Oil's Effect on Ford

Crude oil prices have nearly been cut in half over the past few months, and while U.S. consumers are happy to spend less at the pump, the precipitous fall could cause Ford (F) problems.

One of the original reasons I decided on an unlevered investment in Ford is the degree to which the company is exposed to both operational and financial leverage. Leverage on top of leverage on top of leverage is not generally a good recipe for long-term success in the markets, though short-term gains from this kind of layering can be breathtaking.

[For those of you who need a review of operational, financial, and option-based investment leverage, my (biased) view is that The Intelligent Option Investor, through its chapter on investment leverage and its appendix on operational and financial leverage, does this in a very readable, thorough, and understandable way.]

Several years ago, Ford management made a strategic decision to increase operational leverage that would allow them to be more competitive in a high oil price environment. I am sure that the huge drop in WTI has some people in Dearborn, Michigan on edge, and I also feel the need to consider how large an impact a prolonged low oil price environment will have on the likelihood of different IOI valuation scenarios for Ford.

Apple's Overseas Havens

Researching something about Delaware business registrations, I just stumbled upon a good article regarding Apple's various overseas subsidiaries. This relates to my recent Morningstar article entitled Apple's Conundrum. Not everyone uses Twitter, so I thought I would post the link here as well.

Interesting article regarding $AAPL tax liabilities related to my recent @morningstarinc article "Apple's Conundrum" http://t.co/rlSWJ487CA
— E. Kobayashi-Solomon (@IOI_Erik) December 16, 2014

A Picture is Worth 1,000 Words: General Electric's Revenue Growth

Source: Company Statements, IOI Analysis

In the heatmap above, the FY2013 revenue for each of GE's Industrial and High-Tech segments (in billions of USD) is shown below the segment name; below FY13 revenues is the 5-year CAGR. Box size represents revenue share; box color represents revenue growth rates.

It is obvious from this heatmap that GE's Oil & Gas segment has provided the most revenue growth over the past five years.

Time Decay and the Parable of the Iceberg Salesman

Source: Wikipedia

The inexorable nature of "time decay"--the quality of options that make them naturally lose value over time--is something that anyone who invests using options must understand and deal with. Option sellers are helped by time decay; option buyers are hurt by it. It is a hard concept to grasp for someone used to investing in stocks, but the following Parable of the Iceberg Salesman should implant it firmly in your mind.

Volatility <> Risk

Asset 1 Volatility = 0.6%
Asset 2 Volatility = 350%

In modern financial theory, volatility is taken to be equivalent to risk. However, I believe it is more helpful to think of volatility as simply "sudden price movement", since this phrase removes some of the emotional connotations implied by "risk" and is actually more accurate in terms of the underlying mathematics.

Case in point: when I was working as the risk manager for a hedge fund, a fund-of-funds came to interview my portfolio manager and to take statistics of our performance...

What's Happening?!

I've gotten a few texts and emails from readers asking for my take on the present market turmoil. If you listen to the pundits on cable channels, recent market falls are caused by everything from the fear of the Ebola virus to worries about global growth to worries about the Fed tightening.

The fact is, however, that while all of these issues are factored into market participants' thinking, it is ridiculous to apply some causal connection between these (or any factors) and the market falling.

What's really going on in the markets? It's falling a bit and there doesn't have to be a reason. One of the research articles that sparked my love of the markets was a paper by Larry Summers that investigated the attribution of causal connections to the 50 largest stock market movements. In the majority of cases, he found no evidence of any connection between an identifiable "external" shock and a market movement.

Cheap Chips

Those of you who enjoyed reading my analyses pre-The Intelligent Option Investor--when I was heading up the semiconductor analysis team at Morningstar--will know how much I like the business model and management of Microchip Technology (MCHP), an Arizona firm that specializes in embedded control chips.

Microchip recently offered a lowered revenue guidance and suggested that their industry was heading into a slump. The stock fell over 12% after the announcement.

The announcement is interesting for several reasons, and the firm is now back on my radar screen...

IOI's Analysis of Market Outlook for GE Using a BSM Cone

In this video, I show how to use the online tools at IOITools.com to assess what the market expects as a future stock price range for General Electric. We then compare the market's price range for GE to the valuation range we calculated in an earlier video to assess the possibility of making an investment.

This method is introduced in The Intelligent Option Investor: Applying Value Investing to the World of Options (2014, McGraw-Hill) and in the accompanying online appendices available at IntelligentOptionInvestor.com.

See also the replay of the YCharts conference call on GE as well as the YCharts Focus Report on GE, which you can find on ycharts.com/resources.

A transcript of the video is below.

IOI Leverage Calculations

One of the parts of The Intelligent Option Investor about which I am most proud and happy is the new method of measuring and managing leverage that I develop in the book.

This blog posting shows my current thinking about what I term Loss Leverage and Gain Leverage in the book and shows why a mixed allocation of stocks and options can be such a sensible, powerful asymmetric investment strategy.

IOI Analysis of GE's Free Cash Flow

In this video, I show how to use the online tools at IOITools.com to analyze the free cash flow profile of global industrial giant, General Electric. This video also shows how to calculate Net Expansionary Cash Flows ("Net ECF") and Free Cash Flow to Owners, two owner-centric, cash-centric measures introduced in The Intelligent Option Investor: Applying Value Investing to the World of Options (2014, McGraw-Hill).

See also the replay of the YCharts conference call on GE as well as the YCharts Focus Report on GE, which you can find on the Resources tab of the YCharts site.

Here is a transcript of this video.

IOI Analysis of GE's Revenues and Profits

In this video, I show how to use the online tools at IOITools.com to analyze the revenues and profitability of global industrial giant, General Electric. This video also shows how to calculate Owners' Cash Profit, or OCP, an owner-centric, cash-centric measure of profitability introduced in The Intelligent Option Investor: Applying Value Investing to the World of Options (2014, McGraw-Hill).

See also the replay of the YCharts conference call on GE as well as the YCharts Focus Report on GE, which you can find on the Resources tab of the YCharts site.

Here is a transcript of this video.

The Intelligent Option Investor Receives First Review!

The first review of my new book, The Intelligent Option Investor, was published on Investor.com and ValueWalk.com this week!

The reviewer describes herself as an “option trader,” and since the Intelligent Option Investor takes such a different approach to investing from that taken by traders, I didn’t expect many kind words. Much to my surprise, though, she was complementary about the book and thought that even option traders would get something out of it.

Indeed, in my experience, a lot of people trading options do not have much knowledge of the theory underpinning the instruments they are buying and selling. This represents a huge risk to those traders, and one that they can easily remedy by reading my book.

Certainly, you don’t have to be able to build an engine from scratch in order to be able to drive a car. Similarly, you don’t need to be able to derive Ito’s Lemma to be able to invest successfully using options.

IOI Quick Guide to Option Basics

Options are wonderful, simple, flexible financial instruments that are peerless tools for generating income, boosting growth, and protecting gains. This video kicks off our four-part series that introduces the key concepts of intelligent option investing by explaining options from a unique "range of exposure" perspective.

IOI's Quick Guide to Valuation and Margin of Safety

Margin of safety is one of the great ideas of value investing, but the way most people implement it subjects them to hardwired behavioral biases that too often lead to investment losses. In this video--the second in our series introducing intelligent option investing--we focus on a way to improve upon the margin of safety concept and tilt the balance of risk and reward in your favor by using options.

IOI's Quick Guide to Option Pricing

Do you think that option pricing is difficult? Or not relevant to the way you like to invest? Think again! This video--the third in a four-part series introducing intelligent option investing--shows how easy option pricing is and why understanding it gives a stock investor a leg up on the market. If you understand option pricing, investing becomes like playing poker with an opponent who always leaves his cards face up!

Intelligent Option Investing in Three Easy Steps

This is the capstone video of my introduction to intelligent option investing series. It ties together topics from the three earlier videos to explain the essence of intelligent option investing in three easy steps.

Better Options for Ackman's Investment in Target

Source: Hedgeye.com

There are two main reasons why this investment did not work out for Ackman and his investors: overleverage and bad timing. This article--a follow-up to a previous posting--discusses these root cause elements and suggests a way that Ackman could have used options to better effect in his investment in Target.

Overleverage

The research I did to write the YCharts Focus Report onTarget convinced me that the retailer does indeed have some deep problems related to its culture and management style. Ackman, as an activist investor, invests in companies that have value-destructive faults, so it is no wonder that he was drawn to Target.

The position of an activist investor is sort of like that of a house flipper, except in the latter case, the house is not actively attempting to thwart the owner’s attempts at rehabbing it!

What is Intelligent Option Investing?

Intelligent Option Investing consists of:

1. Rationally assessing the value of a stock.
2. Seeing clearly what the option market is forecasting for the stock's price.
3. Using a sensible combination of stocks, options, and cash to tilt the risk / reward odds in your favor when a stock's value deviates from its price as forecast  by the option market.

Institutional Option Investing Case Study: Bill Ackman’s Calls on Target

Executive Summary

• Even though Ackman’s investment in Target was unsuccessful, the option portion of the trade is well-documented, and an analysis of the structure of this investment is instructive.
• This article analyzes Ackman’s use of the “listed look-alike” option market and how institutional option transactions are structured and traded.
• We find Ackman’s use of In-the-Money (ITM) options to be an intelligent, measured approach and discuss why, in general ITM options should be a go-to strategy for stock investors.
• We find that a combination of overleverage and poor timing lay at the root of Ackman’s losses in Target, and discuss what might have been done better.

Ackman’s Options

While researching the most recent YCharts Focus Report onTarget, I started to get interested in Pershing Square founder Bill Ackman’s ill-fated investment in the company—especially in the substantial option let of it. Derided as “speculative” by Target’s management and taken as an example in the media of how “dangerous” options can be, I was expecting something entirely different from what I found.

While Ackman’s investment in Target investment was not successful, the example holds some valuable lessons for intelligent option investors, especially those of you looking at using options in an institutional context. Unlike Ackman’s Herbalife put options, for which we had little hard data,[1] information regarding his call options on Target are well documented in an SEC form 13-D.[2]

Institutional Option Case Study: Ackman's Investment in Herbalife

My ears perked up listening to Bill Ackman's Herbalife presentation as he talked about his use of options as an investment vehicle in his bearish investment in the company. In October 2013, Ackman informed the limited partners of his hedge fund, Pershing Square, that he had closed about 40% of his fund's short position in Herbalife (which had been suffering mark-to-market losses) and replaced it with long-dated, over-the-counter, out-of-the-money (OTM) put options.

Then, in January of this year, listed OTM put options in Herbalife saw an enormous spike in volume and pundits surmised that either Ackman was doubling down on his bearish bet, the counterparty broker was trying to "hedge out" its exposure to Ackman's investment, or that there was another investor piling in on Ackman's side.

Because this is a bearish position, there is no obligation for Pershing Square to file a form 13-D (required for investors holding more than 5% equity in a public company) or a 13-F (a quarterly listing of all stocks held by investment advisors). As such, we cannot look at detail at Ackman's put positions*, but there are some interesting insights to be gleaned from the various announcements.

Decoding the press announcements gives a good view to how a well-informed institutional investor uses options in an investing program. Let's look at three things in particular--the market in which Ackman is transacting, his strike selection, and the large listed transaction.

Praise for the Intelligent Option Investor

My old boss, the founder and CEO of Morningstar, JoeMansueto, was kind enough to take the time to read through an early version of my manuscript and has this to say:

The Intelligent Option Investor reflects Erik’s keen understanding of how companies create value for their owners, which is essential to successful option investing. In addition to showcasing Erik’s expertise in developing option investment strategies based on fundamental security analysis and a long-term time horizon, this book delivers the information in a way that’s accessible to individual investors, offering them the resources to use options to help them meet their financial goals.

Thanks for the support, Joe!

Understanding Options

Like I explained in my post The Essence of Intelligent Option Investing, the The Intelligent Option Investor is split into three parts. Here's the introduction to Part I, which covers everything an intelligent investor needs to know about options and option pricing.

The Essence of Intelligent Option Investing

What does it mean to be an Intelligent Option Investor? 

The following excerpt from my book (on schedule to ship in August!) explains its essence. I also outline why, even if you never make an option transaction in your life, understanding what the option market is saying will give you an advantage as an equity investor.

---

Introduction

You have a tremendous advantage over algorithmic trading models, investment bank trading desks, hedge funds, and anyone who appears on or pays attention to cable business news shows. This book is written to show where that advantage lies and how to exploit it to make confident and successful investment choices. In doing so, it explains how options work and what they can tell you about the market’s estimation of the value of stocks.

Even if, after reading it, you decide to stick with straight stock investing and never make an option transaction, understanding how options work will give you a tremendous advantage as an investor. The reason for this is simple: by understanding options, you can understand what the rest of the market is expecting the future price of a stock to be. Understanding what future stock prices are implied by the market is like playing cards with an opponent who always leaves his or her hand face up on the table. You can look at the cards you are dealt, compare them with your opponent’s, and play the round only when you are sure that you have the winning hand.