Focus Article – Hedging Our Long Portfolio

With the new bull market in full swing, I have been getting questions from seasoned investors about insider activity and if it points to a potential drop. We have been calculating an insider sell/buy ratio on a weekly basis for close to two years and it is indeed trending higher. There was a noticeable spike two weeks ago when the insider sell/buy ratio hit a high of 52.9 (indicating insiders sold 53 times as much stock as they purchased) and this was the highest the ratio has been since last October. The insider sell/buy ratio is just one indicator and cannot be relied on in isolation. Another indicator that I personally tend to follow is the Volatility Index (VIX), which is also known as the fear index. The VIX hit a low of 14.82, the lowest it has been since last May as you can see from the chart below. Incidentally, April 29th marked the high of the market for 2011 and the market started declining in June before plunging sharply last August.

VIX One Year Chart

VIX One Year Chart

Market forecasters look at a number of different indicators and oddly enough still tend to get the direction of the market wrong. Such are the perils faced by forecasters and soothsayers with crystal balls. However, if the recent bullish move in stocks or either of the two indicators discussed above give you pause, you could hedge your long portfolio through various strategies. We discussed several hedging strategies last June in a special report titled Hedging Against A Sharp Decline Using Put Backspreads and the timing of that report couldn’t have been better given the sharp drop last summer. I believe this bull market still has a lot of room to run but have also started taking steps to hedge against a pull back or an unexpected event that could bring this party to a premature end. Specifically I have started taking profits and increasing the cash position in my long-term portfolio, I have started selling covered calls on positions that have appreciated, I have initiated put back spreads on a couple of companies (Green Mountain Coffee Roasters and Crown Castle International) and am planning on going long the VIX.

 

Our primary focus in the daily reports and weekly focus articles has been insider buying but it sometimes helps to pay attention to the sell side as well. While insiders sell for a variety of reasons unrelated to the value of the stock, several companies where selling was heavy, consistent and by multiple insiders ended up dropping precipitously. A couple of examples of companies that dropped sharply following insider selling in 2011 are Acme Packet (APKT) and First Solar (FSLR).

I decided to look through the last four months of insider sales to identify companies that have seen several insider sales and are trading for more than 50 times free cash flow (FCF). The following list of companies should provide a starting point for further research. Several of these companies have great business models with strong double digit operating margins. I have been getting my burrito fix at Chipotle for years and am currently a customer of Rackspace’s Cloud Sites service. Can these companies grow into these valuations? The market certainly appears to think so and it is entirely possible but not very probable. It is worth repeating that the market can stay irrational longer than you can stay solvent when it comes to momentum stocks.

Stock Symbol Price/FCF EV/EBIDTA Price/Book Price/Sales
Chipotle Mexican Grill CMG 50 29.07 12.44 5.76
Crown Castle International CCI 55 17.12 5.62 7.33
Mercadolibre MELI 68 38.78 19.61 19.43
Rackspace Hosting RAX 103 25.63 12.56 7.2
MicroStrategy MSTR 105 50.65 8.87 2.65
The Ultimate Software Group ULTI 130 70.24 22.35 7.07
Lululemon Athletica LULU 352 33.05 20.79 12.46

There are several ways to hedge your portfolio based on your appetite for risk including but not limited to a direct short position, utilizing put back spreads or selling naked calls. I personally prefer using put back spreads and I have used them on several stocks including Electronic Arts (EA), Acke Packet (APKT), Salesforce.com (CRM), Mercadolibre (MELI), Lululemon Athletica (LULU), Chipotle Mexican Grill (CMG), Crown Castle International (CCI) (still active and at break even) and Green Mountain Coffee Roasters (GMCR) (still active and profitable). All these positions turned out to be profitable except for CRM, where I only made the spread as the stock did not decline much.

 

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