Wednesday, March 14

Radio waves from the past and present

Recently a local community radio station North West FM featured recordings by my late father and youngest daughter. They played 'Mosquito' from the RAAF Glee Singers playlist below and 'Something's Better Than Nothing' from Rachael's Sound Cloud as per below.  


Tuesday, March 13

Introducing stock filters

An introduction to selection criteria’s to identify potential quality companies and sensible sector exposure limits within a portfolio  

This paper was written to assist those not qualifying for government pension to make sage investment decisions. It aims to shed light on the methodologies involved in identifying prospective quality companies for further in depth evaluation. In other words I will talk about a selection criteria, which must inevitably involve some form of filtering.

 Adopting a conservative approach with less need for sophisticated filters  

One can opt to take the more conservative option by investing via LICs (Listed investment Companies ), where the evaluation of quality companies and determining value is a much more straightforward matter. This was illustrated in my prior paper on the subject. The advantage of investing in a large cap LIC is it will mostly cover the entire index for you.

However, to enhance your overall returns, you could also include in your portfolio a small cap LIC, on the expectation you expect small caps to outperform large caps. Another option is to include a LIC whose investments are principally overseas, should you consider the prospects are superior abroad.  

It’s a matter of feeling comfortable with an investment strategy that reflects you aims and risk appetite.
Sector exposure is also important to the extent we don’t want to
be overweight and risk a larger fall than applies to the index.
Sector weightings    
To recap it’s risky to be materially overweight in any one sector relative to the ASX. Their website provide relevant free information on sector weightings and performance. But it can be devilishly difficult to find. This paper sets out the detailed search steps for you.

However, before that, I need to quickly dispel the questionable common theme diversification in itself provides quality and safety. 

The questionable theme of quality through diversification.
This is the idea that a diverse mixture across different asset classes affords safety since as one sector falls it will be compensated by a rise in another asset class held in a portfolio. This is only true at times and it’s a terrible idea if you were only to be invested in shares and interest bearing securities. By way of example take the present US market where most interest rates are fixed whereas in Australia they are mostly variable. The risk for a US investor is if both inflation and interest move up faster than is anticipated, both Bonds and shares will both fall. That’s not the case for Australia because variable rates apply here (as in so many points over the 90 bank bill rate) so shares could fall but it doesn’t mean a fall in interest bearing securities. But nor does it mean one asset class affords protection over the other.

And if there was to be much higher interest rates in Australia I think it very likely house prices, consumer discretionary shares and banks would all fall simultaneously. The so called safe haven gold sector long term is one of the worst long term performers whose price does not keep pace with inflation. That doesn’t mean all the shares in the sector are duds, as you have some that performed very well. 

Sensible sector limits  

Rather obviously there is nothing wrong with diversification, except don’t presume it will always protect you, to offset falls in one asset class with rises in another. Instead what I propose for you is to consider a few simple rules:
1.  No share or individual security to exceed 5- 10% of your total investment portfolio. I use 6%.
2.  No sector exposure exceeds 15 to 20 % of your total portfolio. I usually use 15%.

Limiting exposure to sectors 

However, one can calculate accurately each sectors current relationship with the total index at any time. I invite you now to follow these links from the ASX website    

Firstly go to the ASX website
·       Starting from home click on the top heading called Products and  ·       Scroll down to the heading Indices – click on that.
This will take you to the screen headed ‘What are indices.’ 
·       Scroll down under that until you see the sub heading of ‘Types to sector indices.’ ·       Click on sector indices 
·       Scroll down the heading and narrative headed ‘Types of indices’, until you see the minor heading: to learn more, please refer to the overview of Sector indices.
·       Click on that and it will take you to the indices. You are now in the position to utilise the wealth of information available in relation to the above indexes. Scroll down to the Index with explanatory narrations. By way of explanation click on S&P/ASX 200 Consumer Discretionary Index. This index provides investors with a sector benchmark that reflects all entities in that index. The index provides facilities to measure (1) its relative performance to the broader S&P/ASX 200 and (2) Its relative size or % to the S&P/ASX 200. Additionally there are related comparable indexes to compare such as the S&P/ASX small ordinaries, franking credit adjusted total return index.

Hence you can carry out an exercise for each of the sectors as above to gauge the current respective sector exposures and returns. That can then be compared with your holdings under those sector classifications. You are then is a position to determine what percentage your holdings compare to your portfolio and how that compares with the sectors percentage to the total index.  

An introduction to filters  
As you may recall Professor Benjamin Graham is known as the father of Value investing, who introduced the ideas of more value orientated share selection criteria’s.  He authored 2 books namely Security Analysis and its much friendlier publication, Intelligent Investor.
Graham’s selection criteria was as follows:
·       An earnings-to-price yield twice the AAA bond yield.
·       A PE ratio (price-earnings ratio) less than 40% of the highest price-earnings ratio for the share over the past five years.
·       A dividend yield of at least two-thirds the AAA bond yield.
·       Share price no more than two-thirds of tangible book value per share.
·       Total debt less than book value.
·       Current ratio greater than two.(Ratio of current assets to current liabilities 
·       Total debt less than twice ‘net current asset value’.
·       Earnings growth of prior 10 years at least at a 7% annual compound rate.
·       Stability of growth of earnings in that no more than two declines of 5% or more in year-end earnings in the prior 10 years are permissible.

Comment & Explanation
Both Graham and Buffet were very successful in the early days using these filters to unearth and invest in undervalued entities. Successive acquisitions of undervalued companies, bore fruit in the form of an expanded share price as the quality of consistent earnings per share became much more widely appreciated. 
There is nothing wrong with applying that criteria to day except I would suggest there are no companies trading on the ASX who will meet such strict filters. Probably none in the US either. If there was they would be an aberration and likely to be subject to some obscure circumstances that would render the share as ones to be avoided in any case.
To reiterate Graham and Buffet were hugely successful because they were able to operate in an era when quality companies could be bought very cheaply as value investing was virtually unknown.   

However, with the use of computers and enhanced investor knowledge such opportunities no longer exist. Buffet has repeatedly told investors as far as Berkshire is concerned the salad days are over. Even so the share price continues to grow along with his reputations as a sage investor and that of co-owner Charlie Munger. These days Buffett/Munger talk about 4 key Filters.
1.  Understand the business. Research.   
2.  An enduring competitive advantage. Patents, expertise and circles of virtue.     
3.  Protective moats- barriers to entry to create advantage. 
4.  Ensuring you have a fair value and or a margin of safety.   

The idea of adopting filters has considerable merit and we can apply more realistic filters today in many different ways.
Application of Filters
The easiest way to apply filters is to evaluate shares within sectors or industries to identify new potential buys and sells. The advantage of this approach is it is simple and rather obviously doesn’t involve any additional cost. But it would involve a lot of manual handling (unless you could plug into a google finance or yahoo website that has the info) and even more potentially burdensome calculation.
Alternatively there are many excellent platforms that I have road tested. I prefer Skaffold, because one determines your own filters. Their system gives me maximum flexibility. I never take any notice of model portfolios, although I concede this can be an ideal measure. It’s more a matter I just like to do my own thing so that if I make a mistake I can only blame myself.

I road tested Stock Dr for 3 months and I understand the rudiments of Intelligent investor. All are excellent platforms that have their own inherent strengths and weaknesses. That’s true of course for any system you use and emphasises the importance of understanding their modus operando, as in their particular way or method of doing something.
Here are 2 illustrative examples of 2 filters – One for the entire share universe 
u Only quality companies (rated by a number of factors inclusive of performance metrics ) with a prior track record
u Grown in share value > 5% past 5 years
u Future consensus growth>5%  
u Return on equity >15%
u Has a continuing funding surplus
u Net Debt to equity < 50%
u Safety Margin over intrinsic value

Others filters might be confined to sectors, then broken down to micro, small. Medium, and large caps entities. As you can gather you can build up to a very large number of filters that can be employed across the ASX and abroad. This filter for instance is far less onerous aimed at unearthing a dozen or so names for further in depth analysis.
u Fair quality companies (rated by a number of factors inclusive of performance metrics which aren’t too restrictive) with a reasonable prior track record.  
u Grown in share value > 5% past 5 years
u Future consensus growth> 7%  
u Return on equity >10%
u funding deficit no more than 10%
u Net Debt to equity < 100%
u Don’t have a Safety Margin and allow the stock to be up to 17% over valued.  
Lindsay Byrnes
Value Investing Tutor - University of the 3rd Age. 

Wednesday, March 7

Using options to hedge

This paper was written to assist in the management of risk for those not qualifying for a government pension who manage their own investments as self-funded retirees.  Because of the appalling low interest rates one must invest in a variety of equities and interest bearing securities to secure even a very modest self-funded pension.
This paper is an introduction to options which facilitate hedging strategies that protect investors from sharp falls. It can be regarded as purely educational and general in nature. Readers should not rely on the contents which may not suit individual investors. When contemplating hedging or using options interested parties should always consult a licenced professional. The paper will support one tutorial at the University of the 3rd Age devoted to the management of risk.       

Options are used for a wide group of securities classified under the heading of derivatives. A derivative is anything that derives its value from something else, in this instance for options, from the underlying shares or share indexes. They are only risky when used improperly for purely speculative purposes or in naked trading. In the 2008 Global Financial Crisis mortgage backed securities and credit default swaps caused most of the problems. Options were largely blameless.  

Used properly, options can be useful tools to facilitate modest hedging and gain a small additional income. You can hedge against individual shares or your entire portfolio by buying an index put.
Similarly rises can also be covered without the need to buy any more shares by buying an indexed call. Professional fund managers routinely use indexed options, aimed at enhancing overall returns.  The options market can also influence the share market.  

At the end of the paper is a glossary of terms as a reference point although my aim is to explain comprehensively along the way. 

Options Market
Buyers and sellers take market positions in the underlying shares according to their assessment of likely trends. Contracts are for 100 shares. In Australia daily turnover fluctuates from around 500,000 up to a million. Additionally there is about 40,000 daily trades in indexed options which are traded at much higher values. Contract size is 1000 points plus an investor multiplier of 10, meaning it’s effectively $10 a point.   Option trading can exasperate trends in share prices and their indexes.

This happens when share prices are very close to the exercise prices at close proximity to maturity. Traders then will engage in buying and selling the underlying shares to improve their option outcomes. These activities can sometimes move prices by 1% or more. You can also gauge market sentiment by examining the put-call ratio. This is an indicator ratio that provides feedback about the trading volume of put (sell) options to call (purchase) options. The put-call ratio has long been viewed as an indicator of investor sentiment in the markets. At the moment it is bullish. 

Options Terminology -Options Contract
An agreement between buyers and sellers defining such terms as the underlying security and the exercise (strike) prices. There are 2 contract types, namely European, whose underlying shares or index can only be exercised on maturity and those called American where exercisment can occur at any time up until maturity.  

Description: 79.01 CALL OPTION EXPIRING 28-MAR-2018
Underlying asset: COMMONWEALTH BANK.
Expiry: 28 Mar 2018
Exercise Price: 79.010
Exercise style: European
Open Interest: 2,624
Contract size: 100 securities
Commenced Trading: 26 Apr 2017 

·      Call Option explanation
The above Call option gives the holder the right to buy, but not the obligation, the designated number of shares at the exercise (strike) price of $79.01 which will mature shortly. The exercise (strike) price is the price a share must go to or move above it before a position can be exercised for a profit. However, in all cases, because of the unexpired tine value it makes more senses to sell the share before maturity. Typically this current option would have been bought many months before when the share price was closer to $79.01 than when a buyer expecting its price to increase. The option is very likely to expire worthless but presently would have just a modest unexpired time value. .   

·      In or out of money
A call options is in-the-money if the share price is on or above the exercise (strike) price. A put option is in-the-money if the share price is at or below the strike price. The option can be sold at any time prior to expiration. In both cases options can always be sold prior to expiration when they will have a small unexpired time value.     
·            Putt Option a Put option confers a right, but not the obligation, to have bought, at expiration, at the exercise price, the shares which are the subject of the put option. That is, where shares are at or below the exercise (strike) price.

Description: 79.01 PUT OPTION EXPIRING 28-MAR-2018
Underlying asset: COMMONWEALTH BANK.
Expiry: 28 Mar 2018
Exercise Price: 79.010
Exercise style: European
Open Interest: 1,661
Contract size: 100 securities
Commenced Trading: 26 Apr 2017
·                Putt  Option explanation

This option also began trading on the ASX options market on the the 26th April 2017 but as a put option. A buyer, say in late January may have bought this Put option as insurance against a fall in the CBA share price. Rather than expire worthless, as is the case with the buyer of the call, the put option holder has partially hedged falls in the CBA share price after allowance for the initial premium paid.

For this option we can calculate the intrinsic value and the unexpired time value for a total of the option price as follows:

Intrinsic value: Exercise Price of $79.01 less current share price of $76.39 =$2.62.
One then adds the intrinsic value for time value unexpired, which is   18 cents. The option is currently trading at $2.80, so the time value differences continue to decay but will apply up until expiration.

Hence the time value is ex intrinsic value, a determinant of two variables (1) time remaining until expiration and (2) the closeness of the option exercise (strike) price to being in the money.
In summary options are in the money or out when they are at or compare favourably or not with their exercise (strike) price.
When specifying a particular option it is customary to refer to the strike price in lieu of the exercise price. 

Selling covered calls. 
The difference between a seller of calls and a covered seller is the latter holds already holds the shares in the options being sold. The seller also receives the premium paid by the buyer. To the extent the covered call seller receives premiums this could be regarded as a mild form of hedging against possible falls in the share price. The alternative is called naked trading and is not recommended. 

Hence a covered call is an options strategy to holds shares (what is called in the industry long positions) but sell options over those shares aimed at generating increased income. It can call also be known as a "buy-write".

In summary the position for covered call sellers is as follows:
Out of money options are likely to see their option expire worthless. 

In the money options can be bought back before expiry by sellers. For sellers there is always the possibility of selling another contact at a different exercise price, to recoup or even exceed the buyback cost.  

In and out of money is a common industry term to describe positions. In this case we are talking about an option where the exercise price has been reached or breached. In other words where the underlying shares or indexes exceeds exercise prices. 

When using European style options one is protected from being exercised just prior to dividends becoming due, as the style can only be excised on maturity on the exercisment date.   
Indexed options 
The exact same principles and contracts apply except except we substitute share indexes in lieu of individual share prices. The exercise price then becomes various index levels. A buyers of an index put can cover an entire portfolio as c insurance against a catastrophic market crash. 

However to ensure premiums are not prohibitive discounts can be deducted from the current index levels. 
Illustrative example Index put over S&P/ASX200
Description: 5350.0 PUT OPTION EXPIRING 17-MAY-2018
Underlying asset: S&P/ASX200
Expiry: 17 May 2018
Exercise Price: 5,350
Exercise style: European
Contract size: $1000 / point
Commenced Trading: 17 Nov 2017

The Buyer is desirous of cover for $400,000 over the portfolio. 
Note that by choosing an index exercise price of 5350 the buyer is prepared to wear as an excess a discount of 10% (545 points) since the index is presently trading at 5895, at the time of writing.  
The next step is to calculate how many contracts we have to enter into. This is calculated by dividing the cover required of $400,000 by the current index 5895 and applying the investment multiplier of 10. So we calculate a need to buy 7 contracts.  Under such contracts a specified number of dollars per point of $10 is to be applied. 
The cost at the time of writing is 32 cents per point, so the total cost for a 1000 point contract is $320 to which we must apply the investment  multiplier of 10 =$3200. Each contract then costs $3,200 for a total premium payable of $22,400.

However is there was to be very sharp correction of say 30% prior ton expiry the option purchase would afford hedging as follows:   

The intrinsic value of one contract would be 5350- 4127=1223 points @ multiplier of 10=$12, 230 per contract times 7 contracts =$85610
Less original cost  =                                 $22400
Hedging achieved                                     $63210
Fall in prices                                          $120.000
Loss absorbed in excess 10%                    $40,000
Less cost of cover                                    $22,400
Intrinsic value                                         $57, 600
Time value, the time value unexpired        $5,610
Index  now trading at 4127. 

Note that if the index rose instead of falling the put option does not inhibit any upside. Large scale catastrophic losses (GFC) render the insurance much more worthwhile. 

Final expiration of open positions.
To recap options cover varying time periods and buyers and sellers can elect to take positions any time prior to maturity. In the previous illustrative examples we assumed positions in late January and examined their likely result.

In other words to examine if these positions were likely to be in or out of the money on expiration on the 26th March 2018.
Those options that remain in the money will be automatically exercised on the 26th March and positions finalised by execution by brokers on behalf of their clients. If you elect to use options you will be required to sign a derivatives agreement with your on line or full service broker. Clients get BUY and Sell notifications at brokerage according to broker agreements. 

The market in options.
Just to recap there are 4 participants in the options markets: buyers of calls, sellers of calls, buyers of puts, and sellers of puts.
·      Buying and selling options is very similar to shares in that you receive or pay a premium based on what is called a strike price under a particular share option contract, The premium is determined by factors inclusive of the share price, strike price and the time remaining until expiration of the contract.
·      An option contract typically represents 100 shares of the underlying shares. There are 2 types-American and European. Holders of the latter don’t have any rights until expiration.
·      The European Indexes are for 1000 points and an investor multiplier of 10 is applied.
·      Options materially affect share prices.

Glossary of terms

A "buy-write" is selling a covered call.  
Call Option: gives the Buyer the right, but not the obligation, to buy a share or option index contract at an excise price within a specific time period.
Collateral – to be lodged by sellers as security.  
Contracts that sets out the agreement for Buyers and sellers covering option parameters.
Contract sizes – 100 shares or 1000 points by 10 for indexed options.
A covered call is an options strategy to holds a share (long position) and sell options on that same share aimed at generating increased income from the share held. A covered call is also called a "buy-write".
Exercise price is usually called the strike price.    

In and out of money will be determinants of whether or not the underlying share or index level reaches or exceeds exercise prices.  Outside of money is indicative current prices will render the option worthless on expiration.     
Option Style: An American option is an option that can be exercised any time prior to expiration or in other words anytime during its life. European options are exercisable only at maturity.
Putt Option
A Put option confers a right, but not the obligation, to have bought, at expiration, at the exercise price, the shares which are the subject of the put option. Subject to share prices below or at the exercise (strike)  price.
Time Value of options
The time value is ex intrinsic value, a determinant of two variables (1) time remaining until expiration and (2) the closeness of the option exercise (strike) price to being in the money.
Investment Multiplier
Under a contract a specified number of dollars per point when using European Index Options. Usually $10

Lindsay Byrnes -Value Investing 2018