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Playing The "Long Stock/Short S&P" Hedge: How To Invest In Fundamentally Robust, Undervalued Stocks, While Minimizing The Broader Market Directional Risk...
By Shiraz Lakhi - Self Directed Trader/Publisher
For the trader who wants to advance beyond outright speculation via 'long only' or 'short only' stock positions, and at the same time, insulate his/her position against the broader market risk (major corrections, stock market crashes, sustained negative sentiment), there is a trading strategy, practiced by some of the more astute hedge funds and quant trading desks, which allows the trader to 'neutralize' much of this 'directional' risk...
The strategy involves taking a 'long' position in a stock the trader believes will increase in value (for instance, a potentially undervalued company exhibiting a significantly high free-cash-flow-yield, relative to industry), while taking a simultaneous 'short' position in the S&P index (SPY)...
More popularly termed pairs trading, this particular strategy (long the stock and short the S&P) wagers on the stock 'outperforming' the S&P 500 index. The investor is not concerned about whether the selected stock will move up or down, but how it will do relative to the overall market (S&P).
By entering a long position in stock X, which exhibits strong fundamentals, and at the same time, entering a short position in the S&P index, in exactly the same dollar value (in other words, if you enter long $30,000 XYZ stock, you would short $30,000 SPY), you have established a 'dollar-neutral' market-hedged position, and more critically, significant insulation against the broader market risk...
For stocks which are fundamentally undervalued, such as the businesses exhibiting robust operating-yields, regularly alerted in my stock trading idea articles, and blogs, I always - as a rule - hedge the stock, using the S&P 500 ETF (symbol: SPY). Effectively, no matter which way the overall market moves - whether it corrects, crashes or rallies, direction is of no importance. As a pairs trader, my single point of focus is purely whether stock X will outperform the S&P. The objective is, over time, the fundamentally superior stock tends to outperform the market.
Wishing you every success in your trading... and good spirit... Shiraz Lakhi - Self Directed Trader/Publisher
Think Like An Investor: Whether Investing For The Short, Medium, Or Long Term, Always Remember, You Are Buying A 'Partnership' In A Business...
By Shiraz Lakhi - Self Directed Trader/Publisher
As an investor, it is
good to remind yourself from time to time, that you
are ‘owning’ a part of a business. As elementary as it sounds, many
technical traders often overlook this basic premise. No matter if
you are investing or trading in a stock for the short,
medium or long term, as a proprietor of a business, it is essential
to ‘think’ like an investor. Ignorance is not bliss.
Both technical analysis (use of charts, indicators, overlays) and fundamental analysis (study of company income statements & balance sheets) are both equally, a form of ‘forecasting and prediction’. There is no ‘one method is better than the other’ – a dualistic argument often borne out of the positional need ‘to be right’ rather than objective. At some point, all investors, whether they adopt a technical approach, fundamental, or a healthy mix of both, will need to venture out, and ‘take a chance’…
In other words, the question comes up, ‘will the investment pay off?’. In order to make an objective decision, in many of my investments, I like to know some basic, fundamental facts about the company I am investing in (this process occurs before applying any technical analysis), however short term the investment…
The starting point is to keep a clear, systematic/disciplined attitude. Understand the business you are investing in. When Warren Buffett talks about investing in businesses he “understands”, this is exactly what he means. First and foremost, pick businesses which you recognize, and know (in a general sense) the product or service the company produces and markets. Find companies you understand – businesses which produce a product you likely use yourself (Apple, Microsoft, Dell, Starbucks, Netflix, Disney, Coca Cola, Amazon, Gap, etc.). Think the ‘quality’ Apple products deliver, or the ‘convenience’ Amazon and Netflix deliver, or this seasons original and 'must-have' lines launched by Gap...
Next, become the part-time accountant. this is not as hard and draining as the myth projects. Break a business down into the nuts and bolts, using readily available data. At the very basic, fundamental level, a company exists to develop and market a product or service, and to make money. In order to do this, it has to price the products competitively (where uniqueness, patents and rights have a direct bearing), and to sell it in the free market. This creates ‘revenue’, from which ‘costs of production’ are discounted, and all other ‘running costs’ of the business, including capital expenditure (or capex), needed to renew plant, machinery and property, are discounted, to produce a ‘cash profit’.
The final result, in very simply terms, is what is known as “free cash flow”. And this simple metric is readily available within the cash flow statement of every listed company/stock. For instance, take a look at the Cash Flow Statement for Apple stock (symbol: AAPL). The free-cash-flow, which is the “Net Cash From Operating Activities” minus “Capital Expenditures”, nets $19 Billion in the last 12 months, ending 31st March 2011. This tells us that, after all is said and done, Apple Inc., produced a true profit on all it's core operational activities (after taking out running capital expenditures) of $19 Billion. You can check the 'free-cash-flow' for any company which produces a profit, using the same systematic two step method.
Next, you need to figure out the 'yield' that the company offers. This will tell you the 'percentage' return the company generates in profits, relative to the overall worth (value) of the business. The higher the percentage yield, the stronger the business you are investing in...
To calculate the
'yield' (also know as the 'free-cash-flow-yield'), you divide free-cash-flow
(FCF) by
the ‘value’ of the business. So, if company A is ‘worth’ $250
Billion, with an FCF of $19 Billion, the ‘yield’ is 7.6% (19/250).
Similarly, if company B is ‘worth’ $100 Billion, with an FCF of $10
Billion, the ‘yield’ is 10% (10/100), and so on. Yield is the key…
You have seen an example of how to calculate the ‘Free-Cash-Flow’
figure for any company, using the cash-flow statement (from the AAPL
example provided above). You also know how to work out the
‘yield’, by dividing FCF by the ‘value’ of the company. Many investors simply use the
‘market capitalization’ figure as a value figure. This is
acceptable, however, there is a more accurate measure, also
freely available, which reflects the true worth of a business. This
is known as the ‘enterprise-value’…
By taking the market capitalization value of a
business, then adding the debt, and subtracting the total cash,
you get a more exact reflection of what the business is genuinely
‘worth’, and more crucially, what a potential acquirer would
theoretically consider paying for the business. Think about this. A
potential buyer of the company would not pay the market cap, but
would have to also pay for any debt the company has outstanding,
minus keeping any cash.
When investing in a company, I always – as a rule - use the ’free-cash-flow-yield’ as my starting point. My stock screen starts by looking at companies with a minimum market cap of $50 million, and a minimum free-cash-flow-yield of 10%. This basic, pre-market screening process narrows down an initial 1,500 stocks, to around 30-40 stocks I focus on.
From the short list, I look for solid, well managed, innovative businesses, operating within a growth market, which have, due to broader negative sentiment, become in my view, ‘temporarily’ undervalued. This narrows down the field further to around 10-15 companies, which I invest in, using technical analysis based entry timing signals.
As an investor I am certainly not against technical analysis per se. What I take issue with, is the ‘pure’ dependence on technical indicators as a solitary means in making key trading decisions. Technical analysis comes into play in my own trading, purely as a means to better ‘time’ my entries into the already pre-selected list of 'fundamentally' superior, temporarily undervalued stocks…
Wishing you every success in your trading... and good spirit... Shiraz Lakhi - Self Directed Trader/Publisher
Price/Free-Cash-Flow Vs. Price/Earnings: How To Measure The True Operational Performance Of A Business, And It's Ability To Generate Cash (Profits)...
By Shiraz Lakhi - Self Directed Trader/Publisher
Many traders and investors are already familiar with the popular, but 'questionable' Price-to-Earnings (P/E) ratio, which provides some instantaneous/convenient measure of how the earnings compare to the market capitalization of a company...
For instance if the market cap of a company is $10m, and the earnings for the year are $1m, then the P/E ratio is 10 (market cap/earnings, identical to the P/E). The P/E ratio for one company can then be compared with the P/E ratio of other competing businesses in the same sector/industry in an effort to discover 'undervalued' or 'overvalued' stocks.
The problem with the P/E ratio is that the very basis upon which it is built is, in the opinion of experienced investors, significantly flawed. More sophisticated and astute analysts have learnt much from history, where companies (Enron springs to mind) and their creative accountants, purposely engineer and distort the 'earnings' by (mostly perfectly legal, but still questionable) manipulation of certain accounting tactics, whereby a true reflection of the operational efficiency (cash profits) of the business can be grossly hidden from the 'earnings' figure alone...
Relying only on the much touted 'earnings' data carries considerable risk for investors. In order to mitigate this, there is of course, a more recent version of earnings, known as EBITDA (Earnings before Interest, Tax, Depreciation & Amortization). This metric has become popular, aimed at replacing the over-simplistic 'earnings' data, but again, the EBITDA also contains various noted flaws and does not remove the risk of questionable accounting...
This is why, the only true, untainted, reflection of profit, is via the 'free-cash-flow' (FCF). The FCF is the actual 'booked' profit generated by a business, based on it's core 'operations'. this simple metric is readily available within the cash flow statement of every listed company/stock. For instance, take a look at the cash flow statement for Apple stock...
The free-cash-flow, which is the “net cash from operating activities” minus “capital expenditures”, nets $19 Billion in the last 12 months, ending 31st March 2011. This tells us that, after all is said and done, Apple Inc., produced a 'true profit' on all it's core operational activities (after taking out running capital expenditures) of $19 Billion. This is equivalent to around $20.62 per share. The price/free-cash-flow ratio is hence the current share price for Apple ($320.26) divided by the free-cash-flow-per-share ($20.62), resulting in a P/FCF ratio of 15.5.
The 'lower' the P/FCF, the higher 'value' the investment potentially offers. Astute investors seeking positive medium-long term returns, look for companies with a P/FCF ratio of less than 10, as a key 'starting point', for additional analysis into each qualifying business, seeking out further positive metrics such as a low PEG ratio, entrepreneurial management, low price/book value, positive consensus analyst targets, insider/institutional (smart money) buying, and strongly bullish technical buy signals.
Wishing you every success in your trading... and good spirit... Shiraz Lakhi - Self Directed Trader/Publisher
About the author: Shiraz Lakhi is an independent investor, writer, and founder of free stock analysis/screening site tradepilot.com.
You can follow Shiraz Lakhi's trade alerts, posted live on stocktwits.com/tradepilot, and shirazlakhi.com (free real-time trade ideas). All information, knowledge and trade ideas are disseminated completely free. Numerous educational articles, with a combination of fundamental & technical analysis, are regularly submitted by Shiraz Lakhi at Seeking Alpha, including core free-cash-flow-yield based ideas. In addition, you may join and participate in productive, advanced trading groups selected by Shiraz Lakhi, via LinkedIn, and at twitter.com/tradepilot.
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