ERICOPOLY

People seem to panic and clamor for puts -- maybe it's overeager speculative shorts. I don't have an answer as to who drive up the prices.. That drives up the price of calls too (put/call parity). There are some exceptions for HEAVILY shorted stocks (like SHLD in 2009), but generally speaking a stock like JNJ will have put/call parity. Or maybe it's not panic itself that drives the price up -- maybe it's lack of liquidity (less capital to support the options market leads to less eager options writers). I don't really know, but I know that volatility premiums explode in a crisis, and I know the put/call parity is reality in the shares of companies that aren't the most hated on the street. Some funny stuff happened during those times... when KMX was on the way down... maybe around $15 or so I wrote a $12.50 naked put for about $2.50 (thinking I'd make 25% return on the $10 at risk). Pretty soon the stock was down around $7. Does this mean I would lose money? Well, surprisingly not yet... Because the puts were now fairly deep in the money, I could by them back without much premium. I think I bought them back for about $6 or so (don't really remember). So I was down about $3.50, so far losing about 35% of the $10 that I'd put at risk. Don't worry though, I come out alright! At that time LUK was trading around $17 but the $15 put was selling for $5. So I wrote that put. Now, $5 is a 50% return on the $10 that I'm putting at risk. So now I'm down 35% on KMX but I'm going to make it back almost whole getting 50% return on LUK puts. Well, after LUK drops to $10 I buy those puts back at $6 (lost additional 10% on LUK), and turn around and write $10 strike RWT puts for $5 (stock was at about $12 at the time). Now, I'm going to make my money back and make a profit to boot! And I did -- the RWT puts made me 100% return ($5 premium over the $5 put a risk) -- the stock never traded below $12 if I remember correctly. I spread it around a bit more than RWT, but I'm just using RWT only in the example to simplify. This is something people don't really fully realize about writing far out of the money naked puts... if you get caught in a crash of that magnitude, you can bail water and right the boat with this kind of trading strategy. Yes, time matters. But 21 month options decay very slowly at first and then accelerate. They won't decay by 1/21 in the first month. The time value will decay mostly at first, then the volatility will sort of remain valuable up until a few months before expiration. You'll note that options expiring in a month are not 1/21 as costly as the ones expiring in 2013. I am using 21 months in my example because really that's what these options are -- expiry was just 2 days ago for the April options. (Feb, Mar, Apr) -- 21 months. I can live with a few dollars a share decay in the calls. Primarily, worst comes to worst I will be taking delivery in 2013 of JNJ at forward 11x earnings. So fry me in hot oil!!! And if the stock is $54 at the time, I'll be getting 10x forward earnings instead of 9x (if I had never bought the calls today). Man, what a tough life.

Options are cheap when people are not fearful, and expensive when they panic. When KO was $40 the 20 month calls cost $8 at-the-money. But at the same time the $30 strike KO put was $3. So people would pay 10% premium for an option 25% out of the money. A repeat crisis would put the $60 strike JNJ call at about $6 or maybe more if stock dropped to $53, and the $50 strike call would probably be about $12.

Median income in Australia is over $70,000. And their dollar is stronger! Imagine how cheap some of our stocks look to them... look, Kraft makes their Vegemite! It's not like they've never hear of our global brands. Why should foreign investors not be interested in buying up US multinationals? 10 years ago AUD was at $0.52. Now it's $1.08. So like... because only 25% of KO revenue is in the US, then when will the world wake up.

It's not so much that I believe it's low probability (although I do), it's that I can shrug it off safely with this strategy.

VIX is at 46 month low.

I've been having the same thought and considering switching. That's why I initially starting talking about the 10% downpayment, because I was already evaluating making the switch to the higher down payment $60 calls that have less volatility premium cost. I don't know much about options. I could NOT accurately answer things like "what is a verical spread", or "bull spread", or all the other crap jargon. I just use these things like an engineers uses components... you either build with them when they make sense or you don't. They're just tools.

A person without ethics would not understand where the line is drawn. So that's really not the kind of argument he wants to be making, in terms of salvaging reputation.

And that line of thinking goes for all the calls, MSFT, INTC, HPQ, etc... A big time market crash is going to send volatility so high that you'll be able to recover most of your cost basis and invest near the bottom. But if the crash doesn't happen, volatility is so cheap that you'll be a winner anyhow.

So it's been two years since 2009. If you are worried about a crash like that happening anytime soon, but don't want to miss out if you are wrong, then going the JNJ calls path and the rest in cash makes some sense. $47 in 2009 was the JNJ bottom. Grow it by 7% per annum two years and you get to about $54. So a crash right now just like 2009 would drive JNJ to $54. Then because I've only put 6.5% down payment on JNJ ($4.25 I paid for $65 strike calls is really only 6.5% down payment) at present prices, I can then invest go into margin by 1.065x and put 100% into JNJ at $54. The dividend on JNJ will pay off the margin loan by expiration of the calls. But then I still own the calls too, so I can either sell them if I don't like margin of 1.065x (which doesn't scare me) or I can hold onto everything in a recovery and get some 2x notional leverage as JNJ once again shoots past $65 and onwards before the calls expire. If volatility goes back to 2009 levels, even at stock price of $54 I might be able to sell the $65 strike calls for at least the price I paid for them a few days ago. Talk about upside with no downside risk. It's heads, I win! It's tails, I win! Or you can do what HWIC does and just buy JNJ and hedge with index shorts. But that's getting very expensive for them because the market doesn't always go down. Going forward, their hedges will likely outperform JNJ's decline by a wide margin. But I worry that I could somehow be wrong about hyperinflation, so I want JNJ to run freely into the tens of thousands of percent gains without an index short dragging on it.

I was napping when the shares were $60. Or rather, YTD I was busy watching a big portion of my money grow 54% in SSW. On a thread last Sunday I discussed getting out of my SSW and just buying MSFT and JNJ. The very next three days JNJ jumps $3 per share! I was still sucking my thumb, but not wanting to feel beaten, I devised this plan to get it at an even better discount to IV. Meanwhile, I play chicken with Mr. Market over the price of SSW, but I have $8 in short-term capital gains right now in SSW on a per-share basis. So if I sell it now, I lose $1.60 per share right away at my 35% tax bracket vs waiting until end of July to sell when it's 100% long term capital gains at 15% tax rate. My tax bracket is 35% because I spread my RothIRA conversion over 2011 and 2012, and the conversion was sizable. I would have been able to roll it over back in 2009 (and in fact had already done so), but it got disallowed when my ORH gains from the FFH buyout blew my earnings through the roof. It was really painful because I had done the rollover in early 2009 when the account value bottomed (actually the account only sagged 5% for the year at the time of the bottom), then the account tripled from there by year end. So the disallowed conversion was substantial. If only FFH had issued shares instead of cash for ORH, this never would have happened. Cutting a long story short, $1.60 per share of SSW is more expensive than the volatility premium I paid for JNJ $65 strike at-the-money 2013 calls. There is another school of thought that believe SSW is going to rise another 30%-40% from here... and it is yielding a lot more than the JNJ calls are costing me.

Hi Eric, Sorry if this question is a little too basic, why didn't you just buy JNJ outright at $60. You save the 10% premium that you pay for the calls, and you're getting the (assumed) increase in price between now and 2013. Thanks. -M The calls don't have a 10% premium. The $60 strike for example trades at a $2 volatility premium to the present share price. So the cost basis 21 months from now is only 3.16% above current share price. I actually bought the $65 strike for $4.25 though. And then the shares pulled back 1/2 percent the next day and I checked the price of the calls and they had gone up 10%. Go figure. There are other considerations... For example, volatility is extremely low right now. If we get a big crash, volatility will explode and those calls won't drop much in price -- at least no where near as much as the share price. Remember in March 2009 at-the-money 2011 JNJ calls were a 20% premium! I remember this crisply because at-the-money 2011 FFH calls traded for the exact same premium as JNJ puts. So you could write JNJ puts and use the proceeds to buy FFH calls. At that time, FFH was unhedged, carried all kinds of assets that the market considered high risk, and was exposed to catastrophy risk. Upside of FFH, but downside of JNJ. Epic... makes me laugh.

I'll be getting it at like 8x forward earnings in 2013. That's a sweet spot for me. I mean, some guys have been holding RIMM at that price recently (before the selloff). Risk adjusted, I rest my case.

Yes, when I sink 33% of my net worth into JNJ at 11x P/E my future risk-adjusted returns will be epic because the day will eventually come when it's 17x or 20x P/E again.

How about banning it and just focusing on earnings power? Then the people who actually know how to value companies will not be missing out on anything, and people who get misled by management playing games boosting ROE after writing off goodwill will not be misled either. Everyone will be happy.

Over the past 20 years, have PC prices in Japan fallen more than PC prices in the US? Just seeing whether we've both had the same deflation in tech, or whether Japan has had even more deflation. Point being... if prices for PC's and software have followed the same trend in both countries, then one could argue that MSFT and INTC have thrived despite already having Japan-style deflation. The argument goes that spending collapses because people expect lower prices next year. But I already expect lower prices for PCs next year. I've had that attitude for 20 years and pretty much everyone has. So what, did that cause MSFT and INTC to deliver poor results? Okay, for some companies it would be devastating... then my advice would be to not buy stock in "some companies". Buy MSFT and INTC. And AAPL and GOOG. I'm not sure if the OEM price for Windows has ever changed since 1990. It's like $50 or something like that -- and a consumer only buys one every few years. So it's like $10-$15 annual expense. Upgrading your laptop every 3 years, you spend roughly 4 cents per day on Windows software. It's practically free already. And does lack of demand for credit in the US have anything to do with credit growth in Mexico, one of Ciitgroup's most important markets? Mexico private credit growing 12-13% in 2011. I guess they don't care how indebted US consumer are. I'd like to see deflation try to drive that one down by 80%.

I am going to keep on looking at this the way I presently do, and acknowledge that it's not the best method for all people.

Oh sure, we can still have our Japan, but that's not going to keep cloud computing from happening, Don't they all have laptops and cell phones in Japan? The cloud computing wave just means sales of really expensive Intel products to power the servers. And a stock market down 80% in twenty years? Don't make me laugh! 2x p/e for MSFT where they keep buying shares? That's fifty percent EPS growth! I think this stuff fails the test of logic. It's one of those "nothing to fear but fear itself" sort of situations with MSFT and the Japan rumblings. Some people will tell you that real unemployment is 20%, by the old way of counting it. Yet these companies keep on growing . Hrm. Maybe the underemployed worker still needs a computer to do his job, and an unemployed person is using Monster.com to look for work.

Sorry to quote myself. But lets say the offer is only $1 for every $2 of goodwill. Should the still take the deal? Of course! Or how about only $1 for every $5 of goodwill. Should they still take the deal? Of course! Even at $1 of cash for every $100 of goodwill. Does it still make good economic sense to make the deal? Of course! So that's why it's worth practically nothing -- compared to the other components of book value, such as CASH!!!

This is the kind of reading that makes me excited for my large INTC investment: http://seekingalpha.com/article/266789-intel-no-longer-a-low-growth-company My INTC strategy is similar to my JNJ strategy. With INTC, I have the at-the-money 2013 $22.50 strike calls. I put 10% down now, and buy the shares in 2013 for cost of $25. At that point, I will be purchasing at effective price of P/E under 10. Given their growth rate, I want to stake my claim now rather than hope and pray that it will still be around then at these price levels. In fact, it will be cheaper than at the current price level. I pay only 10% of notional for at the money calls that don't expire for another 21 months from now, yet they are growing earnings at double digit rates. How inefficient can the options market possibly get? I at least find the options pricing strangely working in my favor.

Like, if I had a portfolio of stocks that I managed. I can sell them to you for a premium to underlying asset value because you can argue that my trading skills have value. Obviously, I don't really have trading skills but just pretend for the sake of argument. Except, it gets better in the case of ORH. It's actually your funds that I manage for you! I try to buy your portfolio of funds at 1.x tangible book value (market prices) from you, but you say not so fast, it's worth 1.3x tangible. I ask why, and you say well, because you are so good at management. I say, yes I am, but what the hell does that have to do with you? I have to pay for my own expertise? WTF?? Pretend in this example that we're not talking about an insurer, just investment management. If it seems at all strange to be charged a premium for your own abilities, then that's my position regarding the ORH buyout. I think it was fair at 1.3x book because outside of investment prowess, I'm not so sure ORH would be worth more than 1.3x book if the average manager were running the investments..

I found this guys table rather informative regarding HPQ's past performance: http://seekingalpha.com/article/251415-hp-an-unappreciated-steal Anyhow, look their management expects EPS to be $7 by 2014. That's their stated goal. That seems achievable given their stock price (buybacks at great earnings yield) and huge cap-ex spending. It will be even more likely if the stock doesn't go up. Put a 12x trailing on it and you've got 20% compounding the next 4 years, or 27% compounding over the next 3 years with a 12x forward valuation.

That's what my father says too.

I was bit surprised by the $20 drop shortly after the open. I thought: Wow, that's a bit of an over reaction. But, didn't think much more than that. Back almost to even now . . . quite an odd morning. Mr Market read my comments that ORH goodwill is really understated by 80%. That realization is what supported the stock today.

Reading over this thread the next day, I think that there has been a lot of talking past each other. Ericopoly uses goodwill (in the sense of discounting it) as part of his valuation process, where I do not because I view it as a contribution to earnings power. The differing uses don't make a difference so long as there is an appropriate adjustment to expected ROA and similar ending ROE. It's like people arguing over an asset with 33% of equity in good will. Some people say, the bad news is that we just lost 33% of equity. The good news is that ROE just increased by 50%. Other people will say... I only consider their investment returns, underwriting profits, and growth in float to be valuable. That stuff matters -- but to me the goodwill will not help them achieve any of that because the goodwill doesn't "earn". It just sits. Much rather have 5% of BV in earning tangible investments than in 5% goodwill that does nothing for me. My stance is that tangible assets are what make all of the above possible. There is no problem when an insurance company has 100% of book value in tangible assets. But when none of the assets are tangible it presents a problem. In between, there are shades of gray. Suppose some idiot payed them dollar for dollar for the asset called "goodwill", but let them keep all of the ORH operations. Now FFH is exactly the same, but instead of goodwill they now have cash. Dollar for dollar. Should they take the deal?

Here is why I bought the JNJ 2013 near-the-money calls. It provides a cheap entry point in 2013. Go back to early 2009 in our big crash -- stock got down to about $47. Okay, now grow it by 7% annually for 4 years. That takes you to $61. So the $60 strike 2013 calls allow you to make a 10% down payment today for a 2013 purchase at a mere 10% premium to the 2009 bottom. $61 in 2013 is the same as $47 in 2009. Just planning ahead :) Is 7% annually a reasonable rate of value growth for JNJ? I'm expecting it to be in the 11x forward earnings range by the time I buy it. At any rate, HWIC bought theirs at about $60 in early 2007. I'll be paying a 10% premium to their price -- but six years after the fact!