Get Big Results with “Optionality”

Today's Guest Post comes from Chris Mayer of Penny Sleuth. Get Big Results with "Optionality" originally appeared in the Penny Sleuth. In this piece, Mayer explains the concept of "Optionality" as a way to battle the uncertain and fickle market conditions. If you enjoy this post, please click here to learn more about Penny Sleuth and a complimentary report which will share 3 stocks poised to breakout.

“The world has changed. It is a more fragile and less stable place.”

The speaker was Joshua Friedman, the co-chief at Canyon Partners, which manages $20 billion. He was speaking at Grant’s Spring Investment Conference, which I attended in early April.

Friedman used the imagery of the old bell curves. There is the normal bell curve and the “new normal” curve with fatter tails. In plain terms, it means more crazy things will happen. It means outliers will become more common. It means the unexpected will happen more frequently. Wildness lies in wait, as Chesterton had it.

In many ways, markets have always been this way, as the late Benoit Mandelbrot observed. For instance, financial theory – based on the old bell curve – predicts that a market move of 7% or more in a single day will happen once every 300,000 years. Yet the 20th century alone had 48 such days. “Truly, a calamitous era,” Mandelbrot writes, “that insists on flaunting all predictions.”

What to do?

Michael Harkins, a respected investor at the firm of Levy, Harkins & Co., said to avoid “cash sinkholes.” Exhibit A was Alcoa, a “capitalist catastrophe,” as he put it. Every dime the company earns and more is consumed in costly, capital-intensive projects that generate no free cash.

Harkins likes blue chippy names – Tupperware (NYSE:TUP) (“a cash machine with 85% of sales outside of the U.S.”), McDonald’s (NYSE:MCD) (“a cash machine… competitors are leveraged up”) and American Express (NYSE:AXP) (“a cash machine with pricing power”).

He also pointed out that investors have short memories and that the market is constantly wiping the slate clean, ensuring that cash sinkholes and “capitalist catastrophes” continue to capture the affection of new investors.

The aforementioned Friedman had an idea as well. “Go long optionality,” he said. Invest “not only in cheap assets, but assets where you get optionality cheaply.”

What is optionality?

One way a stock has optionality is if it can deliver big results when certain seemingly unlikely things occur. I think of it as the payoff if that fat part of the tail happens. Think of a publishing company that publishes the next Harry Potter. Or a movie studio that makes the next Avatar.

My best idea on cheap optionality in today’s market is low-cost, pure-play natural gas stocks in North America. Natural gas prices are low, drifting around $4 for last two years. If you buy a natural gas stock that makes sense assuming natural gas prices stay at $4, then you ought to do OK even if natgas continues to drift along at $4.

But the optionality you get is if natural gas prices get to $6, which they must do someday. When is anybody’s guess. But when they do, then the stock doubles. Or if natural gas prices get to $8, then the stock doubles again. You have a stock with a giant free call option on higher natural gas prices.

These are the kinds of stocks you want to buy in this market: Low downside, but huge upside if what seems unlikely or unexpected happens. (Nobody is predicting $6 gas anytime soon.) The promise of small steady gains is not worth the risk in a market with fat tails and that can roll back years of small gains in a few bad months.

Bet on the unexpected, as long as your downside is covered.


Chris Mayer
Penny Sleuth


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