DARK HORSE HEDGE – Any way the wind blows, doesn’t really matter

Housing-keeping note: Thanks to WordPress’s destruction of Phil’s Favorites site (and replacement with an invite to sign up for its service!), I’ve been relocating my blog to TypePad.  Benefits: it looks better, is very user friendly and offers an easy way to search archives for any topic. One unique feature is that while exploring the internet, I can simply click on a button to post an excerpt of an interesting article with a link to the full article. That ability allows me to post links to articles that are worth reading when I do not have reprinting permission, such as articles from major news sources. 

The new Favorites site is here.  I’ve also created a website for Dark Horse Hedge, here.  – Ilene 

DARK HORSE HEDGE – Any Way the Wind Blows, Doesn’t Really Matter

By Scott Brown at Sabrient & Ilene at Phil’s Stock World

Is this the real life? 
Is this just fantasy? 
Caught in a landslide 
No escape from reality 
Open your eyes 
Look up to the skies and see 
I’m just a poor boy (Poor boy) 
I need no sympathy 
Because I’m easy come, easy go 
Little high, little low 
Any way the wind blows 
Doesn’t really matter to me, to me

– Queen, Bohemian Rhapsody

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Ilene and I started the Dark Horse Hedge on July 1, 2010 with the goal of helping self-directed investors weather any storm, no matter which way the wind was blowing.  Today completes the second month of publishing the Dark Horse Hedge and we thought it would be a good time to review.  

The principle theme we follow is simple: Make money in ANY market. 

Every day we hear talk of the bulls and the bears and which one is right or which one is winning. This is where there is “no escape from reality.”  Sometimes the bulls win and sometimes the bears win.  So who do we want to bet on?  The truth is we try to bet on both.  “Any way the wind blows, doesn’t really matter to me” makes all the sense in the world in hedging your portfolio.  We didn’t invent the idea of constructing a Long/Short portfolio by any stretch, but it is a strategy that deserves greater attention by individual investors and market strategists. The problem with focusing primarily on market trends and technical indicators is that market trends reverse, and technical indicators can be wrong. 

So we are designing our virtual Long/Short portfolio using this time-tested Long/Short method which the fat cats on Wall Street have used for years to help them shell out the bonuses we all shake our heads at.  This is a strategy that allows us to maximize Alpha, while keeping Beta relatively low.  Alpha, Beta and the Sharpe Ratios are investment terms that all individual investors should understand.  

Investopedia explains Alpha

Alpha is a measure of performance on a risk-adjusted basis.

It is one of five technical risk ratios; the others are beta, standard deviation, R-squared, and the Sharpe ratio. These are all statistical measurements used in modern portfolio theory (MPT). All of these indicators are intended to help investors determine the risk-reward profile of a mutual fund. Simply stated, alpha is often considered to represent the value that a portfolio manager adds to or subtracts from a fund’s return.

Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund’s alpha.

A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would indicate an underperformance of 1%.

Investopedia explains Beta

A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

Beta is calculated using regression analysis, and you can think of beta as the tendency of a security’s returns to respond to swings in the market. A beta of 1 indicates that the security’s price will move with the market. A beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 indicates that the security’s price will be more volatile than the market. For example, a stock with beta of 1.2 is theoretically 20% more volatile than the market.  

Investopedia explains Sharpe Ratio

The Sharpe ratio tells us whether a portfolio’s returns are due to smart investment decisions or a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater a portfolio’s Sharpe ratio, the better its risk-adjusted performance has been. A negative Sharpe ratio indicates that a risk-less asset would perform better than the security being analyzed.

To consistently make Alpha (return over benchmark, e.g. SPX) by investing in equities, we want Beta (correlation to market movement) as close to zero as possible.  By relying on Sabrient’s quantitative ranking system (click here for a free trial) to find the best stocks to own, and the worst stocks to own (best to short), and by using Phil Davis’s option strategies, we are able to enhance the Alpha of the DHH portfolio while keeping our Beta measure low.

So, how have we done so far and where do we go next?

Open Positions:

TEO – We recommended Telecom Argentina in the first publication of DHH on July 1, 2010 at $16.38.   The stock is at $18.87 giving us a profit to date of +14.77%. With a P/E of 8.1 and a strong buy rating from Sabrient, we still like the stock very much. 

XRTX– We also recommended Xyratex Ltd on July 1, 2010 at $14.64.  The stock had been acting weak and we brought our cost basis down on August 17, 2010 by selling Dec 12.5 calls for $1.25.  Our current basis in XRTX is $13.39 (buy price minus option premium collected) and the stock is trading at $12.05 with a p/e of 2.6. It has been gaining recent upside play from the bidding war over 3Par between HP and Dell.  We still like XRTX as a long position based on value and look to earn option premium while we hold the stock.  

JOE – St. Joe was selected as a short on July 1, 2010 for obvious reasons related to JOE being the largest land developer in the affected area by the BP oil spill.  JOE was $23.74 on July 1 and closed today at $24.08 so not much has changed.  Two lawsuits have been filed on behalf of JOE to attempt to recover its losses but we continue to believe this will be an expensive and perhaps fruitless undertaking. We maintain our recommendation to be short JOE.

USG – USG Corporation is the last of the six positions selected on July 1, 2010 in the first publication of DHH.  Our feeling then and now is the same:

“USG has been losing money for several years and the losses are expected to continue for several more years. The bad news from the housing industry over the past week does nothing to improve the outlook for USG, and I think USG is more likely than not to continue to trend back toward its 2009 low, which was below $5.00 a share.” 

We recommended shorting USG at $12.08 on July 1, 2010 and today it closed at $12.17. Nothing has happened to change our negative outlook.

AIV – Apartment Investment and Management Co. (AIV) was added as a short recommendation on July 13, 2010 at $20.73.  Our analysis at the time was:

“Apartment Investment and Management Co. is rated a STRONG SELL by Sabrient and is ranked #5 at the bottom of the VCU strategy.  AIV scores poorly in VALUE score of 6.4 out of a possible 100 which is a measure of the relationship between a company’s stock price and its intrinsic value.  Additionally, AIV scores below industry averages in both BALANCE SHEET score of 29.8 versus the industry average of 37.3 (possible range is 0 to 100) and FUNDAMENTAL SCORE of 12 compared with an industry average of 37.3 (possible range of 0 to 100).” 

AIV closed trading today at $20.44 and has an above market p/e of 14.8 so we feel comfortable reiterating the short position.

WDC –  Western Digital Corp. (WDC) was added as a long on July 13, 2010 at $31.90.   This is another “No escape from reality" example.  WDC hasn’t performed according to plan.  On August 17, 2010, DHH recommended selling covered calls on most of our long positions, as part of our tilting practice as we felt the market was on a Road to Nowhere at least through mid October.   So we lowered our cost basis in WDC by selling the Oct $26 covered calls for $1.61 bringing our cost basis down to $30.29.  As the premium expires from the calls we will recommend rolling them forward and taking in more option premium as we wait on WDC to preform a little better than it has so far.

TEX – Terex Corporation made the honor roll for shorting on July 19, 2010 when we anticipated another “earnings” shortfall and a quick return off shorting TEX at $17.60.  Terex, true to form announced a loss, but a mere -$.12 rather than the expected  loss of -$.30.  One of the reasons TEX is on our short list is because of the aggressive accounting measures used by the company.  We still believe that, in the long run, this will cost TEX in share price. So we maintain our recommendation of being short TEX which closed at $18.21 on Aug. 31. 

GME – Gamestop Corporation was as a new long at $19.92, the same day we shorted BOOM, on July 23, 2010.  We wrote: “GME is trading at a P/E of 7.5, versus the industry average of 13.8, allowing plenty of room to move higher just by continuing to perform.”  GME closed Tuesday August 31, 2010 at $17.93 and is now trading at a P/E of 7.65 after missing earnings by $.01.  In Road to Nowhere, we decided to write yield enhancing calls on this position: 

"We are recommending selling 3 contracts (300 shares) of GME101016C00020000 for $1.35/contract.  By doing so we are lowering our cost basis by $1.35 and agreeing to sell 300 shares (which we already own) of GME between now and October 15, 2010.  If GME is below $20 we increase our yield (much like a dividend) on GME by $1.35 and can decide at that time based on market and company progress whether to sell another option contract, sell the stock or simply hold.  We also have the option on any date to purchase the option back which we will do if it moves below $.50 with any reasonable amount of time left on the contract."

We continue to like GME at these levels and would buy it again at current prices.

DLX – Deluxe Corporation was added to the DHH portfolio on July 26, 2010 as part of “Balancing Act I” because we believed that DLX is at a good value.  It was trading at a P/E of 8.0 versus the industry average of 16.7.  Sabrient has a STRONGBUY on DLX and it is the highest rated company in the Commercial Services & Supplies group.  DLX closed Tuesday at $16.73 bringing its P/E even lower to 7.13.  We still believe this is a chance to add a strong value stock to the portfolio at a discounted price.

GCI – Gannet Co, Inc. is a strong value play (p/e of 5.58) that was added to the DHH long positions using Phil’s Buy/Write strategy on July 26, 2010.  To acquire our 7.5% position allocation in GCI, we purchased half the number of shares we want to own at $14.52 and sold Jan $15 2011 calls and puts against the position, bringing in $4 in premium.  (One put and one call sold for each 100 shares of GCI.) The net result is that we bought half our position for $14.52/share, less $4 option premium, resulting in a cost basis of $10.52/share.  GCI has been weak, closing today at $12.09. We are obligated to purchase the other half position on January 21, 2011 at $15 if GCI is still under $15 at that time.  If GCI is over $15, we will make another $.48 on the first half of our position, being out with a $4.48 profit.  We still like this trade, although if entering now, we would sell the Jan $12.50 2011 calls and puts.

IM – Ingram Micro (IM) was also added on July 26, 2010 using Phil’s Buy/Write Strategy.  We purchased half of our position in IM for $16.81 before the company beat estimates and guided higher for the year.   Using the Dec $17.50 calls and puts we brought in $2.50 in to bring our cost basis on the first half of our position down to $14.31.  IM closed today at $15.06 with bright prospects for the second half of 2011.  Again, we like the position still and would recommend entering it now, using a lower strike price to reflect the weakness in the stock–the Dec $15 call and puts.

FRX – Forest Laboratories, Inc. was also added on July 26, 2010 as we followed the tilting to the long side.  FRX was added at $28.21 for numerous reasons.  We noted that "FRX is on The Pragmatic Capitalist’s "No Debt" list (via his blog post last week).“  On August 17, 2010 when we published the “Road to Nowhere” FRX calls were added to bring premium into the portfolio during the expected turbulent months ahead.  So we sold the November $29 calls lowering our cost basis to $26.86.  The stock closed today at $27.29 so we are quite comfortable with the position going forward.

CLDA – Clinical Data, Inc. was added as the short of choice on July 30, 2010 at $14.05.  We realize this is not an easy stock to borrow and some have had difficulty doing so.  We posted on July 30:

“CLDA is rated a STRONGSELL by Sabrient with a BALANCE SHEET score barely registering at 1.1 (out of 100) and almost non-existent FUNDAMENTALS score of 0.3 (out of 100).” 

Since then CLDA reported a whopping -$.51/share loss for the June 2010 quarter and analysts are anticipating more of the same in the next 2 quarters with losses of -$.59 and -$.65.  We reaffirm the recommendation in the DHH virtual portfolio to short CLDA at today’s closing price of $14.90.

WFR– MEMC Electronic Materials, Inc. (WFR) was added using Phil’s Buy/Write strategy on August 11, 2010 at $10.31.  One reason we are excited about the company is that since August 3, 2010, six WFR officers have purchased over $1 million in stock on the open market between $9.51 and $9.91. We believe this is positive: insiders showing confidence that the shares are undervalued. Perhaps they know something we don’t.  Another 20,000 shares were purchased by an officer since then, above our entry price.  Using Phil’s Buy/Write strategy, we brought in an additional $2.69 on the January $11 2011 calls and puts.  So we own ½ of the shares we want for a net purchase price of $7.62 and WFR closed today at $10.29.  We like this position very much.

SGEN – Seattle Genetics, Inc. was added to help tilt the portfolio short after the market reversal in August.  SGEN was recommend as a short August 16, 2010 at $12.11 and having closed today at $11.45, we continue to believe this is a good trade.

SCOR – comScore, Inc. was added to the short list on August 23, 2010 at $17.94 and closed today at $18.17. Still recommended as a short position for DHH followers. 

VECO –  Finally, we ended August 2010 going long Veeco Instruments, Inc. which we added using Phil Davis’s Buy/Write strategy on August 25, 2010 at $32.  We brought in $6.20 on the option premium on the Oct $32 calls and puts, lowering our cost basis to $25.73.  VECO closed today at $33.23.

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Where are we going?

No one knows, but I still believe we are on a road to nowhere at least through mid Oct.  The strategy at this point is to take profits when we see opportunities.  We will remain tilted short by selling calls, limiting our upside potential in favor of earning premium on our long positions, and adding to shorts on market bounces (like today).

Ilene and I will continue to monitor the market and our positions to help guide readers so they can always say “Anyway the wind blows, doesn’t really matter to me."  We believe that our current open positions are still reasonable to enter at current prices.  For positions that have corresponding calls and puts written against them, in some cases, noted above, we would sell calls and puts at an adjusted strike price. 

Ilene’s new website for Phil’s Favorites is here.  On this site, we have a separate blog for the Dark Horse Hedge, here. 

Currently, we have a special offer from OptionsXpress for a $500 cash contribution for readers who would like to try Sabrient’s premium service or one of Phil’s Stock World newsletters or trading services.  After opening an OptionsXpress account, taking a subscription to Sabrient’s research, PSW, or both, OptionsXpress will fund your new account with $500. Details for PSW here, and Sabrient here. 

Table 1. Sabrient’s Reports on open long positions.

For more information on the long positions, click on the stock ticker in the table below. Note: this table has been updated with current ratings which might differ from the ratings at the time we initially purchased these stocks.  Eight of the positions in the table below have been hedged with sold calls (GME, WDC, XRTX, FRX) or have been initiated using Phil’s Buy/Write Strategy (GCI, IM, WFR, VECO). 

Table 2. Sabrient’s Reports on open short positions.

For more information on the short positions, click on the stock ticker in the table below. Note: this table has been updated with current ratings which might differ from the ratings at the time we initially shorted these stocks.   

Closed DHH Positions:

AMAG –  DHH recommending shorting AMAG on July 1, 2010 at $34.30 when we wrote: 

“Applying Sabrient’s rating system, AMAG scores very poorly on several key rating measures.  Specifically, a fundamentals score of 4.5 out of a possible 100 (industry average 52.1), measuring the company’s financial health, a balance sheet score of 39.2 out of 100 (industry average 68.8), measuring a company’s liquidity and debt issues, and a value score of 39 out of 100 (industry average 51.6), which measures the company’s stock price against its intrinsic value. These factors combine to suggest AMAG as a good short candidate.”

Ultimately AMAG reported worse than expected results and on July 29, 2010 DHH recommended covering the short position at $31.65 yielding a +7.7% profit in 28 days.  During that same period the S&P 500 traded from 1030 to 1121 so we were happy to take a profit on a short position while the market trended higher.  AMAG has shown continued weakness and is trading at $26.01 today. (Of course, in reviewing this positions, it’s hard to wish we had held on longer but "easy come, easy go" as the song goes. 

HUSA – Also recommended as a short on July 1, 2010 at $9.91. We wrote:

“Regardless of Sharesleuth’s allegations, the company is trading at 81x earnings in a business that its peers receive 22x valuations.  All of this leads me to believe that HUSA is overvalued at $10/share.”

True to form, HUSA, sold off to $8.72 on August 12, 2010 and we recommended covering the position with a +12% profit.

HUSA – We got right back on the saddle with HUSA when its share price rose to $10.54 on August 18, 2010 just after the company announced paying over $600k of the nearly $1 million it recorded as profits to its three executives/employees as bonuses.  Again, following the script, HUSA quickly sold off back to $9.35 two days later giving DHH another chance to take profits of +11.3%.  We are out of this stock currently, but happy to short it again in the future. 

STI – The July 13, 2010 publication of DHH recommended a short position in Suntrust Bank at $25.54 because

“Sun Trust Bank is rated a STRONG SELL by Sabrient and is ranked #3 at the bottom of the VCU strategy.* Earnings (or lack thereof) will be announced July 22, 2010 and 29 analysts project a range of -$.06 (on the best side) to -$.46 (on the worst side) with a consensus of -$.34.”

*VCU is Sabrient’s proprietary forward-looking outlook score which ranks a universe of stocks into quintiles that have proven to be very predictive of performance, allowing us to identify the best of the best and worst of the worst.

Suntrust Bank actually came in at -$.11 beating consensus estimates of -$.34. However on August 23, 2010 after completion of a $750 million tender offer to retire debt and hopefully return the bank to profitability we were able to cover our position at $22.68 for a +11.2% profit.

BOOM! – We had a little fun with BOOM by recommending a short position on July 23, 2010 at $16.19 stating that

“The company announces their 2nd quarter performance on July 29. Six analysts following BOOM are forecasting a breakeven quarter with a low estimate of -$.02  to a high estimate of +$.03.  With a P/E of 51.45 we feel BOOM is overvalued at these prices and is susceptible to any market downturn.”

On July 30, 2010, right on cue, BOOM’s report was poorly received and we issued a recommendation to cover the position at $14.99 for a +7.4% profit.

RAIL – The July 29, 2010 publication of DHH recommended entering a short position on RAIL at $24.19 noting

“RAIL is rated a STRONGSELL by Sabrient with a VALUE score of 25 (out of a possible 100) and a GROWTH score of 30 (out of 100).”

RAIL reported -$.11 for the June quarter and the stock drifted lower allowing us to hop off RAIL on 8/24/10 at $21.50 for a +11.1% profit.

Table 3. Sabrient’s reports on closed short positions. 

For more information on the stocks we shorted and covered, click on the stock ticker in the table below. Note: this table has been updated with current ratings which might differ from the ratings at the time we initiated our short positions. 

Queen, Bohemian Rhapsody

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Road to Nowhere picture credit: Dangerous Minds