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Tetraphase Pharma Offers A Lesson In Risk Management

Summary Limit sell orders wouldn’t have protected investors from Tetraphase Pharmaceutical’s 78% plunge after hours Tuesday. Two ways for investors to limit downside risk from stock plunges like this are diversification and hedging. We examine the pros and cons of both of those methods of risk management. Tetraphase Tanks After Hours Shares of Tetraphase Pharmaceuticals (NASDAQ: TTPH ) closed up 3.54% on Tuesday, to $44.78. Less than 40 minutes later, TTPH was trading for under $10 per share after hours, as the dramatic graph below from YCharts shows. (click to enlarge) What tanked the stock, as Seeking Alpha news editor Douglas House reported , was the failure of its leading drug candidate, a broad spectrum antibiotic called Eravacycline , in a stage 3 clinical trial versus another antibiotic called Levofloxacin in the treatment of complicated urinary tract infections. Limit Sell Orders Don’t Limit The Loss A painful lesson some Tetraphase longs may learn here is that limit sell orders don’t protect against these kinds of drops. Consider, for example, a hypothetical investor who owned Tetraphase on Tuesday and didn’t want to see his position value drop by more than 20%, so he set a limit sell order at $36. The problem with this sort of limit sell order is that it won’t get you out of the stock at $36 per share, if the stock never trades at that price on its way down. Whatever price the stock opens at the next day is the price an investor would be offered for selling the stock then. Two Ways To Limit Stock-Specific Risk Two ways to limit stock-specific risk of this kind are diversification and hedging. Both have their advantages and disadvantages. The big advantage of diversification is that it doesn’t cost much.[i] As the Nobel laureate economist Harry Markowitz famously put it, “diversification is the only free lunch”. If you owned Tetraphase as part of an equal-weighted portfolio of 20 stocks on Tuesday, the worst impact it could have on your portfolio value going forward would have been -5%, because it would have comprised 5% of your portfolio. Of course, the flip side to diversification is that if a particular stock does very well, its impact to your portfolio would be similarly limited. Diversification limits the harm caused by your worst investment, but it also limits the benefit provided by your best ones. As Warren Buffett noted in a lecture at the University of Florida’s business school in 1998, If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into the seventh one instead of putting more money into your first one is going to be terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. Unlike diversification, hedging allows you to concentrate your assets in a handful of securities you think will do best, because your downside is strictly limited. Consider, for example, hedging with put options. Put options (or, puts) are contracts which give you the right to sell a security for a specified price (the strike price) before a specified date (the expiration date). An investor who owned 1,000 shares of Tetraphase on Tuesday and 10 put option contracts (each contract covers 100 shares) with strike prices at $40, would have been able to sell all of his Tetraphase shares for $40 on Wednesday, regardless of what price the stock was trading at then. The main drawback with hedging, though, is its cost. At Portfolio Armor , we look for optimal puts (as well as optimal collars) when hedging. Optimal puts are the ones that will give you the level of protection you are looking for at the lowest cost. A Tetraphase investor scanning for optimal puts on Tuesday against a greater-than-20% drop over the next several months, would have gotten this message, The reason he would have seen that message is that the cost of protecting against a greater-than-20% drop on Tuesday was itself greater than 20% of position value. The smallest decline threshold against which it was possible to hedge TTPH over the same time frame with optimal puts on Tuesday was against a greater-than-27% drop, and, as the image below shows, the cost of doing so was prohibitively expensive – equivalent to nearly 27% of position value. Note that, in the image above, the “cap” field is blank. If an investor had entered a figure in that field, the app would have attempted to find an optimal collar to hedge Tetraphase. A collar is a type of hedge in which an investor buys a put option for protection, and, at the same time, sells a call option, which gives another investor the right to buy the security from him at a higher strike price, by the same expiration date. The proceeds from selling the call option can offset at least part of the cost of buying the put option. An optimal collar is a collar that will give you the level of protection you want at the lowest price, while not capping your possible upside by more than you specify. In a nutshell, with a collar you may be able to reduce the cost of hedging, in return for giving up some possible upside. It was possible to hedge Tetraphase against a greater-than-20% drop over the next several months with an optimal collar on Tuesday, if an investor were willing to cap his possible upside over the same time frame at 20%. The cost of that protection would have been 8.26% of position value, which would still have been fairly pricey. Using Security Selection To Reduce Risk (and Hedging Costs) Another way to reduce risk, and to hedging costs, is to avoid stocks like Tetraphase in the first place. That may sound like hindsight at this point, but remember the hedging cost shown above was calculated using data from before the stock tanked. Hedging cost that high can be a red flag. By way of comparison, look what the cost of hedging Gilead Sciences (NASDAQ: GILD ) against the same percentage drop over the same time period with optimal puts was on Tuesday: As you can see at the bottom of the image above, Gilead cost 2.1% of position value to hedge. Tetraphase was 12.6x as expensive to hedge in the same manner. By limiting your portfolio to securities that are relatively inexpensive to hedge, you will end up avoiding some of the riskiest ones. How much should you be willing to spend to hedge? That depends, in part, on how high you estimate the potential return of your underlying securities. One approach is to calculate both hedging costs and potential returns for your best ideas, then, subtract the hedging costs from the potential returns, rank them by potential return net of hedging cost, and buy and hedge a handful of the highest ranked ones. That’s the essence of the hedged portfolio method, which we detailed in a recent article (“Keeping A Small Nest Egg From Cracking”). —————————————————————————– [i] To be precise, this isn’t quite true if you buy individual stocks rather than a low-cost index fund. All else equal, the more you diversify, the more trading costs you will incur. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

The Market Has Discounted The Biggest Growth Story For The Next Decade

China slowed-growth worries have created a buying opportunity for long-term China. Relative to other international equities – China has value in developed as well as emerging market funds. Investors should consider allocating more capital out of the US which is trading at premium valuations into China trading below historic valuations. Haven’t you heard? Chinese GDP growth is slowing – run for the hills. These seems to be the consensus as Chinese equity markets have taken a plunge YTD . Examine the five-year chart of some popular Chinese ETFs (exchange-traded-funds). (click to enlarge) This dip has created an excellent buying opportunity for certain regions of the world, with China being my top pick. To start I took a look at the major countries and examined the broad ETFs that tracked the respective countries. From there I looked at the sales growth in the funds and removed negative sales; since the focus here is on growth at a reasonable price. From there I accessed data from Worldbank to gather historic and future estimated GDP growth. The results are below, filtered on an average PEG score from low to high. (click to enlarge) China remains my top pick because while growth is slowing; it is still growth! The next four year average growth estimate is still above 7%, with a P/E that is roughly half of the S&P 500. The middle-class continues to expand and disposable income has been on a healthy upward trend. Funds that should do well in the next decade include: SPDR S&P China ETF (NYSEARCA: GXC ), iShares China Large-Cap ETF (NYSEARCA: FXI ), iShares MSCI China ETF (NYSEARCA: MCHI ), and iShares MSCI Hong Kong ETF (NYSEARCA: EWH ). The first three funds are very similar as they are invested primarily in China emerging markets, whereas is 94% developed markets and only 6% emerging. Investors may want to consider one developed and one emerging – which both look attractive after the market correction. If you just want broad exposure to the Asia Pacific region I would recommend the low expense and reasonably valued Vanguard Pacific VIPERS (NYSEARCA: VPL ). This fund is 63% Japan, 18% Australia, 17% Asia developed and 2% Asia emerging. Another interesting way to play China while taking on more firm-specific risk would be to buy a familiar U.S. company with exposure to China. The chart below shows restaurant companies operating income across varied geographic regions: (click to enlarge) My favorite picks in the above list are Starbucks (NASDAQ: SBUX ) with a PEG of 1.6 and Yum! Brands (NYSE: YUM ) with a PEG of 1.7. Other ideas to buy at a discount to the recent selloff with exposure to China include Boeing (NYSE: BA ) who will most likely be unscathed by slightly less growth in this region. Resort companies such as Las Vegas Sands (NYSE: LVS ) or MGM Resorts International (NYSE: MGM ) have fallen more than I would have expected considering the peculiar fact that people tend to continue to gamble even in periods of economic downturns. My prediction is that gambling in the Macau region will pick up and buying now is a good opportunity for the next decade. (click to enlarge) I’m sure there are numerous ways you can conjure to play a re-bound in the Chinese sell-off. I’m interested to hear your comments on what you think the best way to play a rebound in China is. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in FXI,GXC,SBUX,YUM,LVS, MCHI over the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

PJM Capacity Auction Impact On Exelon And Other Electric Utilities

Summary PJM’s annual capacity auction was completed in August. This was the first year using the stricter capacity performance standards, which led to an increase in clearing prices. Exelon was the big winner in this year’s auction, with the potential to earn over $1.7B in capacity payments. Fewer new power plants bid into this year’s auction. This could be a positive sign for the long-run outlook of generation owners. For those who follow the electric utility industry, the PJM capacity auction is usually one of the big events on the calendar. (PJM is the regional transmission organization that essentially controls the operation of the electric grid from New Jersey to Chicago.) This year’s auction completed in August was no exception. The capacity auction was created a number of years ago to help support the reliability of the electric grid in a competitive market. The auction takes place three years before the capacity is needed, so this year’s auction was for the 2018/19 planning year. Electric demand fluctuates by time of day and by time of the year. There are some power plants that are needed for those few hours each year when demand is at its highest, but otherwise don’t have to run. These plants would never stay open if they were only paid for the few hours that they operate. The capacity auction essentially pays plants a standby fee to keep them open so that there is plenty of power available on high demand days. This fee is in dollars per megawatt of capacity for each day of the year. The size of the fee is determined in the capacity auction, and varies by location within PJM based on constraints in the electric transmission system. The following map shows the zones tested for transmission constraints in this year’s auction. Exhibit 1 (click to enlarge) Source: Brattle Group The arrows in the above map represent the connection between the parent zones and smaller sub-zones that might also have transmission constraints. For example, the MAAC zone has EMAAC as one of its sub-zones. EMAAC has its own sub-zones, including PSEG, which has its sub zone, PSEG-N. After the 2014 polar vortex caused reliability scares in PJM, changes, called capacity performance (NYSE: CP ), were made to the auction creating stricter eligibility requirements to participate. It also increased penalties for plants that receive capacity payments but are unable to perform when called upon during periods of peak demand. The creation of CP led to an increase in the clearing price for generation assets this year, as the higher cost of meeting the tighter eligibility requirements raised the auction bids for many participants. The clearing price of the RTO region of PJM (basically the areas in PJM without any transmission constraints) increased almost $45/MW-day over last year’s auction. Exhibit 2 Source: PJM Since this is the first year of CP, PJM only required 80% of the generation capacity to meet the new tougher standard. Eventually all capacity will have to meet the CP standard. Capacity in this year’s auction only meeting the old standard still received almost $150/MW-day in the RTO zone, which was close to a $30/MW-day increase in price. As you can see on the following map, only two areas priced separately due to transmission constraints this year, EMAAC and COMED. The prices in these zones were $50-60/MW-day higher than in the RTO. Exhibit 3 (click to enlarge) Source: PJM There are nine major generators that are impacted by the results of the auction. American Electric Power (NYSE: AEP ), AES Corporation (NYSE: AES ), Calpine (NYSE: CPN ), Dynegy (NYSE: DYN ), Exelon (NYSE: EXC ), FirstEnergy (NYSE: FE ), NRG Energy (NYSE: NRG ), Public Service Enterprise Group (NYSE: PEG ), and Talen Energy (NYSE: TLN ). The following chart shows the capacity each company holds inside PJM, and the zone where it is located. (A free excel file with information on the size, zone, and capacity of each company’s PJM plants, as well has historical auction prices is available here ) Exhibit 4 (click to enlarge) Courtesy Garnet Research, LLC You can see that the big player in PJM is EXC. You can also see that the majority of EXC’s capacity is in the COMED and EMAAC zones, which are the two zones that received higher prices this year because of transmission constraints. One thing to remember, though, is that having capacity in a region doesn’t necessarily mean you will receive payments for all of your capacity. Exelon actually issued a press release after the auction stating that three of its nuclear units (Quad Cities, TMI, and Oyster Creek), totaling 3,230MW of capacity did not clear the auction. The lost revenue from these plants not clearing is about $240M. Exelon already has plans to close Oyster Creek at the end of 2019. TMI and Quad Cities not clearing the latest auction probably means EXC will seriously be reviewing whether or not these plants should also be closed in the next few years. In general companies don’t publish which plants clear the auction because of competitive reasons, so it is difficult to know exactly which units will be receiving this revenue each year. Taking a company’s capacity in each zone and multiplying by the auction clearing price and by 365 days gives you an idea on how much potential revenue it could get from capacity payments. In this year’s auction, if you assume all of EXC’s capacity cleared at the latest prices, they would be receiving almost $2B in revenues. EXC is by far the biggest, but you can see the potential for the major players in the following table: Exhibit 5 (click to enlarge) Courtesy Garnet Research, LLC So without the three nuclear plants we know didn’t clear, Exelon still has the potential to earn over $1.7B of capacity payments. The above table also shows the biggest beneficiaries from the constraints in the electric transmission system. EXC obviously has the biggest benefit on a dollar basis, but PEG gets the biggest percentage benefit. Most of PEG’s plants are in EMAAC or in EMAAC’s sub-zones. Historically this has been a very good place to own power plants, because transmission constraints have impacted at least one sub-zone of EMAAC in all but one of the past capacity auctions. Exhibit 6 (click to enlarge) Courtesy Garnet Research, LLC So one thing to keep in mind when looking at PEG’s historical earnings is that they have been a big beneficiary of these transmission constraints. These constraints have been there for a long time, and with the difficulty in building new generation and transmission capacity, it is likely PEG will continue to be a beneficiary well into the future. This is actually the first time that COMED has ever broken out separately in the auction, which was partly driven by some power plant retirements. It remains to be seen if this year’s breakout was a one-time event, or the start of a trend. The ATSI zone, where the majority of FE’s assets are located, actually set an auction record with a $357/MW-day clearing price for 2015/16. But this year’s 2018/19 auction had ATSI just receiving the RTO price. So just because a zone received premium prices in an auction, it doesn’t mean this will continue for a long time. While EXC has the most potential revenue from the auction, on a percentage basis the impact to the bottom line is significantly greater for independent power producers Dynegy, NRG, and Talen. If you assume a $20 change in the auction clearing price across all zones, that all of each company’s capacity clears the auction, and a 40% tax rate on the incremental revenue, the impact is over 35% of NRG’s 2016 Street earnings estimate. The IPPs tend to trade more on EBITDA than EPS, and Talen Energy is actually the most sensitive on that metric. You can see the impact by company in the table below: Exhibit 7 (click to enlarge) Courtesy Garnet Research, LLC AEP, EXC, FE, and PEG all have sizable regulated wires businesses as part of their companies, which leads to the auction’s smaller bottom line impact for these names. While these names might not get as big a boost from the auction increase, their regulated business helps protect them when power markets suffer any downturns. Besides the increase in prices, this year’s auction may have brought additional positive news for competitive electric generators. Over the past few years record numbers of bidders have proposed adding new capacity to PJM. Last year almost 6,000 megawatts of new capacity cleared the auction, but this year less than 3,500MW was even offered. Exhibit 8 (click to enlarge) Courtesy Garnet Research, LLC This could be a sign that the economics of building a new power plant are becoming less attractive. The decrease in natural gas prices over the past few years has knocked down power prices and has been a big reason for the building binge, with generators trying to take advantage of a cheaper fuel source. If this buildout slows there would be fewer new power plants to compete with the current set of plants and would be supportive to companies that currently own capacity. This would be a positive for all generation in PJM, and could mean increased stability for power prices in the region. It also gives hope that the higher level of this year’s capacity auction might stick around for a while. Conclusion If the latest auction is a sign for a turnaround in the mid-Atlantic electricity markets, investors would benefit most by obtaining shares in DYN, NRG, or TLN. If investors want exposure to these markets, but with more regulatory assets to give some downside protection, then Exelon is probably the preferred name. FE and PEG are also similar to EXC, but they lack the added protection of Exelon’s geographic diversity. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.