2/18/2006 newsletter
*** Market
DJIA is pushing into new territory above 11000. Oil price is volatile battling at high level. If you have energy stocks, you must have felt it. My portfolio stands at +8.5% YTD. Hang in there okay. Latest annual reports from high profile value investors indicate that large-cap now is their nest. People have been rushing into small-cap and make that sector overvalued. Large-cap (and tech stocks) has become the baster child that nobody wants, just the opposite of 6 years ago. Therefore, value investors began to collect from the dumpster. Intel's PE ratio can well justify being a value stock, than a growth stock... The fact that Longleaf got hold of DELL implies something unusual. If large-cap is undervalued, then there is a good chance that DJIA will break into new high, this will make people quite happy...
Market news includes: Microsoft is taking on Google, iPod and BlackBerry. This is the typical large-cap strategy, waiting for smaller companies to prove the market, and then smashing them with high-power alliance and marketing. Google is a tough enemy though. On the Wall Street, following the example of asset swap between Legg Mason and Citigroup, Merrill Lynch swapped its equity assetment arm with BlackRock for 50% shares. This deal is called triple-win (the other party involved is PNC Bank) and creates one of the largest asset mgmt firms in the world, managing 1 trillion dollars of asset. For me, I made a couple thousand bucks from BLK stock. Pretty decent gain though.
*** Comment
I read an interesting article about option pricing I want to share with you. It is not about trading stock option. You know I do not play those games. It is about stock itself. A NYU professor wrote an essay that you can view most stocks as an option on its senior debt because the stock with underlying borrowing has the same property as an option: E: Net asset value, D: debt, Y: years before debt is due, sigma: Volatility of E. The value of stock at due S is then E-D if E greater than D, zero if E less than D.
What is the value of this new way of thinking? This will not help you too much to make money in stock because it is very hard to determine E and sigma (That is what the bankers do). But it explains some phenomena quantitatively. Why are some stocks more volatile than others? Why was there big price swing in the bottom of a business cycle. This model explains it very well. Basically, if a company is taking a risky business plan, sigma can be very large. This results in very large price premium to compensate that risk. The price premium does not mean the business will succeed. It only means the outcome of the business can vary a lot. It does not make sense from intuition (that is why speculator loses money), but it makes sense by viewing it in an option model. A special case is when E is much smaller than D. This is called "out-of-money" option. It is known to be a high risk play in option strategy. Unbeknown to you, when you buy a company in deep trouble and risk of being taken by the debtor, you are doing something similar to buying deeply out-of-money option. And that is why penny stocks are very volatile.
You may ask. There is chance of turnaround and you will make a lot of money. Indeed you will. The very reason the stock still have residual value even when E is less than D is explained very well by an option. Out-of-money option still has value because there is still a chance it can rise above the strike price before it expires. And that chance depends on the volatility, that is the risk of the business plan. A proper accessment of the risk can make you a fortune as many value investors and traders do. But just remember you are playing a volatile option game. This is why management tends to take risky steps when a company is in trouble, to increase the likelihood of swimming above the strike price. Or he will be going to bankruptcy court.
Acutally if you think of CEO's compensation package, it is also option-like. Usually it goes like: If you turn the company around, you will get XYZ bonus (hopefully proportional to the price appreciation). If you fail, you get your base pay (which is lofty enough). So CEO takes much less downside risk than the shareholders. This often causes problem as you can see in airline industry and lately in GM (CEO salary is cut in half so that it is better aligned with shareholder's risk. But nobody mentioned how much stock option he got in exchange). If you view life through option model (figure out what are all the options available to each side under the contract), it becomes very interesting. No wonder Black and Sholes won Nobel prize.
I do not blame the union workers any more. They are just trying to protect themselves from becoming a commodity-like labor, which in an option world, will be much less valuable, if not totally of no value. People can leave their job, company can fire people. I have another essay about how to view employment contract in terms of option model. But I will spare it here.
Steve
DJIA is pushing into new territory above 11000. Oil price is volatile battling at high level. If you have energy stocks, you must have felt it. My portfolio stands at +8.5% YTD. Hang in there okay. Latest annual reports from high profile value investors indicate that large-cap now is their nest. People have been rushing into small-cap and make that sector overvalued. Large-cap (and tech stocks) has become the baster child that nobody wants, just the opposite of 6 years ago. Therefore, value investors began to collect from the dumpster. Intel's PE ratio can well justify being a value stock, than a growth stock... The fact that Longleaf got hold of DELL implies something unusual. If large-cap is undervalued, then there is a good chance that DJIA will break into new high, this will make people quite happy...
Market news includes: Microsoft is taking on Google, iPod and BlackBerry. This is the typical large-cap strategy, waiting for smaller companies to prove the market, and then smashing them with high-power alliance and marketing. Google is a tough enemy though. On the Wall Street, following the example of asset swap between Legg Mason and Citigroup, Merrill Lynch swapped its equity assetment arm with BlackRock for 50% shares. This deal is called triple-win (the other party involved is PNC Bank) and creates one of the largest asset mgmt firms in the world, managing 1 trillion dollars of asset. For me, I made a couple thousand bucks from BLK stock. Pretty decent gain though.
*** Comment
I read an interesting article about option pricing I want to share with you. It is not about trading stock option. You know I do not play those games. It is about stock itself. A NYU professor wrote an essay that you can view most stocks as an option on its senior debt because the stock with underlying borrowing has the same property as an option: E: Net asset value, D: debt, Y: years before debt is due, sigma: Volatility of E. The value of stock at due S is then E-D if E greater than D, zero if E
What is the value of this new way of thinking? This will not help you too much to make money in stock because it is very hard to determine E and sigma (That is what the bankers do). But it explains some phenomena quantitatively. Why are some stocks more volatile than others? Why was there big price swing in the bottom of a business cycle. This model explains it very well. Basically, if a company is taking a risky business plan, sigma can be very large. This results in very large price premium to compensate that risk. The price premium does not mean the business will succeed. It only means the outcome of the business can vary a lot. It does not make sense from intuition (that is why speculator loses money), but it makes sense by viewing it in an option model. A special case is when E is much smaller than D. This is called "out-of-money" option. It is known to be a high risk play in option strategy. Unbeknown to you, when you buy a company in deep trouble and risk of being taken by the debtor, you are doing something similar to buying deeply out-of-money option. And that is why penny stocks are very volatile.
You may ask. There is chance of turnaround and you will make a lot of money. Indeed you will. The very reason the stock still have residual value even when E is less than D is explained very well by an option. Out-of-money option still has value because there is still a chance it can rise above the strike price before it expires. And that chance depends on the volatility, that is the risk of the business plan. A proper accessment of the risk can make you a fortune as many value investors and traders do. But just remember you are playing a volatile option game. This is why management tends to take risky steps when a company is in trouble, to increase the likelihood of swimming above the strike price. Or he will be going to bankruptcy court.
Acutally if you think of CEO's compensation package, it is also option-like. Usually it goes like: If you turn the company around, you will get XYZ bonus (hopefully proportional to the price appreciation). If you fail, you get your base pay (which is lofty enough). So CEO takes much less downside risk than the shareholders. This often causes problem as you can see in airline industry and lately in GM (CEO salary is cut in half so that it is better aligned with shareholder's risk. But nobody mentioned how much stock option he got in exchange). If you view life through option model (figure out what are all the options available to each side under the contract), it becomes very interesting. No wonder Black and Sholes won Nobel prize.
I do not blame the union workers any more. They are just trying to protect themselves from becoming a commodity-like labor, which in an option world, will be much less valuable, if not totally of no value. People can leave their job, company can fire people. I have another essay about how to view employment contract in terms of option model. But I will spare it here.
Steve
posted by Steve at 5:18 PM
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