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About Jim Walker

Jim Walker has been a member since November 8th 2010, and has created 696 posts from scratch.

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How Can You Use Options to Protect Your Investment Portfolio?

The stock market has had a long bull run and now is in danger of a major correction. We have written about how to deal with this possibility in our articles about safe investment niches, if you want to buy gold, and how you might switch your investment focus from growth to value. Today, we would like to look at another approach. How can you use options to protect your investment portfolio?

The Use of Options in Investing

Stock options can be useful in getting into an investment, providing a little extra income along the way, and protecting your investment. The tools of options trading are call and put contracts.

Buying Call Options

Call options can provide a cheap entry into a stock position. How do call options work? Our sister site, discusses calls and puts.

A call contract gives the buyer the option to purchase the underlying equity which he will do if the equity price moves in the direction anticipated. A call contract confers an obligation on the seller (writer) of the call option to sell the underlying equity if the buyer executes the contract.

If you the investor expect that a given stock is going to go up in price you may choose to buy a call option on that stock. This option gives you the right to purchase the stock as the contract price, called the strike price, no matter how high the stock price goes. The beauty of the call option is that if the stock price does not go up or even goes down your losses are limited to the price of the options contract. This fact makes call options a valuable tool in a volatile market.

Selling Call Options

If you own a very stable stock it is possible to make extra money by selling call options on that stock. The buyer will believe that the stock price will go up and will pay you a premium to have the right to purchase from you when that happens. If you believe the stock will remain stable and not go up then you can sell call options and make extra money. In the end the option contract will expire, you will still own the stock, and you will make a profit. For more info on this idea, look at the article, how to write a covered call.

Buying Put Options

This gets back to our original question. How can you use options to protect your investment portfolio? Do you think that the bull market has run its course and is in danger of a big correction? Do you also believe that not all stocks will fall and that timing a correction is difficult to do? Then you may wish to protect your gains in one or more stocks by buying puts. A put option gives the buyer the right to sell a stock at the contract or strike price no matter how far the price falls. If the stock does not correct you will have paid a premium for the contract and may consider that to be insurance against potential loss.

What Affects the Current Value of an Investment?

We have written at length about determining intrinsic stock value as a guide to value investing. But, what affects the current value of an investment? How can the current value of an investment vary over time? Along this line of reasoning Bloomberg writes about how stocks today do not seem to reflect the improving economy and earnings.

Neither this year’s impressive corporate earnings results nor the synchronized pickup in global growth nor record levels of stock buybacks by companies has led to impressive gains in stocks.

The performances of the Dow and the S&P suggest the improvement in economic and corporate fundamentals has been accompanied by a de-risking illustrated most vividly by the decline in market price-to-earnings ratios.

The point of the article is that despite better earnings, stocks have leveled off. Regarding what affects the current value of an investment, the author says that positive earnings were already priced into the market, investors are worried about sustainability of profits, and the Federal Reserve backing off its easy money policy is a headwind for rising stock prices.

The Basis of Intrinsic Value

Value investing is based on intrinsic value assessment and repeated re-assessment. The intrinsic value of any investment is based on future earnings. A strong product line, few competitors in its sector, and R&D that produces new and profitable products are all positives for intrinsic value. A failing economy, high interest rates, and social or political unrest are negative factors. The current stock market rally started as a recovery from the depths of a crash and then continued based on strong earnings. But now, as earnings continue, stock prices are leveling off and have even show evidence of a significant correction. If earnings are still strong then it would seem that societal factors, the prospect of higher interest rates, and political issues are at fault.

Value Instead of Growth

If you have decided to switch your investment focus from growth to value, where do you find and how do you calculate value?

Value stocks are often not ones favored by current market sentiment. Investing novices too often look at what has appreciated recently and assume that the same stock or other investment will continue on its upward course. The history of market bubbles and collapses over the decades is clear proof that this approach does not work. If you are a student of the markets and want to both make a profit and sleep soundly at night, switch your investment focus from growth to value before the market teaches you a painful lesson.

The best profits are often gained when you invest early in a company that has invented or learned how to monetize a new technology. Those investments can also turn around and bite you when someone else enters the market niche with a better approach or simply invents a new technology that replaces the old. If you are looking for a safe investment you will look for products that will predictably remain strong in their markets for years and decades to come. For example, people have been drinking Coca Cola, eating Snickers Bars, and cleaning with Clorox for a long, long time. The current value of investments in Coca Cola and similar companies will be predictable and less likely to lead to losses the negative factors hit the markets.

Do You Use a System for Investing?

Investors are always on the lookout for profitable investment opportunities. And a profitable investment tip may make the difference between a dismal investment portfolio and a stellar one. But, profitable investing tips may require some work before you can put them to use. Do you use a system for investing? You should because that is how you can sort out good tips from bad and pick the best opportunities. Years back we wrote about investing tips.

The best investing tips commonly have to do with how to go about the business of investing. Specific investing tips from your broker, your best friend, investment advisors, or news sources should be investigated by both fundamental analysis and technical analysis before they are acted upon. The problem with second hand investing tips is that they are often yesterday’s news. The market has already acted upon them and driven the stock price up. The best of all investing tips usually come from successful investors and are general in nature. Successful investors like to buy at bargain prices. Successful investors commonly sell stocks and get out of the market when it does not make sense.

Stock investors use fundamental analysis and technical analysis to pick stocks to buy and sell. Long term value investors primarily use fundamental analysis to determine intrinsic stock value and let that be their guide. Short term investors use technical analysis of the market to profit from trends, both up and down. Which system do you use for investing? What are the strong and weak points of each approach?

Value Investing

The first system for investing is to assess the long term value of the investment. There are investors who have used the principles of value investing to become very wealthy. This approach requires patience and the ability to keep your money in an investment for many years. Last year we asked how many years are required to make an investment long term to qualify for true buy and hold investing.

Calculating intrinsic stock value takes into account the long term. If a company shows long term promise its intrinsic value may well exceed its market value and it is a stock to buy and hold. Then, to take advantage of the market you need to hold the stock for a decade or more in order to see the long term benefits of buy and hold investing.

If your system is to calculate intrinsic value you will buy and hold stocks with the promise of a healthy income stream for years to come. You can apply this approach to any given stock tip to pick the winners and ignore the losers.

The down side of long term value investing is that if you need your money for an emergency or an expected expense like a child’s college education you may well end up pulling money out of the investment during a down market and lose money.

Technical Analysis and Short Term Investing

The second system of investing is to use statistical analysis to predict and profit from temporary swing in the market. Short term investment and even day trading both allow you to avoid the problem of having to pull money out of a down investment. This is because you mostly hold cash and only buy and sell when the market presents an opportunity.

There are two things a person may be looking for in a short term investment. One is a place to park their money that is safe and pays better than a bank savings account. The other is a way to profit from the ups and downs of the stock market. The first just has to do with checking out interest rates on T Bills, CD’s, and other short term debt instruments. The second is where technical analysis tools such as Candlestick pattern formations can help a person to trade stocks and make a substantially better profit than the bank offers or even what one can gain from long term investing.

In this case when you are presented with an investing tip you will not look at fundamentals. You will look at market price patterns and buy or sell for the short term in search of profits. The down side of this approach is that no one is perfect at market timing. Thus you will miss out on opportunities and also lose money at times by making poor choices. On the other hand, when you choose correctly you may make the same profit in a couple of days that a long investor will need to wait years for!

In either case, the point is to use a system. Modify your system as needed. And always use your system to avoid falling into the twin traps of greed and fear that torpedo so many investors.

Will Selling Starbucks Coffee Help Nestle?

Nestle just paid Starbucks $7.15 Billion for the right to sell Starbucks coffee worldwide. The question is, will selling Starbucks coffee help Nestle? Reuters reports on the global coffee alliance.

The deal on Monday for a business with $2 billion in sales reinforces Nestle’s position as the world’s biggest coffee company tries to fortify its place atop a fast-changing market.

It is a bold stroke by new Nestle Chief Executive Mark Schneider, who has made coffee a strategic priority as he tries to convince uneasy shareholders, including activist Third Point, that he can boost the sprawling group’s performance.

Bernstein analyst Andrew Wood said that Nestle’s third-biggest acquisition would allow the Swiss company to expand the brand through its global distribution network.

Nestle shares rose 1.4 percent by mid-session, having fallen by more than 8 percent so far this year. Starbucks stock was indicated 2.8 percent higher.

Nestle is the largest food company in the world with operations in 186 countries. Its roots go back to the 19th century and sales of condensed milk and infant formulas. Today Nestle has the sort of problems commonly seen in old, well established companies. They do not have a lot of room to grow. As such there is always the risk of activist shareholders looking to break up the company to “create value of stockholders.” Thus Nestle is looking to expand its already huge coffee product line with the Starbucks brand. Starbucks is perhaps the most recognized high end coffee name in the world. Will selling Starbucks coffee help Nestle? The market thinks so, as the stock edged up a percent or so.

Is Nestle a Good Investment?

Last week we wrote about what to look for in value investing.

Investors like Warren Buffett look for companies whose products and business plans are easy to understand. And they look for companies that are reliably going to be making money with those products and business plans 5 and 10 years in the future. Buffett famously explained that he did not know what a given tech product would be worth 5 years hence in a fast evolving tech world. But he did have a pretty good idea what a Snickers bar would be worth! Value investments have two characteristics, intrinsic value and margin of safety.

Nestle certainly seems to be a secure investment and perhaps a good one if the tech darlings take a hit in the near future. In that case investors will flock to companies like Nestle for security and thereby drive up their stock prices. But what do you get out of investing in Nestle? After a ten for one stock split in 2008 the company traded at $43 a share. At the end of 2017 it traded briefly for $85 a share before dipping back into the $70 range. News of the Starbucks deal has lifted the stock by $2 a share. In short the stock price has gone up by about 70% in the last ten years and the company has paid a dividend of around 3%. During this time the S&P 500 has doubled.

The argument can be made that Nestle was not a good investment coming out of the market crash of 2008 and the Great Recession. However, let’s look at how Nestle compared to the S&P 500 going into the 2008 crash. In October of 2007 the S&P 500 was above 1500 and it lost half its value when the market bottomed out in March of 2009. Allowing for the 2008 stock split, Nestle lost a couple of percent of its stock value at most during the crash.

Nestle is a secure stock that is likely to grow slowly over the years and has a huge margin of safety in the event of a market crash.

What to Look for in Value Investing

As the bull market ages and becomes more volatile many investors are starting to hedge their bets. For some this simply means selling and holding on to cash for the time being. For others it has to do with re-balancing their investment portfolios. More and more we hear that it is time to switch over from a focus on growth and move to value investing. This is probably good advice but how do you do that? Today we consider what to look for in value investing.

Value Investing

Years ago we wrote about value investing for long term profits.

There is always a degree of market inefficiency due to lack of information, poor information, or market psychology. And the market eventually discovers the true value of any given stock as fundamental analysis comes to the fore. Investors who study the fundamentals to discover the intrinsic value of a stock and its margin of safety will tend to profit in the long term. But, what are the tools that one must use in value investing for long term profits?

Investors like Warren Buffett look for companies whose products and business plans are easy to understand. And they look for companies that are reliably going to be making money with those products and business plans 5 and 10 years in the future. Buffett famously explained that he did not know what a given tech product would be worth 5 years hence in a fast evolving tech world. But he did have a pretty good idea what a Snickers bar would be worth! Value investments have two characteristics, intrinsic value and margin of safety.

Look for a Margin of Safety in a Value Investment

Finding the margin of safety of a stock is the first thing to look for in value investing.

The most reliable margin of safety of a stock is money in the bank and no debt. Next is ownership of real estate, factories, and more unencumbered by mortgages. Years ago when Sears broke up it was essentially a penny stock until investors realized the value of its real estate holdings! The same has been true of railroads, steel mills, and companies in the oil and gas industry.

Apple is good case in point. When Steve Jobs came back to Apple he had to go hat in hand to Bill Gates to get a loan to keep Apple afloat. When the company made its comeback Jobs was adamant about Apple keeping a huge cash reserve in case of a rainy day. Periodically Apple buys back stock with its cash reserve but it still keeps a substantial amount of money on hand. The first thing to look for in value investing is a margin of safety.

Intrinsic Value in Investing

We often refer to our article about intrinsic stock value.

The dictionary definition of intrinsic stock value is its fundamental value. It is obtained by adding up predicted future income of a stock and subtracting current price. It can also be seen as actual value of an equity versus its book value or market value.

Read the article for the formula for calculating intrinsic value. Determining intrinsic value is being able to predict that people will be paying for Snickers bars in ten years at the same time that they will quit buying one tech product and switch to another.

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