Tuesday, August 21, 2007

Paper Trade Followup

This is a followup on the paper trade experiment started last month. There were two paper trades for EBAY & WLL, one a front month (Aug) covered call (CC) and one a second month (Sep) CC. Here are the results for the Aug positions.

EBAY - Paper Trade #1 (Aug)

The Aug 32.50 Call was in-the-money (ITM) on Friday so this position would have been called away for a profit. This ends this paper trade.

Stock Investment: $3,258.00
Income Generated: $94.00
Net Profit If Called: $86.00
Percent Return: 2.64%
Annualized Return: 45.88%
Duration of Trade: 21 days

Trade History:

27-Jul-07 - Initial Stock Position - BTO 100 EBAY @ 32.58
27-Jul-07 - Initial Call Option - STO 1 Aug07 32.50 Call @ 0.94

EBAY - Paper Trade #2 (Sep)

27-Jul-07 - Initial Stock Position - BTO 100 EBAY @ 32.58
27-Jul-07 - Initial Call Option - STO 1 Sep07 32.50 Call @ 1.64

Stock Investment: $3,258.00
Income Generated: $164.00
Percent Income Generated: 5.03%
Annualized Income Generated: 32.81%
Net Profit If Called: $156.00
Percent Return If Called: 4.79%
Annualized Return If Called: 31.21%
Days to Expiration: 56 days

EBAY - My Real Position

27-Jul-07 - Initial Stock Position - BTO 100 EBAY @ 32.95
27-Jul-07 - Initial Call Option - STO 1 Sep07 32.50 Call @ 1.84

Stock Investment: $3,294.50
Income Generated: $184.00
Percent Income Generated: 5.59%
Annualized Income Generated: 36.40%
Net Profit If Called: $139.50
Percent Return If Called: 4.23%
Annualized Return If Called: 27.60%
Days to Expiration: 56 days

WLL - Paper Trade #1 (Aug)

The Aug 70 Call was out-of-the-money (OTM) in Friday so it would have expired worthless. A new Sep 70 Call was sold using the open price on Monday.

20-Aug-07 - Continued Trade - STO 1 Sep07 40.00 Call @ 1.99 -

Stock Investment: $4,164.00
Income Generated: $433.00
Percent Income Generated: 10.40%
Annualized Income Generated: 67.78%
Net Profit If Called: $269.00
Percent Return If Called: 6.46%
Annualized Return If Called: 42.11%
Days to Expiration: 56 days

Trade History:

27-Jul-07 - Initial Stock Position - BTO 100 WLL @ 41.64 -
27-Jul-07 - Initial Call Option - STO 1 Aug07 40.00 Call @ 2.34 - Expired
20-Aug-07 - Continued Trade - STO 1 Sep07 40.00 Call @ 1.99 -

WLL - Paper Trade #2 (Sep)

27-Jul-07 - Initial Stock Position - BTO 100 WLL @ 41.64
27-Jul-07 - Initial Call Option - STO 1 Sep07 40.00 Call @ 2.99

Stock Investment: $4,164.00
Income Generated: $329.00
Percent Income Generated: 7.90%
Annualized Income Generated: 51.50%
Net Profit If Called: $165.00
Percent Return If Called: 3.96%
Annualized Return If Called: 25.83%
Days to Expiration: 56 days

WLL - My Real Position

27-Jul-07 - Initial Stock Position - BTO 100 WLL @ 41.02
27-Jul-07 - Initial Call Option - STO 1 Sep07 40.00 Call @ 2.99

Stock Investment: $4,102.00
Income Generated: $299.00
Percent Income Generated: 7.29%
Annualized Income Generated: 47.51%
Net Profit If Called: $197.00
Percent Return If Called: 4.80%
Annualized Return If Called: 31.30%
Days to Expiration: 56 days

For EBAY, the Aug CC produced a better annualized return, but lower dollar profit then the potential for the Sep CC. One criteria that I use is the amount of profit in dollars. I prefer to make at least $100 profit per position. Since the Aug CC offered less than $100 profit, I chose the Sep CC for my "real" position.

For WLL, because the Aug call expired and a new Sep call was sold, the potential annualized return and dollar profit is greater than the original Sep paper trade. So, in this case the Aug CC would have been the better choice, in hindsight. However, the original dollar profit was also below my $100 limit, so again I chose the Sep CC for my "real" position.

This proves that front month calls usually offer a better annualized return, but I already knew that. However, the further out calls offered more initial downside protection when measured in dollars (i.e. a lower cost basis). Either choice provides good returns so it comes down to how much downside protection you feel more comfortable with. There's no right or wrong here. You should do what you're most comfortable with. Don't get greedy and just look at the potential returns, think about risk also, and decide which is better for YOU!

Monday, August 20, 2007

Taking a Loss

Well, it finally happened. I sold two positions at a loss today, since the company fundamentals no longer met my criteria. These are the first losing positions I've had in over two years of covered call trading, but it was the right thing to do according to my trading plan.

As my knowledge of value investing and how to analyze a company improves, my criteria for "What to Buy" has evolved, thanks in part to F Wall Street. After reading their analysis of Johnson & Johnson, and the accompanying spreadsheet, I began to look more closely at the company balance sheet, cash flow sheet, and key ratios.

I've also thought more about "When to Sell". As stated in my previous article on the subject, I'll only sell a losing position if/when the company fundamentals no longer meet my criteria. That's what happened to the two positions I sold for a loss today. After writing that article, I went back to re-analyze all of my current positions using my new spreadsheet, which is modeled after the one from F Wall Street.

The following explains why I sold each of these positions.

AMD

I established this position in Jan07 since it met my criteria at that time. When I looked at AMD now, using my new fundamental analysis spreadsheet, I was surprised to see that it didn't meet any of my fundamental criteria. So, obviously either my previous criteria wasn't robust enough or I was asleep at the wheel when I established this position.

If you look at the spreadsheet for AMD, you'll see that the company has negative free cash flow, and negative returns. Now, compare that with the spreadsheet for INTC, which is their major competitor. It's like night and day. Clearly, INTC has a competitive advantage over AMD and is much more profitable, generating a lot of free cash flow and double digit returns. It's pretty much a no-brainer when you compare these spreadsheets.

So, obviously I made a mistake in establishing this position, therefore the decision to sell, even at a loss, is the right thing to do.

PALM

I established this position Apr06, again because it met my criteria at that time. The fundamentals aren't as bad as AMD, however, they aren't that good either. But the main reason for selling this position is that PALM is losing it's competitive advantage to its competitors, like MOT.

Again, comparing the spreadsheets on PALM and MOT you can see that PALM is not doing as well as MOT. They've lost market share, which is affecting their profitability and the prospects going forward don't look too good.

So again, the decision to sell, even at a loss, is the right thing to do.

Conclusion

Now, I could have held these positions, and eventually exited at a profit, for the sake of keeping my winning streak intact, but that would have been an emotional response. But this is not about emotions or my ego, it's about making the right decision according to my trading plan. No emotion, no regret, just follow the plan.

You can be sure that going forward I'll be more careful in my analysis of company fundamentals, so, hopefully, mistakes like this should be rare. Everyone makes mistakes, but it's how you deal with them that matters. It's better to admit a mistake and learn from it then to bury your head in the sand and deny it. The most important thing to remember is to make sure you gain from the experience. No one wants to learn the hard way, but you learn more from your mistakes than from watching or reading about others. Mistakes are an inevitable part of life, so you better learn the right way to deal with them. This will not only make you a better person, it will also make you a better investor.

XTO - New Position

A new position was established today on XTO. The following is the trade information, including IB commissions:

20-Aug-07 - Initial Stock Position - BTO 100 XTO @ 54.31
20-Aug-07 - Initial Call Option - STO 1 Sep07 55.00 Call @ 2.04

Stock Investment: $5,431.00
Income Generated: $204.00
Percent Income Generated: 3.76%
Annualized Income Generated: 42.84%
Net Profit If Called: $273.00
Percent Return If Called: 5.03%
Annualized Return If Called: 57.34%
Days to Expiration: 32 days

WSM - New Position

A new position was established today on WSM. The following is the trade information, including IB commissions:

20-Aug-07 - Initial Stock Position - BTO 100 WSM @ 32.17
20-Aug-07 - Initial Call Option - STO 1 Sep07 30.00 Call @ 3.20

Stock Investment: $3,217.00
Income Generated: $320.00
Percent Income Generated: 9.95%
Annualized Income Generated: 113.46%
Net Profit If Called: $103.00
Percent Return If Called: 3.20%
Annualized Return If Called: 36.52%
Days to Expiration: 32 days

RS - New Position

A new position was established today on RS. The following is the trade information, including IB commissions:

20-Aug-07 - Initial Stock Position - BTO 100 RS @ 46.23
20-Aug-07 - Initial Call Option - STO 1 Sep07 45.00 Call @ 3.21

Stock Investment: $4,623.00
Income Generated: $321.00
Percent Income Generated: 6.94%
Annualized Income Generated: 79.20%
Net Profit If Called: $198.00
Percent Return If Called: 4.28%
Annualized Return If Called: 48.85%
Days to Expiration: 32 days

PLCM - New Position

A new position was established today on PLCM. The following is the trade information, including IB commissions:

20-Aug-07 - Initial Stock Position - BTO 100 PLCM @ 31.64
20-Aug-07 - Initial Call Option - STO 1 Sep07 30.00 Call @ 2.55

Stock Investment: $3,164.00
Income Generated: $255.00
Percent Income Generated: 8.06%
Annualized Income Generated: 91.93%
Net Profit If Called: $91.00
Percent Return If Called: 2.88%
Annualized Return If Called: 32.81%
Days to Expiration: 32 days

PFCB - New Position

A new position was established today on PFCB. The following is the trade information, including IB commissions:

20-Aug-07 - Initial Stock Position - BTO 100 PFCB @ 35.78
20-Aug-07 - Initial Call Option - STO 1 Sep07 35.00 Call @ 2.30

Stock Investment: $3,578.00
Income Generated: $230.00
Percent Income Generated: 6.43%
Annualized Income Generated: 73.32%
Net Profit If Called: $152.00
Percent Return If Called: 4.25%
Annualized Return If Called: 48.46%
Days to Expiration: 32 days

WFMI - Adjustment

The following adjustment was made today on WFMI:

20-Aug-07 - Continued Trade - STO 2 Sep07 50.00 Call @ 0.20 -

Current Position Summary:

Stock Investment: $8,563.00
Income Generated: $239.00
Percent Income Generated: 2.79%
Annualized Income Generated: 6.75%
Net Profit If Called: $1,676.00
Percent Return If Called: 19.57%
Annualized Return If Called: 47.31%
Days to Expiration: 151 days

Trade History:

23-Apr-07 - Initial Stock Position - BTO 100 WFMI @ 47.19 - VICC
23-Apr-07 - Initial Call Option - STO 1 May07 50.00 Call @ 0.83 - Expired
21-May-07 - Interim Trade - STO 1 Jul07 45.00 Call @ 0.24 - Closed
21-Jun-07 - Buy Back and Roll Out - BTC 1 Jul07 45.00 Call @ -0.03 -
21-Jun-07 - Dollar Cost Averaging - BTO 100 WFMI @ 38.44 -
21-Jun-07 - Combined Cost Basis - $8,563.00 200 @ 42.82 -
21-Jun-07 - Continued Trade - STO 2 Aug07 45.00 Call @ 0.29 - Expired
24-Jul-07 - Dividend Received - DIV 200 Dividend @ 0.18 -
20-Aug-07 - Continued Trade - STO 2 Sep07 50.00 Call @ 0.20 -

Note that as a Value Investing Covered Call (VICC) position the primary objective is capital appreciation. The stock will be held long term until it reaches or surpasses it's fair value. Front month OTM call options are sold to bring in a small amount of income while waiting for the stock to appreciate. The calls are sold far enough OTM to avoid assignment and the need to make any mid-month adjustments.

TEX - Adjustment

The following adjustment was made today on TEX:

20-Aug-07 - Continued Trade - STO 1 Sep07 80.00 Call @ 2.29 -

Current Position Summary:

Stock Investment: $8,381.00
Income Generated: $826.00
Percent Income Generated: 9.86%
Annualized Income Generated: 64.24%
Net Profit If Called: $445.00
Percent Return If Called: 5.31%
Annualized Return If Called: 34.61%
Days to Expiration: 56 days

Trade History:

27-Jul-07 - Initial Stock Position - BTO 100 TEX @ 83.81 -
27-Jul-07 - Initial Call Option - STO 1 Aug07 80.00 Call @ 5.97 - Expired
20-Aug-07 - Continued Trade - STO 1 Sep07 80.00 Call @ 2.29 -

STLD - Adjustment

The following adjustment was made today on STLD:

20-Aug-07 - Continued Trade - STO 1 Sep07 40.00 Call @ 1.39 -

Current Position Summary:

Stock Investment: $4,338.00
Income Generated: $626.00
Percent Income Generated: 14.43%
Annualized Income Generated: 56.03%
Net Profit If Called: $288.00
Percent Return If Called: 6.64%
Annualized Return If Called: 25.78%
Days to Expiration: 94 days

Trade History:

19-Jun-07 - Initial Stock Position - BTO 100 STLD @ 43.38 -
19-Jun-07 - Initial Call Option - STO 1 Aug07 40.00 Call @ 4.72 - Expired
13-Jul-07 - Dividend Received - DIV 100 Dividend @ 0.05 -
13-Jul-07 - Dividend Received - DIV 100 Dividend @ 0.10 -
20-Aug-07 - Continued Trade - STO 1 Sep07 40.00 Call @ 1.39 -

NUE - Adjustment

The following adjustment was made today on NUE:

20-Aug-07 - Continued Trade - STO 1 Sep07 50.00 Call @ 2.59 -

Current Position Summary:

Stock Investment: $5,224.00
Income Generated: $608.00
Percent Income Generated: 11.64%
Annualized Income Generated: 75.86%
Net Profit If Called: $384.00
Percent Return If Called: 7.35%
Annualized Return If Called: 47.91%
Days to Expiration: 56 days

Trade History:

27-Jul-07 - Initial Stock Position - BTO 100 NUE @ 52.24 -
27-Jul-07 - Initial Call Option - STO 1 Aug07 50.00 Call @ 3.49 - Expired
20-Aug-07 - Continued Trade - STO 1 Sep07 50.00 Call @ 2.59 -

MCO - Adjustment

The following adjustment was made today on MCO:

20-Aug-07 - Interim Trade - STO 1 Sep07 55.00 Call @ 0.89 -

Current Position Summary:

Stock Investment: $6,241.00
Income Generated: $592.00
Percent Income Generated: 9.49%
Annualized Income Generated: 40.73%
Net Profit If Called: -$149.00
Percent Return If Called: -2.39%
Annualized Return If Called: -10.25%
Days to Expiration: 56 days

Trade History:

28-Jun-07 - Initial Stock Position - BTO 100 MCO @ 62.41 -
28-Jun-07 - Initial Call Option - STO 1 Jul07 60.00 Call @ 3.49 - Expired
25-Jul-07 - Continued Trade - STO 1 Aug07 60.00 Call @ 1.54 - Expired
20-Aug-07 - Interim Trade - STO 1 Sep07 55.00 Call @ 0.89 -

Note that this is an Interim trade, meaning the strike price is below the cost basis, which would result in a loss if called. I'll monitor this position closely and will roll it out and up to a higher strike if it goes ITM.

LM - Adjustment

The following adjustment was made today on LM:

20-Aug-07 - Continued Trade - STO 1 Sep07 90.00 Call @ 2.09 -

Current Position Summary:

Stock Investment: $9,109.00
Income Generated: $558.00
Percent Income Generated: 6.13%
Annualized Income Generated: 39.93%
Net Profit If Called: $449.00
Percent Return If Called: 4.93%
Annualized Return If Called: 32.13%
Days to Expiration: 56 days

Trade History:

27-Jul-07 - Initial Stock Position - BTO 100 LM @ 91.09 -
27-Jul-07 - Initial Call Option - STO 1 Aug07 90.00 Call @ 3.49 - Expired
20-Aug-07 - Continued Trade - STO 1 Sep07 90.00 Call @ 2.09 -

ITG - Adjustment

The following adjustment was made today on ITG:

20-Aug-07 - Continued Trade - STO 1 Sep07 40.00 Call @ 1.44 -

Current Position Summary:

Stock Investment: $4,536.00
Income Generated: $662.00
Percent Income Generated: 14.59%
Annualized Income Generated: 25.25%
Net Profit If Called: $126.00
Percent Return If Called: 2.78%
Annualized Return If Called: 4.81%
Days to Expiration: 211 days

Trade History:

22-Feb-07 - Initial Stock Position - BTO 100 ITG @ 45.36 -
22-Feb-07 - Initial Call Option - STO 1 Jul07 45.00 Call @ 4.79 - Expired
25-Jul-07 - Continued Trade - STO 1 Aug07 45.00 Call @ 0.39 - Expired
20-Aug-07 - Continued Trade - STO 1 Sep07 40.00 Call @ 1.44 -

BRCM - Adjustment

The following adjustment was made today on BRCM:

20-Aug-07 - Continued Trade - STO 1 Sep07 35.00 Call @ 1.19 -

Current Position Summary:

Stock Investment: $3,527.00
Income Generated: $552.00
Percent Income Generated: 15.65%
Annualized Income Generated: 26.95%
Net Profit If Called: $525.00
Percent Return If Called: 14.89%
Annualized Return If Called: 25.63%
Days to Expiration: 212 days

Trade History:

21-Feb-07 - Initial Stock Position - BTO 100 BRCM @ 35.27 -
21-Feb-07 - Initial Call Option - STO 1 Aug07 35.00 Call @ 4.33 - Expired
20-Aug-07 - Continued Trade - STO 1 Sep07 35.00 Call @ 1.19 -

EXPD - Closed

The EXPD position was closed today for a profit. This one was a gift from the options Gods. The Aug07 45 call actually closed ITM on Friday, but for some strange reason the stock didn't get called away. This is the first time this has happened in over 2 years of trading covered calls. But I'm not complaining since I ended up with a greater profit. The following is the trade history and returns, including IB commissions.

Covered Call Results

Stock Investment: $4,515.00
Income Generated: $1,057.00
Net Profit: $1,130.00
Percent Return: 25.03%
Annualized Return: 23.42%
Duration of Trade: 390 days

Buy & Hold Comparison

Opening Price: $45.15
Closing Price: $45.88
P/L per Share: $0.73
Shares: 100
Dividends: $0.14
Net Profit: $87.00
Percent Return: 1.93%
Annualized Return: 1.80%
Duration of Trade: 390 days

Trade History:

26-Jul-06 - Initial Stock Position - BTO 100 EXPD @ 45.15 -
26-Jul-06 - Initial Call Option - STO 1 Jan07 45.00 Call @ 6.69 - Closed
22-Dec-06 - Buy Back & Roll Out - BTC 1 Jan07 45.00 Call @ -0.16 -
22-Dec-06 - Continued Trade - STO 1 May07 45.00 Call @ 2.04 - Expired
21-May-07 - Continued Trade - STO 1 Jun07 45.00 Call @ 0.99 - Expired
15-Jun-07 - Dividend Received - DIV 100 Dividend @ 0.14 -
19-Jun-07 - Continued Trade - STO 1 Aug07 45.00 Call @ 0.87 - Expired
20-Aug-07 - Position Closed - BTC 1 Closed @ 45.88 -

PALM - Closed

The PALM position was closed today for a loss since the company no longer met my fundamental criteria. I'll explain the reasons in a separate article. Notice that the buy & hold loss would have been greater. The following is the trade history and returns, including IB commissions.

Covered Call Results

Stock Investment: $3,917.00
Income Generated: $613.50
Net Profit: -$133.00
Percent Return: -3.40%
Annualized Return: -2.57%
Duration of Trade: 483 days

Buy & Hold Comparison

Opening Price: $19.59
Closing Price: $15.85
P/L per Share: -$3.74
Shares: 100
Dividends: $0.00
Net Profit: -$374.00
Percent Return: -10.09%
Annualized Return: -14.43%
Duration of Trade: 483 days

Trade History:

24-Apr-06 - Initial Stock Position - BTO 100 PALM @ 23.16 -
24-Apr-06 - Initial Call Option - STO 1 Aug06 22.50 Call @ 2.95 - Closed
05-Jul-06 - Buy Back & Roll Down - BTC 1 Aug06 22.50 Call @ -0.11 -
05-Jul-06 - Dollar Cost Averaging - BTO 100 PALM @ 16.01 -
05-Jul-06 - Combined Cost Basis - $3,917.00 200 @ 19.59 -
05-Jul-06 - Continued Trade - STO 2 Feb07 20.00 Call @ 1.20 - Closed
19-Dec-06 - Buy Back & Roll Out - BTC 2 Feb07 20.00 Call @ -0.11 -
19-Dec-06 - Continued Trade - STO 2 Aug07 20.00 Call @ 0.55 - Expired
20-Aug-07 - Position Closed - STC 2 Closed @ 15.85 -

AMD - Closed

The AMD position was closed today for a loss since the company no longer met my fundamental criteria. I'll explain the reasons in a separate article. Notice that the buy & hold loss would have been greater. The following is the trade history and returns, including IB commissions.

Covered Call Results

Stock Investment: $1,624.00
Income Generated: $257.00
Net Profit: -$161.00
Percent Return: -9.91%
Annualized Return: -17.48%
Duration of Trade: 207 days

Buy & Hold Comparison

Opening Price: $16.24
Closing Price: $12.06
P/L per Share: -$4.18
Shares: 100
Dividends: $0.00
Net Profit: -$418.00
Percent Return: -25.74%
Annualized Return: -45.39%
Duration of Trade: 207 days

Trade History:

25-Jan-07 - Initial Stock Position - BTO 100 AMD @ 16.24 - Closed
25-Jan-07 - Initial Call Option - STO 1 Jul07 16.00 Call @ 2.14 - Expired
25-Jul-07 - Continued Trade - STO 1 Aug07 16.00 Call @ 0.43 - Expired
20-Aug-07 - Position Closed - STC 1 Closed @ 12.06 -

Sunday, August 19, 2007

EXBD - Closed

The EXBD Aug07 65.00 Call was exercised on Fri and the stock was called away for a profit. The following is the trade history and returns, including IB commissions.

Covered Call Results

Stock Investment: $6,745.00
Income Generated: $349.00
Net Profit: $104.00
Percent Return: 1.54%
Annualized Return: 26.80%
Duration of Trade: 21 days

Buy & Hold Comparison

Opening Price: $67.45
Closing Price: $69.81
P/L per Share: $2.36
Shares: 100
Dividends: $0.00
Net Profit: $236.00
Percent Return: 3.50%
Annualized Return: 60.81%
Duration of Trade: 21 days

Trade History:

27-Jul-07 - Initial Stock Position - BTO 100 EXBD @ 67.45 -
27-Jul-07 - Initial Call Option - STO 1 Aug07 65.00 Call @ 3.49 - Exercised
17-Aug-07 - Option Exercised - EX 1 Aug07 65.00 Call @ 65.00 -

ATVI - Closed

The ATVI Aug07 17.50 Call was exercised on Fri and the stock was called away for a profit. The following is the trade history and returns, including IB commissions.

Covered Call Results

Stock Investment: $1,757.00
Income Generated: $199.00
Net Profit: $192.00
Percent Return: 10.93%
Annualized Return: 22.66%
Duration of Trade: 176 days

Buy & Hold Comparison

Opening Price: $17.57
Closing Price: $18.21
P/L per Share: $0.64
Shares: 100
Dividends: $0.00
Net Profit: $64.00
Percent Return: 3.64%
Annualized Return: 7.55%
Duration of Trade: 176 days

Trade History:

22-Feb-07 - Initial Stock Position - BTO 100 ATVI @ 17.57 -
22-Feb-07 - Initial Call Option - STO 1 Aug07 17.50 Call @ 1.99 - Exercised
17-Aug-07 - Option Exercised - EX 1 Aug07 17.50 Call @ 17.50 -

Friday, August 17, 2007

When to Buy More

In my previous article I discussed my thought process for "What to Buy, "When to Buy", and "When to Sell". But there's one more question that needs to be answered, and that is "When to Buy More".

As stated in the previous article, you don't want to sell just because the stock price has declined, as long as you followed the "What to Buy" guidelines, and the company fundamentals haven't changed. This past week is a prime example of when not to sell. The market has been extremely volatile, mainly due to the subprime debacle. When the market falls like this many innocent companies get caught in its wake.

Again, as long as you followed the "What to Buy" guidelines, and the company was a good buy when you bought it, it's an even better buy after a decline in price. This is an opportunity to buy more shares at a lower price, thereby lowering your average cost. This technique is known as averaging down, or dollar cost averaging (DCA) if you're making regular periodic purchases. The terms are sometimes interchangeable, but they basically mean the same thing (i.e. you're lowering your average cost).

As Bill Miller, manager of the Legg Mason Value Trust fund, advises, “If you have a chance to lower your average cost you should do so.” Because in the end, “The guy with the lowest average cost wins." Since that philosophy helped him outperform the S&P 500 for 15 consecutive years, I’d say it’s battled tested and worth following.

This is one of the methods I've successfully used in my covered call (CC) strategy to recover from stocks that have declined in price. The added advantage of averaging down a CC position is that you can sell more call options. So, not only do you lower your average cost basis in the stock, you also make it possible to increase the income generated from selling call options.

But again, you must be sure that you followed the "What to Buy" guidelines and that the company fundamentals haven't change before deciding to buy more. You also want to be sure that the new average price is worth the trouble. It's usually not worth buying more if the stock only declined by a small amount. You need a sizable decline to make it worth while. Another consideration is position sizing. I limit all my positions to 5% of total capital, and will usually only average down if the new position remains 5% or less.

So, that's my thought process for "When to Buy More". Again, I hope you found this useful.

Tuesday, August 14, 2007

What to Buy, When to Buy, and When to Sell

Probably the three most important questions a stock investor needs to answer is "What to Buy", "When to Buy", and "When to Sell". I'll try to address all three questions in this article from my perspective as a value investor. This is a long article, so you might want to grab a cup of coffee and a snack ;-)

What to Buy

Value investors look to buy companies with solid fundamentals. These are companies that generate positive Free Cash Flow (FCF), provide above average Cash Return on Invested Capital (CROIC), Return on Assets (ROA), and Return on Equity (ROE), have low or reasonable debt and are financially healthy (Debt/Equity Ratio, Current Ratio & Quick Ratio), have strong, and preferably shareholder friendly, management (Stewardship), and, last but not least, have a strong competitive advantage (Economic Moat). Let's briefly look at each of these criteria:

Free Cash Flow (FCF)

Companies that generate a lot of free cash flow can do all sorts of things with the money, like pay dividends, buy back shares, use it for acquisitions or expansion, etc. Free cash flow gives the company financial flexibility and allows it to survive during bad times. In a sense, free cash flow is money that could be extracted from the company without damaging the core business. Strong free cash flow is an excellent sign that the company has a competitive advantage (Economic Moat).

Companies that have negative free cash flow need to raise money, by taking out loans or selling additional shares, just to stay in business, which can lead to financial trouble and bankruptcy.

IMHO, free cash flow is more important than earnings. Here's a good article on earnings from F Wall Street.

The formula for FCF is:
Free Cash Flow = Cash Flow from Operations - Capital Expenditures

Cash Return On Invested Capital (CROIC)

Cash Return On Invested Capital (CROIC) measures how effectively a company uses the money (borrowed or owned) invested in its operations. Here's a good article about CROIC from F Wall Street.

The formula for CROIC is:
Cash Return on Invested Capital = Free Cash Flow / Shareholder Equity + Total Liabilities - Current Liabilities

Return on Assets (ROA)

Return on Assets (ROA) measures how efficient a company is on translating its assets into profits. If a company is able to consistently post high ROA's, it may have a competitive advantage over its peers.

The formula for ROA is:
Net Margin = Net Income / Sales
Asset Turnover = Sales / Assets
Return on Assets = Net Margin x Asset Turnover

Return on Equity (ROE)

Return on Equity (ROE) measures the profits per dollar of the capital shareholders have invested in the company. Like ROA, if a company is able to consistently post high ROE's, it may have a competitive advantage over its peers.

The formula for ROE is:
Financial Leverage = Assets / Shareholder Equity
Return on Equity = Return on Assets x Financial Leverage

Financial Health

Financial health relates to a company's indebtedness and it's ability to manage its debt. The following three ratios provide a means to measure a company's financial health.

Debt/Equity Ratio

Debt/Equity Ratio measures how much long-term debt the company has per dollar of equity.

The formula Debt/Equity is:
Debt/Equity Ratio = Long-term Debt / Shareholder Equity

Current Ratio

Current Ratio measures how much liquidity a company has (i.e. how much cash it could raise if it absolutely had to pay off its liabilities all at once). A low ratio means the company may not be able to source enough cash to meet near-term liabilities. As a general rule, a current ratio of 1.5 means the company should be able to meet operating needs without much trouble.

The formula for Current Ratio is:
Current Ratio = Current Assets / Current Liabilities

Quick Ratio

Quick Ratio is an even more conservative measure of a company's liquidity. This measure is especially useful for manufacturing companies and retailers, since both tend to have a lot of their cash tied up in inventories. In general, a quick ratio of 1.0 puts a company in fine shape.

The formula for Quick Ratio is:
Quick Ratio = Current Assets - Inventories / Current Liabilities

Management (Stewardship)

Management can make the difference between a mediocre company and an outstanding one. The goal is to find a management team that thinks like shareholders and treats the business as if they owned a piece of it, rather than as hired hands. I use Morningstar's Stewardship grade, which rates a companies management.

Competitive Advantage (Economic Moat)

Another important criteria is competitive advantage, otherwise know as an economic moat. Companies that have a strong competitive advantage (i.e. wide moat stocks) can usually weather most storms, either company/sector specific or market wide. If a company starts to lose it's competitive advantage the fundamentals will suffer (i.e. sales, revenue, profit margins, etc.).

When to Buy

Now that we know what to buy, the next question is when to buy it. Value investors always look to buy stocks when they're on sale, i.e when the company can be purchased with a "Margin of Safety" to its intrinsic value.

I use Morningstar ratings to determine when to buy. A 5 Star rated stock is a company that's selling at a discount to its intrinsic value, and at or below Morningstar's "Consider Buy" price. These are the ideal stocks to buy as long as they meet the "What to Buy" criteria.

My CC strategy looks at 3-5 Star rated stocks. Since I'm selling covered calls on these stocks I don't need such a large discount on the stock price because the call premium will lower my cost basis.

When to Sell

Probably the hardest question of all is when to sell. There are many opinions on this depending on your perspective. A value investor would only sell a stock when the company fundamentals start to deteriorate or when the stock price reaches or surpasses the company's intrinsic value. A CC trader would allow the stock to be called away if it meets the annualized return requirement.

As a value investor, as soon as you notice that the fundamentals of a company are beginning to deteriorate, you may want to consider getting out of the stock. A good place to look for deteriorating fundamentals is the balance sheet. Things to look for include rising debt levels, rising inventory levels, and accounts receivable that are rising faster than revenues. These are three common warning signs that a company's efficiency is deteriorating. Here are some other warning signs that the fundamentals of a company are deteriorating:

  • Shrinking return on equity
  • Declining profit margins
  • Market share losses
  • Unwise acquisitions
  • Unexpected management shakeups
Since fundamentals usually take a long time to change, I take a long term view and don't worry to much about the short-term fluctuations. In fact, I profit from the short-term fluctuations by selling calls on the stocks I own. I'm also willing to let my CC stocks get called away, since I've already pre-determined that the annualized return if called meets my requirements.

There's a good article at Morningstar which further describes some of the criteria I use when deciding when to sell.

When Not to Sell

Probably just as important as "When to Sell" is "When Not to Sell".

Assuming you followed the guidelines in "What to Buy", you don't want to sell just because the stock price has declined and don't want to use stop losses blindly (a stop loss is a order or mental note to sell the stock once it declines to a certain price). This is typically done by technical traders to cut their losses in case they're wrong (e.g. they picked the wrong direction). Price action is short term and usually unrelated to a company's fundamentals. Value investors don't judge a company solely by its stock price. Stock prices fluctuate for a variety of reasons that don't necessarily reflect a change in company fundamentals. So, selling a stock just because its stock price has declined, without regard to the company fundamentals, is like throwing the baby out with the bath water.

As someone on the Yahoo Group so eloquently said "Value investors have an entirely different perspective on companies whose stock price is less than what they paid for them. They are more likely to buy more of those companies than sell them. While it's wise to occasionally take a loss on a position and admit that a mistake may have been made, the mistake in question is not simply because the stock price has gone down. In that case it is the market that has made the mistake -- an error in valuation. A value investor would and should only sell a losing position because something has fundamentally changed in the valuation of a company. When that happens, and only then, the value investor would sell."

Conclusion

I use this same approach for both my buy & hold portfolio and my covered call portfolio. The differences are slight.

For my B&H portfolio, I only buy 5 Star Wide Moat stocks, since the only way I profit is from capital appreciation, and dividends. These stocks are usually held long-term and sold once they reach or surpass the company's intrinsic value.

For my CC portfolio, I'm not so rigid, since I'm able to generate income on my stocks from selling call options. Although the intent is to have these positions called away in the short-term, since they meet my annualized return requirement, I select the stocks as if I was going to hold them for the long-term. About 72% of my initial positions get called away, leaving about 28% that have declined and need to be managed. Currently, about 60% of my positions are "management" positions.

While this strategy appears to sell the winners and keep the losers, it all depends on your definition of a loser? For me, a loser is not a company whose stock price has gone down just because some irrational investors decided to sell their stocks when the company missed EPS by a penny. I judge a company by its fundamentals not by its stock price. So for me a loser is a company that's losing money (e.g. negative free cash flow), has high debt, and is in financial trouble (sounds like many of the old Dot.com stocks). None of my "management" positions fall into this category. So, while some people might call these losers, just because their stock price has declined, I don't.

There's a big difference between a losing stock and a losing company. Here's a perfect example:

Last week: "Wal-Mart Stores Inc. posted a 1.9 percent same-store sales gain, beating the 1.5 percent estimate of analysts surveyed by Thomson Financial."

The day of that announcement, WMT stock dropped 4%.

Today: "Wal-Mart's earnings rose to $3.1 billion, or 76 cents per share, in the second quarter ended July 31, from $2.08 billion, or 50 cents per share, a year earlier. Earnings per share from continuing operations were 72 cents per share before a gain of 4 cents. Analysts on average were expecting 76 cents. Sales rose nearly 9 percent to $91.99 billion. U.S. sales at stores open at least a year, a key retail gauge known as same-store sales, rose 1.9 percent. Same-store sales increased 1.2 percent at Wal-Mart stores."

As of this writing, WMT stock is currently down about 5%. A losing stock, YES, a losing company, NO. Here's a look at WMT from F Wall Street.

So there you have it. Now you know the thought process I go through when deciding "What to Buy", "When to Buy", and "When to Sell". I hope you found this useful.

Monday, August 13, 2007

Morningstar's New Options Feature

Morningstar Options is a new feature on the Morningstar website. Here you'll find Morningstar's Approach to Options Investing and their newly created Morningstar Volatility Index.

This is a welcomed addition to the Morningstar services, which I use extensively for all my investing research.