Building A Hedged Portfolio Around A Position In Novo Nordisk
Summary One of the more appealing stocks to consider as part of a concentrated portfolio is Novo Nordisk, the leading diabetes care and biopharmaceutical company. We review some reasons why Novo Nordisk is appealing, and discuss how an investor can include it in a concentrated portfolio, while limiting his risk and maximizing expected return. We recap the method, show how you can build a concentrated hedged portfolio yourself, and present a sample hedged portfolio built around Novo Nordisk. The sample portfolio is designed for someone with $80,000 to invest, who wants to limit his risk to a drawdown of no more than 18%. The sample portfolio has a negative hedging cost. The Number One Stock In the World Part of the attraction of Seeking Alpha articles is often the comments they generate. In the latest installment of his series on his top investments (“The #1 Stock In the World, Part II”), hedge fund manager and Seeking Alpha contributor Chris DeMuth, Jr. named Ocean Shore (OCSH) as his current favorite. In a comment on that article, his fellow Seeking Alpha contributor Harm Elderman offered an intriguing alternative selection for that title, Novo Nordisk (NYSE: NVO ), and added: “It’s been my largest share of my portfolio for over 8 years and every year it’s been an incredible cash cow (as it has been all the years before and will be in the future). Seriously, take a look. This firm has bent some stock market rules (in my view) over the last 25 years in regards of risk/reward profile.” The Appeal of NVO Although DeMuth aims to “sift the world”, it’s understandable that he can’t cover every promising stock. At the same time, a closer look at NVO illuminates the appeal it has had for Elderman and many other investors. (click to enlarge) Riding a global mega trend Although Novo Nordisk is active in other areas such as growth hormone treatments, it remains a leading manufacturer of diabetes medications, such as the NovoLog FlexPen prefilled insulin syringe, pictured above. Diabetes is a global epidemic: according to the World Health Organizaton, as of 2014, 9% of the world’s adult population was estimated to suffer from the disease. The International Diabetes Foundation’s Diabetes Atlas estimates the total number of diabetes cases globally is 387 million. By way of comparison, the WHO estimates there are 37 million patients in the world living with HIV. The scale of the diabetes epidemic, and Novo Nordisk’s 90-year history in diabetes treatment, provides some context to the remarkable long-term chart of the company’s shares: (click to enlarge) Not only does the scale of diabetes dwarf that of HIV and AIDS (fewer than half of those infected with HIV currently suffer from AIDS), but the epidemic is expected to grow considerably over the next two decades. The Diabetes Atlas estimates 592 million people will be living with the disease in 2035. Selected Fundamentals Novo Nordisk shares aren’t cheap on an absolute basis – according to Fidelity’s data, the current PEG ratio for the stock (using 5-year earnings growth projections) is 1.97, while a PEG ratio of 2 or greater is often considered to be high. However, the average PEG ratio for the pharmaceutical industry is 4.13. Particularly striking, though, are the company’s returns on sales, equity, assets, and investment, as shown below (image via Fidelity). (click to enlarge) Equity Summary Score Fidelity aggregates opinions on stocks from multiple research shops and weights each opinion by the historical accuracy of the researchers. It then consolidates that data into an “equity summary score”, on a scale from 1 to 10, with 10 being the most bullish. As the image below shows, the current equity summary score for NVO is very bullish. Building a Hedged Portfolio Around an NVO Position Given the appeal of NVO, why consider hedging it? For two reasons: Any stock may be subject to unpredictable, idiosyncratic risk. For a recent example , consider the emissions scandal at Volkswagen ( OTCQX:VLKAY ). All stocks are subject to market risk: in the event of a major market correction, all stocks are likely to plummet. You could simply buy and hedge NVO, and we’ll show a sample hedge for it below, but the benefits of the hedged portfolio method are that it can lower your overall hedging cost and let you maximize your expected return. So, we’ll use NVO as starting point and show how you can build a hedged portfolio around it for an investor who is unwilling to risk a drawdown of more than 18%, and has $80,000 that he wants to invest. First, though, let’s address the issue of risk tolerance, and how it affects potential return. Risk Tolerance and Potential Return All else equal, with a hedged portfolio, the greater an investor’s risk tolerance, the greater the maximum drawdown he is willing to risk (his “threshold”, in our terminology) and the higher his potential return will be. So, we should expect that an investor who is willing to risk a 28% decline will have a chance at higher potential returns than one who is only willing to risk an 8% drawdown. In our example, we’ll be splitting the difference and using an 18% threshold. Constructing A Hedged Portfolio We’ll outline the process here briefly, and then explain how you can implement it yourself. Finally, we’ll present an example of a hedged portfolio that was constructed this way with an automated tool. The process, in broad strokes, is this: Find securities with promising potential returns (we define potential return as a high-end, bullish estimate of how the security will perform). Find securities that are relatively inexpensive to hedge. Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high potential returns net of their hedging costs (or, ones with high net potential returns). Hedge them. The potential benefits of this approach are twofold: If you are successful at the first step (finding securities with high potential returns), and you hold a concentrated portfolio of them, your portfolios should generate decent returns over time. If you are hedged, and your return estimates are completely wrong, on occasion – or the market moves against you – your downside will be strictly limited. How to Implement This Approach Finding promising stocks In this case, we’ve got one promising stock already, NVO. To find others, you can use Seeking Alpha Pro , among other sources. To quantify potential returns for these stocks, you can use analysts’ consensus price targets for them, to calculate potential returns in percentage terms. For example, via Nasdaq’s website , the image below shows the sell-side analysts’ consensus 12 month price target for NVO as of October 9th, 2015: Since NVO closed at $54.61 on October 9th, the consensus price target suggests a 16.4% potential return over 12 months. In general, though, you’ll need to use the same time frame for each of your potential return calculations to facilitate comparisons of potential returns, hedging costs, and net potential returns. Our method starts with calculations of six-month potential returns. Finding inexpensive ways to hedge these securities Whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater-than-18% decline over the timeframe covered by your potential return calculations (our method attempts to find optimal static hedges using collars as well as protective puts going out approximately six months). And you’ll need to calculate your cost of hedging as a percentage of position value. Select the securities with highest, or at least positive, net potential returns When starting from a large universe of securities, you’d want to select the ones with the highest potential returns, net of hedging costs, but, at a minimum, you’d want to at least want to exclude any security that has a negative potential return net of hedging costs. It doesn’t make sense to pay X to hedge a stock if you estimate the stock will return