Thursday, February 7, 2013

Create Your Own Apple Stub

Einhorn is unhappy with Apple's $137 billion cash hoard on the balance sheet and wants Apple to issue perpetual preferred shares to enhance shareholder value.  He said in an open letter that every $50 billion of preferred shares it distributes (at 4% rate) will increase value to Apple shareholders by $32/AAPL share.

First of all, I noticed that there were some mistakes in talking about this and one press report stated that Einhorn made this claim "without elaborating".   I think he made it very clear how the value would be realized.

So let's just look at this for a second before I go on.

Here are just some basic figures I pulled off the internet:

AAPL shares outstanding:               940 million
Analyst EPS estimates:
      Year-ending September 2013:  $45/share
      Year-ending September 2014:  $50/share

Einhorn assumptions:
          AAPL valuation:             10x P/E
          Yield on preferred:            4%

Before Preferred Distribution: 
          EPS:                                  $45/share
          Cash per share:                  $145/share
          Value per AAPL share:     $595/share (10x p/e + cash per share).

After $50 billion Preferred Distribution:
          EPS:                                  $43/share  (EPS - ($50 bn x 4% pref dvd/ 940 mn SOS)
          Value per AAPL share:
               Cash per share:             $145/share
               AAPL shares:               $575/share (EPS of $43 x 10 + cash per share)
               Value of preferreds
                      (per AAPL share):  $53/AAPL share ($50 bn / 940 mn SOS)
               Total Value:                 $628/AAPL share

$628 - $595 = $33/share (difference due to rounding).


[ Note after the fact: In response to comments below, I revised the above table to include cash per share in the total valuation of AAPL. The result is the same as before as cash per share doesn't change pre and post preferred distribution.  But by not including it, it looked like it would be even more value accretive if AAPL distributed cash instead of preferreds.  Anyway see comments below. ]

This is pretty much the stub stock scenario in Greenblatt's Genius book.  Speaking of which, this is another perfect case of where we can go out and create our own stub, like Greenblatt said we could (and should).

Create Your Own Stub
So the problem with AAPL is basically that it is ridiculously underleveraged.  They have so much cash on their balance sheet that it's a drag on the performance of the whole company.  They have $137 billion cash on the balance sheet that comes to $145/share.  That's just nuts.

But Greenblatt reminded us that even if companies don't do leveraged recapitalizations too much anymore (except private equity owned entities), we can do our own recap and create our own stub.

So here I'll just take a quick look at creating an AAPL stub, which I thought I'd never do.  Who the heck buys LEAPs on volatile tech stocks?  Who needs leverage to own a stock that went from $100 to $700 almost overnight?

Anyway, let's just say we want to lever up 2-1.  I'll just look at the $250 strike January 17, 2015 calls.  You can go up or down the strikes according to your taste.
Apple is now trading at $458.60/share and the 250 strike calls is offered at $211.

So buying the $250 strikes at $211 means you are paying a $2.4/share premium (($250 + $211) - $458.60).  Plus you don't get dividends by owning LEAPs, so you lose out on that.  Dividends now is an annualized $10.40/share.  The $2.40/share premium above is for two years (let's round this to two years), so that's a premium of $1.20/share per year.  Add that to the $10.40 in dividends you don't get and that's an annualized carry cost of $11.60/share.

Since you are 'borrowing' $250 over two years, your annualized financing cost is 4.6%/year.  But this assumes dividends don't go up this year and next.  This may be unlikely given all the talk of too much cash on AAPL's balance sheet.   If dividends go up 20%, then the carry cost will go up to 5.5% (assuming a one time bump up in dividends of 20% for the two years).

But this ignores the put option value of owning a 250 strike call instead of actually borrowing cash to buy shares.  If you bought AAPL on margin and the stock really tanked, you would get margin called.  With a call option, you can't possibly lose anything below $250 as you are only long a call option that becomes worthless (if AAPL goes below $250 and stays there).

A $250 strike January 2015 put option is offered at $8 or so, so to be really accurate, you should deduct $4/year off of the financing cost above.  That gets the carry cost (cost of loan) down to 3% (or 4% if dividends are 20% higher). 

That's not bad at all.  I know interest rates are zero, but for a small investor to be able to borrow money at 3-4% is not bad at all.  I realize there are discount brokers that offer lower margin rates, but still.

All Options Expire Worthless!
I don't want to push this stuff too much (as I don't really know who is reading this), but just to show how low risk something like this can be, let's think about this for a second.

Many people rightly believe that all options expire worthless.  Never mind that that's not really possible, but it's not a bad way to think so as to stay out of trouble and not buy calls and puts out of an urge to hedge or get some 'free' upside on a momo stock.

But a well thought out LEAPs strategy can be very good. 

Let's take a look at this trade, for example.

If you buy a 250 strike AAPL LEAP for $211, you can't lose your entire investment unless AAPL goes down to $250/share in two years.  From what I read, I think that's a low probability (well, more on what I think of AAPL later). 

One thing that kills option investors is the time value decay.  You buy at-the-money or out-of-the-money calls to try to capture upside in a big momo stock that you are afraid to own outright.  Or you buy at-the-money or out-of-the-money SPY puts because you are terrified at what the fiscal cliff will do to your IRA.

When you buy at-the-money options over the near term, you are not really borrowing money.  You are paying more for the volatility; you are paying a premium for the opportunity to buy or walk away depending on what happens to the stock.   This optionality is what you are paying for.  You can test this easily by calculating the financing cost of a position and compare it to the option premium.  For short-dated options, the financing component is tiny compared to the total option premium.

I have no proof, but I think if someone did a study on options and how people lose money in them, I bet that most of the money is lost due to the amount people pay over the instrinsic value of an option (intrinsic value is simply the in-the-money amount of an option).  In other words, it's the time value that kills them.

So using this unproven rule of thumb that I just pulled out of thin air, let's look at this AAPL LEAP trade again.

The stock is at $458.60/share.  The strike price plus option premium on the 250 strike LEAP is $461/share.  So you are paying $2.40/share over the stock price.  Add the $21/share of dividends you won't get and you are paying $23.40 over the stock price.   So if the stock price does nothing for the next two years, this is what you lose.  You lose $23.40/share (or more if dividends go up).  That's just 5% of the notional amount of the trade, or 2.5%/year.  That doesn't sound too traumatic.

If the stock price goes up or down, you make the same amount as if you were holding the stock, pretty much on a dollar for dollar basis (at expiration, of course.  Until then, your option will go up and down according to the delta of the option).   And then under $250, you don't lose any more.

My point is that on a time value basis, you are paying very little premium so you don't lose a lot of money here if the stock goes nowhere.  Compare that, for example, to owning an at-the-money call option which, by the way, is offered at $69 now for the same maturity (2 years).  That means you lose 20% of the notional amount of the trade with the stock flat over two years (including dividends you don't get).

So I would tend to look at these in-the-money LEAP trades (and even shorter maturity options) differently than 'typical' option trades; they act more like financing trades.  Of course it's still risky as you are levering up.

What I Still Think of Apple
Not that I have much to add to the Apple debate going on all over the place, I still view Apple the same way as when I made my previous posts about it last year.  (Why I Left Apple and Apple is No Polaroid)

I still think Apple was a Steve Jobs story and not an Apple Inc. story.  I still think the market breathed a huge sigh of relief after Jobs passed away as Apple continued to perform in the following year.  That's what took the stock up to $700.   I keep reading about how "Apple did this.  Apple did that.  Dell couldn't do that.  Microsoft didn't do that".  And I always think, no,  Steve Jobs did this.  Steve Jobs did that.

I still think that the cell phone market will get more and more competitive and mobile companies will get more and more resentful about the huge subsidies they pay for subscribers to get iPhones.  When price competition heats up in mobile markets around the world, more and more operators will opt not to pay $500-600 subsidies.   I understand that early on it was the other way around.  Mobile operators needed the iPhone to attract subscribers.

Over time, I think the "amazingness" of Apple products will become increasingly commoditized. Sure, Apple may still be able to maintain a premium brand status just as they held on to that over time with the Mac, but that may not be enough to maintain or increase the value of Apple as a company.

I do think that Apple is only cheap if one assumes that Apple will come out with something just as mind-blowing as the iPod was, then the iPhone and then the iPad.  If all we have going forward are upgrades to iPhones and iPads and competitors continue to close the gap, then I tend to believe that Apple is probably not a cheap stock.

Anyway, I know many people disagree with this view (and many agree), and the hard thing about this discussion is that there really is nothing I can point to to prove it one way or the other.  There are plenty of people who know way more about Apple than I do so don't mind my opinion too much.

Advantage for the Little Guys
But having said all of that, this Apple LEAP trade does look interesting.  This is one of the advantages of being small investors.  Someone like Einhorn probably couldn't put this trade on.  He has no choice but to activist management into action. 

But little guys like us can just say, hey, if you don't want to lever up, I'll just do it myself, thank you very much.


  1. One risk with the LEAPs -- if Einhorn succeeds in getting this perpetual preferred idea done, you're going to see some value leakage from your security depending on how the Options Clearing Corp. treats the Special Dividend.

    Long shot that Einhorn's idea gets any traction, but it's a risk.

    P.S. I'm long some LEAPs, hence why the topic is front-of-mind for me.

    1. Hi,

      Yes, good point. I'm sure the OCC will adjust for a special dividend even if it's noncash (many spinoffs recently).

      But also, if something does get announced, don't forget the stock price will react to it. So if the market sees a $32/share increase in value due to an announced deal, the stock price will probably go up $32/share +/-, and you will be able to act accordingly then (like sell out if you are not sure of what will happen).

      An increase in regular cash dividends is a very real risk, though, even though I suspect it won't go up too much. I don't think they want to lock themselves into a high dividend especially when they may (or may not) feel that current earnings are peak-ish (conservatively speaking).

      Anyway, there are a lot of moving parts here, but if bulls (I am not one of them) think AAPL is worth $650 - $700/share as is, then these risks are marginal, I think...

    2. Yes, selling would be my M.O. if the OCC did not adjust for it... it's a bit more problematic for out-of-the-money options on an intrinsic value basis though. i.e. if I owned LEAPs with a strike of $500 and the stock price appreciated to $490 on the record date, intrinsic value should not be any different unless the market viewed the move as indication of some sort of newfound capital allocation wisdom by Management. Anyway, the options market would have to be pretty dumb to not price this in, but who knows... Black-Scholes and computer trading can result in some pretty silly outcomes for options at times.

      Who knows what happens to the stock price if they doubled the common dividend anyways... stock price would probably go up then too since the market appears to be valuing the B/S cash at zero.

      P.S. Btw, why do I think the Einhorn idea goes nowhere? Management / BoD incentives -- it does absolutely nothing for employees holding RSUs or options. That's why I think a buyback is much more likely. I prefer that too given the more tax-efficient nature of the buyback.

    3. " it does absolutely nothing for employees holding RSUs or options. That's why I think a buyback is much more likely. I prefer that too given the more tax-efficient nature of the buyback." -- Actually, for the RSUs Apple announced about a year ago that Dividends would accrue for employee's stock. Tim Cook opted out of the plan.

  2. There is no arbitrage here. You did not account for the cash while valuing it based on PE, but did after issuing the preferred.

    1. Hi,

      Thanks for the comment. Yes, I should have added cash per share to all of the above figures. You would still get the same result, though, as cash per share doesn't change pre and post preferred distribution.

      Without adding the cash back, yes, it looks as if distributing cash would be more value enhancing to AAPL shareholders (with P/E unchanged at 10x, might as well distribute all of the cash and still value AAPL at 10x and all the cash is accretive to shareholder value according to my table).

      So I will write a note in the above post to read the comments down here; I'd rather do that than redo the above table as I'd rather not change posts after the fact.

      Thanks for the comment.

    2. OK, screw it. It's too complicated to so I just revised the table in the original post. It's much simpler that way.

      I generally don't want to tamper with blog posts once posted, but corrections and clarifications are OK, I guess. I'm not changing a bullish call to a bearish call or anything like that. And the change doesn't change the substance of the post so I guess it's cool...

      Thanks for the comment, though, as it helped me clarify.

    3. It's a big IF that the P/E- ratio will remain the same.

      Also, would the cash really not change? The pref dividends must come from somewhere?

      I'm of the opinion that this will not change the value of AAPL (since this is only a capital allocation decision of prefs which do not have a tax shield as regular debt. This change will have no effect on the operating performance of AAPL). However, it may act as a price catalyst...

    4. Hi, yes, it will change cash over time. A preferred is just a promise to pay out cash over time. And yes, it's doesn't change the value of AAPL as a firm; just the cap rates of the respective pieces of issued security; the common stock and preferred.

      As for changing the P/E ratio, I don't know. I suppose it should theoretically. But then again, what would happen to the P/E ratio if AAPL paid out cash? Theoretically, AAPL would become slightly less sound balance-sheet-wise, but I sort of doubt the P/E would contract due to that as long as AAPL keeps printing money the way it is.

      Anyway, for me, this is more of an interesting intellectual exercise than anything. I'm not pounding the table here demanding that AAPL issue preferreds or anything like that...

  3. Did you even bother to look at Einhorn's presentation or the backup excel?

    Spend 5 minutes of our time with this --

    You can disagree with the yield assumptions on the preferred, but you can't charge him with doing something he doesn't do.

  4. Btw, the comment at 5:07pm was in response to the comment at 4:42pm, not kk

    1. Thanks for the comment. Either way, I didn't see the presentation either, lol... Shame on me.

      The gist of my post is correct, so...

  5. KK,

    I'm enjoying your blog and used to blog myself. If you're interested in getting paid for you blogs please contact me through your profile. No Joke.


    1. Hi. I'm not looking for income from this, but thanks anyway.

  6. There is no question that Apple does not need all that cash and that returning it to shareholders is a possibly good idea. But a drag on performance or results? Mostly what is being discussed is financial engineering. It in no way helps the company! Sure buying back shares, doing preferreds, or increasing its dividend all are nice, but none add to the business. What CEO Cook needs to focus on is the business. Having the huge cash horde has tons of advantages. They could for instance buy Berkshire or AIG and BAC. That would be a much better use of their cash than issuing preffereds.

    Just because Einhorn wants the PPS to increase doesn't mean he's right. The stock will reflect IV over the long-term. Increasing the PPS so he can cash out at the top isn't helpful to Apple. Quite the contrary, with the rapid changes in Tech is probably much better from a business standpoint to have the cash lying around in case something major takes place and they need to act quickly.....

    1. Well, it is a drag on results in the sense that the cash sits there and earns close to nothing. Maybe they should buy Goldman Sachs, or give the cash to Einhorn to manage!

      I don't have a strong view on this either way. It's an interesting idea, this preferred. But I don't think it's a good idea for them to issue a lot of preferreds as Einhorn says they can. As Milken said long ago, tech companies shouldn't have debt. I know, preferred isn't debt, but still, you don't want to commit to annual cash payments even if you can't possibly default (it will crush the common and preferred if AAPL for some reason couldn't or decided not to pay the preferred dividend).

      So I do agree with you in that sense.

      Anyway, it is interesting.

  7. Not for nothing but any comments or opinions about Braeburn and its likely impact on future free cash flows?

    1. Hi,

      I don't know anything about Braeburn other than what's been discussed in the press etc. I don't think there is anything special there other than it's located in Nevada, presumably for tax purposes.

      It just seems like a giant cash/tax management operation. It looks like most of their holdings is in fixed income. So whatever equity and other stuff they say they do must be really small.

  8. The flaw I see in both your and Einhorn's calculation is that you are assuming that the PE will stay the same and the preferred will trade at par. Both of those seems to be wrong when you are changing the capital structure. Check Prof.Aswath Damodaran's latest blog post and the comments if you are interested.


    1. Hi,

      That's a good post and he is definitely more an expert than I am. But I have to say that although I sort of agree with him (if AAPL issued a LOT of preferreds, P/E would go down and preferred yield would go up), I don't think it's as simple as he states.

      I guess in theory, that's the way it should work since as he says, there is a sort of law of thermodynamics.

      But on the other hand, there is a lot of proof that he is not correct. Why is it that company shares pop up, oftentimes substantially when they do spinoffs and other corporate events which actually don't change anything significantly? Some people used to think spinoffs were bad since it had a negative synergy effect (need to have two human resource departments instead of one, two investor relations departments, two legal departments, two CEOs etc. post-spin).

      So I do think there is effects like that where the market prices certain streams of cash flow differently.

      The play here for Einhorn is that this idea takes advantage of that. There are probably a lot of willing buyers of 4% preferreds from AAPL who may not want to own the common stock even for a 10% earnings yield (or 14% ex-cash).

      If that is the case, there can be something created out of nothing. It is financial engineering.

      As for preferreds issuance reducing p/e ratio, that is probably true to some extent if they issue a lot of preferreds.

      As for increasing the common dividend, special dividend or share repurchases, it won't have the same effect as you are not creating an instrument that may be valued by the market at 4% yield (instead of the 10% yield on the common).

      In any case, I don't have a horse in this race; it's more of an interesting discussion than anything else.

      And for an investor/trader like me, the second half of the above post is more important. It's an actionable trade to do synthetically by myself what much of the street seems to want AAPL to do. That's more the gist of my post.

      Thanks for reading.

    2. kk,

      Your analysis is much better than most folks in financial media :-) I like to separate the quantitative analysis from behavioral analysis.

      The financial engineering related value creation that you/Einhorn are referring to is more to do with investor behavior. I think, it is called signaling and Clientele Effect where the management attracts a different set of investors by changing capital distribution policy. But, I think, it is better to keep that out from quantitative valuation either by using DCF or multiples (which is a short handed way of applying DCF).

      I can see how this financial engineering can give a short term bump to the stock. But over longer term, if we agree that stock price loosely tracks the intrinsic value of the operating business, ultimately the price trajectory will depend on how the competitive forces play out and how Apple executes/innovates in future.

      Thank you for the post and reply.


  9. I don't think I'm slow-witted, but I don't get any of this. If the company issues $50B in preferred shares, then it has $50B *more* cash-- unless one proposes that the shares be given away rather than sold. (Charitable donation?)
    Presumably, adding more cash is the last thing we need from AAPL. So why do we want them to issue more equity?

    1. Einhorn proposes that Apple issue preferreds to existing common shareholders. No new cash is being raised under the proposal.

  10. A little off topic here, but wouldn't buying back stock make the most sense for everyone? Apple eliminates the dividend, which is costing them more than they are earning on the cash they have sitting around in treasurys... In other words, take cash that is earning you 1%, and pay off "debt" that is costing you 2%+ Plus, this is accretive to shareholders in a non-taxable way, by reducing outstanding shares...

    A similar twist would be to borrow against the offshore cash, using the cash itself as collateral, thus side-stepping the tax consequences of repatriation... then, use this cash for a buyback, thus eliminating the dividend payments associated therewith, which of course offsets the interest they pay on the loan for the offshore cash... (assuming they can borrow at 2%, which seems a no-brainer since they are collateralizing the loan with cash).

    1. Bingo... And we have a winner.

      1. Dividends dont help out employees (as much... Though there will be some price appreciation due to signalling affects) = like it or not, this is an objective for Silicon Valley

      2. Stock buybacks are more tax-efficient

      3. When your stock price implies a FCF yield of 20% (inverse of 5x P/E) and you can borrow at <5%, you should be buying back stock all day long (assuming you think earnings are sustainable)

      4. Borrowing against foreign-cash is highly tax-efficient and is done by companies all the time. Rate will be higher than 2%, but it'll still be low.

      Anyway, this is all hypothetical since I don't think they'll do any of this = there's no evidence that Tim Cook turned into Henry Singleton over the last 3 months. They're still going to be conservative.

      That said, this could easily be a $1,500/sh stock if they did a modest levered recap.

    2. Good points (all of the above from both post and response). I think Einhorn's (I am not advocating preferreds; just explaining Einhorn's view) idea is that it will allow AAPL to retain the cash on the balance sheet (which of course will be paid out over time via the preferreds to some extent), and the market values a steady stream of income higher than tech stock earnings. So it is financial engineering.

      But I agree that anything to do something intelligent with the cash would boost the stock price.

  11. all this is analysis fabulous but what happens when the fed announces the end of QE10?

    oh wait, just leverage up on the big dog stock and shut up baby! :) seriously though apple should go up this week. hopefully past 500. bitchez.

  12. Einhorn is reaching a bit on this one. Its a trade gone bad for him plus he loves the limelight so what better way to do it than to scream and shout about AAPL? Compare Apple's roic with einhorn's and it will become very clear who you should trust with your cash. I am not against activism. But this is to me a clear case of shorttermness of a fund manager who has underperformed recently and is looking to divert attention.

    1. Well, I don't want to rush to judgement here, but Einhorn did propose this same structure last May when the stock was doing fine.

      I don't think Einhorn is the type of person to do something to divert attention. In fact, if he is doing poorly (2012 was not a great year), he is just calling more attention to himself.

      Anyway, I understand your viewpoint for sure. This looks like some short term, one-time bump that has nothing to do with improving the value of AAPL as a business.

      On the other hand, this is how our system works. Shareholders have a stake in the company and they are allowed to make their views known to the board, management and the public (why not?).

      Then the shareholders can decide via voting their proxies etc...

      I think this sort of thing is what makes U.S. capital markets the best in the world.

      I may not agree or disagree all the time, but I love that this sort of thing happens.

      As a sad contrast, look at Japan.

    2. he did return 7.9% in 2012 after Apple dropped from 705 to low 500s which is one of his bigger holdings. And that is after December i believe alone dropped him 4.7% (correct me if i'm wrong, i don't have the shareholders letter in front of me).

      On Apple, I worked at a firm where we used DCF models, but it became apparent to me the main flaw of DCF. besides trying to project 5-10+ years out, is that we assume that cash is actually the shareholders cash! But apple does nothing with it, small acquisitions here and there that they try to keep under wraps, but essentially the shareholders cash is returning what 1-2% a year in interest? My bet is that if they decide to allocate more FCF to buybacks and dividends, they will jump back up to at least 550+. Then once they have a quarter with 40%+ GM again, it will shoot over $600 (I can imagine the sell side reports now, GM improving, Q1 GM one-time event BUY TP $750).

  13. Deep in the money far in the the future call options "stubs" as you call them (never heard that name before) can be great when fundamentals are pointing to a good outcome.

    I've used several of those with USG, WDC, DELL, AMAT, INTC mostly in the past and currently still have some. All did nice up to now, some very very nice (USG, WDC).

    But I am wary of Apple (stub or not) for the same fundamental reasons you point out. Here is what I wrote about it a few months back:

    Congrats on your writing ! ! fellow investor friend pointed me to your WFC latest post, being my biggest position I got interested.

    Since then you are one of the very few bloggers from whom I have read more than 3 posts.


  14. Einhorn proposes Apple to distribute $500B to shareholders as prefereds @ 4%.

    I see this as IOUs.

    Apple's EPS reduces by $20/share since they are paid out as dividends on preferds. So the Mcap comes down based on the reduction of EPS and the value of prefered in the open market. If prefereds are distributed on 1:1 (1 prefered for 1 share held)basis and carry a face value of $500, and say they trade in the open market at $300, then Apple share may come down to less than $100/share.

    But, Einhorn shows $500B in balance sheet which does not exist, why? This is just financial engineering with smoke and mirrors.

    1. but if the preferred traded at $300, the potential dividend yield if ever paid out would be 6.7%. So it would likely not trade at such a low value.

    2. I think you are right, it might be higher.

      We can look at this in simpler terms. Suppose Apple will trade at the current price of $480 at the time of issuing prefered, then the total value of stock price and the prefereds would still be approximately $480.

      Apple stock price + Value of Prefered share = $480 (approx)

      If prefered share is valued at $300, then Apple share will be valued at approx $180.

  15. I really enjoy reading your blog. Thanks for sharing your knowledge.

    Have you thought about applying your Apple stub strategy to WFC call options? Depending on the option, the carrying cost is about 1-2%.

    1. Hi,

      Thanks for the comment.

      Yes, it can work with WFC very well too (be careful of dividend risk, though, as LEAPs adjust for extraordinary dividends but not ordinary dividends which can get hiked a lot from here for the banks).

      I have done this with BAC, C and it size with BRK last year and it has worked out really well. I don't intend to make a post about every situation, though, as they are all basically the same trade. (unless, of course, I have something specific to say about the underlying).

      Thanks for reading.

    2. Yes, the dividend risk adds a little less than 3% to the carrying cost. Since there's still a lot of warrants outstanding, my bet is that WFC will not increase their dividends beyond $1.36 per year(at least for the next 2 years). I'm sure you already know but if they declare a higher number, they need to adjust the warrants. Thus, the total carrying cost should be approximately 4%.

      Your analysis is spot on for WFC and very thorough.

      It looks like Warren Buffett added to his position. I was surprised he didn't do it sooner at lower prices. Is he maxed out at 10% of the company due to regulations?

    3. Hi, I think a lot of people were disappointed that Buffett didn't really back up the truck during 2008-2009. But I think he was being conservative... The stock portfolio was down, his short puts were going against him etc... So it's not surprising that he was cautious and didn't just plunge in head first. He's not a nimble hedge fund anymore but a big conglomerate/insurance company.

      And yes, I think there is a 10% limit on his holding of banks. A quick look at Yahoo shows that the ownership percentage was 8%; this may be due to the financing done during the crisis and maybe due to the Wachovia acquisition (diluting his holding)...

    4. I just want to clarify my 4% carrying cost is a holding period rate. The annualized rate would be approximately 2%.

  16. Hi There,

    Lovely post as always.

    I understood the technicality of using the option as a financing tool but did not understand WHY it should be used in this case.

    Greenblatt puts a lot of stress on risk:reward.

    "With a call option, you can't possibly lose anything below $250 as you are only long a call option that becomes worthless (if AAPL goes below $250 and stays there). "

    That "only" would cost $211. If the market crashes, this will indeed turn to 0 while owning the common will not, even at $100. You could then sell it after the crash and buy something which is much cheaper. In a sense, then, the common also hold some of the "cash option" value.

    Not sure if I made much sense, just trying to understand WHY it's worth it to make the stub in this case, the risk:reward looks rather bad. I don't think this is something Greenblatt would do but what do I know...

    Thanks again!

    1. Hi,

      This is riskier than just owning the stock, of course. Why would you do this? Because AAPL is very unlevered. So the point is that you add leverage to the position yourself synthetically.

      It doesn't have the same risk/return profile of the WFC trade that Greenblatt talks about, though.

      If AAPL paid out the cash on the balance sheet as a special dividend and the investor bought other stocks with it, in a good market, the AAPL shareholder will make more money than if AAPL held onto the cash. This is what some AAPL shareholders want. They want the cash to be put to work or paid out in some way.

      The point of this post is that an investor can do that synthetically via a LEAP. The return profile is not exactly the same, of course, as if AAPL paid out cash. But the investor can take cash out of the AAPL stock position and put it to work just as if AAPL paid out a dividend.

      I wrote about recapping Berkshire Hathaway so it's a similar idea to that one. In that post I talk about why you would do this on BRK:

      Thanks for reading / posting.

    2. Thank you for your prompt reply, I read the BRK post again but still do not completely get it: this extra leverage with the LEAP can be applied with the same arguments to any company. Be they leveraged or not is surely not the defining condition, what's important is if one judges the company to have certain positive potential upside with a reasonable bottom risk.

      So, I don't get this "Why would you do this? Because AAPL is very unlevered."...


    3. Hi,

      Well, thanks for trying. If you don't get it, don't worry. It's not that important. Many investors do just fine without touching LEAPs or anything like that at all.

      Thanks for reading.

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  19. Hi kk,

    I'm trying to apply this logic on BBRY. (No, there's no reason to leverage up such a speculative stock. Just trying to understand the mechanics.)

    Current share price is $14.62. Looking at $7 strike Jan 17, 2015. Calls offered at $7.95 and puts offered at $0.81

    So premium inclusive of put value = (7.95 + 7) - 14.62 - 0.81 = -0.48
    That is -4.11% p.a.

    What does it mean when it's negative? Does it mean such leveraged trade is so stupid that the market is willing to "pay" me 4.11% p.a. interest to carry it?

    1. Hi, a discount usually means that it's a tight stock to borrow. Since a synthetic forward (long call / short put) reflects the carry cost (interest expense minus dividends), if it is negative that usually means the stock borrowing cost is high.

      In that case, if you like the stock, you can buy it synthetically at a discount in the options market, but that also means that you can buy the stock and earn a good stock loan fee on it (to reflect the rebate), but individual investors might not get paid that...

      Thanks for reading and commenting.

    2. Hi kk,

      Thanks for the explanation!

      Btw, is there a (short) book you can recommend on all these delicate mechanics and reasoning about options?

    3. Hi,

      I don't know, actually. I haven't read an options book in ages, and there are many, many more books out there now than when I was reading up on this stuff. You can probably find enough stuff free on the internet too.

      For what it's worth, one book that the options traders used to read a long time ago was "Options as a Strategic Investment" by McMillan. Frankly, I find most of the strategies in the book not for me... I have no interest in butterflies, condors, christmas tree spreads and whatnot.

      Also "Options Volatility and Pricing" by Natenburg was good.

      There's a lot of stuff out there depending on how deeply you want to study options. CBOE used to have a pretty good book that was like an options study guide, but I couldn't find it on a quick googling.

      I would suggest just reading the reviews and ratings at Amazon on various options books... those would be more up-to-date reviews than what I can offer...

      Thanks for reading.