Tag Archives: potential

An Alternative To Cash For A Risk-Averse Investor

Summary Investors nearing retirement and others wary of current market conditions can use the hedged portfolio method to get a higher return than cash. We explain the method, and present a sample hedged portfolio for an investor unwilling to risk more than a 4% drawdown over the next six months. This sample hedged portfolio has a negative hedging cost and an expected return 20 times that of the average jumbo money market yield. Searching For A Safe Harbor In A Stormy Market After the turbulence of the last week, some investors expected Monday’s calmness to continue on Tuesday, but, as Seeking Alpha news editor Carl Surran reported , that wasn’t the case (“Stock sell-off, turbulence return with a vengeance”): Investors had hoped last week’s volatility had passed after calmer sessions on Friday and Monday, but the turbulence returned today, showing ” we’re not out of the woods by any means ,” said Meridian Equity Partners’ Jonathan Corpina. Surran went on to note that the major indexes all ended the session in correction territory, with the Dow off 12% from its high in May. While corrections can offer opportunities for more aggressive investors, some investors have less tolerance for risk. In this post, we’ll look at an approach that can offer a safe harbor for the next several months for risk-averse investors. Dealing With Uncertainty One way to deal with the uncertainty exemplified by the last several market sessions is to invest in a handful of securities you think will do well, and hedge against the possibility that you end up being wrong. That approach is systematized in the hedged portfolio method, which we detailed in a previous post (“Backtesting The Hedged Portfolio Method”). One advantage of the hedged portfolio method is that it can accommodate a broad range of risk tolerances. If you can tolerate a drawdown of more than 20%, our research (summarized in the previous post we mentioned above) suggests you can achieve returns as good or better than the market over time with less risk. But a similar approach can also be used for investors who can only tolerate smaller drawdowns. Below, we’ll recap how you can build a hedged portfolio yourself (or for a client), and present an example of a hedged portfolio created for an investor with $1,000,000 to invest who can’t tolerate a drawdown of more than 4%. Risk Tolerance, Hedging Cost, 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”) – the higher his expected return will be. In a previous post (“Keeping A Small Nest Egg From Cracking”), we created a hedged portfolio for a small investor who could tolerate a drawdown of as much as 20%. In this case, with an investor who can only tolerate a 4% drawdown, we would expect a lower return. Constructing A Hedged Portfolio The process, in broad strokes, is this: Find securities with high 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). Note that when creating a hedged portfolio for an extremely risk-averse investor, such as in this case, the second criteria (“inexpensive to hedge”) will outweigh the first (“high potential returns”) because it may not be possible to hedge the securities with the highest potential returns against such small declines. 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 securities with positive potential returns For this, you can use Seeking Alpha Pro , among other sources. Seeking Alpha articles often include price targets for long ideas, and you can convert these to percentage returns from current prices. But you’ll need to use the same time frame for each of your expected return calculations to facilitate comparisons of expected returns, hedging costs, and net expected returns. Our method starts with calculations of six-month potential returns. Finding Securities That Are Relatively Inexpensive To Hedge For this step, you’ll need to find hedges for the securities with positive potential returns, and then calculate the hedging cost as a percentage of position value for each security. Whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater-than-4% decline over the time frame covered by your potential return calculations. Our method attempts to find optimal static hedges using collars as well as protective puts. Buying Securities That Score Well On The First Two Criteria To determine which securities these are, you may need to first adjust your potential return calculations by the time frame of your hedges. For example, although our method initially calculates six-month potential returns and aims to find hedges with six months to expiration, in some cases the closest hedge expiration may be five months out. In those cases, we will adjust our potential return calculation down accordingly, because we expect an investor will exit the position shortly before the hedge expires (in general, our method and calculations are based on the assumption that an investor will hold his shares for six months, until shortly before their hedges expire or until they are called away, whichever comes first). Next, you’ll need to subtract the hedging costs you calculated in the previous step from the potential returns you calculated for each position, and sort the securities by their potential returns net of hedging costs, or net potential returns. The securities that come to the top of that sort are the ones you’ll want to consider for your portfolio. Fine-Tuning Portfolio Construction You’ll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs. Another fine-tuning step is to minimize cash that’s leftover after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won’t need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash you can potentially boost returns. In this step, our method searches for what we call a “cash substitute”: that’s a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better-than-cash return while keeping the investor’s downside limited according to his specifications. You could use a similar approach, or you could simply allocate leftover cash to one of the securities you selected in the previous step. Calculating An Expected Return While net potential returns are bullish estimates of how well securities will perform, net of their hedging costs, expected returns, in our terminology, are the more likely returns net of hedging costs. In a series of 25,412 backtests over an 11-year time period, we determined two things about our method of calculating potential returns: it generates alpha, and it overstates actual returns. The average actual return over the next six months in those 25,412 tests was 0.3x the average potential return calculated ahead of time. So, we use that empirically derived relationship to calculate our expected returns. Example Of A Hedged Portfolio Here is an example of a hedged portfolio created using the general process described above by the automated portfolio construction tool at Portfolio Armor . With that tool, you just enter the dollar amount you are looking to invest and the largest drawdown you are willing to risk (your “threshold” – in this case, 4%), and the tool does the rest. This portfolio was generated as of Monday’s close (results will vary at different times, depending on market conditions), and used as its inputs the parameters we mentioned for our hypothetical investor above: $1,000,000 to invest, and a goal of maximizing potential return while limiting downside risk, in the worst-case scenario, to a drawdown of no more than 4%. Worst-Case Scenario The “Max Drawdown” column in the portfolio level summary shows the worst-case scenario for this hedged portfolio. If every underlying security in it went to zero before the hedges expired, the portfolio would decline 3.97%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was negative, -1%, meaning the investor would receive more income in total from selling the call legs of the collars on his positions than he spent buying the puts. Best-Case Scenario At the portfolio level, the net potential return is 3.55% (as predicted, it’s less than the potential return for the 20% threshold portfolio we alluded to above, which was 17.79%). This represents the best-case scenario, if each underlying security in the portfolio meets or exceeds its potential return. A More Likely Scenario The portfolio level expected return of 1.23% represents a more conservative estimate, based on the historical relationship between our calculated potential returns and actual returns. A Better Return Than Cash According to the FDIC , the national average rate for jumbo money market accounts as of August 31 was 0.12%, which equates to a 0.06% rate over 6 months. The 1.23% expected return of the hedged portfolio above is 20.5x as high. Of course, your maximum drawdown on the money market is 0%, which is not the case with the hedged portfolio. Each Security Is Hedged Note that in the portfolio above, each of the three underlying securities – Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ), Intuitive Surgical (NASDAQ: ISRG ), and Precision Castparts (NYSE: PCP ) is hedged (Google appears twice in the portfolio, once as a primary security, hedged with an optimal collar capped at its potential return, and once hedged as a cash substitute, with its cap set at 1%. Because of the different way these positions are hedged, they have different expected returns). Hedging each security according to the investor’s risk tolerance obviates the need for broad diversification, and lets him concentrate his assets in a handful of securities with positive potential returns net of their hedging costs. Here’s a closer look at the hedge for one of these positions, ISRG: As you can see in first part of the image above, ISRG is hedged with an optimal collar with its cap set at 4.95%, which was the potential return Portfolio Armor calculated for the stock: the idea is to capture the potential return while offsetting the cost of hedging by selling other investors the right to buy ISRG if it appreciates beyond that over the next six months.[i] The cost of the put leg of this collar was $7,800, or 7.75% of position value, but, as you can see in the image below, the income from the short call leg was $6,660, or 6.61% as percentage of position value. Since the income from the call leg offset some of the cost of the put leg, the net cost of the optimal collar on ISRG was $1,140, or 1.13% of position value.[ii] Note that, although the cost of the hedge on this position was positive, the hedging cost of this portfolio as a whole was negative . Why These Particular Securities? Ordinarily, Portfolio Armor aims to include seven primary securities and one cash substitute for a $1 million portfolio, but very few securities can be cost effectively hedged against a drawdown of no more than 4%. Google, Intuitive Surgical, and Precision Castparts were exceptions on Monday. Of the three, readers might be most surprised to see Precision Castparts included, given the announcement last month that Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ) would acquire the company for $235 per share. Usually, Portfolio Armor won’t include a security after an announcement that it is going to be acquired, because option market sentiment indicates that there’s no chance of any significant further appreciation for the stock to be acquired. In this case, on Monday, option market sentiment indicated there was a chance for a small amount of further appreciation beyond the 2.35% the stock would rise if the Berkshire deal closes at $235. That said, Seeking Alpha contributor Lukas Neely estimates that there’s a 95% chance the Berkshire deal closes (“Is Warren Buffett’s Precision Castparts Deal A Merger-Arb Opportunity”), in which case, the actual return for this position, net of hedging costs, would be 0.35%, rather than the 1.25% our algorithm expects. Possibly More Protection Than Promised In some cases, hedges such as the ones in the portfolio above can provide more protection than promised. For an example of that, see this recent instablog post on hedging Tesla (NASDAQ: TSLA ). Hedged Portfolios For Even More Risk-Averse Investors The hedged portfolio shown above was designed for a small investor who could tolerate a decline of as much as 4% over the next six months, but the same process can be used for investors who are even more risk-averse, willing to risk drawdowns of as little as 2%. Notes: [i] This hedge actually expires in a little more than 7 months, but the expected returns are based on the assumption that an investor will hold his positions for six months, until they are called away or until shortly before their hedges expire, whichever comes first. [ii] To be conservative, the net cost of the collar was calculated using the bid price of the calls and the ask price of the puts. In practice, an investor can often sell the calls for a higher price (some price between the bid and ask) and he can often buy the puts for less than the ask price (again, at some price between the bid and ask). So, in practice, the cost of this collar would likely have been lower. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

A $23 Billion Potential Shortfall For 27 Utilities With Nuclear Power Plants

According to Callan Investment Institute, underfunded decommissioning costs could amount to $23 billion from investor-owned utilities. The industry has already set aside $50 billion to fund specific trust funds designated exclusively for decommissioning expenses, mostly collected from ratepayers. While decommissioning costs have an upward sloping cost curve over time, utility contributions to NDTs have the opposite – a downward sloping trend line. A newsletter subscriber emailed me a question concerning the decommissioning cost for nuclear power operators, specifically what is Entergy (NYSE: ETR ) exposure to the costs to shut down and dismantle their nuclear power plants. ETR recently announced the closing of the nuclear plant in Vermont and there have been concerns about this cost. I thought this question warranted and deserved a bit of research and a response. An additional 26 publicly traded companies have similar exposure to various degrees. As part of the Nuclear Regulatory Commission commissioning and licensing of a power plant, the plant owners establish a trust fund, known as the Nuclear Decommissioning Trust, or NDT. The sole purpose of this trust fund is to provide funds for the cost to decommission the facility when that time comes. The owners contribute annually to the fund, in relationship to the percent ownership, based on projected costs and length of the license. The companies are the final backstop to shortfalls in funding to these trusts. The origin of the capital for fund contributions is from customer rate cases – in other words, NDT funding is part of our monthly electric bills. Owners are required to review annually and submit every two years to the NRC both the fund balance and cost estimates for decommissioning. The NRC provides a formula of costs for operators to compare with the balances on the NDT, or the companies can file site-specific cost projections for each facility. For more than a decade, Dodge and Phelps compiled nuclear power industry figures on trust fund balances, annual contributions and projected costs. In 2013, this annual study was transferred to Callan Investment Institute, a research and data firm. Their 2014 study can be found here . NDT sums are not small potatoes. As of the end of 2013, the fund balances for investor-owned utility’s NDT total $50.4 billion. While the funds value increased from $44.5 billion in 2012, annual contributions from both public and private owners decreased from $560 million in 2007 to $333 million in 2013. Investor-owned utilities are contributing 70% of their 2007 level while public owners like the TVA are contributing just 16% of their 2007 levels. However, costs for decommissioning are increasing and are up 44% since 2008. The total industry-wide decommissioning costs are estimated by Callan to be $80 billion. Below are tables outlining fund balances, annual contributions, and total estimated decommissioning costs from 2007 to present: Source: callan.com Source: callan.com Source: callan.com According to Callan cost projections, investor-owned utilities could have a current decommission funding shortfall of $23 billion, or an underfunding of 25%. Callan’s cost estimates are based on either the NRC approved rate per KW capacity as provided by the company or an industry-wide average of all decommissioning cost estimates at $798 per KW, whichever is higher. In many instances, companies use an estimate that is substantially below the industry average. Callan offers an interesting table by company. They produced the following table for the 27 investor-owned utilities with nuclear power plants, and includes average years remaining for their plant licenses; MW nuclear capacity across the company; total decommission costs, in millions, as offered by the company; the average decommission cost per KW; projected cost at either the industry average or the company cost, whichever is higher; company specific fund balance; the potential shortfall in total dollars; 2013 fund contribution; and the pro forma annual amount of the shortfall to make up the difference based on the average license expiration. (click to enlarge) To answer the immediate question concerning Entergy, according to the study, their NDT could be short by about $2 billion and to make up this difference over the average life remaining of their licenses, management should be setting aside $186 million a year rather than the $39 million currently. However, ETR is not alone in the study. The industry contributed $315 million in 2013 when Callan calculates the amount should be closer to $1.6 billion. Below are some shortfall numbers for the five largest nuclear power generators, Exelon (NYSE: EXC ), Duke Energy (NYSE: DUK ), Entergy , Dominion Resources (NYSE: D ), and NextEra (NYSE: NEE ). Source: callan.com According to Callan, EXC has potential net deficiencies of $7.7 billion including Constellation Energy; DUK has a potential net deficiency of $2.3 billion; ETR of $2.0 billion; D of $1.3 billion; and NEE has a potential surplus of $208 million. Combined, the largest five producers of nuclear power have a potential decommissioning deficit of $13.1 billion, or 57% of the projected total industry-wide. It is extremely difficult to calculate decommissioning costs for projects that not only span 15 to 20 years but also do not begin for an additional 10 to 15 years or more. There are currently three basic types of decommissioning with three distinct cost structures. A large portion of decommissioning budgets is directed to the cost of long-term storage of spent fuel, which in its own right is unsettled. Waste disposal can cost upwards of 30% of the entire decommissioning budget. It is easy to criticize the study’s methodology as being simplistic, but it has value for investors. The importance of the study is to bring awareness of the potential downside to the decommission process for certain utilities. For example, ETR could have a potential unfunded liability of $146 million a year, or about $2 billion. On a per share basis, this could represent about $0.44 to $0.60 a share in after tax earnings and at a valuation of a PE of 15, could equate to $6.50 to $9.00 a share. However, it is important to understand the timeframe for the realization of these potential shortfalls. The shortfall would be experienced towards the end of the decommissioning process. Using ETR as an example, with their average license expiration of 14 yrs. and a project life cycle of 10 to 20 yrs., the potential shortfall may not be material until 2050 to 2060. The industry will become more adept at projecting decommissioning costs and cost controls as these projects progress. As an operating cost, increasing NDT funding through rate relief may be an avenue in states where the regulatory environment is more favorable. There are currently 17 nuclear decommissioning projects in various stages. Costs associated with these range from several hundred million to $4.4 billion for the San Onofre facility in southern CA . The San Onofre facility begins its decommissioning process in 2016, and could take 20 years to complete. In 1996, Connecticut Haddam Neck nuclear facility began the decommissioning process with a budget of $720 million, but the process actually cost $1.2 billion. In an innovative approach Exelon transferred the operating license at its Zion 1 and 2 facilities to a third party for the decommission phase, and will take back the facility once it is completed. The NDT associated with the Zion plant started the decommission phase in 2010 with a balance of almost $800 million and it has been depleted to around $280 million as of Dec 2014. The decommissioning firm projects a surplus of $13 million in the NDT after completion in around 2020. According to documents from the state of Vermont, at present, Entergy’s NDT contains $642 million of the $1.24 billion in 2014 dollars that the Site Assessment Study believes could be required to fully decommission the Vermont Yankee site. Of immediate need is almost $400 million to begin the fuel storage process in 2016. However, decommissioning will not be completed until 2073. While incoming cash flow from customers’ bills ceases, the fund will continue to grow with higher interest income over the next 57 years. Utility investors should be aware of the fuel breakdown of each of their electric utilities. In turn, shareholders in utilities with nuclear power plants should feel comfortable with the potential higher costs associated with decommissioning. Personally, I am more concerned about the state of utilities over the next 10 years than in 2050 and beyond. While NDT exposure should be a factor in weighing the desirability of owning companies with nuclear power plants, it should not be the determining factor. Author’s Note: Please review disclosure in Author’s profile. Disclosure: The author is long D, ETR, EXC. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

The Greek Share Market: Poised For Significant Gains, After The Situation Calms Down

Summary The Global X FTSE Greece 20 ETF has declined by more than 50% since the beginning of 2014. The Greek government seems to understand the negative impacts of the potential grexit and they will have to fulfill the conditions of their Eurozone partners in the end. The Greek share market will grow significantly after the current problems are resolved. The growth will be strengthened by the European QE. The Greek share market represented by the Global X FTSE Greece 20 ETF (NYSEARCA: GREK ) has declined by more than 50% since the beginning of 2014. A major part of the decline happened in the second half of 2014 and in 2015 and it was caused by the renewed concerns about the potential grexit. The GREK share price behaved in line with the major markets (chart below) from the beginning. The problems started during the summer months and culminated in December and January when a political crisis led to early elections. The elections were won by Syriza, a party with a strong and loud anti-austerity rhetoric. Their way to power was paved by refusing the austerity measures and by a lot of unrealistic promises to the electorate. The new Greek government, led by prime minister Alexis Tsipras, initially demanded another debt writedown as well as a renegotiation of terms of the bailout program. After four weeks full of furious negotiations and a free fall of the Greek financial markets, the Greek government promised reforms, promised that it will not introduce any unilateral measures that would negatively impact the fiscal targets set by the “troika” and it declared its intention to fulfill its financial obligations. As a result, the bailout program should be extended by another four months. But a new list of reforms must be accepted by the Eurozone finance ministers before another financial aid disbursement. The proposed reforms were rejected by the Eurozone partners on March 9 and there is a threat of a Greek default as soon as this month. Although the initial reaction of the Greek representatives was highly negative, ranging from demands for German war reparations to threats of flooding Europe with immigrants. But on Friday, Tsipras reassured that Greece will hold its word given in February. It is more evidence that the Greek government realizes the painful consequences of the potential grexit. All the screaming and kicking around is just theatre for the Greek electorate. The grexit and the Greek default would lead to an immediate decline of the purchasing power of Greek citizens. The unemployment rate would grow above the current 25% level and the bank sector would be on the brink of a total collapse. Any chances of the current Greek government for a future re-election would drop to values close to zero. Yes, the grexit could be positive for Greece from a long term point of view. But the long term positives are not a sure thing. The only sure thing is huge pain in the short term. The most probable scenario is that the Greek government will keep on screaming and kicking, so that it can show their voters that they want to keep their promises and they fight for Greece, but they will surrender in the end in order to avoid the grexit and the responsibility for it. The Eurozone partners may make some minor compromises in order to give Syriza an opportunity to show their voters some “success”. But any major reliefs are highly improbable. The economy of the Eurozone is stronger than in 2012 and what is more important, the European financial sector is much better prepared for a potential grexit. The grexit is a much bigger threat for Greece than for the Eurozone today. As I wrote above, I expect that the situation will calm down and Greece will stay in the Eurozone. This is why I see a huge investment opportunity in Greek shares. As the chart below shows, GREK increased rapidly after its bottom in May 2012. It grew from $8.85 on June 1, 2012, to $18.80 on October 22, 2012. That’s more than 100% in less than five months. Yes, the historical results are no guarantee of future results, but history tends to repeat itself. Moreover, there is another powerful card in play this time. The European QE. The QEs led to inflation of a share market bubble in the USA. The same process has started in Europe now. And a lot of investors will direct their money into cheap Greek shares, after the situation around Greece calms down a little. I admit, I have no idea where the bottom will be and when it will come. It is possible that GREK will retest the 2012 lows in the coming weeks and it is possible that the bottom is somewhere near the current price level. Everything will depend on the progress of the Eurozone – Greece negotiations. The longer the negotiations last, the more the market’s nervousness will grow and the lower GREK will fall. The best solution is to wait until any kind of solution is reached and initiate a position in GREK. It may mean buying shares 10% or 20% above the bottom, but there will likely still be a huge upside remaining. Conclusion Although the Greek government is very loud and very aggressive, Tsipras seems to realize the negative impacts of the grexit on Greece and the future political careers of him and his party. I believe that Greece will surrender and fulfill the demands of its partners. In this case we can expect a huge increase of the GREK share price. It increased by more than 100% in less than five months, back in 2012. Similar gains are possible this time, given the supporting effects of the European QE. The best way to play this situation is to wait until the current complications between Greece and its Eurozone partners are resolved and initiate a long position. It may mean losing some initial gains of the bull run, but there should be still more than enough profits left. Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.