Things you really need to understand before you start buying stocks

After running this blog for almost a year, I realized I haven’t dedicated too many articles for investment beginners. I will drill down the very basic of stock (equity) investing. Please mind that I am assuming the readers are interested in investing (holding the stocks for longer than a year) rather than trading (buying and selling stocks in a short span of time).  Also, I will keep the concepts as simple as possible so please bear with me if some details seem lacking.

What is stock?

Simply speaking, stock is a piece of a company. Buying a stock is equivalent of buying a piece of a company.  For some, it might be difficult to grasp this concept. If so, think of it like a pie. A company can be divided into pieces like a pie and people can buy/sell in a market.

sweets_applepie.png

What is value of a stock?

As mentioned before, a stock is a piece of a company.
[The value of stock = Total value of company / # of stocks of the company outstanding]
If the total value of a company is worth $100M and there are 50M shares, each share should worth $2.

This is equivalent of
[The value of a piece of pie = Total value of whole pie / # of pieces]
If the whole pie is worth $10 and it’s divided into 5 pieces, each piece should worth $2.

What is the value of a company, then?

The fundamental value of a company is mainly composed of two factors:

  1. How much cash can a company generate if it sold everything it owns today?
  2. How much cash can a company generate in future by running the business?

Putting aside the time value of money (insert link), the sum of above two is the value of a company. In terms of the pie example, as a company’s cash generating capacity gets larger, the pie (value) becomes larger as well.

Why and when do investors buy a stock?

Investors buy (or should be buying) a stock when they believe the stock price is lower than the value of the stock.

Simply speaking, finding a good stock is similar to finding a bargain while shopping. For example, say you found $80 authentic Chanel bag at a flea market with mint condition. You know the price of the bag should be at least $800 even in a second-hand market. In such case, the only rational decision would be to buy the bag, own it (or give it to your wife) or resell it at a higher price to make money.

You may not find such a cheap Chanel bag (I wish, my wife keeps asking me to buy one) but similar bargains can be found occasionally in stock markets. Some stocks might be priced too low as some people might underestimate the cash generating capacity of a company. Investors buy such stock, hold it and sell it once other people realize the true value (cash generating capacity) of the company.

Summary & Conclusion

You should follow the decision process below when purchasing a stock:

  1. Determine the value of a company by analyzing the company’s financial statement
    (especially the cash flow statement), the company’s business model, the company’s growth strategy, etc.
  2. Divide the value of a company by number of shares (stocks) outstanding. This gives us the value of the company’s stock.
  3. Compare the value of the stock and the price of the stock.
  4. If the price is significantly less than the value, it’s a bargain. You should buy the stock.

Of course, determining the value of a company is not easy and requires some financial knowledge and rigorous analysis. I’m not going into the details of valuation in this article to focus on the fundamental concepts, however, if you would like to learn more, you should subscribe to the blog and stay tuned for updates!

 

Personal Anecdote: I shorted a put option

In my last article, I discussed shorting a put option as a useful investment strategy for value investors. In theory, shorting a put option allows investors to “buy” stocks cheaper than the current market price. Recently I had a chance to short a put option; I decided to share my personal experience to show whether such strategy works in real life.

  • May 25, 2017 – Shorted a put option

I sold 1 put option of Michael Kors (KORS) stock at $1 with a strike price of $35 and an expiration date of June 16, 2017. The stock price was $36.63 on that day. Since each option contract is associated with 100 shares, I collected $100 at the time of sale. There were 2 possible results at the time of option expiration:

(1) The stock price remains above $35 and the option expires: I get to keep $100

(2) The stock price drops below $35: I am forced to buy 100 Michael Kors stock at $35 per share.

In other words, it was equivalent to buying Michael Kors stocks at $34 per share when the actual stock price was $36.63.

  • May 31, 2017 – Q1 Earnings release

On May 31, Michael Kors released its earnings result. Even though the company’s earnings beat the consensus, its FY18 guidance was below the market’s estimate. Here is the example of the headline I saw on that day…yikes.

 Credit: Ben Levisohn (Barron's)

Credit: Ben Levisohn (Barron's)

Even though the stock price dropped to $33.18, which was well below the strike price ($35) of the put option, the option was not exercised by its holder. 

  • ·June 16, 2017 – Option Expiration Date

At market closing on June 16, the stock price was $34.60, which was lower than the strike price of $35. The put option was exercised and I was forced to buy 100 Michael Kors stock at $35. My unrealized gain at this point was $60 [$1 x 100 – ($35 - $34.60) x 100] after risking $3400. In terms of % return, I made about 1.76% gain in 3 weeks (from May 25, 2017 – June 16, 2017) which translates to the annualized return about 35.42%. Not a terrible return, however, I decided to hold the stock hoping for a better return.

Summary

 Shorting Michael Kors’ put option was the perfect example of shorting a put option as an investment strategy. If I had bought the stock outright on May 25, 2017, my purchase price would have been $36.63 and I would still be at a loss at the current price of $36.55 (as of July 30, 2017). Shorting the put option and purchasing the stock at the hypothetical price of $34 resulted in a gain of 7.5% instead. While there is a considerable risk in shorting put options, I would recommend value investors to try it at least once. You cannot beat the market if you are doing the same thing as everyone else.

 

This is how you buy stocks cheaper than anyone else

The most important factor in value investing is buying stocks at cheap price. In fact, If you aren’t buying stocks at a discount, you aren’t really value investing. Today, I would like to introduce one of the tools that will help you buy stocks cheaper than anyone else: shorting put options.

What is an option?

There are 2 kinds of options: call option and put option. A call option is the right to buy a stock while a put option is the right to sell a stock at a certain price, the strike price, until a cert date, the expiration date. For example, say you buy a call option for stock A with a strike price of $10 and it is set to expire on May 26th, 2017. This option would let you buy stock A at $10 until May 26th, 2017 regardless of the current stock price.

The main advantage of buying an option is that it provides leverage with limited downside risk. In the example above, you can earn 100% return on an option as opposed to a 20% return in stock purchase, if the option price is $1 and the price of stock A increases to $12. The downside risk is limited because you can simply let the option expire and lose $1 if the price of stock A doesn’t go above the exercise price.

The main disadvantage of buying an option is that the time frame of investment is rather short (2 years at longest) and you can lose your money pretty easily. An option becomes worthless, a 100% loss, if the stock price does not reach the exercise price until the expiry date comes. When you purchase a stock, you can hold and wait even if the price goes down.

How can I use shorting put options in value investing?

Shorting a put option means you are selling the put option. In other words, you are selling the right to sell the stock at the strike price. If the buyer exercises the option, you are obligated to buy the stock at the strike price. In a sense, you are “buying” the stock at the (strike price – price of the put option).

Let me show you a real life example. Recently, I’ve been laying eyes on Big Lots, Inc. (BIG), a discount retailer in the U.S. The company is quite profitable and its earnings are growing. The stock has a payback period of less than 10 years and the stock is traded near its 52 week low at $48.16 per share as of March 24, 2017.

I’m interested in buying stock in the company but I’m thinking of shorting a put option instead to get a “discount”. Though there are many options of Big Lots, Inc. I will discuss the following put option in particular.

Selling this put option at $3.5 would mean that “I am receiving $3.5 to sell the right for someone to force me to buy the stock at $47.5 until Jul 21, 2017”.

There are 2 scenario in terms of return.

1.            The stock price remains above $47.5 until Jul 21, 2017.

In this case, the put option would not be exercised because the stock price is above the exercise price. I get to keep the $3.5.

In a sense, I get 7.4% return on $47.5 in 4 months. About 24% annualized return.

2.            The stock price becomes lower than $47.5 before Jul 21, 2017.

In this case, I keep the $3.5 but I would be forced to buy the stock at $47.5, even though the actual price is lower.

In a sense, I get to buy the stock for $44 ($47.5 - $3.5), which is about an 8.5% discount from the current stock price ($48.16).

In either scenario, I will be happy. In one scenario, I get 24% annualized return. In another, I get to buy the stock 8.5% cheaper than today’s price.

Risks

Even though I said that I can buy a stock at a discount by shorting its put option, it’s not entirely true. In the example above, say if the stock price goes to 0 before July 21, 2017, I am still forced to buy the stock at $47.5. I instantly lose $44 ($47.5 - $3.5).

I could also lose the upside potential as the stock price could go well above $51.66 (current stock price + option price) before July 21, 2017. For example, if the stock price increases to $53, I would’ve been better off buying the stock because I would have gained $4.84 ($53 – current stock price) which is more than $3.5, the money I made by selling a put option.

Conclusion

Sometimes you get to “buy” stocks at more than a 10% discount depending on the market situations. Even though shorting options is not a common practice and can be considered as an advanced technique, it is a very useful tool that can enhance your portfolio performance.