Contrary to what most people have been told about options, if used correctly, options should actually reduce your investment portfolio’s risk profile, not increase it as many people have been lead to believe.
In recent times, many derivatives contracts have received a raw deal in terms of receiving their share of bad press. The recent Global Financial Crisis and the inappropriate use of many different derivatives contracts during this period of time lead many investors to cause serious financial harm to themselves and, unfortunately, others. But the fact is, in almost all circumstances, every derivative contract was designed and developed firstly for the primary purpose of helping investors reduce and better manage risk.
In order to achieve the goal of cost effectively reducing an investor’s risk profile and or their exposure to a financial asset, these contracts had to inherently contain some form of leverage in order to deliver a cost effective means to provide protection to that investor. However, with almost any device, instrument or tool created to assist humans in their everyday lives, there is almost always a way in which that same device, instrument or tool could be used to inflict or create harm if not used for the purposes initially
Derivatives such as futures, options, contracts for difference (CFD’s), credit default swaps (CDS’s), interest rate swaps and forward contracts are no different. When used appropriately they can be a very useful tool which can help make investing and return generation more fruitful and less risky. Used inappropriately for the purposes of speculation and these same instruments can become your worst nightmare.
In the last article I wrote on options “Increasing your money making options” , we discussed how using the Buy/Write (a.k.a. Covered Call) options strategy can help you safely target consistent income returns of approximately 15% to 20% per annum before a company pays a dividend. Today we will show you the first step we take in identifying ideal companies in which to use to employ this strategy.
The first thing we want to do before looking to make any options trade, where we have to own the shares in that company or we are potentially going to have to buy those shares at some point in the future, is to make sure that we would want to own those shares in the first place. Therefore, for us at UGC, that means we have to be extremely comfortable with the companies that we are going to own or could potentially end up owning at some point in the future.
In order to feel comfortable about owning any company to conduct this strategy over, we need to have a high level of conviction that, no matter what was to happen in the economy or broader market, each company would remain a viable business no matter how bad things got.
So our first step is to find only financially sound companies which have a very good chance of surviving economic and financial melt downs, no matter how bad things got.
To do this, the first place we go to is the company balance sheet and profit and loss statement and we make a few quick calculations to ensure:
- The company has low levels of debt
- The company is producing high returns on capital invested
- The company produces large amounts of free cash flow
To determine whether a company has a low level of financial debt, meaning it has a greater chance of survival in an economy wide financial crisis, we first start by ensuring that:
Net Debt (Total Financial Debt less Cash) to Equity (Shareholder’s equity, not market capitalisation) is in most cases less than 50% and that Net Debt to Earnings Before Interest Tax Depreciation and Amortisation (The approximate level of a company’s debt to its operating cash flows) is less than 4x. Broadly what we are trying to determine here is whether or not, first the company has a low level of debt when compared to the shareholder equity it contains on its balance sheet, and secondly, that any debt it does have could be paid off by its operating cash flows within 4 years or less. Once that is determined, we then look at a third measure being the interest cover ratio, which is calculated by dividing Earnings Before Interest and Tax by the Net Interest Expense amount. Essentially here we are trying to determine how many times profit before interest and tax could service the company’s interest costs. Generally we don’t like to invest in businesses where net interest cover is less than five times, meaning profits could fall by 80% and the business would still have sufficient earnings to meet its interest bill, but in reality, if we find businesses that meet our first two metrics, more often than not, interest cover well exceeds 5x.
These measures are a starting point for any company we begin to analyse, but depending on the industry, for instance in the case of infrastructure and utility companies, we make certain allowances for these industries because of the certainty of their cash flows and nature of their businesses.
Now that we have determined that the company we are looking at is not highly leveraged, we need to ensure that the company is actually generating a sufficient level of return on the capital employed. Two quick measures to begin your investigation is to look at the company’s level of Return on Shareholder Equity and Return on Total Assets. To give you a rough calculation of these measures you can simply take the level of net profit the business generates and divide it by first the level of shareholder equity on the balance sheet and then secondly by the value of assets during the financial year. But probably the best place to go to get this data would be Google Finance or Yahoo Finance, if you don’t have access to more industry standard tools. The reason being that these measures can be impacted by large movements on and off the balance sheet throughout the year.
For most companies we are looking for a return on equity above 15% and higher and for most non-financial companies we are looking for a return on assets of 10% or higher. The average benchmark return on assets measure will often vary from industry to industry but as a starting point, we generally don’t want to be accepting a business that struggles to generate more than a 10% return on the assets employed in the business. The higher the return generated in either of these measures, the more efficient management is at generating a return on capital and this is often a sign of good management, especially when debt levels are low and leverage is removed as a variable.
Thirdly, we like to know that any company we invest in produces large amounts of free cash flow. Free cash flow is the amount of money that is left over for the payment of dividends, share buybacks, debt retirement or reinvestment once everybody else has been paid their dues. Free cash flow and expectations around future levels of free cash flow is, after all, what gives a company its value. So to ensure that we know that the company is strong and selling at a reasonable price, the lower the multiple of shareholder equity to free cash flow and enterprise value to free cash flow and the higher the ratio of free cash flow to net interest, the better the odds are that you will be buying a safer investment to write options over. The benefit being that even if the share price takes a tumble, you can benefit from continuing to write call options over your investment knowing that your investment will continue to be around to write call options over and often at higher premium levels. PLUS the company will be able to continue paying you a solid dividend, which should all combine to help improve your returns and lower your risk.