About
GSK consumer is a 1300 Cr consumer goods company with well known brands such as Horlicks, Boost, Maltova, Crocin etc. The company is a part of the Glaxo smithkline group which specialises in pharma products
Financials
The company has done well for the last 5 years after a dip in performance in 2001-2002. The company topline dropped by 12% in 2002 and the bottomline by 33%. The company has since then recovered the topline growth to around 10% per annum and Net profit growth to around 12-15% CAGR.
The RONW/ROCE have improved to 20%+ levels due to improvement in margins and Asset turns. The company has no debt and an approximate cash of 300 Crs.
Positives
The company has strong brands, well established distribution network and a high market share in its category (around 70%). In addition the company has cash of 300 Crs on its balance sheet.
The management has been a rational allocator of capital. They have maintained a dividend payout of almost 35%. In addition the management executed a buyback in 2006 of around 125Crs using up the excess cash. The current cash on the Balance sheet is for acquisitions and to grow the business.
The company plans to introduce 2-3 of its international brands in the couple of years such as sensodyne, breathe right etc.
Risks
This is a single product company. Crocin and Iodex brands are not owned by it. The company only distributes it for the parent and gets a fee for it. As a result topline and bottom line is based on a single product category and it can get hit again as in the past by a drop in the demand or competition or both.
The company has plans to acquire new brands and businesses, but it remains to be seen how that will play out.
In addition it remains to be seen if the Global brands to be introduced in india would be successful or not.
Valuation
The company current sells at around a PE of 13.5 (after taking out the cash). A rough calculation (ROE = 20%, growth around 7-10% and CAP of 8-10 years) would give an intrinsic value of around 3000 Crs. This valuation does not include upside from Global brands or any accquisition. Those would be icing on the cake, but I would not value them as yet.
conclusion
The company seems to be undervalued by 20-30%. In addition the upside from introducing global brands or any acquisition is not included in the calculation. So that could be a positive upside (or a negative if it fails). I find the investment idea good, but not mouth watering. Would like to wait and watch
Disclaimer : I don’t hold the stock (as yet). In addition I may change my mind at any time on that and may not put that on the blog. So please look at the disclaimer below and take your own decision.
Thursday, February 28, 2008
GSK consumer products
About
GSK consumer is a 1300 Cr consumer goods company with well known brands such as Horlicks, Boost, Maltova, Crocin etc. The company is a part of the Glaxo smithkline group which specialises in pharma products
Financials
The company has done well for the last 5 years after a dip in performance in 2001-2002. The company topline dropped by 12% in 2002 and the bottomline by 33%. The company has since then recovered the topline growth to around 10% per annum and Net profit growth to around 12-15% CAGR.
The RONW/ROCE have improved to 20%+ levels due to improvement in margins and Asset turns. The company has no debt and an approximate cash of 300 Crs.
Positives
The company has strong brands, well established distribution network and a high market share in its category (around 70%). In addition the company has cash of 300 Crs on its balance sheet.
The management has been a rational allocator of capital. They have maintained a dividend payout of almost 35%. In addition the management executed a buyback in 2006 of around 125Crs using up the excess cash. The current cash on the Balance sheet is for acquisitions and to grow the business.
The company plans to introduce 2-3 of its international brands in the couple of years such as sensodyne, breathe right etc.
Risks
This is a single product company. Crocin and Iodex brands are not owned by it. The company only distributes it for the parent and gets a fee for it. As a result topline and bottom line is based on a single product category and it can get hit again as in the past by a drop in the demand or competition or both.
The company has plans to acquire new brands and businesses, but it remains to be seen how that will play out.
In addition it remains to be seen if the Global brands to be introduced in india would be successful or not.
Valuation
The company current sells at around a PE of 13.5 (after taking out the cash). A rough calculation (ROE = 20%, growth around 7-10% and CAP of 8-10 years) would give an intrinsic value of around 3000 Crs. This valuation does not include upside from Global brands or any accquisition. Those would be icing on the cake, but I would not value them as yet.
conclusion
The company seems to be undervalued by 20-30%. In addition the upside from introducing global brands or any acquisition is not included in the calculation. So that could be a positive upside (or a negative if it fails). I find the investment idea good, but not mouth watering. Would like to wait and watch
Disclaimer : I don’t hold the stock (as yet). In addition I may change my mind at any time on that and may not put that on the blog. So please look at the disclaimer below and take your own decision.
GSK consumer is a 1300 Cr consumer goods company with well known brands such as Horlicks, Boost, Maltova, Crocin etc. The company is a part of the Glaxo smithkline group which specialises in pharma products
Financials
The company has done well for the last 5 years after a dip in performance in 2001-2002. The company topline dropped by 12% in 2002 and the bottomline by 33%. The company has since then recovered the topline growth to around 10% per annum and Net profit growth to around 12-15% CAGR.
The RONW/ROCE have improved to 20%+ levels due to improvement in margins and Asset turns. The company has no debt and an approximate cash of 300 Crs.
Positives
The company has strong brands, well established distribution network and a high market share in its category (around 70%). In addition the company has cash of 300 Crs on its balance sheet.
The management has been a rational allocator of capital. They have maintained a dividend payout of almost 35%. In addition the management executed a buyback in 2006 of around 125Crs using up the excess cash. The current cash on the Balance sheet is for acquisitions and to grow the business.
The company plans to introduce 2-3 of its international brands in the couple of years such as sensodyne, breathe right etc.
Risks
This is a single product company. Crocin and Iodex brands are not owned by it. The company only distributes it for the parent and gets a fee for it. As a result topline and bottom line is based on a single product category and it can get hit again as in the past by a drop in the demand or competition or both.
The company has plans to acquire new brands and businesses, but it remains to be seen how that will play out.
In addition it remains to be seen if the Global brands to be introduced in india would be successful or not.
Valuation
The company current sells at around a PE of 13.5 (after taking out the cash). A rough calculation (ROE = 20%, growth around 7-10% and CAP of 8-10 years) would give an intrinsic value of around 3000 Crs. This valuation does not include upside from Global brands or any accquisition. Those would be icing on the cake, but I would not value them as yet.
conclusion
The company seems to be undervalued by 20-30%. In addition the upside from introducing global brands or any acquisition is not included in the calculation. So that could be a positive upside (or a negative if it fails). I find the investment idea good, but not mouth watering. Would like to wait and watch
Disclaimer : I don’t hold the stock (as yet). In addition I may change my mind at any time on that and may not put that on the blog. So please look at the disclaimer below and take your own decision.
Sunday, February 24, 2008
Reverse engineering the L&T stock price
I got the following comment from abhishek
Hi Rohit,
Using the same concept, dont u think L&T is a very expensive stock trading at PE of above 70.
To sustain this PE, how much growth it must show in the future?
Does this PE look sustainable?
If no, could u please help us understand this calculation by using L&T as an example?
Following is a very brief unpacking or analysis of the expectations embedded in the stock price. Is the stock undervalued?…that is your call
Caution: I have done a quick analysis and hence there are a lot of assumptions (such as net profit = Free cash flow) and shortcuts. i have not done a detailed analysis as the company does not pass my initial selection criteria
The stock sells at a PE of around 30 (assuming consolidated profits of around 3000 crs for the year. LY was 2250 Crs).
The ROE is around 30%+ and Debt equity is around 1:1 based on 2007 Balance sheet.
You can plug the following numbers in the spreadsheet – quantitative calculation – ROC and PE to calculate the embedded expectations
1. ROE = 30% (approximate). Use the DCF calcluations on line 88
2. Growth ~ 20% ( 5 year average growth was 50% per annum). This is clearly an assumption and one can play around with it
3. CAP – Take as 10 years. Again an assumption. Increase or decrease based on your assesment of competition and industry
4. Free cash flow = Net profit
If you plug the above numbers, the model throws a PE of around 36 (close enough!)
So the expectations seem to be
- Company will maintain an ROE of 30% or more
- Growth for the 10 years would be 20%. If you are more optimistic, increase the number and you will find the company is undervalued (as expected).
- After 10 years , L&T would be a 40 bn dollar company! , with net profit of 4.5 bn dollars (19000 crore)
So the stock market is discounting the above performance. If you think the company is undervalued you are saying
The ROE of the company will be higher than 30%
Growth with higher than 20% and hence 10 years later the company would be a much larger company, making the same margins and profits.
Suggestion: I have not done this, but look around for such EPC companies worldwide and check the size, growth and PE for these companies. That could give a hint how large and profitable L&T can get.
Reverse engineering the L&T stock price
I got the following comment from abhishek
Hi Rohit,
Using the same concept, dont u think L&T is a very expensive stock trading at PE of above 70.
To sustain this PE, how much growth it must show in the future?
Does this PE look sustainable?
If no, could u please help us understand this calculation by using L&T as an example?
Following is a very brief unpacking or analysis of the expectations embedded in the stock price. Is the stock undervalued?…that is your call
Caution: I have done a quick analysis and hence there are a lot of assumptions (such as net profit = Free cash flow) and shortcuts. i have not done a detailed analysis as the company does not pass my initial selection criteria
The stock sells at a PE of around 30 (assuming consolidated profits of around 3000 crs for the year. LY was 2250 Crs).
The ROE is around 30%+ and Debt equity is around 1:1 based on 2007 Balance sheet.
You can plug the following numbers in the spreadsheet – quantitative calculation – ROC and PE to calculate the embedded expectations
1. ROE = 30% (approximate). Use the DCF calcluations on line 88
2. Growth ~ 20% ( 5 year average growth was 50% per annum). This is clearly an assumption and one can play around with it
3. CAP – Take as 10 years. Again an assumption. Increase or decrease based on your assesment of competition and industry
4. Free cash flow = Net profit
If you plug the above numbers, the model throws a PE of around 36 (close enough!)
So the expectations seem to be
- Company will maintain an ROE of 30% or more
- Growth for the 10 years would be 20%. If you are more optimistic, increase the number and you will find the company is undervalued (as expected).
- After 10 years , L&T would be a 40 bn dollar company! , with net profit of 4.5 bn dollars (19000 crore)
So the stock market is discounting the above performance. If you think the company is undervalued you are saying
The ROE of the company will be higher than 30%
Growth with higher than 20% and hence 10 years later the company would be a much larger company, making the same margins and profits.
Suggestion: I have not done this, but look around for such EPC companies worldwide and check the size, growth and PE for these companies. That could give a hint how large and profitable L&T can get.
Wednesday, February 20, 2008
Correction to the post : valuation – reverse engineering the stock price
There was an error in the analysis of crisil in the post . I had looked at the standalone numbers only and not the consolidated numbers (as an anonymous reader has pointed out in the comments)
So crisil may not be a good example of over valuation. I am not sure how undervalued the company is. It sells at a PE of 33 (approximate Net profit of 100 odd crs for 2007). I have analysed the company earlier here …and I have underestimated the competitive advantage of this company and its ability to keep increasing its instrinsic value.
That said, if I were make my point in the post again, I would replace crisil with any of the Real estate companies or capital goods company which have a high performance hurdle to cross (due to their high PE) to deliver good returns to investors in the future.
The post was however was not an analysis of CRISL. The key point is this – A good company may not be a good stock and vice versa (important word is ‘may’) . That depends on whether the stock price fully discounts the future performance of the company or not. If one has to make money in such high PE stocks, then the actual performance has to be better than what is implied by the stock
Low PE or low valuation stocks have low expectations built in and hence a small improvement in the company performance can deliver good returns. High PE or stocks selling at high valuations are stars of the Stock market. If they stumble even a bit, the stock price can get butchered. So one has to be confident and sure that the company will meet the high expectations well into the distant future.
I have personal experience of seeing a stock drop 90% when the company was not able to meet its high expectations (see here).
Ofcourse you can say that I am not as dumb as rohit and will not make a mistake like him :)
Feb 23 :
Following quote from peter lynch is very relevant to the topic of this post
“It’s a real tragedy when you buy a stock that’s overpriced; the company is a big success and you still don’t make any money.” Peter Lynch, “One Up on Wall Street,” New York, Penguin Books, 1989, p. 244.
I am a big fan of Mohnish Pabrai. He is a very succesful investment manager and has recently written a great book - dhandho investor.
Following article from mohnish explains the key point of the post - A good company may not be a good stock and vice versa in a great (and much better) way.
Valuation by intrinsic value.
In addition you can find the links for a lot of mohnish's articles here. I strongly recommend reading each article
So crisil may not be a good example of over valuation. I am not sure how undervalued the company is. It sells at a PE of 33 (approximate Net profit of 100 odd crs for 2007). I have analysed the company earlier here …and I have underestimated the competitive advantage of this company and its ability to keep increasing its instrinsic value.
That said, if I were make my point in the post again, I would replace crisil with any of the Real estate companies or capital goods company which have a high performance hurdle to cross (due to their high PE) to deliver good returns to investors in the future.
The post was however was not an analysis of CRISL. The key point is this – A good company may not be a good stock and vice versa (important word is ‘may’) . That depends on whether the stock price fully discounts the future performance of the company or not. If one has to make money in such high PE stocks, then the actual performance has to be better than what is implied by the stock
Low PE or low valuation stocks have low expectations built in and hence a small improvement in the company performance can deliver good returns. High PE or stocks selling at high valuations are stars of the Stock market. If they stumble even a bit, the stock price can get butchered. So one has to be confident and sure that the company will meet the high expectations well into the distant future.
I have personal experience of seeing a stock drop 90% when the company was not able to meet its high expectations (see here).
Ofcourse you can say that I am not as dumb as rohit and will not make a mistake like him :)
Feb 23 :
Following quote from peter lynch is very relevant to the topic of this post
“It’s a real tragedy when you buy a stock that’s overpriced; the company is a big success and you still don’t make any money.” Peter Lynch, “One Up on Wall Street,” New York, Penguin Books, 1989, p. 244.
I am a big fan of Mohnish Pabrai. He is a very succesful investment manager and has recently written a great book - dhandho investor.
Following article from mohnish explains the key point of the post - A good company may not be a good stock and vice versa in a great (and much better) way.
Valuation by intrinsic value.
In addition you can find the links for a lot of mohnish's articles here. I strongly recommend reading each article
Correction to the post : valuation – reverse engineering the stock price
There was an error in the analysis of crisil in the post . I had looked at the standalone numbers only and not the consolidated numbers (as an anonymous reader has pointed out in the comments)
So crisil may not be a good example of over valuation. I am not sure how undervalued the company is. It sells at a PE of 33 (approximate Net profit of 100 odd crs for 2007). I have analysed the company earlier here …and I have underestimated the competitive advantage of this company and its ability to keep increasing its instrinsic value.
That said, if I were make my point in the post again, I would replace crisil with any of the Real estate companies or capital goods company which have a high performance hurdle to cross (due to their high PE) to deliver good returns to investors in the future.
The post was however was not an analysis of CRISL. The key point is this – A good company may not be a good stock and vice versa (important word is ‘may’) . That depends on whether the stock price fully discounts the future performance of the company or not. If one has to make money in such high PE stocks, then the actual performance has to be better than what is implied by the stock
Low PE or low valuation stocks have low expectations built in and hence a small improvement in the company performance can deliver good returns. High PE or stocks selling at high valuations are stars of the Stock market. If they stumble even a bit, the stock price can get butchered. So one has to be confident and sure that the company will meet the high expectations well into the distant future.
I have personal experience of seeing a stock drop 90% when the company was not able to meet its high expectations (see here).
Ofcourse you can say that I am not as dumb as rohit and will not make a mistake like him :)
Feb 23 :
Following quote from peter lynch is very relevant to the topic of this post
“It’s a real tragedy when you buy a stock that’s overpriced; the company is a big success and you still don’t make any money.” Peter Lynch, “One Up on Wall Street,” New York, Penguin Books, 1989, p. 244.
I am a big fan of Mohnish Pabrai. He is a very succesful investment manager and has recently written a great book - dhandho investor.
Following article from mohnish explains the key point of the post - A good company may not be a good stock and vice versa in a great (and much better) way.
Valuation by intrinsic value.
In addition you can find the links for a lot of mohnish's articles here. I strongly recommend reading each article
So crisil may not be a good example of over valuation. I am not sure how undervalued the company is. It sells at a PE of 33 (approximate Net profit of 100 odd crs for 2007). I have analysed the company earlier here …and I have underestimated the competitive advantage of this company and its ability to keep increasing its instrinsic value.
That said, if I were make my point in the post again, I would replace crisil with any of the Real estate companies or capital goods company which have a high performance hurdle to cross (due to their high PE) to deliver good returns to investors in the future.
The post was however was not an analysis of CRISL. The key point is this – A good company may not be a good stock and vice versa (important word is ‘may’) . That depends on whether the stock price fully discounts the future performance of the company or not. If one has to make money in such high PE stocks, then the actual performance has to be better than what is implied by the stock
Low PE or low valuation stocks have low expectations built in and hence a small improvement in the company performance can deliver good returns. High PE or stocks selling at high valuations are stars of the Stock market. If they stumble even a bit, the stock price can get butchered. So one has to be confident and sure that the company will meet the high expectations well into the distant future.
I have personal experience of seeing a stock drop 90% when the company was not able to meet its high expectations (see here).
Ofcourse you can say that I am not as dumb as rohit and will not make a mistake like him :)
Feb 23 :
Following quote from peter lynch is very relevant to the topic of this post
“It’s a real tragedy when you buy a stock that’s overpriced; the company is a big success and you still don’t make any money.” Peter Lynch, “One Up on Wall Street,” New York, Penguin Books, 1989, p. 244.
I am a big fan of Mohnish Pabrai. He is a very succesful investment manager and has recently written a great book - dhandho investor.
Following article from mohnish explains the key point of the post - A good company may not be a good stock and vice versa in a great (and much better) way.
Valuation by intrinsic value.
In addition you can find the links for a lot of mohnish's articles here. I strongly recommend reading each article
Thursday, February 14, 2008
Some Interesting ideas
I am analysing some of the following stocks in detail as these stock have passed my initial filters
Concor
Balmer Lawrie
GSK Smithline consumer
Disclosure – I have owned Concor and Balmer lawrie for the last few years and currently re-analysing the stocks. So my analysis could be biased. I would be posting the analysis soon.
In addition Mid-caps and some value stocks have now become even cheaper. Some companies now sell for almost or slightly less than cash on the balance sheet. I am now finding quite a few ideas to work on and hoping that the cheap would get cheaper.
In addition I am reading the following books and have found them to be good. I would definitely recommend reading both the books
More than you know by Michael J. Mauboussin
Margin of safety by seth Klarman
Concor
Balmer Lawrie
GSK Smithline consumer
Disclosure – I have owned Concor and Balmer lawrie for the last few years and currently re-analysing the stocks. So my analysis could be biased. I would be posting the analysis soon.
In addition Mid-caps and some value stocks have now become even cheaper. Some companies now sell for almost or slightly less than cash on the balance sheet. I am now finding quite a few ideas to work on and hoping that the cheap would get cheaper.
In addition I am reading the following books and have found them to be good. I would definitely recommend reading both the books
More than you know by Michael J. Mauboussin
Margin of safety by seth Klarman
Some Interesting ideas
I am analysing some of the following stocks in detail as these stock have passed my initial filters
Concor
Balmer Lawrie
GSK Smithline consumer
Disclosure – I have owned Concor and Balmer lawrie for the last few years and currently re-analysing the stocks. So my analysis could be biased. I would be posting the analysis soon.
In addition Mid-caps and some value stocks have now become even cheaper. Some companies now sell for almost or slightly less than cash on the balance sheet. I am now finding quite a few ideas to work on and hoping that the cheap would get cheaper.
In addition I am reading the following books and have found them to be good. I would definitely recommend reading both the books
More than you know by Michael J. Mauboussin
Margin of safety by seth Klarman
Concor
Balmer Lawrie
GSK Smithline consumer
Disclosure – I have owned Concor and Balmer lawrie for the last few years and currently re-analysing the stocks. So my analysis could be biased. I would be posting the analysis soon.
In addition Mid-caps and some value stocks have now become even cheaper. Some companies now sell for almost or slightly less than cash on the balance sheet. I am now finding quite a few ideas to work on and hoping that the cheap would get cheaper.
In addition I am reading the following books and have found them to be good. I would definitely recommend reading both the books
More than you know by Michael J. Mauboussin
Margin of safety by seth Klarman
Sunday, February 10, 2008
Using puts to reduce cost basis
A thought experiment -
Lets assume you find a stock which is undervalued and it is liquid (otherwise you may not get options on it). You buy the stock and would continue to buy if the price were to drop further (the critical point). In addition you sell puts for strike price say, 20% below the current price.
If the price does not drop, you keep the premium and reduce your cost basis. If the price drops by more than 20%, the put gets exercised and you buy the stock (which you any way planned to do so).
The key objections to this strategy could be
· Does not work with illiquid, lesser known stocks which are more likely to be undervalued
· if the price drops more than the strike price, say 30% then I am losing out on the additional 10% cost of the stock . In worst case scenario if I have mis-analysed the stock I could be in a lot of trouble as I may end up incurring huge losses in that scenario.
· Someone has to be ready to buy these puts (puts should be saleable)
· Stock has to be volatile enough to make the puts attractive and worth the effort
· Contract size – Does the contract size fit with the investment plan. May not work out for an investment plan of a few hundred shares in some cases
A few other cases
· Buying undervalued stock and sell calls at 60-70% above strike price
· Buying long term options on a stock (LEAPS in the US ..not sure if available in India)
I have analysed a few cases such as the above in the past. However once I have looked at the possible scenarios which can play out, done an expected value analysis and compared it with the cost, most of the cases turn out to be low in returns and moderate to high in risk.
Please feel free to comment on the above strategy or any better ones you may have tried.
Lets assume you find a stock which is undervalued and it is liquid (otherwise you may not get options on it). You buy the stock and would continue to buy if the price were to drop further (the critical point). In addition you sell puts for strike price say, 20% below the current price.
If the price does not drop, you keep the premium and reduce your cost basis. If the price drops by more than 20%, the put gets exercised and you buy the stock (which you any way planned to do so).
The key objections to this strategy could be
· Does not work with illiquid, lesser known stocks which are more likely to be undervalued
· if the price drops more than the strike price, say 30% then I am losing out on the additional 10% cost of the stock . In worst case scenario if I have mis-analysed the stock I could be in a lot of trouble as I may end up incurring huge losses in that scenario.
· Someone has to be ready to buy these puts (puts should be saleable)
· Stock has to be volatile enough to make the puts attractive and worth the effort
· Contract size – Does the contract size fit with the investment plan. May not work out for an investment plan of a few hundred shares in some cases
A few other cases
· Buying undervalued stock and sell calls at 60-70% above strike price
· Buying long term options on a stock (LEAPS in the US ..not sure if available in India)
I have analysed a few cases such as the above in the past. However once I have looked at the possible scenarios which can play out, done an expected value analysis and compared it with the cost, most of the cases turn out to be low in returns and moderate to high in risk.
Please feel free to comment on the above strategy or any better ones you may have tried.
Using puts to reduce cost basis
A thought experiment -
Lets assume you find a stock which is undervalued and it is liquid (otherwise you may not get options on it). You buy the stock and would continue to buy if the price were to drop further (the critical point). In addition you sell puts for strike price say, 20% below the current price.
If the price does not drop, you keep the premium and reduce your cost basis. If the price drops by more than 20%, the put gets exercised and you buy the stock (which you any way planned to do so).
The key objections to this strategy could be
· Does not work with illiquid, lesser known stocks which are more likely to be undervalued
· if the price drops more than the strike price, say 30% then I am losing out on the additional 10% cost of the stock . In worst case scenario if I have mis-analysed the stock I could be in a lot of trouble as I may end up incurring huge losses in that scenario.
· Someone has to be ready to buy these puts (puts should be saleable)
· Stock has to be volatile enough to make the puts attractive and worth the effort
· Contract size – Does the contract size fit with the investment plan. May not work out for an investment plan of a few hundred shares in some cases
A few other cases
· Buying undervalued stock and sell calls at 60-70% above strike price
· Buying long term options on a stock (LEAPS in the US ..not sure if available in India)
I have analysed a few cases such as the above in the past. However once I have looked at the possible scenarios which can play out, done an expected value analysis and compared it with the cost, most of the cases turn out to be low in returns and moderate to high in risk.
Please feel free to comment on the above strategy or any better ones you may have tried.
Lets assume you find a stock which is undervalued and it is liquid (otherwise you may not get options on it). You buy the stock and would continue to buy if the price were to drop further (the critical point). In addition you sell puts for strike price say, 20% below the current price.
If the price does not drop, you keep the premium and reduce your cost basis. If the price drops by more than 20%, the put gets exercised and you buy the stock (which you any way planned to do so).
The key objections to this strategy could be
· Does not work with illiquid, lesser known stocks which are more likely to be undervalued
· if the price drops more than the strike price, say 30% then I am losing out on the additional 10% cost of the stock . In worst case scenario if I have mis-analysed the stock I could be in a lot of trouble as I may end up incurring huge losses in that scenario.
· Someone has to be ready to buy these puts (puts should be saleable)
· Stock has to be volatile enough to make the puts attractive and worth the effort
· Contract size – Does the contract size fit with the investment plan. May not work out for an investment plan of a few hundred shares in some cases
A few other cases
· Buying undervalued stock and sell calls at 60-70% above strike price
· Buying long term options on a stock (LEAPS in the US ..not sure if available in India)
I have analysed a few cases such as the above in the past. However once I have looked at the possible scenarios which can play out, done an expected value analysis and compared it with the cost, most of the cases turn out to be low in returns and moderate to high in risk.
Please feel free to comment on the above strategy or any better ones you may have tried.
Wednesday, February 06, 2008
Futures, Options and hedging
If your first thought is – Options and value investing …what a combination? You are not alone. You will rarely find discussions on options and derivatives in books and articles on value investing. But then just because most value investors don’t talk about options, does not mean one should not even try to understand them.
That said, let me clarify – I am not an expert, heck not even a novice on options. I have read a few books on options and derivatives, bought a few here and there. However I am planning to read up more on options and understand them better – it would improve my understanding of probability.
Most of the discussions I have seen on options is around the strike price. A lot of investors look at options as leveraged bets on the stock price. It goes like this – Lets assume I am bullish on L&T (who isn’t :) !).
The current price is around 2500 (for argument sake). I expect it to rise by 20% in the next 6 months. So instead of investing 250000 and making 20% on that, I can invest buy 2500 contracts (for argument sake each contract is 100 Rs) and if the prices increases by 20%, then each contract is worth 500 Rs ( 2500*1.2- 2500). So I have made 5 times my investment. So I have leveraged my bet. The downside is that if price drops, I am out of the entire 250000
The above math is not accurate, but depicts the basic argument. The problem is that short of having a crystal ball, it is difficult to know what the future price would be. In addition to getting the price right, I need to get the timing right. If the contract expires in 6 months and the rise increases after that, I may be right but still lose money. Finally I am not sure how profitable this strategy is in the long term (net of all profits and losses) as one keeps losing money often and makes money in chunks a few times.
I think value investing principles, not in its traditional sense, are still relevant when investing in futures and options. Let me explain –
Options pricing is generally dependent on the following variables
- strike price
- time for expiration
- Interest rates
- Volatility
Value investing is about find undervalued securities which can include options. That would mean figuring out the option pricing based on the above variables and comparing it with the market prices. If the market prices are lower than the actual price, then it makes sense to buy the options. I have read about it, but have never tried it myself. In addition I think the options pricing is far more efficient and hence it is not easy to make money this way.
The second approach would be to look at options to help in hedging my portfolio. For example if I plan to sell part of my portfolio in the next couple of months as they seem to overvalued, I would like to buy put options to hedge those specific stocks. This however works only for specific stocks and is not useful as a general strategy.
The last approach is to buy long term call/put options on stocks which I think are undervalued. That would be equivalent of making a leveraged long term bet on a stock. However it suffers from the same, time related disadvantage I discussed earlier and also from the lack of such options in the Indian market (not sure if we have these options at all)
In summary I see options currently as an insurance against market crashes. However due the cost factor I need to still figure out if it is profitable to protect the portfolio against such crashes in the long term.
Ps: I would appreciate if anyone can suggest some good books on options and option pricing etc.
That said, let me clarify – I am not an expert, heck not even a novice on options. I have read a few books on options and derivatives, bought a few here and there. However I am planning to read up more on options and understand them better – it would improve my understanding of probability.
Most of the discussions I have seen on options is around the strike price. A lot of investors look at options as leveraged bets on the stock price. It goes like this – Lets assume I am bullish on L&T (who isn’t :) !).
The current price is around 2500 (for argument sake). I expect it to rise by 20% in the next 6 months. So instead of investing 250000 and making 20% on that, I can invest buy 2500 contracts (for argument sake each contract is 100 Rs) and if the prices increases by 20%, then each contract is worth 500 Rs ( 2500*1.2- 2500). So I have made 5 times my investment. So I have leveraged my bet. The downside is that if price drops, I am out of the entire 250000
The above math is not accurate, but depicts the basic argument. The problem is that short of having a crystal ball, it is difficult to know what the future price would be. In addition to getting the price right, I need to get the timing right. If the contract expires in 6 months and the rise increases after that, I may be right but still lose money. Finally I am not sure how profitable this strategy is in the long term (net of all profits and losses) as one keeps losing money often and makes money in chunks a few times.
I think value investing principles, not in its traditional sense, are still relevant when investing in futures and options. Let me explain –
Options pricing is generally dependent on the following variables
- strike price
- time for expiration
- Interest rates
- Volatility
Value investing is about find undervalued securities which can include options. That would mean figuring out the option pricing based on the above variables and comparing it with the market prices. If the market prices are lower than the actual price, then it makes sense to buy the options. I have read about it, but have never tried it myself. In addition I think the options pricing is far more efficient and hence it is not easy to make money this way.
The second approach would be to look at options to help in hedging my portfolio. For example if I plan to sell part of my portfolio in the next couple of months as they seem to overvalued, I would like to buy put options to hedge those specific stocks. This however works only for specific stocks and is not useful as a general strategy.
The last approach is to buy long term call/put options on stocks which I think are undervalued. That would be equivalent of making a leveraged long term bet on a stock. However it suffers from the same, time related disadvantage I discussed earlier and also from the lack of such options in the Indian market (not sure if we have these options at all)
In summary I see options currently as an insurance against market crashes. However due the cost factor I need to still figure out if it is profitable to protect the portfolio against such crashes in the long term.
Ps: I would appreciate if anyone can suggest some good books on options and option pricing etc.
Futures, Options and hedging
If your first thought is – Options and value investing …what a combination? You are not alone. You will rarely find discussions on options and derivatives in books and articles on value investing. But then just because most value investors don’t talk about options, does not mean one should not even try to understand them.
That said, let me clarify – I am not an expert, heck not even a novice on options. I have read a few books on options and derivatives, bought a few here and there. However I am planning to read up more on options and understand them better – it would improve my understanding of probability.
Most of the discussions I have seen on options is around the strike price. A lot of investors look at options as leveraged bets on the stock price. It goes like this – Lets assume I am bullish on L&T (who isn’t :) !).
The current price is around 2500 (for argument sake). I expect it to rise by 20% in the next 6 months. So instead of investing 250000 and making 20% on that, I can invest buy 2500 contracts (for argument sake each contract is 100 Rs) and if the prices increases by 20%, then each contract is worth 500 Rs ( 2500*1.2- 2500). So I have made 5 times my investment. So I have leveraged my bet. The downside is that if price drops, I am out of the entire 250000
The above math is not accurate, but depicts the basic argument. The problem is that short of having a crystal ball, it is difficult to know what the future price would be. In addition to getting the price right, I need to get the timing right. If the contract expires in 6 months and the rise increases after that, I may be right but still lose money. Finally I am not sure how profitable this strategy is in the long term (net of all profits and losses) as one keeps losing money often and makes money in chunks a few times.
I think value investing principles, not in its traditional sense, are still relevant when investing in futures and options. Let me explain –
Options pricing is generally dependent on the following variables
- strike price
- time for expiration
- Interest rates
- Volatility
Value investing is about find undervalued securities which can include options. That would mean figuring out the option pricing based on the above variables and comparing it with the market prices. If the market prices are lower than the actual price, then it makes sense to buy the options. I have read about it, but have never tried it myself. In addition I think the options pricing is far more efficient and hence it is not easy to make money this way.
The second approach would be to look at options to help in hedging my portfolio. For example if I plan to sell part of my portfolio in the next couple of months as they seem to overvalued, I would like to buy put options to hedge those specific stocks. This however works only for specific stocks and is not useful as a general strategy.
The last approach is to buy long term call/put options on stocks which I think are undervalued. That would be equivalent of making a leveraged long term bet on a stock. However it suffers from the same, time related disadvantage I discussed earlier and also from the lack of such options in the Indian market (not sure if we have these options at all)
In summary I see options currently as an insurance against market crashes. However due the cost factor I need to still figure out if it is profitable to protect the portfolio against such crashes in the long term.
Ps: I would appreciate if anyone can suggest some good books on options and option pricing etc.
That said, let me clarify – I am not an expert, heck not even a novice on options. I have read a few books on options and derivatives, bought a few here and there. However I am planning to read up more on options and understand them better – it would improve my understanding of probability.
Most of the discussions I have seen on options is around the strike price. A lot of investors look at options as leveraged bets on the stock price. It goes like this – Lets assume I am bullish on L&T (who isn’t :) !).
The current price is around 2500 (for argument sake). I expect it to rise by 20% in the next 6 months. So instead of investing 250000 and making 20% on that, I can invest buy 2500 contracts (for argument sake each contract is 100 Rs) and if the prices increases by 20%, then each contract is worth 500 Rs ( 2500*1.2- 2500). So I have made 5 times my investment. So I have leveraged my bet. The downside is that if price drops, I am out of the entire 250000
The above math is not accurate, but depicts the basic argument. The problem is that short of having a crystal ball, it is difficult to know what the future price would be. In addition to getting the price right, I need to get the timing right. If the contract expires in 6 months and the rise increases after that, I may be right but still lose money. Finally I am not sure how profitable this strategy is in the long term (net of all profits and losses) as one keeps losing money often and makes money in chunks a few times.
I think value investing principles, not in its traditional sense, are still relevant when investing in futures and options. Let me explain –
Options pricing is generally dependent on the following variables
- strike price
- time for expiration
- Interest rates
- Volatility
Value investing is about find undervalued securities which can include options. That would mean figuring out the option pricing based on the above variables and comparing it with the market prices. If the market prices are lower than the actual price, then it makes sense to buy the options. I have read about it, but have never tried it myself. In addition I think the options pricing is far more efficient and hence it is not easy to make money this way.
The second approach would be to look at options to help in hedging my portfolio. For example if I plan to sell part of my portfolio in the next couple of months as they seem to overvalued, I would like to buy put options to hedge those specific stocks. This however works only for specific stocks and is not useful as a general strategy.
The last approach is to buy long term call/put options on stocks which I think are undervalued. That would be equivalent of making a leveraged long term bet on a stock. However it suffers from the same, time related disadvantage I discussed earlier and also from the lack of such options in the Indian market (not sure if we have these options at all)
In summary I see options currently as an insurance against market crashes. However due the cost factor I need to still figure out if it is profitable to protect the portfolio against such crashes in the long term.
Ps: I would appreciate if anyone can suggest some good books on options and option pricing etc.
Friday, February 01, 2008
Seesaw markets,my plans, a good book and market crisis
The month of jan was a complete rollcoaster. Initially the market shotup, then crashed and now seems to go one step forward and one step backward.
One could have made a killing shorting the market or by buying puts. I however did none of that. I personally need to do more homework in that area to venture into it. However I do see puts as a decent option to hedge the portfolio. The part I still need to work out is this -
Most options expire worthless. The reason is that the options market is fairly efficient, definitely more than straight equity. So is it possible to buy puts over the long term, make money a few times only and still have a decent return after all the costs ?
Some of my own holdings, some of which I have discussed (and some not), have declined below 50% of intrinsic value. Earlier I would get mixed feeling – pained by the decline and excited by the opportunity to buy more. Now I get more excited than pained. I however try to re-analyse the position and check if I have missed something which the market is discounting. In the past my key mistake was not putting more money into such ideas – Blue star, concor, Pidilite etc.
I just finished reading the book – A demon of our own design. I am not going ga ga over it. However it is a good book. This book came out 6-8 months back and is fairly presceint of the current subprime crisis. The book discusses the past crises like the 1987 US market crash and the LTCM collapse. One key point the author makes is that the main cause of the market crises is tight coupling and complexity.
Complexity in the markets is mainly due to the complex instruments such as CDO, derivatives etc which very few understand. In addition these instruments are non linear and it is diffcult to model them. That’s why a lot of the companies holding these instruments are not able to compute their value and appear clueless. By tight coupling the author means is refering to the linkages between companies and markets. That is easy to see even in India. 10 years back a subprime crisis would not have affected the Indian markets. However inspite of no direct exposure, indirect linkages via hedge funds and FII are causing these wild swings in the market. All in all a decent book.
I am a big fan of warren buffett and have read his annual reports several times. He purchased a company called GenRe in 1999 and wound down their derivative operations over 3-4 years. This was done during normal times and by one of the smartest investors around. Inspite of that the company took 400Mn or higher writedowns. Buffett noted in his letter then (2002 I think) that inspite of such orderly and planned unwinding, they faced such losses for such a small derivative operation. The larger banks (read citi, JP morgan and others) may face much higher losses if they have to unwind their derivatives during a market crisis (now).
So personally I think market problems are far from over and we may get more buying opportunities in the future. Will the market crash or will it be a bear market?? ..i don’t know. Either way I think it would be good to keep some cash around to take advantage of opportunities as they come up.
One could have made a killing shorting the market or by buying puts. I however did none of that. I personally need to do more homework in that area to venture into it. However I do see puts as a decent option to hedge the portfolio. The part I still need to work out is this -
Most options expire worthless. The reason is that the options market is fairly efficient, definitely more than straight equity. So is it possible to buy puts over the long term, make money a few times only and still have a decent return after all the costs ?
Some of my own holdings, some of which I have discussed (and some not), have declined below 50% of intrinsic value. Earlier I would get mixed feeling – pained by the decline and excited by the opportunity to buy more. Now I get more excited than pained. I however try to re-analyse the position and check if I have missed something which the market is discounting. In the past my key mistake was not putting more money into such ideas – Blue star, concor, Pidilite etc.
I just finished reading the book – A demon of our own design. I am not going ga ga over it. However it is a good book. This book came out 6-8 months back and is fairly presceint of the current subprime crisis. The book discusses the past crises like the 1987 US market crash and the LTCM collapse. One key point the author makes is that the main cause of the market crises is tight coupling and complexity.
Complexity in the markets is mainly due to the complex instruments such as CDO, derivatives etc which very few understand. In addition these instruments are non linear and it is diffcult to model them. That’s why a lot of the companies holding these instruments are not able to compute their value and appear clueless. By tight coupling the author means is refering to the linkages between companies and markets. That is easy to see even in India. 10 years back a subprime crisis would not have affected the Indian markets. However inspite of no direct exposure, indirect linkages via hedge funds and FII are causing these wild swings in the market. All in all a decent book.
I am a big fan of warren buffett and have read his annual reports several times. He purchased a company called GenRe in 1999 and wound down their derivative operations over 3-4 years. This was done during normal times and by one of the smartest investors around. Inspite of that the company took 400Mn or higher writedowns. Buffett noted in his letter then (2002 I think) that inspite of such orderly and planned unwinding, they faced such losses for such a small derivative operation. The larger banks (read citi, JP morgan and others) may face much higher losses if they have to unwind their derivatives during a market crisis (now).
So personally I think market problems are far from over and we may get more buying opportunities in the future. Will the market crash or will it be a bear market?? ..i don’t know. Either way I think it would be good to keep some cash around to take advantage of opportunities as they come up.
Seesaw markets,my plans, a good book and market crisis
The month of jan was a complete rollcoaster. Initially the market shotup, then crashed and now seems to go one step forward and one step backward.
One could have made a killing shorting the market or by buying puts. I however did none of that. I personally need to do more homework in that area to venture into it. However I do see puts as a decent option to hedge the portfolio. The part I still need to work out is this -
Most options expire worthless. The reason is that the options market is fairly efficient, definitely more than straight equity. So is it possible to buy puts over the long term, make money a few times only and still have a decent return after all the costs ?
Some of my own holdings, some of which I have discussed (and some not), have declined below 50% of intrinsic value. Earlier I would get mixed feeling – pained by the decline and excited by the opportunity to buy more. Now I get more excited than pained. I however try to re-analyse the position and check if I have missed something which the market is discounting. In the past my key mistake was not putting more money into such ideas – Blue star, concor, Pidilite etc.
I just finished reading the book – A demon of our own design. I am not going ga ga over it. However it is a good book. This book came out 6-8 months back and is fairly presceint of the current subprime crisis. The book discusses the past crises like the 1987 US market crash and the LTCM collapse. One key point the author makes is that the main cause of the market crises is tight coupling and complexity.
Complexity in the markets is mainly due to the complex instruments such as CDO, derivatives etc which very few understand. In addition these instruments are non linear and it is diffcult to model them. That’s why a lot of the companies holding these instruments are not able to compute their value and appear clueless. By tight coupling the author means is refering to the linkages between companies and markets. That is easy to see even in India. 10 years back a subprime crisis would not have affected the Indian markets. However inspite of no direct exposure, indirect linkages via hedge funds and FII are causing these wild swings in the market. All in all a decent book.
I am a big fan of warren buffett and have read his annual reports several times. He purchased a company called GenRe in 1999 and wound down their derivative operations over 3-4 years. This was done during normal times and by one of the smartest investors around. Inspite of that the company took 400Mn or higher writedowns. Buffett noted in his letter then (2002 I think) that inspite of such orderly and planned unwinding, they faced such losses for such a small derivative operation. The larger banks (read citi, JP morgan and others) may face much higher losses if they have to unwind their derivatives during a market crisis (now).
So personally I think market problems are far from over and we may get more buying opportunities in the future. Will the market crash or will it be a bear market?? ..i don’t know. Either way I think it would be good to keep some cash around to take advantage of opportunities as they come up.
One could have made a killing shorting the market or by buying puts. I however did none of that. I personally need to do more homework in that area to venture into it. However I do see puts as a decent option to hedge the portfolio. The part I still need to work out is this -
Most options expire worthless. The reason is that the options market is fairly efficient, definitely more than straight equity. So is it possible to buy puts over the long term, make money a few times only and still have a decent return after all the costs ?
Some of my own holdings, some of which I have discussed (and some not), have declined below 50% of intrinsic value. Earlier I would get mixed feeling – pained by the decline and excited by the opportunity to buy more. Now I get more excited than pained. I however try to re-analyse the position and check if I have missed something which the market is discounting. In the past my key mistake was not putting more money into such ideas – Blue star, concor, Pidilite etc.
I just finished reading the book – A demon of our own design. I am not going ga ga over it. However it is a good book. This book came out 6-8 months back and is fairly presceint of the current subprime crisis. The book discusses the past crises like the 1987 US market crash and the LTCM collapse. One key point the author makes is that the main cause of the market crises is tight coupling and complexity.
Complexity in the markets is mainly due to the complex instruments such as CDO, derivatives etc which very few understand. In addition these instruments are non linear and it is diffcult to model them. That’s why a lot of the companies holding these instruments are not able to compute their value and appear clueless. By tight coupling the author means is refering to the linkages between companies and markets. That is easy to see even in India. 10 years back a subprime crisis would not have affected the Indian markets. However inspite of no direct exposure, indirect linkages via hedge funds and FII are causing these wild swings in the market. All in all a decent book.
I am a big fan of warren buffett and have read his annual reports several times. He purchased a company called GenRe in 1999 and wound down their derivative operations over 3-4 years. This was done during normal times and by one of the smartest investors around. Inspite of that the company took 400Mn or higher writedowns. Buffett noted in his letter then (2002 I think) that inspite of such orderly and planned unwinding, they faced such losses for such a small derivative operation. The larger banks (read citi, JP morgan and others) may face much higher losses if they have to unwind their derivatives during a market crisis (now).
So personally I think market problems are far from over and we may get more buying opportunities in the future. Will the market crash or will it be a bear market?? ..i don’t know. Either way I think it would be good to keep some cash around to take advantage of opportunities as they come up.
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