Blue Penguin Report

By Red Sox Steve & Matthew Storey

Thanks for the guidance last week Guru. I've got to play to my strengths, and remember to practice, practice, practice in order to fully develop my capabilities. Like my dad always told me, "your head is more than just something to hang your hat on!" He is right about a lot more than that, no doubt about it! I want to start to put our discussions to use and explore the possibility of profit on my own, so here's what I'm going to do: I've already taken a keen interest in a global chemical company (recall, I was an honors chemistry graduate. I'm quite intelligent, you know, but I digress...:) ). OK - I like Dow Chemical Company, for a number of reasons. I'm going to do the research and put those reasons forward in a column. I understand the science that is going on, and, yes, they've successfully managed to pay every quarterly dividend since the Titanic went down; when considering the 20th century economic picture, this is VERY impressive. Can you point out some things about Dow Chemical that you think would assist me in my understanding?

Posted by Red Sox Steve at 05:31 PM | Permalink | Comments (0) | TrackBacks (0)

Alright Guru, last week you sated my desire for a triple-stack. I set up a spreadsheet myself to understand the expenditures and risks that were taken on Apple equity and options, and am grateful for your guidance. There's a chance in the not so distant future that I'll set up a hypothetical options trading strategy to see how I do without actually risking any money.

In the prior week, we discussed 3 factors related to the macro-analysis of equities: 1) political environment, 2) macro-economic environment, 3) relationship of a given company to the global economic future.

Let's take our analysis a step further so I can start picking companies myself: Can you give me some company-specific pointers that I should be looking at? Also, what aspects of a stock's past performance do you find useful, if any, to better understand what kinds of risks you are about to take?

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Thanks, Steve!

As we've discussed previously, stock-picking requires acumen and data.

Every investor has certain strengths and those should be exploited fully - in your case, as a scientist, you do an excellent job of breaking down technology and extrapolating its potential usages. That is why you have the role you have here at VagabondGuru.com. You have a broad, scientific education and an easy facility with materials and mathematics. This is your acumen.

If you expose yourself to material (data) relating to your processing strengths, your brain will continue to provide better and better answers and automatically draw connections between various data streams, without being induced to do so. If you repeat the data exposure over time, the neural pathways and habits will form, unbidden, that will allow you to replicate these processes.

I gave you the example of Annie Oakley, the sharpshooter and 19th Century Celebrity whose uncanny ability to pinpoint moving objects and shoot them out of mid-air evidenced an intrinsic geometric capability that might never have been augmented by a Geometry textbook, AND a seamless interaction between her spacial calculations and her physical reflexes. Had her mind been pointed towards mathematics or physics, she may have been able to process great understandings.

She had the acumen for precision shooting.

And.

She practiced.

Mark Teixeira, 1B on the New York Yankees made a spectacular play on a sharply hit ground ball to his right the other day. The ball was hit like a laser by Victor Martinez, hitting LH, a powerful hitter who generates incredible torque on a baseball. Teixeira, moved towards the ball in an instant, and turned his body, so that the glove on his left hand would be positioned to receive the ball. In the last bounce on the ground before he was going to have a chance to catch this ball, traveling at a high rate of speed, with his body twisted away from his line of sight, the ball took a 'bad hop' (might have hit a pebble...) and altered its trajectory upwards. Teixeira shot his glove along the plane of the ball and snared it with his eyes facing away from the ball, rolling his glove over his shoulder in the process to absorb the impact AND position him to run to the base to complete the play.

Elapsed time? A fraction of a second.

He has the acumen, and he's fielded thousands upon thousands of baseballs.

This then, is my short-term, non-answer.

We will continue to explore valuation tools, not in concert but piecemeal, and you will build your data-points upon an axis of your own construction, secure in the understanding that the way your mind processes data is distinct from mine. I will show you the tools that guide me, book-value, earnings-per-share, price-earnings-ratio, balance sheet analysis, technical indicators, understanding the company executive and add those company-specific data points to those macro-economic elements we began with, and the stocks will begin to sort themselves out for you.

The Market is not scientific, the human elements and hidden data will always factor into our equation in ways that cannot be accounted for. Like a 'bad hop'.

But, if you take the time and do the work and grok it completely. You'll roll with these elements, grab the ball and be running directly towards the base without even remembering the process that led you there.

Posted by Matthew at 11:18 AM | Permalink | Comments (0) | TrackBacks (0)

Alright Guru, you gave a great answer last week - now I know where I need to look first (political environment, macro-economic situation and the future with respect to any given investment). Let's incorporate time into the mixture though. I know that stock option prices (a/k/a option contracts) are based on a given stock's price at a given time. In terms of the securities you look at, how are you playing the options market on those securities? How are you making money buying and selling options?

Thanks, Steve!

First off, its important to understand what Options ARE and what they are not. The derivatives market has metastasized and destabilized much of the world's financial system and options ARE derivatives.

A derivative is a financial instrument that 'derives' from another financial instrument.

The damage has been wrought by derivatives that derive from Mortgages that have been bundled, sold, and re-sold (MBS - Mortgage Backed Securities) and debt that has been bundled (CDO - Collateralized Debt Obligations). That is NOT the sort of instrument you are referring to and NOT the kind of investable security that any investor should consider, unless you are looking for an ENORMOUS write-off for your portfolio.

The derivatives we ARE interested in are 'Equity Options', which derive from common Stocks.

An Option contract is the right to BUY ('Call') or SELL ('Put'), 100 shares of a particular Stock, at a particular price ('Strike Price'), over a defined period of time.

The Price of the option has two components, the first is 'Intrinsic Value', which denotes the actual price above the 'Strike Price' the stock is trading for at the time of purchase. The second component, is the 'Time Value', which is an imprecise measure based upon market forces (supply and demand) that is loosely related to how much time remains until the Option Contract expires. Options are deteriorating assets that lose 'Time Value' with each market day and expire worthless if not sold for market price or if held to closing date at a value below (call) or above (put) the Strike Price.

For Guru, and other market professionals, the allure of Options is their versatility and affordability, this is PARTICULARLY true in markets like the current one, where conditions are treacherous and an investor wants to limit their downside exposure.

An Equity Option has a separate Ticker Symbol from it's underlying security, as it is, literally - a separate security. It derives its value from the Stock, but trades independently of that Stock, and trades a FRACTION of the volume. For this reason, with lesser liquidity, the market for Options is less efficient than for Stocks. To the Professional, this means a greater chance of finding an 'Arbitrage', a gap in the pricing between similar securities trading on different exchanges or in the pricing itself (Guru will write about Arbitrage again and again, it is a critical concept to understand in all arenas).

Option Symbols are comprised of five letters, the first three are that Stocks 'Option String' the three letters associated with Options for that Security. The fourth letter is the Expiration month for the option (Options expire on the 3rd Friday of every month, known, not surprisingly as 'Option Expiration Day'!). The year has been broken down by letter, so A - L equate to January - December for Calls, and M-X equate to January - December for Puts. The fifth letter equates to the Strike Price, with letter values assigned for prices ending from 5/105/205/305 (A) and ascending in 5 dollar increments up to 100/200/300/400 (T), and (U) -( Z) are used for smaller increments of 2.5 dollar increments.

For EXAMPLE (since understanding the previous paragraph can be dicey!).

Apple Computer has an option string with a Base Symbol of 'APV'.

The Stock, AAPL, closed yesterday (WEDS) at $116.32 per share.

An Investor, named 'Guru' is interested in buying Options on Apple shares, because he does not wish to tie up cash in outright purchases of the stock (100 shares would cost $11,632). Purchasing Option contracts allows me to use 'Leverage' and control lots of 100 shares each, potentially benefiting from price movements in the interim and locking in my purchase price at the same time.

I will select a 'strike price' that appears reasonable, in the case of Apple, a stock that has moved from under $80 per share in late January to $116 in early April (a 45% gain), 'reasonable' is just about anything - either a continuance of those spectacular gains, or a retracement - back towards $80.

EXACTLY the reason I'd prefer to use Options when dealing with a stock like Apple.

For our example, I have chosen a strike price of $125 per share, an upward move of $9.

What I would typically do is look to build a 'Stack' (a Bodybuilding term) of Options at that strike price, with different expiration dates. This means I am relatively certain the stock will move towards that price, but not sure WHEN. In other examples, I might look to purchase a 'Homey String' (these are both proprietary terms, so you won't get anything but a quizzy look if you use them...) which means I buy various options at DIFFERENT strike prices, usually in the same expiration month - that would indicate I am relatively certain the stock is moving up and want to dabble in various levels.

For Apple, then, I'd look to build my Stack as follows:

* Buy 100 APVDE (APV is Apple Option/D is April Expiration/E is 125 strike price) at .44 (x 100 shares) for a purchase price of $44.00 per contract. These are contracts that expire in 7 trading days (TH/FR/M/T/W/TH/F) - such contracts are known as 'Suicides', for obvious reasons, because you are almost certain to 'DIE'! (have them expire worthless). The extremely inexpensive cost and the reality of the underlying Stock's recent strength, make it worth the risk, since even a move TOWARDS the Strike Price can result in high profits of 100 or 200 percent in a matter of days. High Risk/High Reward is the tip of the Stack.

100 contracts (44.00) = $4,400.00 Purchase

* Buy 20 APVEE (May 125's) at 4.00, or $400 per contract.

20 Contracts (400) = $8,000.00 Purchase

* Buy 10 APVGE (July 125's) at 8.00, or $800 per contract.

10 Contracts (800) = $8,000.00 Purchase

* Buy 5 APVJE (October 125's) at 12.40, or $1,240 per contract.

5 Contracts (1,240) = $6,200.00 Purchase

So, now I've identified 125 as my Strike Price for Apple Computer and built a Stack that captures that movement in four different expiring months, at four different price points.

Then I may decide to make it a 'Double Stack' (also used by 'Wendy's'!) and purchase a LEAP (Long Term Equity Anticipation) contract, which expires in January of the following YEAR and has it's own Ticker Symbol.

* Buy 10 LEAP Contracts/ WAAAE (January '10 125's) at 15.90, or $1,590 per contract.

10 contracts (1,590) = $15,900.00 Purchase

And, if I am really hungry for Apple, let's go ahead and make it a 'Triple Stack' and purchase LEAPS that expire the FOLLOWING January (2011).

* Buy 10 LEAP Contracts/ VAAAE (January '11 125's) at 26.30, or $2,630 per contract.

10 contracts (2,630) = $26,300.00 Purchase.

What have I done?

I have assured myself of the right to buy Apple shares, in lots of 100, at differing expiration dates for the price of $125 per share. I know, going forward, that I can own shares at that price and I believe the price will move upwards, so I believe I will be able to sell some contracts for profit and use that profit to exercise on the other contracts, thus using the Option outlay to pay for Stock AND make profit.

I have risked a total of $68,800 (there are transaction costs involved, but they are nominal) to make this investment, and, if I have miscalculated, I risk that entire investment.

On the other hand, I have built a Triple Stack, which provides me with about 20 months time to realize my gains, and believe the stock will move above the Strike Price at SOME point in that period.

The same $68,800 would have allowed me to purchase 591 shares of Apple computer, OUTRIGHT, but with the shares in hand, a $9 gain in price would only result in (591 x 9) in a gain of $5,319. Not worth it in such a volatile market, in this case, the volatility works FOR me and my investment need only return MORE than $5,319 to be successful.

We will track this Triple Stack and follow the results.

Hopefully, this has expanded your understanding of Option investments and answered your question of the week!

Posted by Matthew at 07:51 AM | Permalink | Comments (2) | TrackBacks (0)

By Red Sox Steve and Matthew

Steve: International Global Marketplace: Please describe the three most important factors that will influence your decision to purchase or sell any non-US equity during the 2nd quarter of 2009. You have the option of including or excluding a discussion of the purchase and sale of stock options in your answer.

Guru: Thanks for asking!

I've been investing Internationally for about 26 years and have boiled the process down quite a bit, the important thing to remember is the PROCESS should not be impacted by a particular timeline (2nd Quarter of 2009) - it must remain uniform.

It is the DATA that changes.

If you follow the process and assess the current data, you should be able to avoid bad mistakes and place your investments in solid position, regardless of the underlying climate. And, if an investment DOES turn against you for reasons outside of the scope of your research, don't waste energy on recriminations - run your models with the NEW information and make a determination, if they say 'SELL' - do so, and move on.

Three Steps to take before buying Non-US Equities

1.) The FIRST thing you must do is assess the POLITICAL climate.

The security you are considering is based in a country and lists its securities in that country or another, you need to get a sense of the political climate in both places, if they are different.

There are plenty of good companies with solid securities that operate in countries where the marketplace infrastructure and regulatory environment are not sufficiently transparent and effective enough to insure safety of transaction and certainty of reporting. Investments should never be contemplated in such environments, it will make little difference to your portfolio to find yourself correct about a particular company's prospects, only to see its profits flowing to Government officials, Company executives or gangsters.

Examples can be found anywhere in the World.

In Russia, where a thriving equity market was beginning to take hold, three events have undermined all confidence and made the country radioactive for new foreign investment;

A.) The Invasion of Georgia.

This action, taken during the height of Oil Prices, at the dawn of the Beijing Olympics signaled to the world that Russia had an aggressive posture towards its neighbors/customers, based upon Nationalistic concerns that would likely trump commercial ones. That is a negative for equity investors, who want solid footing and an absence of 'off-the-balance-sheet' risks. Sudden invasions of other countries are WAY off the balance sheet and inject inherent instability into the Russian equity equation, instability is the enemy of equity investors.

B.) The Fleecing of British Petroleum.

BP engaged, on its own behalf, and with the specific encouragement of Vladimir Putin, in a series of lease and development deals with Gazprom and in TNK partnerships with Russian Oil Oligarchs. As soon as the BP investment had been made and the development of fields begun, the Russian government moved to restructure BP's stake arbitrarily and the eventual fiasco found BP trading assets in other regions in order to extricate itself from the deals gone bad. The result is a 20B+ hole in BP's balance sheet, borne by its investors, and a chilling impact on additional foreign investment in Russia's Oil & Gas industry. The same situation has been occurring regularly in Venezuela.

3.) The Plummet in the Price of Oil.

Just as Russia restructured its entire economy around maximum exploitation of its Oil and Gas reserves and built its expansionist budget around extrapolations of Oil and Gas revenues from historic high levels, the Global economy imploded and the demand model of consumption evaporated, taking Oil down by $100 a barrel, decimating the Russian economy, stock market and currency and leaving a badly wounded Russian bear trapped into a corner of its own making.

NOT a place to invest.

In China, which, as the global engine of the Planet, home to more graduating engineers and scientists, higher savings rates and possessing a stable government with demonstrated economic foresight would appear to be an IDEAL place to invest. But it is not that simple.

Chinese equity markets are labyrinthine and subject to the autocratic designs of the ruling party, those are not risks that can easily be borne by individual investors of ANY means. Still, you need to be invested in Chinese equities - so you should look to Taiwanese or Japanese companies that do extensive business with the Chinese but are not subject to Mainland secrecy or oversight, or invest in ADR (American Depository Receipts) where you have the more comprehensive reporting requirements and transparency while still holding a piece of Chinese industry. The rewards may be more modest but the risks are all but eliminated, making it a stronger overall investment, particularly in this climate of peril.

2.) The SECOND thing you must assess is the MACRO-ECONOMIC climate.

Every country operates in both a domestic climate and an international one. The situation in any particular country or company is likely to be materially impacted by the state of both and Investors must understand that environment before plunging. You not only need to know the political character of elected officials, but their economic stance and how that positions them relative to the rest of the world. You must assess how the particular industry you are interested in will function relative to those plans...Dubya in the US meant positive things for Oil & Gas, Defense, Commodity based businesses, Extraction industries and a de-regulated climate for Banks and Insurers, but was poor for knowledge-based industries, commercial technology, domestic infrastructure...Obama flips those priorities 180 degrees and investors have to understand that.

Globally, an investor must remain conversant with developments broadly and with countries where investment if contemplated, specifically. In the 2nd Quarter of 2009, it is critical to understand which countries are positively disposed towards the Stimulus infusions and which are opposed, as this will impact on domestic industry and its ability to engage in trade. At the current G20 summit, we are seeing that Conservative German Chancellor, Angela Merkel, stranded politically by the socialist designs, has staked out ground in opposition to the stimulus just as UK Prime Minister, Gordon Brown is declaring a 'Global New Deal' and Japanese Prime Minister, Taro Ase is ridiculing her position as being shortsighted and immature. These differences have real-world implications that you must measure if dealing with one of these countries equities. Regardless of how you feel PERSONALLY, it is important to assess events and trends on what IS, not what you WISH it to be.

Don't play philosophy with Money - observe, deduce, react. Have a solid understanding of local matters of foreign investment, taxation and trade policy BEFORE you invest.

3.) The THIRD consideration applies to ANY contemplated equity investment, particularly in the current climate.

You must assess the relationship of the particular company to the global economic FUTURE, not its past.

Certain industries (Oil & Gas, Automotive, Banking, Insurance) have suffered seismic shocks and have altered in fundamental and permanent fashion. You need to be able to make a case for a particular situation being able to swim against those tides before investing in these industries.

Other industries (clean energy, new transportation modalities, biotechnology, environmental engineering, infrastructure construction, space, robotics) are the beneficiaries of broad governmental focus and expenditure and are likely to be supplemented by huge subsidies to their underlying educational feeder pools, thus identifying them not only as 'Hot' areas for investment but sustainable ones. However, many of these companies either do not yet exist in investable form or do not yet have profitability that will grow them in the near term, you must assess the likely timeline, tweak it regularly and compare it with your own investment/risk objectives.

It's 2009, purchase equities in those businesses that make SENSE for the 21st Century and avoid those that no longer do or have short time horizons looking forward - investment is a FORWARD-looking enterprise, your assessments must not be guided by past dynamics.

Posted by Matthew at 05:41 PM | Permalink | Comments (1) | TrackBacks (0)