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In
2009 I had a return of +31.6% compared with the S&P500’s +23.5%. Before anybody congratulates me, please keep
in mind that the NASDAQ increased a remarkable +43.7%. My
return in 2009 was powered by a 107% increase in Fossil Watches and a 55% increase
in a new addition to the portfolio – American Eagle. K-Swiss was the worst performer of 2008,
clocking in at -11% for 2009. My
personal account recaptured the dollar losses that occurred in 2008. Many individuals comment (correctly I might
add) that a 50% decline in a portfolio in the first year requires a 100% return
in the second year in order to break even.
Although the aforementioned observation is true, it assumes that during
arguably the worst economic collapse in modern U.S. history, an investor
deployed no money, allowing a massive opportunity to come and go. Keeping
that comment in mind, in this year’s op-ed piece I would like to provide a more
robust accounting of some of the investing ideas that cross my mind from time
to time.
Our
cash decreased as the markets fell and we allocated capital into American Eagle
and The Buckle. Here is a brief look at
the relative sizes of the companies in the portfolio:
NEW ADDITION I
added American Eagle to my portfolio at the start of 2009 at approximately
$11. I have been following the company
for awhile and $11 hasn’t been seen since 2001.
By waiting 8 years to get the company at the same price, this is what I
got:
Even
if the 2009 numbers never change, this was a good deal. If the company recovers to its former glory,
then this will be a 10 bagger. On
the other side of the coin, K-Swiss continued to work through their
difficulties. Their share price in 2009
hasn’t been seen since 2001, however, the only difference between K-Swiss and
American Eagle is that K-Swiss’s unflattering performance in 2009 is the same
as it was in 2001 - revenues of $265M,
gross profit of $87.0M, operating margin of -$41.2M, and profit margins of
-$29.2M. The company continues to try
and weather the one-two punch of a decline in top line sales and the economic
downturn. Only time will tell when Steve
Nichols can right the ship that he set sail decades ago. The
Buckle continued on a tear despite its share price falling by 40-50% in 2008
the year earlier. Trailing twelve month
(TTM) numbers show revenue at $875.3M (all time high), gross profit at $386.9M
(all time high), operating profit at $187.7M (all time high) and net profit of
$119.5M (all time high). The Buckle is also
an extremely efficient operator posting TTM gross margin of 44.2%, operating
margin of 21.4%, and net margin of 13.7% against a backdrop of an ROA of 26.6%
and ROE of 37.5%. The
Buckle paid a special one-time cash dividend of $1.80 per share and their
regular $0.20 quarterly dividend for a total of $2.00 per share in Q4
2009. I disliked this payout because of
2 reasons 1) I don’t want the money and 2) I can’t find an alternative investment
that will compound it at 37.5%. It is
not possible. And although they never
said so in their press release, I suspect that the owner of the company (Daniel
Hirschfeld @ 16.8M shares) wanted to be paid in dividend rather than regular
(highly taxed) income. In
most cases, an attractive price is usually associated with a problem. In The Buckle’s case, revenue and profits
kept coming in increasing amounts, but the price tanked. The price is still modest because the
investment community expects another shoe to drop. Finally,
there is nothing exciting to say about Berkshire Hathaway, Fossil and Columbia
Sportswear. They all made money and all
their share prices climbed higher – from 2% in the case of Berkshire Hathaway
to 10.5% for Columbia Sportswear and 107% for Fossil. Due to the sheer size of Berkshire Hathaway
it is likely to remain a perpetual anchor in my portfolio. I may not have had any intent to increase my
investments into the insurance juggernaut run by Warren Buffett, but the
recently announced 50-for-one stock split pretty much sealed my decision to
stand pat. BUY There
was an article in the newspaper that stated that Robert Cable, Toronto-based
head of ScotiaMcLeod's Cable Group noted that while investors may want to
emulate Warren Buffett and buy and hold forever, in practice "nobody does
it," he says. This is one of the
big reasons most are not able to secure any significant gains while investing
in the stock market. Mr.
Cable recalls asking 300 advisors at a Florida conference how many of their
clients had bought and held the same portfolio a decade or more. The only hand
that went up represented a client who was literally in a coma following an
accident and whose account could not be traded. The
problem with this anecdotal story is that individuals who used advisors are
always cajoled into churning their portfolio on a regular basis – to the
benefit of the advisor. "Anyone
who goes into investing with the intent of buying and holding virtually always
succumbs to outside pressures to abandon the strategy. My guess is when we have
nobody believing in buy-and-hold again, we will again be ready for one big bull
market to take off," says Mr. Cable. It
cannot be said often enough that the biggest challenge that an individual faces
as an investor is not the evaluation of a business, but buying when everyone is
selling and not buying when everyone is buying. With
the idea of buying low, Warren Buffett made the following comment, “With
some, the idea of buying dollar bills for forty cents takes, and with some it
doesn’t take. It’s like an inoculation. It’s extraordinary to me. If it doesn’t
grab them right away, I find that you can talk to them for years and show them
records–and it just doesn’t make any difference. I’ve never seen anyone who
became a convert over a ten-year period with this approach. It’s always instant
recognition or nothing. Whatever it is, I’ve never understood it.” From
my limited experience, the vast majority (probably 95% of individuals) do not
buy low. They either buy high, sell low
or don’t do anything. Regardless of my
limited success in the area of investing, the vast majority of individuals who
understand how I invest are unwilling to buy low; they don’t believe that it
works. Although
it is frustrating to try and convince these individuals (especially if they are
close friends or family), ultimately it doesn’t matter since their disbelief
doesn’t impact my particular quality of life. SIMPLE IS BEST A
book once said that losing weight is simple: eat less and exercise more. To debate the pros and cons of the South
Beach Diet compared to the Akins Diet is irrelevant! The simple truth of having money is to save
more and spend less. Too many people try
to get too fancy too early with their investments. When
you start you should focus less on complex investment strategies and focus more
on establishing a pool of capital by saving more and spending less. Other
basic skills including how to interpret an income statement and balance sheet,
learning to avoid buying when others are buying (which is 99% of the time), and
buying when everybody is selling (which is 1% of the time). Too
many people who haven't mastered the basics jump into options trading, real
estate investing, currency and commodities, and all kinds of things just
because they saw an infomercial on television or because their rich aunt gave
them a 'tip'. In
the game of money there are no shortcuts and those who promise you an easy way
to jump ahead in line are more than likely looking to take your money. OPPORTUNITY With
regards to opportunity let's be brutally honest. If an investor can't see
opportunity when home prices dropped by 50% in Toronto in the early 90s
(finally reversing their downward spiral in 1996), the NASDAQ going from 4500
to 1400 in 2002 and the In
other words, if an investor cannot buy when others are selling, then they are
not prepared to invest; they will lose money. In
addition, individuals often use quotes that they don’t understand such as “Be
fearful when others are greedy and greedy when others are fearful” and “Buy low
and sell high”. It took me a long time
to recognize what these sayings mean, and more importantly, how they feel. Once an investor learns to fully understand
the emotions, reactions and feelings associated with these common investment
sayings, they will be well on their way to becoming successful. In
one sense opportunity is difficult to find.
Indeed, markets are fairly priced most of the time and many
opportunities require a high level of specialization to uncover. In another sense, opportunity is easy to
find. When the market collapses by 50%
everybody is running away and opportunity becomes clear as day (if you are
emotionally prepared to take advantage of it). IMPATIENCE Most
automobile drivers, when surveyed, say that they are above average
drivers. Most individuals when asked if
they are long-term investors say that they are.
A test of patience is the ability to wait the 3-5 years before a stock
price recovers. Selling at the first
sign of a price decline, or during a multi-year price decline is a clear
indication of the lack of patience. The
lack of patience can also manifest itself in impulse buying. In my twenties I had a problem with impulsive
buying; I always bought too early. When
I wanted something I would rush out to buy it.
To temper this behaviour in my investing I avoided having cash readily
available in my trading account. I would
have my capital (in CAD) in a high interest savings account from an institution
that didn't have tellers or ATMs. This savings
account was linked to my checking account.
If
I wanted to invest in a stock I would need to first transfer the money from my
high interest savings account into my checking account. This alone would take a couple days. After the money arrives I would need to
transfer the capital again from my checking account into my trading
account. All the while, I would continue
to research the stock I was interested in buying. Sometimes, by the time the money reached its
final destination, I ended up finding something through my research and avoided
buying the stock. BULLS MAKE MONEY,
BEARS MAKE MONEY, PIGS Shop
during bull markets, buy during bear markets.
This may seem intuitive, but most don't do this. During rising markets, many people rush to
invest their RRSP and non-registered funds into stocks and equity funds. A recent example was 2007 where equity funds
flourished with infusions of capital. In
2007, my portfolio was heavily weighted in cash. Stocks were expensive so I spent time window
shopping. When
the economy soured at the end of 2008 and beginning of 2009, when it was time
to buy, investors rushed to the exits and equity funds began reporting massive
redemptions. Meanwhile, the cash portion
of my portfolio shrank dramatically as I deployed all available cash. As
a general rule, in a 10 year period, an investor should be spending 9 of those
years in research and 1 year (in a downturn) buying the best asset that was
researched in the last 9. NOBODY, EVEN MADOFF,
WILL TAKE Too
many Canadians work extremely hard, week after week, month after month, for years
and what do they do with their excess capital?
They give it to a stranger called a financial planner or money manager,
who proceeds to burn it. What
I find disappointing is that people complain about gas prices jumping 5 cents a
litre. Assuming that a person drives a car with a 60 litre tank, this comes out
to $3.00 per fill up. Assuming that they
fill up 50 times a year, this translates to $150.00 per year. Meanwhile,
a fund that a financial planner puts Canadian's in can cost thousands of
dollars in fees within the same time frame, but Canadians will still complain
about the 5 cents a litre. Stop sweating
the 5 cents a litre and look to the 2.5% and 6% fees on your overly diversified
portfolio! Another
reason individuals lose their money when they invest is because they have
little or no financial knowledge. How
would they know that 1% a day is unreasonable?
How would they know that flow-through shares are a rip off? How would they know that labour-sponsored
funds will lose them a fortune? How
would they know that hedge funds take custody of investor money directly? Throughout
my life, from time to time, I get tired of investing and delude myself into
believing that somebody else can help take care of my money – a financial
planner, assistant, hedge fund etc. But
I am always proven wrong. If I want to
make money, there is nobody that I can trust except myself. Anybody that I think can help me will always
need a (significant) cut for themselves. In
investing, ignorance isn't bliss, it's expensive. IF IT’S SOLD, IT’S
QUESTIONABLE Many
individuals are sold ridiculous investments and investment ideas such as
labour-sponsored, funds, flow-through shares, mutual funds, diversification,
and asset allocation. Oftentimes,
they are sold to investors who happen to have an uneducated opinion about a
sector of the economy - "I believe China will be the next high growth
area", “technology is the place to be", etc. It is safe to say that any investment or
concept that needs to be “sold” is a waste of time and a bigger waste of money. AVOID QUICK PROFITS Many
times, individuals ask me why I don’t sell to bag a quick profit despite the
strength of the business. The easy
answer is that a two bagger today will be worth a ten bagger later. The
deeper truth is that I don’t want to create a mental positive association with
quick profits. If I sell a stock that
has appreciated in price over a short time, my brain will begin to associate
quick selling as a good thing. If I do
something successfully once, human nature will cause me to do it again. I take the analogy of gambling - a series of
small wins will tend to lend itself to bigger and bigger bets until a catastrophic
loss. Flipping
stocks is similar to gambling (or the excessive use of debt) - sooner or later
it will come to a bad end. In order to
prevent this I don't even bother to start along that road. Some argue that my returns could be boosted
by taking small wins and avoiding large risk.
The problem is human nature - small wins will tend to convince me of the
validity of taking larger risk. If you
do well with a $10 bet, sooner or later a $100 bet won't seem unreasonable, and
then $1000 and so on and so forth. I
do not want to create a pathway in my mind to create a positive experience with
short-term price volatility. Conversely,
in my experience I have found it more difficult (but more useful and
worthwhile) to build a positive association with 1) buying investments during
downward price movements and 2) holding investments as they rise in price. The
only time I want to sell, is when I want the money. NO DIVERSIFICATION Diversification
never made sense to me. When
I was in high school I was obsessed with getting a 90% overall average in
school. Actually it would be more
accurate to say that my parents were obsessed in my getting a 90% overall
average in school. At
the time I had 8 different courses such as physics, math, English, physical
education, drama, etc. In the
quantitative courses I was able to score high marks. However, in subjects such as physical
education and drama, where the marks were more subjective I was perpetually
stuck in the 70s. Knowing
that a few courses were going to be stuck in the 70s, I came to learn exactly
what marks I needed in the computational courses to get my 90. Every test, assignment, and lab report gave
me more information and I would tweak my calculations daily, weekly – until the
term ended. If this seems obsessive to
you, let me assure you that it was. By
running these calculations almost daily, it was inevitable that I would
calculate what my overall average would be if I didn’t have subjective courses
such as physical education and drama (music wasn’t a problem because my parents
had me playing an instrument at an early age).
I was silently astounded as my overall average skyrocketed upwards when
I removed drama, and its associated 70% mark. I
learned very early that concentration into courses where I was very strong, was
far (far) better than tacking on more courses where I was average, or in some
cases, poor. I
took this learning into my investing years and decided to focus my investments
in assets that I felt I had a very strong understanding and cut out everything
else. Even
today, after over a decade of success in investing, there are people who come
up to me and ask why I only hold so few stocks – and why all of them are in
retail. All I can say is that what I
invest in is related to where I feel my competency lies. I
didn’t plan to have all my investments in retail. My plan was to invest in businesses that have
very specific financial characteristics (outlined in previous year’s
letters). The market dropped the price
of retail stocks fell so I bought them. This
doesn’t mean that I don’t like other sectors.
It just means that the other sectors have never been as attractive in
price. This is an important thing to
understand. If
an individual is able to navigate the emotional minefield of investing to be
able to avoid buying during bull markets, the next problem is running out of
juice just before the party gets interesting. I
employ a system that will not allow me to fully deploy all my available
capital. The downside to this system is
that I will always have post-recession regret – that is, that I should have
deployed more money. The upside is that
I will never run out of capital to deploy.
When I begin buying a specific asset or asset class during a downturn, I
deploy 25% of my desired capital (whatever that amount happens to be). I will stop buying once I hit 25% of capital
deployed. I will only continue buying on
a further 25% decline in price from my original buy. I continue to stagger my purchases upon each
successive 25% decline, finally ending my purchases once the asset price moves
upwards. I
lied. This system will not prevent me
from running out of capital to deploy, but what it will do is only have me run
out of capital in an “end-of-the-world” scenario of perpetual declines. Thankfully, I have yet to experience this
kind of downturn. THE MEDIA IS ALWAYS
LATE I
only use the media to reinforce my opinion of either a bull or bear
market. There is no useful information
in the media as far as investments are concerned. Never make an investment decision based on
something seen on television, read in newspapers or the internet. The information is usually late, priced into
the stock, inconsequential or all three. If
all media sources tell you that we are in a bear market it is a good time to
shop around for a deal. If the media
outlets talk about rising stock markets, increases in M&A activity,
earnings beating expectations, then it’s time to read the comics. CURRENCY Currency
considerations over the long-term are negligible. I do not make investment decisions based on
the exchange rate between the USD and CAD.
If the numbers for a real estate investment doesn’t work, it
doesn’t matter which currency is used. I
understand that in my multi-decade investing career I will have periods of time
where the CAD is strong and periods of time where the USD is strong. The primary concern for an investor is
whether or not the company’s income statement and balance sheet can become
stronger with each passing decade. This
critical determination will create more money than spending the time thinking
about where the CAD and USD are headed. COMPOUNDING Compounding
is the “secret sauce” of investing success.
Good investment decisions are magnified when they are applied
early. It
is important not to allow time to create emotional stress. Even if I started investing in my 50s, I
would avoid “rushing” to get into investments.
I always look back and think that I should have started earlier or
deployed more capital or used more leverage.
Looking back at the “what ifs” are not productive. The
only reason I look back is to try and avoid mistakes that I made in the past. ECONOMISTS CAN’T
PREDICT THE FUTURE EITHER I
never (ever) try to predict the future.
A lot of people spend 99% of their time and discussions around what the
economy, interest rates, trade deficit and a host of other economic indicators,
will do. There
are tens of thousands of economists trying to do the same thing and if they
could do it twice in a row they would all be extremely wealthy and retired by
now. The
only reason individuals predict the future are as follows: 1)
They want to keep their jobs (an economist
who says “I don’t know” will soon find themselves unemployed) 2)
They want to sell books, seminars, investing
programs 3)
They find it “fun” It
can’t be said enough that predicting the future is a waste of time. All predictions are like coins – they all
have two sides. The well thought out
predictions of the future by one economist can always be contradicted by a well
thought out argument by another. If
I wanted to sell books, I would sell my predictions. That is the only way to generate interest in
my product. If I want to invest, I will
focus on the financial statements of my investments. Individuals who make predictions are a dime a
dozen, the irony is that they are worth far less than that. "There
are 60,000 economists in the U.S., many of them employed full-time trying to
forecast recessions, oil prices and interest rates, and if they could do it
successfully twice in a row, they'd all be millionaires by now...as far as I
know, most of them are still gainfully employed, which ought to tell us
something." - Peter Lynch "Thousands
of experts study overbought indicators, oversold indicators, head-and-shoulder
patterns, put-call ratios, the Fed's policy on money supply, foreign
investment, the movement of the constellations through the heavens, and the
moss on oak trees, and they can't predict markets with any useful consistency,
any more than the gizzard squeezers could tell the Roman emperors when the Huns
would attack." - Peter Lynch STOCKS AND REAL
ESTATE IN CONTEXT All
investors need to know how to interpret financial statements in order to have
any kind of success. Specifically an individual needs to know their way around
an income statement and a balance sheet. The cash flow statement would be
something that can be picked up later. An
individual can either learn how to interpret financial statements by doing a
Google search online or by looking for an easy-to-understand book at the local
bookstore. Once
an individual feels that they have a rudimentary understanding of reading
financial statements they can contact various publically traded companies such
as Coca Cola, Disney, Tootsie Roll and Nike and order their plain vanilla,
audited and well-documented financial statements; the easier the business, the
better. This is good practice. After
that learning, if there is a desire to invest in real estate, the individual
can then wade into the lawless world of unaudited pro forma financial
statements that are provided by the Sellers of real estate. This will take some
time since Sellers are notorious for 'excluding' expense items, but the same
principles apply. In real estate, my
personal rule of thumb is that the price of the investment must be equal or
less than 5 times the gross annual rent.
If a property generates $10,000 a year in gross annual rent, I will only
pursue the property if it is priced at $50,000 or less. This
strict criterion has not only allowed me to avoid a lot of problems, but given
me the leeway to create a very solid cash cushion for the unexpected pleasures
of owning real estate. The
only threat to an investor’s money is impatience; the desire to “do something”. Personally
I use stocks as a way to compound capital tax-free (or more accurately, tax
deferred since taxes have already been paid once by the corporation and will
only be paid by me when I decide to sell).
I invest in real estate for useable cash flow. I only invest in real estate because having
$10 or $1M or $10M of stock is similarly worthless in grocery stores across
Canada. ANCHORING AND
ADJUSTMENT HEURISTIC From
my observations, economists and the public at large exhibit an anchoring and
adjustment heuristic. This heuristic has
individuals setting an implicit reference point (the "anchor") and
make judgments to reach their estimate with associated probabilities. Among
the various studies includes one by MIT professor Dan Ariely. The study group
is first asked to write down the last 2 digits of their social security
number. They are then asked to submit a
bid on a wide variety of items such as wine and chocolate. The
study participants who had higher two-digit
numbers (in the top half) submitted bids that were 60% to 120% higher
than those who had lower two-digit numbers; far higher than could be explained
by a chance outcome. The
simple act of thinking of the first number (the 2-digit social security number)
strongly influenced the second, despite no relevant connection between them. This
explains why, in boom times, when a high value was achieved (e.g. The
converse is also true. After a crash
(e.g. This
is currently happening with economists in both the RE market and of the
Canadian economy as a whole (albeit in opposite directions). This
behavior is fatal for an investor since it results in either, rosy expectations
or the exact opposite - paralyzing fear.
An investor should strive mightily to recognize and control this
behavior. VOLATILITY Most
people dislike volatility, but that is a mistake. With companies that exhibit
extreme volatility it is easier to make money. I don't need to be as 'accurate' when picking my
buy points. One
of the reasons that I find it difficult to make a decent return with Berkshire
Hathaway is that it is not very volatile. My timing has to be very good
(impossibly good) to make a decent return and my timing is terrible to
non-existent. The
example I gave was picking up Berkshire Hathaway class B shares when they fell
from $2700 to $1400 at an average cost of $1800. As you can calculate, the
return based on an $1800 cost basis is mediocre at best and would have been
significantly better if I could buy it at $1400. However, looking back at that
time, I don't see how I could possibly have bought the bulk of my shares at
$1400. One
of the reasons I've made so much money with companies like Fossil or The Buckle
is that they swing wildly. Once I have evaluated a company like Berkshire
Hathaway, The Fossil, The Buckle, or whatever, as something I would like to
own, the next “break” for me is if the stock price swings wildly. As I
mentioned with Berkshire Hathaway, a “wild” swing is pretty narrow and doesn't
happen often. With
The Fossil or The Buckle, they can go from $40 to $10 at the drop of a hat
(despite improving or stable fundamentals). My timing doesn't need to be very
good to make money - I can buy at a number of price points and make a very good
return. "There's
no reason we should become fearful if a stock goes down. If a stock goes down
50%, I'd look forward to it. In fact, I would offer you a significant sum of
money if you could give me the opportunity for all of my stocks to go down 50%
over the next month." - Warren Buffett HOW MORTGAGE RATES
ARE CALCULATED Many
people think that the mortgage rates are determined every time Bank of Canada governor
Mark Carney sets the fed funds rate. The following comment was made in the
Globe and Mail and keeps the misinformation going: "The
banks have received extra help from BoC governor Mark Carney, who issued a conditional
commitment to keep the policy rate at the record low of 0.25 per cent until
next summer. That means mortgage rates will hold near their record lows for at
least a little longer." The
Bank of Canada doesn't have a say on mortgages rates. The chartered banks set
their mortgage rates based on yields in the bond market. A Government of Canada
bond represents a risk free investment to the banks. If the banks choose to
invest in a mortgage, they are taking on added risk and incurring costs to set
up and service it. The banks will set their mortgage rates high enough above
the equivalent bond yield to cover their costs and provide some sort of profit
margin for the added risk they are taking on. Bond
yields are determined by investors’ expectations for interest rates in the
future. These expectations are arrived at by assessing the state of the
Canadian economy and predicting where it is headed relative to other world
economies. There is no science to such predictions (although some economists
spend a lot of time trying to make it into a science). Interested
in seeing where 1-year, 5-year mortgage rates are headed? Look no further than
the respective 1-year, 5-year Government of Canada bond yield. Although
the BoC does not have an impact on mortgage rates, there is one exception to
this rule. Most variable rate mortgages are affected by changes to the prime
rate as set by each of the chartered banks. The
prime rate will change, in the same direction and by the same amount, as any
change to the overnight rate. So if the BoC announces a decrease in the
overnight rate by 25 basis points, then you can expect most variable rate
mortgages to also drop by the same amount. THERE IS NO MIDDLE
GROUND When
I speak about value investing I only get 2 reactions: 1.
Immediate understanding 2.
Rejection I
have never met somebody who was #2 who later 'learned' to become #1.This is
likely related to the saying that the very poor think day-to-day, the poor
think week-to-week, the middle-class think month-to-month and the rich think
year-to-year and the very rich think decade-to-decade. If
the thoughts in this paper are foreign or unbelievable to the reader, it is
likely that the reader will not do well with this style of investing. STOCK OPTIONS Considering
my reluctance to sell any stock (or asset) that finds its way into my
portfolio, you may wonder what use I have with options. I will spend a few sentences here explaining
options and how I use them. Please keep
in mind that I do not use options to any significant degree and that my
knowledge and use of them is rudimentary at best. An
option is a contract between a buyer and a seller that gives the buyer the
right, but not the obligation, to buy or to sell a particular stock at a later
day at an agreed price. In return for granting the option, the seller collects
a payment (called a premium) from the buyer. A
‘call’ option contract gives the buyer the right to buy the stock; a ‘put’
option gives the buyer of the option the right to sell a stock. Option
contracts are reconciled on the 3rd Friday of every month. There
are many types of options including stock, commodity, bond, index and futures
but this is beyond the scope of this article.
If you want to learn more about options including pricing models, types,
and historical uses simply buy an option textbook. I'm sure that you'll find it as engrossing as
I did. This
is a good time for an example. As
I mentioned before there are two types of options, call options and put
options. I want to focus on the call
option - or the option that gives the right to buy a stock. Let
us say that we purchase 1 call option contract for $2.00 on Fossil stock in Jan
2009 at a strike (execution) price of $15 per share that expires in Jun
2009. Let us further assume that the
price of Fossil stock stands at $14 per share on Jan 2009. Each
call option contract represents 100 shares of Fossil stock (10 call option
contracts represent 1000 shares of Fossil stock and so on and so forth). Since
we are buying 1 call option contract, we pay the seller $2.00 per share in
premium or $200 ($2.00 per share x 100 shares). For
simplicity's sake let us assume that the person who sold me this contract is
holding 100 shares of Fossil stock. Who
is this seller? How did I find him? The short answer to this question is that I
didn't. The discount brokerage found
him, somewhere somehow in the sea of the market, wanting to sell 1 call option
contract at $15 per share on Fossil stock that expires in Jun 2009. From
our (buyers) point of view, we paid $200 to control 100 share of Fossil
stock. We don't own the stock. If
the conditions in the contract are met (i.e. Fossil stock soars to $15+ on or
before the 3rd Friday of June 2009), we (the buyer) will be asked to put up the
money to buy 100 shares of Fossil stock at $15 per share, or $1500. Our total cost if this were to come to pass
would be $1700 ($1500 for the stock and the $200 we spent on the
contract). This transaction (where the
premium is deposited into the seller's account, and the stock is assigned to
us) all happens instantaneously and automatically. There is no confirmation or further action
necessary on our part. Why
would somebody want to spend $200 to do this?
The buyer of the call option would do this because they believe that $14
per share for Fossil stock is low. In
fact, they feel that Fossil stock should be far above $17 per share. Since the upside is technically 'infinite'
the buyer of the call option would make a profit once the price per share rises
above $17 ($15 per share for the cost to buy stock + the $2 premium paid to the
seller). The
seller of the call option feels that the stock is overpriced at any price over
$15 and is willing to limit their upside gain in return for $2 per share
premium. Why
doesn't the buyer just buy Fossil stock at $14 per share if they believe that
Fossil should be far above $17? They do
this because they're not sure. If they
purchased 100 shares of Fossil stock at $14 it would cost them $1400 and if
they were wrong, they could potentially lose a lot of money. By paying a $2 per share option premium to
the seller, they would effectively control the stock without spending
$1400. If they were wrong and the stock
moved sideways or down, they would only be out-of-pocket by $2 per share or
$200. Why
would the seller sell a call option to a buyer?
Why don’t they just sell the stock at $14 and be done with it? They do this because they’re not sure. If they sold the stock at $14 and the stock
ran up to $15, the seller would lose out on $1 per share. By selling a call contract the seller would
receive $1700 ($1500 for selling 100 stock + $200 premium received from the
call option buyer). If the stock moves
downwards or sideways, they would get to pocket the $200 (minus taxes) for
nothing. During
a call option transaction one person (the buyer) is buying the right to buy and
the other person (the seller) is selling the right to buy. Conversely
the opposite also exists: put options are the right to sell. One person (the buyer) can buy the right to
sell and the other person (the seller) will sell the right to sell. Aren't
options fun? I think that they're at
least as fun as going to the dentist - if not more so. TEXT BYTES In
the world of the obvious I would like to mention that:
Last but not least,
after the violent upside recovery of the North American stock markets, I still
had capital to deploy. I added U.S. real
estate in 2009 to my existing portfolio of stocks and Canadian real
estate. To answer the question on
whether or not I adhered to my aforementioned rule of paying 5 times gross
annual rent – I paid less. Best regards, Jim Chuong Jim Chuong is not certified as a financial planner nor does he have a securities designation or business degree. The information provided by Jim Chuong is not to be construed as investment advice. Under no circumstances does the information represent a recommendation to buy, sell or hold any security or asset. Any and all references to "the portfolio" or "portfolio" refers only to my personal trading account. This website in no way offers or represents financial or investment advice. Information is provided for entertainment purposes only. Please read my disclaimer for more information. Jim Chuong is a Mississauga-based private investor and has been interviewed in MoneySense magazine, The Globe and Mail, The Toronto Star, CP24, and Report on Business Television. His interviews can be found on his website at http://www.ticonline.com |
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| Chuong Letters |
| Quote of the moment |
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"Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell." "There's no reason we should become fearful if a stock goes down. If a stock goes down 50%, I'd look forward to it. In fact, I would offer you a significant sum of money if you could give me the opportunity for all of my stocks to go down 50% over the next month." "If you have more than 120 or 130 I.Q. points, you can afford to give the rest away. You don't need extraordinary intelligence to succeed as an investor." |
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Jim Chuong In The Media |
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Jim Chuong can be reached by emailing jimchuong@hotmail.com or calling 416-254-0159.
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