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ValueXVail 2013 - Erik Kobayashi-Solomon

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  • 7/28/2019 ValueXVail 2013 - Erik Kobayashi-Solomon

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    Value Investing with OptionsVALUEx Vail 2013

    Erik Kobayashi-SolomonIOI, LLC | www.IntelligentOptionInvestor.com

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    Three Questions

    What are options and why do value investors hate them?

    What can the option market tell an investor about stock valuations?

    How can understanding options tilt the risk / reward equation in ones favor?

    2 2013 IOI, LLCwww.IntelligentOptionInvestor.com

    Morale of the Story

    An intelligent investor using rational valuation methodology

    always has an edge over

    mechanically-determined,

    EMH-based market valuations

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    Buffett hates options

    I view derivatives as time bombs, both for the parties that deal in them and the economicsystem. Basically these instruments call for money to change hands at some future date, with the

    amount to be determined by one or more reference items, such as interest rates, stock prices, or

    currency values

    --Warren Buffett (2002)

    Insurance

    Manufacturing, service,and retailing

    Railroad

    Investment and derivativegains / losses

    Utilities

    Finance and financialproducts

    Insuranceselling put

    optionsis Berkshire

    Hathaways biggest business,

    accounting for 30% of

    corporate profit in 2012

    3 2013 IOI, LLCwww.IntelligentOptionInvestor.com

    Or does he?

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    Options are directional instruments that offer greater

    flexibility than stocks

    Stocks

    Directional instruments

    Investors must accept the opposite exposure

    to that which they are trying to gain

    Perpetual legal claim

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    10/7/2011 10/4/2012 249 499 749 999

    Sto

    ck

    Price

    Advanced Building Corp. (ABC)

    4 2013 IOI, LLCwww.IntelligentOptionInvestor.com

    20

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    10/7/2011 10/4/2012 249 499 749 999

    Sto

    ck

    Price

    Advanced Building Corp. (ABC)

    Options

    Directional instruments

    Investors may flexibly gain and / or accept

    exposure

    Legal contract granting time-limited exposure

    Pay premium toGain exposure

    Receive premium when

    Accepting exposure

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    Hating options because fools use them is as rational

    as hating cars after driving in New Jersey

    Most option gurus are ex floor traders or spreadsheet jockeys who couldnt tell the value of a stock if

    it hit them with a club

    Gurus advocate option strategies that 1) benefit market makers and 2) attempt to minimize rather than

    exploit the inherent directionality of options

    When you combine ignorance and leverage, you get some pretty interesting results.

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    10/7/2011 10/4/2012 249 499 749 999

    Stock

    Price

    Advanced Building Corp. (ABC)

    5

    (Iron Condor diagrams courtesy of Optionetics.com)

    2013 IOI, LLCwww.IntelligentOptionInvestor.com

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    What can the option market tell you about stock

    valuations?

    6 2013 IOI, LLCwww.IntelligentOptionInvestor.com

    Option pricing is a mathematical

    representation of how the EMH (readMr. Market) determines an intrinsicvalue range for a stock

    Option pricing formulas use purely

    historical price and volatility measures

    without regard for fundamentals

    The option market is a sausage

    grinderit takes inputs and spits out a

    valuation in a purely mechanical way

    Scared investors pay enormous premia

    for downside insurance in times of

    stressintelligent, rational investors

    are happy to accept the downsideexposure

    Solid line: Implied volatility = 14%

    Dashed line: Implied volatility = 21%

    Stock investing in a market that has actively traded options is like playing poker with an opponent who always

    lays his cards face up on the table

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    Tilting the risk / reward balance in ones favor

    7 2013 IOI, LLCwww.IntelligentOptionInvestor.com

    Efficient Market Intelligent Investor

    Extrapolate value from current stock price Look for opportunities where valuation differs from current

    stock price

    Valuation range determined by

    - Risk-free rate

    - Dividend yield

    - Market fear (implied volatility)

    Valuation range determined by

    - Best / worst likely revenue growth

    - Best / worst likely profitability

    - Best / worst likely medium-term FCF growth

    Risk = (Symmetrical) Uncertainty Risk = Not having an edge over the market

    Low Uncertainty | High Risk

    Lock in at worst a 15% loss, at best a 10% gain

    High Uncertainty | Low Risk

    Lock in at worst a 15% gain, at best a 80% gain

    Rational best-case valuation = BlueRational worst case = Yellow

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    Intelligent Option Investing

    8 2013 IOI, LLCwww.IntelligentOptionInvestor.com

    Step 1:Create scenarios based on best / worst cases of:

    Revenue growth

    Profitability

    Medium-term growth

    Total of 23 = 8 scenarios

    Select most likely valuation range & improbable scenarios

    Step 2:Option strategy becomes a trivial exercise

    Look for mispriced upside and / or downside

    Effect investment using listed or listed look-alike

    options

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    In PracticeCaterpillar (CAT)

    9

    Revenue Projections

    Best 5Y CAGR: 0%

    Worst 5Y CAGR: -4%

    Profit Projections

    Best Case Avg EP Margin: 5%

    Worst Case Avg EP Margin: 3%

    Marginal Real EP Growth (Hist) Nominal FCFE (Hist)

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    CAT Scenarios

    2013 IOI, LLCwww.IntelligentOptionInvestor.com

    10

    Case / Scenario Value

    -4% | 3% | 5% 17

    -4% | 3% | 6% 18

    0% | 3% | 5% 190% | 3% | 6% 20

    PSR Implied Low 41

    -4% | 5% | 5% 54

    -4% | 5% | 6% 56

    0% | 5% | 5% 64

    0% | 5% | 6% 67

    252-day Low 78252-day High 99

    PSR Implied High 103

    52-week range

    Historical High/Low Price/Sales * High/Low Rev Proj.

    Price Range Implied by Option Market

    8 Valuation Scenarios

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    Stock Price History vs. Valuation Range

    2013 IOI, LLCwww.IntelligentOptionInvestor.com

    11

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    CAT Option Strategy

    2013 IOI, LLCwww.IntelligentOptionInvestor.com

    12

    Gain Exposure to Downside Potential by

    Purchasing 50-strike Put.

    Expires JAN 15 (574 Days)

    Price: $1.80

    Return to Best Case: -100% (-$1.80)

    Return to Worst Case: 1,733% (+$33.00)

    Return to Blended: 344% ($6.20)


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