Goldman Sachs analyst Salveen Richter launched coverage on a group of smid-cap biotech stocks Wednesday, rating the sector as neutral but flagging four stocks as worthy of investor attention. Here are his top picks: Bluebird Bio (BLUE): Richter gave this young biotech a buy rating at a price target of 165, a whopping 107% premium over Tuesday’s closing price. Bluebird stock suffered a setback earlier this month when its gene-therapy treatment
Summary BITE is the first ETF to target the restaurant industry. This ETF currently has 45 holdings (most mentioned in this article) and includes many of the “best” eateries. This ETF may be the best way to invest in what can be a mine field of stocks. I have never felt compelled to invest in the restaurant industry. To start with, I’m not sure which kind of “restaurant” I would be interested in investing in. To begin with, there are so many eateries around that it helps to subdivide the industry into categories , but even then it can be difficult to classify some of the companies. Typical categories might include: Upscale: Ruth’s Chris Steak House / Ruth’s Hospitality, Inc. (NASDAQ: RUTH ) Casual: Ruby Tuesday, Inc. (NYSE: RT ) Fast Casual: Noodles & Company (NASDAQ: NDLS ) Entertainment: Dave & Buster’s Entertainment, Inc. (NASDAQ: PLAY ) Family: Bob Evans Restaurants ; Bob Evans Farms, Inc. (NASDAQ: BOBE ) Ethnic: Chipotle Mexican Grill, Inc. (NYSE: CMG ) International: The Olive Garden 1 Regional: El Pollo Loco, Inc. (NASDAQ: LOCO ) 2 Regional Atmosphere: Texas Roadhouse, Inc. (NASDAQ: TXRH ) 3 Upper-Scale Burger: Red Robin Gourmet Burgers, Inc. (NASDAQ: RRGB ) Mid-Level Burger: Steak ‘n Shake 4 Fast-Food Burger: McDonald’s, Inc. (NYSE: MCD ) Drive-Thru: Sonic Corp. (NASDAQ: SONC ) Pizza: Pizza Hut 5 Pizza Delivery: Domino’s Pizza, Inc. (NYSE: DPZ ) Chicken: Popeyes Louisiana Kitchen, Inc. (NASDAQ: PLKI ) 6 Bakery: Panera Bread Co. (NASDAQ: PNRA ) 7 Donuts: Dunkin’ Donuts 8 Café-Style: Starbuck’s Corp. (NASDAQ: SBUX ). It is not easy to categorize some restaurants, however, so we end up almost needing to make a separate category for each eating establishment. It can also be difficult to find out just what company to invest in, as many restaurants are owned by holding companies that may own several restaurants and/or restaurant chains 9 – and maybe some non-food related businesses as well. 10 It is also possible to invest in franchisees. Besides investing in McDonald’s, one can also invest in Arcos Dorados Holdings, Inc. (NYSE: ARCO ) – the largest McDonald’s franchisee in the world. 11 As well, one can invest in Burger King restaurants through parent company Restaurant Brands International, Inc. (NYSE: QSR ) 12 and also through Carrols Restaurant Group, Inc. (NASDAQ: TAST ), the largest Burger King franchisee in the world. 13 The All-Restaurant ETF There are other reasons why I am reluctant to put my money into restaurants, and we will get to them. For the present, we can try to address the issue of just how many restaurants, types, styles, menus, etc., there are. On 28 October 2015, ETF Managers Group issued a new ETF: The Restaurant ETF (NASDAQ: BITE ), the first ETF to focus exclusively on the restaurant industry. Its current portfolio of 45 companies contains all of the companies mentioned so far in this article, making it right there very impressive. It would be excessive to try to list all 45 holdings – not to mention even more boring than it has been already – so I will say only that the remaining holdings are just as impressive as those listed. 14 The Index The fund’s index is managed by Solactive A.G. , which uses the following five criteria for eligibility for inclusion in the index: 15 The entity must derive the majority of its assets or revenues from the operation of restaurants (the entity may be from any sector of the restaurant business). The securities involved must be U.S.-listed common equity stocks. ADRs are eligible. The entity must have a free-float adjusted market capitalization of at least $200 million , and must maintain that minimum. Constituents must has a three-month average daily turnover of at least $1 million to ensure adequate liquidity . Holdings are equal-weighted . In fact, it would be difficult to use market-cap weighting or many other weighting systems. As it is, the four largest companies in the fund ( McDonald’s , Starbucks , Chipotle and Yum! ) account for 68.67% of the total market cap for all companies in the portfolio. A market-cap-based weighting would be hard to use with the 25%-maximum-per-holding restrictions that are imposed on ETFs. 16 Rebalancing and reconstitution are performed semi-annually , in June and December. Any holding that warrants being dropped from – or added to – the portfolio would also be accomplished during these adjustments. 17 Dividends If you look at the table above, you will note that this is not likely to be an ETF that makes large distributions to its shareholders. Of its 45 holdings only 20 pay dividends, and the average dividend is 2.61% – not bad, but it amounts to a gross income yield (Inc. Yld.) on NAV of 1.14% . After expenses, the net return on NAV (RoNAV) is 0.39% ; 18 that is the income that is left with which to pay out dividends to shareholders. 19 Let me remind readers that these figures are my own, not those of the fund’s managers; all income I have considered is derived from dividends paid by the holdings. ETFs also distribute income from other sources – notably capital gains and interest received – that are not able to be estimated in advance of their receipt. Therefore, my estimates tend to be less than actually distributed, to a greater or lesser extent. Any dividends are to be paid out quarterly, with capital gains paid at least annually. 20 Performance As usual, I like to run a test on the holdings of a new ETF in order to get an idea of how the fund’s performance might have been had it already been in existence a few years ago. This was something of a challenge with BITE , as many of its holdings have had recent IPOs. Nearly 10% had IPOs in the past year – nearly 20% in the past two years. I opted to begin the test on 14 April 2011 , when two-thirds (30 companies, in all) of the portfolio were available for trading. The test was begun with a $20,000 initial stake with equal weighting applied, with quarterly reconstitution and rebalancing. Since dividends do not figure heavily in this fund they are not reflected in the results. As this is the first ETF to track the restaurant industry there are no ETFs to which to compare BITE ; therefore, I have adjusted the S&P 500 to $20,000, with that index being used for comparison. The following chart shows the performance for the BITE portfolio: (click to enlarge) Outside of the recent drop that affected the entire market, the BITE portfolio has performed quite well, although it clearly has very distinct periods of negative performance. Overall, however, the portfolio has performed with a CAGR of 18% (compared to a CAGR of around 11% for the S&P). 21 Making the Restaurant Investment Safer As I alluded to earlier, I have never felt compelled to invest in a restaurant, and, at first glance, BITE looks to be one way of taking the anxiety out of this industry. At the very least, the fund gives broad access to the restaurant market – all of the companies mentioned so far in this article, or the holding companies that own them, are BITE holdings. Can BITE resolve other concerns about the restaurant market? Here are some of the risk factors that I have about restaurants, and how this ETF could take a bite out of them. 22 Failures : It is estimated that approximately 90% of new restaurants fail in their first year. This may be an exaggeration, although a study by The Restaurant Brokers confirms this figure for independent restaurants; chain restaurants tend to do (slightly) better. Beyond the first year, approximately 70% of restaurants will close before their fifth year of operation (no distinction between independent or chain). Beyond the fifth year, 90% of restaurants tend to stay open a minimum of 10 years . 23 Reasons for failure? Undercapitalization is common for the first year. Beyond that, inability to differentiate from the competition and inability to identify and adjust to changing trends seem to be significant reasons. 24 A risk that is particular to chain outfits is that of market saturation , a pet peeve of mine. 25 Most of BITE’s holdings are established companies, and even many of those which have held IPOs in the past two years (approximately 20%) were in operation well before entering the stock market. Statistically, at least, the portfolio seems to be reasonably safe on this score. Competition : Drive down any major street in a city and you instantly get a feel for the level of competition that exists among restaurants – particularly the fast-food burger eateries. McDonald’s and Burger King mix it up with places like Wendy’s Co. (NASDAQ: WEN ) and Jack In The Box, Inc. (NASDAQ: JACK ). And that barely scratches the surface, considering the fast-food restaurants that are not included in BITE . In fact, every restaurant in BITE ‘s portfolio, in every category, faces stiff competition – some of the stiffest coming from other holdings in this fund. Denny’s and Ruby Tuesday, for instance, are challenged by International House of Pancakes and Applebee’s Grill & Bar , respectively. 26 Even Ruth’s Chris finds competition in the portfolio from Del Frisco’s Restaurant Group (NASDAQ: DFRG ). 27 Of course, all ETFs are going to have holdings that are competition for other holdings in that portfolio, but in terms of a restaurant-centric portfolio, that competition is going to look cutthroat. The eatery that appeals to the greater audience will have the advantage, unless one is talking about a large metropolitan area with lots of mouths to feed. 28 It might also be a concern that local, independent, restaurants (which would presumably have a better sense of the area’s tastes) put extra strain on out-of-town chains. 29 The restaurant industry is not a zero-sum game where competition implies that one company’s win translates into another company’s concomitant loss. Competition does help to improve companies, and although BITE does hold shares of competing firms, its overall diversification within the industry should mute any adverse effects on share values. Volatility : On 31 October 2015, Chipotle ( voluntarily ) closed 43 stores in Oregon and Washington when as many as 45 people became ill from E. coli , and the infection was traced to the restaurant chain. In response, Chipotle closed all restaurants in the affected area and conducted a thorough cleaning of the facilities. The restaurants re-opened on 11 November. It was the third food-borne illness to affect the company in three months. 30 Chipotle is not the first restaurant to experience an outbreak of food-related illness, but it does give a rather stark example of how such an outbreak can effect share value. On 13 October, Chipotle reached a high of $750.42/share. The following chart shows what happened to the company’s value as the extent of the outbreak was revealed: (click to enlarge) Over the one-month period from 13 October through 13 November, Chipotle dropped $157.53 in value, a decrease of 20.99%. Of course, it would be a mistake to assume that all of that loss was attributable to the outbreak. That four-week period was rather volatile for markets as a whole, and the restaurant industry (along with the retail industry) saw particularly dramatic losses during the fourth week of that period. The following graphic breaks down the losses suffered by the restaurants in the BITE portfolio for the period in question: (click to enlarge) During the first three weeks of the period, when the BITE companies suffered an average loss of -2.69%, Chipotle saw losses of – 18.39% ; over the entire four-week period – when Chipotle dropped by – 20.99% , portfolio holdings saw an average loss of -8.07%. However, while portfolio holdings averaged a -5.46% loss over the fourth week of the period, Chipotle lost only – 3.19% . By the week of 9 – 13 November, then, the major impact of the E. coli outbreak would seem to have mostly played out, with Chipotle seeing something of a “comeback” of sorts. There are many questions we might ask about this incident, as far as share value is concerned: was there any complementarity between market perception of Chipotle and the restaurant industry as a whole (keeping in mind that there have been several food-related outbreaks in the past few years),where Chipotle’s losses were influenced by the general market downturn and/or vice versa? 31 In any event, the restaurant industry is high-visibility, and constitutes a significant portion of daily life. Bad press invariably results in dropping stock values , and there seems to be no lack of bad press, lately. This volatility has the potential of affecting not only individual companies, but could affect the portfolio as a whole. Labor : the past couple of years have seen a growing concern and dissatisfaction with wages paid to part-time workers, and the bulk of labor in the restaurant industry is part time. There are over seven million hourly wage earners in the food preparation and serving occupation, approximately 20% of whom are paid at or below the federal minimum wage. 32 Across the country there are states and cities that are trying to boost the minimum wage to anywhere from $10.00 to $15 .00 per hour. This may stress restaurant costs, with an increase in food prices a likely result. An increase in labor costs could also affect franchisers. In 2014 the National Labor Relations Board ruled that McDonald’s was a “joint employer” of workers in its franchised restaurants, making franchisers responsible for working conditions heretofore assumed to be the franchisee’s responsibility. This would extend to the wages paid by franchisees. 33 Needless to say, a rise in labor costs will result in a decrease in profits, whether from additional costs being taken from an existing level of revenue, or a decreasing stream of revenue brought about by increasing prices, which could dissuade some diners from eating out. 34 Evaluation I am undecided as to whether I would invest in BITE . However, let me say that if one is going to invest in the restaurant business, this ETF is definitely an excellent alternative to buying shares in a few eateries. The portfolio is loaded with high-profile companies and proven performers, so I am not overly concerned about a high turnover rate with the portfolio. At the same time, there are a couple of concerns that I have. Narrowly targeted industry-specific ETFs carry with them a level of risk that is not present in a more diversified portfolio: industry-related influences can, and frequently will, affect the entire portfolio, for good or bad. Given the high profile the restaurant industry has, and its vulnerability to several risk factors, one wonders if diversification across the spectrum of eateries is enough. Next, those readers who are familiar with my non-ETF-related articles know that I have a thing for fundamentals. I don’t usually worry about the fundamentals of a portfolio’s holdings when dealing with ETFs, but for some reason curiosity got the better of me here. I compared the restaurant industry averages for a few fundamentals with the average for BITE’s holdings. The following chart gave me “pause for the cause.” 35 (click to enlarge) Except for the average quick ratio, the BITE portfolio does not perform as well as the industry average. I am satisfied with the average ROE, but on the other four measures, BITE ‘s portfolio does not impress me. This may be because several of its holdings are rather new (or have recent IPOs); several of the companies in the portfolio have expanded; Fiesta Restaurant Group, Inc. (NASDAQ: FRGI ) was formed out of restaurants shed when Carrol’s chose to focus on Burger King. 36 There are undoubtedly good reasons for any given company to be underperforming at the present time. This does not mean that BITE is not a good ETF, but it might be an ETF that should be watched for as much as a year before investing. At the very least, this would be a candidate for a gradual approach to buying. Disclaimers This article is for informational use only. It is not intended as a recommendation or inducement to purchase or sell any financial instrument issued by or pertaining to any company or fund mentioned or described herein. All data contained herein is accurate to the best of my ability to ascertain, and is drawn from the Company’s Prospectus, Statement of Additional Information, and fact sheets. All tables, charts and graphs are produced by me using data acquired from pertinent documents; historical price data from Yahoo! Finance . Data from any other sources (if used) is cited as such. All opinions contained herein are mine unless otherwise indicated. The opinions of others that may be included are identified as such and do not necessarily reflect my own views. Before investing, readers are reminded that they are responsible for performing their own due diligence; they are also reminded that it is possible to lose part or all of their invested money. Please invest carefully. —————————————– 1 Darden Restaurants, Inc. (NYSE: DRI ). Darden also owns LongHorn Steakhouse , Bahama Breeze Island Grille , Seasons 52 Fresh Grill , The Capital Grille , Eddie V’s Prime Seafood , and Yard House . 2 It has restaurants only in the southwest – Texas, Arizona, California, Utah and Nevada. 3 The company was founded in Clarksville, Indiana, and is currently headquartered in Louisville, Kentucky. Not that it’s important – just struck me as interesting that it wasn’t founded in Texas. 4 Biglari Holdings, Inc. (NYSE: BH ). BH also owns Western Sizzlin’ restaurants. 5 Yum! Brands, Inc. (NYSE: YUM ), which also owns Kentucky Fried Chicken and Taco Bell . 6 The restaurants are known as Popeyes , Popeyes Louisiana Kitchen , Popeyes Famous Fried Chicken and Popeyes Chicken and Biscuits . The restaurant is named for “Popeye” Doyle, the character in The French Connection (according to the company website ). I always thought it was Popeye the sailor . I am disillusioned. Also, for the grammar-conscientious reader, I think it should be spelled Popeye’s with an apostrophe, but the company, throughout its website, spells it without the apostrophe. So now I am disheartened and disillusioned. 7 The company still goes by the original name, St. Louis Bread Co ., in its home city. 8 Dunkin Brands Group, Inc. (NASDAQ: DNKN ), which also owns Baskin-Robbins . 9 Darden, for instance, owns seven restaurant chains (see 1, above) – and used to own Red Lobster , which became private in 2014. 10 Biglari (see 11, above) also owns Maxim Inc. (the magazine), First Guard Insurance Company , Biglari Real Estate Development Corp. , and Biglari Design Inc. 11 The company, which operates in 20 countries in Central and South America and the Caribbean, accounts for 6.7% of McDonald’s business globally. 12 The Canadian company also owns the Tim Hortons restaurants. The Burger King and Tim Hortons merger was completed in December, 2014. 13 Carrols used to own the chains Pollo Tropical and Taco Cabana , but sold those holdings to focus on Burger King; the two restaurants are now part of the Fiesta Restaurant Group, Inc. 14 A full listing of BITE ‘s holdings can be downloaded here . Or you may visit BITE ‘s website . I try to limit my examples and restaurants/holding companies to those represented in the ETF. 15 BITE The Restaurant ETF Index Methodology , p. 2. 16 In cap-weighted systems, the standard method for handling companies that would otherwise exceed the 25% limit is to distribute the excess capital among the remaining holdings. Applied to BITE’s portfolio, that would leave McDonald’s and Starbucks with 25% each, YUM with nearly 10%, and Chipotle with 6.25% – giving the top four holdings 66.14% of the assets, leaving the remaining 41 companies with an average weight of 0.83% each. 17 Kona Grill, Inc. (NASDAQ: KONA ) may be the first test of this requirement. Recent losses have left it with a capitalization of $172.36 million – nearly $28 million shy of the minimum. 18 Keep in mind that these figures are my estimates based on dividends currently being paid by the fund’s holdings, and reflect the fund’s NAV and expense ratio. Much of this is subject to change, and is provided only to give potential investors an idea of what may reasonably be expected. 19 “Inc. Yld.” and “RoNAV” are used to compare the fund’s gross and net income to the fund’s NAV (RoNAV may be thought of as the fund’s operating margin). One may note that RoNAV is the same as the dividend yield. Due to the closeness of an ETF’s “market cap” and its NAV, this is to be expected, as the net income is where the dividends come from. The only difference would arise where the fund is trading at a noteworthy premium or discount to NAV. 20 BITE The Restaurant ETF Prospectus , p. 10. 21 Readers are advised that the performance of these holdings over the past years is not an indication of how they will continue to perform in the future. The test is only intended to provide an indication of how these stocks would have performed as an aggregate since April 2011. 22 I’m sorry. I just couldn’t help myself. 23 Cited in “The Average Life Span of a Restaurant,” Hannah Wickford, azcentral.com . 24 Wickford. Lousy cooking doesn’t get mentioned. It should. 25 Or maybe market blitz – where a chain opens several stores in an area in quick succession, without adequately determining what that particular market will bear. This tactic usually results in the closure of several stores, and can result in the chain pulling out of the area completely. Einstein Bros. Bagels was an example of the former result, and Winchell’s Donuts ‘ attempt to move into the mid-west is an example of the latter. Both chains are now subsidiaries of private companies. 26 Both IHOP and Applebee’s are owned by DineEquity, Inc. (NYSE: DIN ). 27 This company owns high-end restaurant “concepts” Del Frisco’s Double Eagle Steak House , Del Frisco’s Grille and Sullivan’s Steakhouse . 28 Determining and targeting one’s best consumer base is almost a science in itself, as restaurants try to build customer loyalty. This can be especially important for large national chains. “Restaurant Selection Criteria: Understanding the Roles of Restaurant Type and Customer’s Sociodemographic Characteristics,” Soyeon Kim and Jae-Eun Chung. PDF available here . 29 “Independent vs. Chains Studies” by Main Street America ( preservationnation.org ) contends that local businesses generate two to three times as much local economic activity as chains. This idea is challenged by Bob Bradley, in his article “The Chains are Winning, and it’s all in the Marketing,” available at restaurantreport.com , here . The truth probably resides in the attitude of the players. Chains have advertising, larger capitalization, “proven” menus; while locals have recognition and familiarity, closer community contact, a more targeted menu. It becomes a matter of how well the independent (and the chain) approach the immediate market they serve. “How Independent Restaurants Can Beat National Chains,” Matthew Sonnenshein, Gourmetmarketing.net . 30 Chipotle to reopen restaurants shuttered in E. coli outbreak in northwest,” Aamer Madhani, usatoday.com . Previously, Minnesota Chipotles experienced a salmonella outbreak, while Simi Valley, California, experience a norovirus outbreak traced to the restaurant. 31 Needless to say (so, why am I saying it?), in any industry, a generalized trend will tend to influence all companies in that industry. Thus, in a period where restaurant stocks in general trend in a particular direction, it is to be expected that any given company in the restaurant business will follow suit. 32 “Characteristics of Minimum Wage Workers, 2014,” Bureau of Labor Statistics , here . 33 “McDonald’s loses big on labor ruling,” Claire Zillman, Fortune , 29 July, 2014. The decision as it stands cannot be appealed, as it was made by general counsel Richard Griffin. The full board has not ruled, and the issue is still before the NLRB . The main impact of the decision for now is that McDonald’s can be made a defendant in any action against one of its franchisees (“McDonald’s can’t appeal NLRB franchise decision,” Sean Higgins, Washington Examiner ). 34 This claim would likely start arguments among some people, but I side with James Sherk (Senior Policy Analyst at The Heritage Foundation), who argues that – next to food and supplies – wages are the second-highest cost item for the average fast-food restaurant. These restaurants have a low profit margin, so an increase in labor costs would result in – unavoidably – higher food costs; higher food costs would translate into reduced sales. 35 Restaurant industry data from CSIMarket.com . 36 See note 13, above.
Summary Brief overview of the series. Why I hedge. Taking profits and rolling positions. List of favorite candidates. Discussion of the risks inherent to this strategy versus not being hedged. Back to 2,753 Percent Profits on Men’s Warehouse (NYSE: MW ) Strategy Overview As I write this the S&P 500 Index is within 3.6 percent of its May record high. Are we going higher or not? Hard to say. Market internal appear to be very weak as I explained in my recent article, ” Major Indices at a Crossroads…Again ,” where I point out that just last Friday 329 (65.8 percent) of the 500 component companies of the S&P 500 were trading below their respective 200-day simple moving averages and that 37.2 percent were more than 20 percent below their respective 52-week highs. Those numbers do not paint a picture of broad strength. If you are new to this series you will likely find it useful to refer back to the original articles, all of which are listed with links in this instablog . It may be more difficult to follow the logic without reading Parts I, II and IV. In the Part I of this series I provided an overview of a strategy to protect an equity portfolio from heavy losses in a market crash. In Part II, I provided more explanation of how the strategy works and gave the first two candidate companies to choose from as part of a diversified basket using put option contracts. I also provided an explanation of the candidate selection process and an example of how it can help grow both capital and income over the long term. Part III provided a basic tutorial on options. Part IV explained my process for selecting options and Part V explained why I do not use ETFs for hedging. Parts VI through IX primarily provide additional candidates for use in the strategy. Part X explains my rules that guide my exit strategy. All of the above articles include varying views that I consider to be worthy of contemplation regarding possible triggers that could lead to another sizeable market correction. I want to make it very clear that I am NOT predicting a market crash. I just like being more cautious at these lofty levels. Bear markets are a part of investing in equities, plain and simple. I like to take some of the pain out of the downside to make it easier to stick to my investing plan: select superior companies that have sustainable advantages, consistently rising dividends and excellent long-term growth prospects. Then I like to hold onto to those investments unless the fundamental reasons for which I bought them in the first place changes. Investing long term works! I just want to reduce the occasional pain inflicted by bear markets. Why I Hedge If the market (and your portfolio) drops by 50 percent, you will need to double your assets from the new lower level just to get back to even. I prefer to avoid such pain. If the market drops by 50 percent and I only lose 20 percent (but keep collecting my dividends all the while) I only need a gain of 25 percent to get back to even. That is much easier than a double. Trust me, I have done it both ways and losing less puts me way ahead of the crowd when the dust settles. I may need a little lead to keep up because I refrain from taking on as much risk as most investors do, but avoiding huge losses and patience are the two main keys to long-term successful investing. If you are not investing long term you are trading. And if you are trading, your investing activities, in my humble opinion, are more akin to gambling. I know. That is what I did when I was young. Once I got that urge out of my system I have done much better. I have fewer huge gains, but have also have eliminated the big losses. It makes a significantly positive difference in the end. A note specifically to those who still think that I am trying to “time the market” or who believe that I am throwing money away with this strategy. I am perfectly comfortable to keep spending 1.5 percent of my portfolio per year for five years, if that is what it takes. Over that five year period I will have paid a total insurance premium of as much as 7.5 percent of my portfolio (approximately 1.5 percent per year average, although my true average is less than one percent). If it takes five years beyond the point at which I began, so be it. The concept of insuring my exposure to risk is not a new concept. If I have to spend 7.5 percent over five years in order to avoid a loss of 30 percent or more I am perfectly comfortable with that. I view insurance, like hedging, as a necessary evil to avoid significant financial setbacks. From my point of view, those who do not hedge are trying to time the market. They intend to sell when the market turns but always buy the dips. While buying the dips is a sound strategy, it does not work well when the “dip” evolves into a full blown bear market. At that point the eternal bull finds himself catching the proverbial rain of falling knives as his/her portfolio tanks. Then panic sets in and the typical investor sells after they have already lost 25 percent or more of the value of their portfolio. This is one of the primary reasons why the typical retail investor underperforms the index. He/she is always trying to time the market. I, too, buy quality stocks on the dips, but I hold for the long term and hedge against disaster with my inexpensive hedging strategy. I do not pretend that mine is the only hedging strategy that will work, but offer it up as one way to take some of the worry out of investing. If you do not choose to use my strategy that is fine, but please find a system to protect your holdings that you like and deploy it soon. I hope that this explanation helps clarify the difference between timing the market and a long-term, buy-and-hold position with a hedging strategy appropriately used only at the high end of a near-record bull market. Taking Profits and Rolling Positions It is that time of year again when I need to decide what to do with my current positions and how to best protect my portfolio into the year ahead. I will begin with those positions that have the largest positive values as we need to use the gains or remaining values to fund some new hedge positions with expirations further out into the future. The largest gainer of this series has been Men’s Warehouse, which was recommended in August 2015. At that time MW stock was trading at $58.49 and I bought put options with a strike price of $45 and expiration of January 2016 for a premium of $0.75. Currently MW is trading at about $18.50 per share and my options (if I still had them) are trading at a premium of $26.20. I sold my position once the shares dipped below my target of $25.00 per share. If you still hold those options as a hedge it is decision time. You can continue to hold if you expect the stock to fall further, but the payoff becomes less and less as the shares get closer to zero. At this time I do not expect the company to file bankruptcy. If you disagree you can hold onto your position. If you agree that the company is more likely to work its way out of this situation over time I would suggest not being too greedy. I have sold already. If you decide to sell today you will have a gain of $2,545 per contract, or 3,393 percent. I had bought ten contracts originally, so I am very happy with the results. I plan to use these proceeds to purchase additional hedge positions in other candidates that have much further to fall when the next recession comes. The gains from this one position will pay for my entire hedge for the next year. That is how the strategy works. It only takes being right once or twice a year for the hedge to pay for itself and such occurrences happen even when there is no recession. When the next recession finally hits most, if not all, positions will begin to work in our favor to protect us from significant losses during the ensuing market downturn. I will list a few of my favorite candidates at current prices later in this article. Another winner this year has been Micron Technologies (NASDAQ: MU ). I took nice profits from option positions that expired this summer but held onto my January contracts. I am glad I did and hope you did also. Below is a table with the month in which I recommended buying MU put options for January expiration, the strike price recommended, the ask premium as of that time, the current bid premium, the dollar amount gain per contract and the percent gain per contract. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available December $17 $0.60 $2.24 $164 273% January $17 $0.59 $2.24 $165 280% March $17 $0.40 $2.24 $184 460% April $20 $0.49 $4.65 $416 849% May $18 $0.33 $3.00 $267 809% June $15 $0.47 $1.21 $74 157% I purchased (from the October Update article) some MU put options last month that expire in April 2016 with a strike price of $11 for a premium of $0.27. The current premium on those contracts has risen to $0.39. That makes these options too costly at the current level relative to the potential gain. It is always a risk/reward trade off when choosing the right hedge positions. I intend to sell all of my January expiration positions at these levels and use the gains, if necessary, to add new positions in other candidates for future protection. Another candidate that has begun to give us some gains is Sotheby’s (NYSE: BID ). I started buying BID put options for January expiration in April. Below is a table with the results of all my January 2016 BID option recommendations. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available April $30 $0.50 $2.00 $150 300% May $35 $0.90 $5.70 $480 533% June $35 $.50 $5.70 $520 1,004% August $31 $0.55 $2.70 $215 390% August $30 $1.05 $2.00 $95 90% I also purchased BID put options last month with an April expiration. The contracts had a strike price of $27 and were purchased at a premium of $1.15. The current bid premium is $1.60. I plan on holding this position but selling the January 2016 contracts and using the proceeds to purchase additional hedge positions. I intend to add some January 2017 BID put options as I believe this one is likely to keep dropping to at least my $16 target within the next year as the new wealth creation machine called China continues to slow down. I will include my selections later in this article. The next candidate that is beginning its descent as expected is Williams-Sonoma (NYSE: WSM ). I have recommended WSM January 2016 puts eight times with all but two showing gains. The purchases from early in 2015 have not yet paid off. The premiums for higher strikes became more advantageous as the year went on and WSM shares rose higher. This is why I usually add only partial positions at the beginning of each year and add more positions whenever a candidate’s stock price rallies. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available January $55 $1.90 $0.90 -$100 -53% February $55 $1.60 $0.90 -$70 -44% March $60 $1.65 $2.15 $60 30% April $60 $1.85 $2.15 $30 16% May $60 $1.25 $2.15 $90 72% June $70 $1.90 $6.80 $4.90 258% August $72.50 $1.80 $8.20 $640 355% August $70 $1.90 $6.80 $490 258% I intend to continue to hold these positions until closer to expiration. WSM has exhibited weakness as of late and I expect more of the same. Each individual investor needs to consider what he/she wants to do in situations like this. However, since the cost of the hedge this year is already covered from other gains I would rather continue to hold contracts that are well-positioned for additional gains. Another candidate that has begun to struggle is Seagate Technologies (NASDAQ: STX ). I only have three open positions in STX and all expire in January 2016 and all are profitable. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available April $38 $0.58 $4.45 $387 667% May $35 $0.43 $2.55 $212 493% June $35 $0.52 $2.55 $203 390% This is another case of a company that could easily see further erosion by January 2016. I like the contracts with the $38 strike price the most and will definitely hold those longer. I am on the fence with the $35 strike contracts but will hold them at least until I get a better sense of whether the current weakness is likely to continue or abate. It is easier to hold positions when my costs for the next year are already covered by gains elsewhere. This remains a hedge strategy and not a trading system so keeping well-positioned contracts longer is always a good idea. If these contracts expire worthless I will try to not suffer remorse. The article is beginning to get a little long so I will continue with more about what I intend to do with other open positions in another article that I will do my best to submit by tomorrow. Now, on to the list of what I like at current levels. List of favorite candidates E*TRADE Financial (NASDAQ: ETFC ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $29.42 $7.00 $25.00 $.090 $1.05 1614 $3,390 0.21% I need two April 2016 ETFC put contracts as defined above to provide the indicated loss coverage for each $100,000 in portfolio value. If a recession hits, and especially if the financial markets are roiled, ETFC will take a significant hit and provide us with nice hedge protection gains to offset portfolio losses. However, I do not recommend starting a full position at current levels. We need to use volatility to our advantage. If the ETFC stock price rallies from here we will be able to lock in better positions in the future. I intend to open a partial position (about 1/3 of my intended full position) here and add more at a later date if we get a rally. This same strategy applies to all listed positions. I only need two April 2016 put option contract to provide the coverage indicated for a $100,000 portfolio. Goodyear Tire (NASDAQ: GT ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $33.30 $8.00 $27.00 $0.60 $0.70 2,614 $3,660 0.14% If a recession comes to the U.S. car sales will fall off precipitously and people will put off purchases as long as possible. Tires are important but when people are losing jobs or witnessing others in trouble there is a tendency to make such things last a few more months. GT share price is making new highs so now is a good time to get a healthy position. I would still refrain from taking a full position just yet as there could be additional upside to the price in the near term which should provide us with an even better entry point. I only need two GT April 2016 put option contract to provide the coverage indicated for a $100,000 portfolio. Morgan Stanley (NYSE: MS ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $33.98 $15.00 $28 $0.55 $0.58 2,141 $3,726 0.174% Similar to ETFC, MS is vulnerable to financial market disruptions and I do believe that massive growth in junk bonds, both domestic and U.S. dollar-denominated foreign, represent such a potential trouble for the global economy. Again, this stock is off its high so we could potentially see a better entry opportunity in the future unless the market turns down abruptly sooner than I expect. I will add a starter position here. I only need three April 2016 put option contract to provide the coverage indicated for a $100,000 portfolio. I intend to start with one contract as described for each $100,000 in portfolio value. Royal Caribbean Cruise Lines (NYSE: RCL ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $94.25 $22.00 $65.00 $1.26 $1.41 2,950 $4,159 0.141% RCL shares have been on a tear this year, but in a recession this issue will see capacity utilization drop and margins evaporate. It happens like clockwork. RCL shares are about six percent below their respective 52-week high. One might get a better entry point but this is pretty good. I will add a starting position for 2016 and need one June RCL put option contract to provide the protection shown above for each $100,000 of portfolio value. The number of contracts indicated are for a full position. United Continental (NYSE: UAL ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $58.01 $18.00 $50 $1.96 $2.10 1,424 $2,990 0.21% UAL is nowhere near its high of the year after exhibiting weakness even in the face of falling fuel costs. A recession, in my opinion, would devastate this stock as businesses would reduce business travel for employees dramatically. I only need one March UAL 2016 put option contract to provide the coverage indicated for a $100,000 portfolio. In order to limit my purchase to one-third of a full position I will buy only one contract for each $300,000 of portfolio value. Summary As I pointed out in the article linked at the beginning of this article I believe that the market is at a crossroads. There is very little impetus to drive prices higher other than cheap money, but cheap money may be enough to keep things going a little longer. If a bear market does not show itself before January 2017 I will be surprised. Many stocks are already experiencing a “stealth” bear market and therefore I believe it is prudent to make prudent hedging decision for 2016. I would like to extend the expirations on contracts more than I have for more extended coverage but the open interest/volume is not yet high enough to wade into those contracts. That should change over the next few months and I will be ready to add more positions as it happens. That is one of the primary reasons why I have tried to emphasize that I am only adding partial positions at this time. I will do my best to submit another installment for this series tonight (Wednesday) for publication on Thursday. In that article I will attempt to include the remaining outstanding positions and what I intend to do with them. Going forward I want to write more often about this strategy for two reasons. The first is simply that is seems the global economy is nearly ready to fall into a recession and growth in the U.S. also seems rather stagnant. If profits continue to fall year/year as happened in the third quarter it may portend the beginning of the next recession. Retail sales and profit margins may prove to be the most important measure of the health of the consumer and, by extension, the U.S. economy. The second reason is that I would like to publish whenever I see a good entry point in one of the candidates or when I identify another candidate immediately instead of waiting for a monthly update. I hope these changes will be beneficial to readers following the series. Brief Discussion of Risks If an investor decides to employ this hedge strategy, each individual needs to do some additional due diligence to identify which candidates they wish to use and which contracts are best suited for their respective risk tolerance. I do not always choose the option contract with the highest possible gain or the lowest cost. I should also point out that in many cases I will own several different contracts with different strikes on one company. I do so because as the strike rises the hedge kicks in sooner, but I buy a mix to keep the overall cost down. My goal is to commit approximately two percent (but up to three percent, if necessary) of my portfolio value to this hedge per year. If we need to roll positions before expiration there may be additional costs involved, so I try to hold down costs for each round that is necessary. My expectation is that this represents the last time we should need to roll positions before we see the benefit of this strategy work more fully. We have been fortunate enough this past year to have ample gains to cover our hedge costs for the next year. The previous year we were able to reduce the cost to below one percent due to gains taken. Thus, over the full 20 months since I began writing this series, our total cost to hedge has turned out to be less than one percent. I want to discuss risk for a moment now. Obviously, if the market continues higher beyond January 2016 all of our old January expiration option contracts that we have open could expire worthless. I have never found insurance offered for free. We could lose all of our initial premiums paid plus commissions, except for those gains we have already collected. If I expected that to happen I would not be using the strategy myself. But it is one of the potential outcomes and readers should be aware of it. I have already begun to initiate another round of put options for expiration beyond January 2016, using up to two percent of my portfolio (fully offset this year by realized gains) to hedge for another year. The longer the bulls maintain control of the market the more the insurance is likely to cost me. But I will not be worrying about the next crash. Peace of mind has a cost. I just like to keep it as low as possible. Because of the uncertainty in terms of how much longer this bull market can be sustained and the potential risk versus reward potential of hedging versus not hedging, it is my preference to risk a small percentage of my principal (perhaps as much as two percent per year) to insure against losing a much larger portion of my capital (30 to 50 percent). But this is a decision that each investor needs to make for themselves. I do not commit more than three percent of my portfolio value to an initial hedge strategy position and have never committed more than ten percent to such a strategy in total before a major market downturn has occurred. The ten percent rule may come into play when a bull market continues much longer than expected (like three years instead of 18 months). And when the bull continues for longer than is supported by the fundamentals, the bear that follows is usually deeper than it otherwise would have been. In other words, at this point I would expect the next bear market to be more like the last two, especially if the market continues higher through all of 2016. Anything is possible but if I am right, protecting a portfolio becomes ever more important as the bull market continues. As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other’s experience and knowledge.