets) any longer. We separated our proprietary pharmaceutical business into a a separate public company, now known as AbbVie (ABBV), in 2013. Today, Abbott only develops diagnostics, devices and nutrition products in the U.S.

I asked Ms. Ross whether Abbott's diabetes testing equipment would be affected by President Trump's "most favored nation" proposal, but haven't heard back yet. In any event, the hedges below will protect your ABT shares if something else were to cause the shares to decline.

Different Types Of Downside Protection For ABT

Up until recently when I've posted hedges for securities, I've used expiration dates approximately six months out. That's been Portfolio Armor's default for years, partly out of convenience for investors and partly for the reason Riskalyze CEO Aaron Klein explained here: Investors seem to be better able to conceptualize risk over six-month periods than longer ones. That's still Portfolio Armor's default, but we've just added a new feature that lets users select their own expiration dates.

This raises an interesting question: What's the cheaper way to hedge if you adjust for the different times to expiration? To enable an apples to apples comparison, I've highlighted the annualized cost of each ABT hedge below, two of which expire in September and two of which expire next June. Each of these hedges is designed for an investor unwilling to risk a decline of more than 19% in his ABT shares.

Uncapped Upside, Expiring In September

These were the optimal, or least expensive, puts, as of Friday's close, to hedge 1,000 shares of ABT against a >19% decline by late September of this year.

Optimal hedge for Abbott Labs via Portfolio Armor

The cost here was $290, or 0.34% of position value (the cost of the puts in all of these examples was calculated conservatively, using the ask price - in practice, you can often buy puts at some price between the bid and ask). That works out to 1.63% of position value annualized.

Uncapped Upside, Expiring In June

This hedge uses the same parameters except it expires next June.

Optimal hedge for Abbott Labs via Portfolio Armor

The annualized cost here was higher, 3.23% of position value.

Capped Upside, Expiring In September

This was the optimal, or least expensive, collar, as of Friday's close, to hedge against a >19% decline by late September if you were willing to cap your possible upside at 10% by then. The income generated from the short calls for this collar and the next one was calculated conservatively, assuming you sold them at the bid.

Optimal hedge for Abbott Labs via Portfolio Armor

Optimal hedge for Abbott Labs via Portfolio Armor

Optimal hedge on Realty Income via Portfolio Armor

As you can see here, you would have had a net cost of $120 when opening this hedge, assuming you placed both trades (buying the puts and selling the calls) at the worst ends of their respective spreads. That works out to a cost of 0.14% of position value, or 0.67% of position value annualized.

Capped Upside, Expiring In June

This optimal collar uses the same parameters as the one above, except it expires in June of 2020.

Optimal hedge for Abbott Labs via Portfolio Armor

Optimal hedge for Abbott Labs via Portfolio Armor

Optimal hedge for Abbott Labs via Portfolio Armor

Here, you would have collected a net credit of $440 when opening the hedge, which worked out to a cost of -0.52% of position value or -0.54% of position value annualized.

Wrapping Up

For readers wondering why I used an upside cap of 10% in the collars above, the answer is that was the highest cap at which the cost was negative when hedging against a >19% decline by next June. If you are willing to risk a larger decline, you may be able to find a collar with a negative cost with a higher cap.

Also, for readers wondering why I have given Abbott Labs a bullish rating here: I have done so because Portfolio Armor estimates a potential return for it greater than that of the SPDR S&P 500 ETF (SPY) over the next six months.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.