I’m sure it’s no shock to hear that stocks are expensive right now. But you might be surprised to find out just how expensive they are.
Goldman Sachs (NYSE: GS) recently measured the market and found that the median stock trades in the 99th percentile of its historical valuation. Stocks are near historic highs on numerous valuation metrics, including price-to-earnings growth (PEG), enterprise-to-sales and forward price-to-earnings (P/E).
You can argue that rock-bottom interest rates make stocks a “relatively” better investment than bonds and other asset types, but that argument sounds a little like every other excuse investors make at the height of a market bubble.
Investors with long time horizons can shift to cash and wait until the market rolls over, snapping up stocks at better valuations. Traders and shorter-term investors don’t have that luxury. They need to capitalize on weakness and hedge their long holdings.
I’ve found a company that may be a perfect candidate for one of my favorite market-hedging strategies.
Insiders and an activist hedge fund are unloading millions of this company’s shares, which are trading at a 74% premium to the five-year average multiple. If anything happens to investor sentiment, or if the broader market turns lower, there will be nothing left to support this stock.
A $1 Billion Vote of No Confidence in Microsoft
Activist hedge fund ValueAct Capital began building a position in Microsoft (NASDAQ: MSFT) in 2013 to push for a board seat and a strategic shift in the business. By last year, the fund owned more than 75 million shares, or about 10% of the company.
After pushing through a new focus on cloud computing and shares roughly doubling, ValueAct may be signaling there is little upside left for the tech giant. The hedge fund sold almost 19 million shares in November and just ditched another 18 million shares worth more than $1 billion in July.
That’s 49% of the fund’s Microsoft position dumped in just eight months.
ValueAct isn’t the only one selling. Microsoft insiders have sold more than $23 million worth of shares since May, including $11 million worth sold by CEO Satya Nadella.
Microsoft has been relatively successful getting its Azure cloud business off the ground, but it faces tough competition from Amazon.com (NASDAQ: AMZN) and other competitors. Legacy hardware business will likely continue to see weakness, and the company’s enterprise business is very cyclical.
While I’m generally optimistic on the outlook for social media, Microsoft’s recent $26.2 billion acquisition of business networking platform LinkedIn (NYSE:LNKD) at sky-high multiples reminds me too much of Yahoo’s (NASDAQ: YHOO) failed acquisition of Tumblr. As of this year, Yahoo has been forced to write down two-thirds of the $1.1 billion it paid for the social media site in 2013.
Microsoft paid 54 times forward earnings for LinkedIn, so management really needs to prove the deal can be profitable for shareholders.
MSFT currently trades for 27.6 times trailing earnings, nearly double the 15.8 average multiple over the past five years, according to Morningstar data. Full-year earnings are expected to squeak out 3.6% growth to $2.89 per share, but that still puts the current price at 20 times forward earnings.
Shares of Microsoft tumbled 60% from their 2007 high to their March 2009 low, compared with a 55% loss in the S&P 500 during that time. I’m not calling for another bear market like we saw during the Great Recession, but MSFT could once again underperform the broader market when we finally get a meaningful pullback. And even if the market manages to eke out gains, there doesn’t seem to be much upside left for MSFT.
How Microsoft’s Weakness Can Help Protect Your Portfolio
Earlier I mentioned that I planned to use one of my favorite market-hedging strategies for today’s trade: a basic put option.
A put option gives you the right (but not the obligation) to sell the underlying stock at a certain price (the strike price) at a future date (the expiration date). This allows you to enjoy the stock’s downside with less risk than shorting it outright. Puts are also a great tool for hedging your portfolio, because the outsized gains they generate can be used to offset losses in other investments when the market turns south.
Small corrections of 5% to 10% could become common if market sentiment starts breaking down, and I want to be ready with a few put option trades on weaker names like Microsoft.
The $55 level, which acted as resistance for MSFT over the past year until it was broken in mid-July, could now act as support on a pullback. So we can use that as a conservative downside target that could easily be reached on any market weakness or investor concern about valuation.
With MSFT trading at $57.95 at the time of this writing, a drop to $55 would only result in a gain of about 5% if we simply shorted the stock. But using put options, we can leverage this potential move into a 43% profit in less than three months.
Specifically, I recommend buying the MSFT Nov 60 Put for about $3.50 per share, which gives us the right to sell the shares for $60 on Nov. 18.
Because each option contract controls 100 shares of the underlying security, the trade will cost us $350. That is much cheaper than shorting 100 shares of MSFT, though, which would cost about $2,900 on a 50% margin.
The trade breaks even at $56.50 per share ($60 strike price minus $3.50 options premium), which is about 2.5% below the current price.
The absolute most we can lose is the $350 cost of the option. Losses for a short seller, on the other hand, are potentially unlimited because there’s theoretically no telling how high a stock can go.
The goal is for MSFT to drop to $55 by expiration in November. At that price, the put option would be worth at least $5 (strike price of $60 – stock price of $55) and deliver a return of 43% in less than three months. Set a good ’til cancelled order to sell your put option for $5 to automate your exit.
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