Investing With the Gurus

If you'd like to find out what stocks the great investors like Warren Buffett, Peter Lynch, Marty Zweig and others would be buying right now, there is a place on the Internet where you can do exactly that. It is a subscription service provided by Validea Capital Management, LLC. The Web site lets users/subscribers analyze stocks based on the strategies of the investment greats, and you can access it by clicking on "VALIDEA" in our "Links" section.

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Beware the Pitfalls of Covered Calls

Among the most popular of strategies is covered call writing. A covered call consists of taking a short position in a call option against a long position in the underlying stock, on a one-to-one basis. And thus the term of "buy-write" to describe the strategy.

While covered calls are a great tool, they don't come without drawbacks. So before ever employing a covered call or buy-write strategy, it's important to have an understanding of the nature of its risks and rewards.

One of the biggest misperceptions is that covered calls are a way to hedge a position. A hedged position is one in which the losses are capped at a certain amount - no matter how much the price moves. Quite to the contrary, a covered call is not really a risk reduction strategy but rather, it is a substitution of the standard risk and reward distribution of owning a stock for the payoff profile of owning a bond. In fact, the case can be made that a covered call is not even a good way to limit losses, and the risk profile is very similar to that of simply owning the stock outright.

Buy-writes are advertised as a conservative strategy, but one must have an exit strategy when the underlying stock goes against you. It is a discipline that you must have - as opposed to selling lower-priced calls - because all this will do is limit the possibility of recouping losses if the stock were to rebound. A good rule of thumb might be to use the break-even point, the price at which the position would be a scratch at expiration, as a mental stop or exit point for closing the position.

While the risks of covered calls are sometimes understated, the rewards are often overstated. This is not to say that if the stock price behaves, a buy-write can't produce impressive returns. Indeed, when brokers or money managers describe a covered call strategy, they use examples of static price to show how selling 30-day options can produce double-digit annualized returns. While this may be a true theory, it's hardly easy to achieve this in reality. And there's no guarantee that one month's returns represent a repeatable event.

One way to determine which strike price offers the best returns is to calculate not only the break-even point (at what point you would lose money) and the maximum profit point (typically equal to the strike price of the calls sold), but also the crossover point. The crossover point is the price at which owning the stock outright or uncovered would deliver a higher return than the covered position. The crossover price is equal to the strike price plus the premium collected.

This is by no means the whole story on covered calls -- there are plenty of nuances, and there's a veritable decision tree of choices of how best to employ this powerful but simple strategy. In fact, there are whole books devoted to the subject. One that comes highly recommended is, New Insights on Covered Calls by Lawrence McMillan and Richard Lehman.

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A Number That You Should Watch

Options traders are always trying to figure out which way the market is headed next. One tool at their fingertips is the put/call ratio. It's used to measure the current sentiment - and try to foretell when the market is about to peak or bottom.

The put/call ratio measures how many put options are bought versus call options.

The formula is simple: puts divided by calls. If there are 5,000 puts sold and 10,000 calls, the ratio is 0.5, a neutral number. Traders are interested in the extreme numbers: below 0.3 and above 0.8.

The low reading means that not many people are interested in puts... everybody wants calls.

They're feeling very bullish - and that's bearish!

The higher numbers mean people are buying a lot of puts and likely feeling bearish at the moment... and that may be bullish for the future.

The put/call ratio is one of the so-called contrarian indicators. That is, you can read an extreme position as a warning of change to come.

The idea here is that if a wide majority believes one direction is a sure thing, then they pile on. By the time that happens, the market is usually ready to turn the other way. The thundering herd is hardly ever right. So the smart money always bets against this ratio.

But there is one problem with this theory: The put/call ratio does not give you the most important clue, time!

How to Get the Most From Extreme Numbers


The best use of the put/call ratio is to watch for extremes and be ready for a change in market direction. But don't take it as gospel. Take it as a warning. And here are a couple of problems to watch out for:

1. Not everyone who buys a put is really bearish. Many institutions use protective puts as insurance to hedge against losses in their large holdings. For this reason, the put/call ratio on indexes is of little use when predicting the market direction, because so many index puts on the S&P 500 or Nasdaq are merely hedges against big portfolio losses. It is the put/call ratio for individual equities that tells the most.

2. The put/call ratio jumps from one extreme to the other quickly, so it's best to look at a moving average. The average over 10 days is a popular number, and many professionals use a 21-day moving average.

You can follow the put/call ratio by linking to the Chicago Board Options Exchange (CBOE) located in our "Links" list. About halfway down the page you'll see the columns that provide you the numbers of puts and calls. But don't jump yet... There's a bit more art involved in understanding the put/call ratio.


How Low Can You Go? ... Better Question: How Long can You Go Low?


In March, 2000, the put/call ratio was at one of the lowest points in the past 30 years - many more calls were being bought versus puts... We all remember what happened the following year as the Nasdaq 100 lost more than two-thirds of its value, with the S&P and Dow suffering losses as well.

Of course, nobody knew that this would prove to be the lowest historical ratio of puts to calls until after the damage was done. In fact, the put/call ratio had already been extremely low the previous October, but the market continued to rise for another five months.

On the upside of the ratio, in May, 2002, the put/call ratio based on a 10-day moving average recorded 0.81 and 0.83 on successive readings. Extremely high.

That meant that more than eight out of 10 options traded were puts - a very glum sentiment. And the market soon followed with one of the most explosive bull market rallies in history, just as the contrarians would have expected.

So the ratio does have good use... just be careful not to trust it as infallible.


Using the Put/Call Numbers to Adjust Your Risk Tolerance


No doubt, keep an eye on the ratio - and be ready to adjust your risk tolerance accordingly. Here are some numbers to guide you:

A ratio of 0.8 is extremely bullish. If you see the ratio approaching that number again, it would be a good idea to begin going long on strong ideas.

As the ratio falls below 0.5, the market is beginning to be too optimistic, and you should begin to think about paring your long positions.

The market is perennially skewed toward the bulls. People are more interested in finding stocks going up - and therefore calls - than they are looking for losers. So as soon as the calls begin to outnumber puts by less than 2-to-1 (a ratio of 0.5), something's afoot. When it reaches 0.3 or goes even lower, it's time for some serious unloading as the market may be so bullish it is about to peak.

The lowest readings on record were right around 0.10 - a sign of extreme bullishness.

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The Role of Commodities

Physical commodities are either pulled out of the ground or grown on top of it. Each year there is more than $1 trillion in global production in these areas. Here are the five major commodity groups, with examples of each:

1. Energy: such as crude oil, unleaded gasoline, natural gas and heating oil.

2. Agricultural Products: such as wheat, corn, soybeans, cotton, sugar, and coffee.

3. Industrial Metals: such as aluminum, copper, nickel, and zinc.

4. Livestock: such as live cattle, and lean hogs.

5. Precious Metals: such as gold, and silver.


There are a variety of ways to invest in these commodities. You might think about owning them physically, but that's both expensive and impractical.

Another possibility would be to own shares of commodity producers. If you are interested in energy, for example, you could always choose to own oil-company stocks. The share prices of commoditity producers, however, do not behave like the underlying commodities because they are impacted by other market factors.

There are also actively managed commodity pools. These investments are generally expensive, returns are dependent on the manager's skill, and the results do not necessarily reflect the returns in the commodity markets.

A remaining alternative is index investing at an asset-class level. The Goldman Sachs Commodity Index (GSCI) and the Dow Jones AIG Commodity Index both provide continuous exposure to physical commodities through derivitives. The GSCI is a weighted index of global production in those five commodity groups. Seventy percent of the market value of those five groups is energy, so the GSCI is heavily tilted toward energy.

Whereas a more traditional portfolio strategy might focus on U.S. stocks, bonds, and cash, an alternate approach might be as follows: Change your focus to FOUR equity classes instead which includes U.S. stocks, non-U.S. stocks, real estate, and commodities. This can be thought of as a "big-picture approach" which is not dependent upon superior skill - either in selection of securities or market findings.

Commodities as an asset class, are a unique building block compared to other financial asset classes. Combining U.S. stocks, international stocks, real estate securities and commodities provides the highest return and the lowest standard deviation. You can win both by reducing risk and improving return.

If you look at combinations of two assets classes such as half U.S. stocks and half commodities, this would have the least risk and a higher return than any other combination, which is rather surprising. How did that happen? The answer has to do with correlation.

It is very important whether or not asset classes in a portfolio tend to move up and down together. All other things being equal, a negatively correlated asset is a more powerful thing to include in a portfolio than a positively correlated asset. You can reduce volatility by adding an asset class that tends to move in a countercyclical pattern compared to the other components of the portfolio. And when you reduce the volatility, the rate at which money compounds tends to go up.

While commodities tend to be countercyclical to the other asset classes and for that reason reduce risk in a portfolio, it doesn't always work that way. From 1980 to 1985, for instance, U.S. stocks and commodities moved up and down together.

The return implication of the countercyclical nature of commodities shows the growth of a dollar in the U.S. stock market versus that of commodities from 1971 to 2005.

A dollar invested in the S&P 500 Index (with full reinvestment of income) grew to $37.25 over those years. Meanwhile, a dollar in commodities alone with full reinvestment over the same time period grew to $47.56. But when you split that dollar between the two asset classes and annually rebalanced back to the 50-50 allocation, the investment grew to be worth $62.51, considerably ahead of either component.

Correlation between the four asset classes can also help explain whether or not these kinds of payoffs can continue. With all other things equal from a portfolio construction point of view, negative correlation is a good thing. Average correlation between U.S. stocks, international stocks and real-estate securities were all positive between 1972 and 2005. Commodities, on the other hand, had a negative correlation to each of those asset classes.

There isn't any reason to believe over a multiple-decade time period that any one of these asset classes will necessarily do any better than any other. In fact, their growth paths would tend to converge.

The beauty of this, however, is they are like different cylinders firing in a car. You don't want your cylinders to all fire at the same time, or your engine would explode. You are much better off having your cylinders taking turns firing, and this is exactly what these asset classes tend to do.

Because they have dissimilar patterns of return, if you are patient and continue to own the underperforming asset class, it tends to eventually take its turn in the sunshine again. By having payoffs at different periods of time, you smooth out your returns and create a better overall rate of return. You tend to win both in terms of risk reduction and return enhancement.

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FORBES - Special Issue

The December 11, 2006 edition of FORBES magazine is out and this is the very special 2007 Investment Guide Issue. Well worth the $4.99 cover price and highly recommended!

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The Dow Dividend Approach

Here is a strategy that you may want to consider, one that has historically trounced the market averages and requires only about fifteen minutes a year to implement. The Dow Dividend Approach has roughly doubled the average annual return generated by the market over the last 25 years.

The Dow Approach is based on the Dow Jones Industrial Average (DJIA), the most famous index in the world. In the case of the DJIA, you're measuring the performance of the overall stock market by using a group comprising 30 American multinational conglomerates, companies like General Electric, Disney, and ExxonMobil.

The Dow stocks represent the cream of American big business. The Dow Dividend Approach teaches you to divide up your money in five even lots, select a group of beaten-down DJIA stocks, and buy and hold for one year, playing the likely turnaround.

OK, so how do you use the Dow Dividend Approach? Well the first step is to simply get a list of the 30 DJIA stocks which you can find in sources like Barron's, The Wall Street Journal, and Investors' Business Daily. Then you'll need two numbers for each stock, the stock price and the annual dividend yield. Then rank the 30 stocks by yield, from highest to lowest.

There are three main variations of the Dow Dividend Approach. The first of these, known as the High Yield 10, is simply to buy the top ten yielding stocks from the list (in equal dollar amounts, not equal share amounts) and hold them for one year. After the year is up, update your statistics, sell any of these stocks not still on the top ten list, and replace them with the new highest yielders. Simple enough? For the last 25 years, this approach has compounded at an annual rate of 16.85%, beating most professional money managers soundly. What does that mean in terms of dollars? Well, a $10,000 portfolio would have increased to $490,000 over those 25 years.

The second variation is called the Beating the Dow 5 (or BTD5). In this version, you start with the same ten stocks used for the High Yield 10, but you buy only the five least expensive of the ten. Buying the cheapest of the ten stocks has proven over time to improve the approach's returns without adding undue risk. For the last 25 years, the BTD5 approach has compounded at an annual rate of 19.17%, turning a $10,000 investment 25 years ago into $802,000.

The third variation - popularized by the Motley Fool (www.fool.com) - is known as the Foolish Four. Historically, the cheapest of the group of ten high yielders has proven to be a weak performer for the group, while the second-cheapest stock has been the best performer of the group. This isn't a fluke of nature, but rather a principle based on common sense. The lowest-price stock is often one in real financial trouble, so it drags the historical average down. The next stock in order is rarely in such trouble and its low price gives it the necessary room to rebound impressively.

To take advantage of these historical patterns, the Foolish Four follows the same steps as the BTD5, but then it skips the cheapest stock of the five and doubles the weighting of the second-cheapest. For example, if you're investing $5,000 in the Foolish Four, and the five cheapest stocks are General Electric (GE), General Motors (GM), J.P. Morgan Chase (JPM), DuPont (DD), and Merck (MRK), you would ignore General Electric, invest $2,000 in General Motors, and $1,000 apiece in J.P. Morgan Chase, DuPont, and Merck. Over the last 25 years, the Foolish Four approach has compounded at an annual rate of 22.23%. The $10,000 investment we looked at earlier would have grown to $1.5 million using the Foolish Four.

So if you're convinced that the stock market is the best investment vehicle around, and you want to take the next step in portfolio management beyond a simple index fund, then the Dow Dividend Approach should be for you!

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