1/10/2003 9:54:38 PM
By Jim Jubak
Quiz time.
What has been the best-performing stock in the Standard & Poor’s 500 index ($INX) since the stock market low on Oct. 9?
Need a hint? I’ll tell you which stocks it wasn’t. Not Xilinx (US:XLNX, news) , the chip maker that scored a technological breakthrough in partnership with IBM (US:IBM, news) . No, Xilinx was up just 75% from Oct. 9, 2002 through the close on Jan. 8, 2003. It wasn’t Yahoo! (US:YHOO, news) , even though that Internet survivor climbed 88% on the strength of growing revenue. It wasn’t retail turnaround story JC Penney (US:JCP, news) , up 62% for the period, or perennial market laggard Eastman Kodak (US:EK, news) , which finally got its act together and rose 53%.
Nope, the correct answer is Dynegy (US
YN, news) . The independent power company rose an astounding 224% from the market low.
And if you go looking for runners up to that performance, you’ll start to pull up strikingly familiar names from that same bubble and bust. AES Corp. (US:AES, news) , another independent power producer, was up 206% -- a gain exactly matched by optical fiber and components maker Corning (US:GLW, news) . Ciena (US:CIEN, news) , another former communications equipment star, was up 144%, and PMC-Sierra (US
MCS, news) , a chip maker for that market, climbed 132%.
Tiny fractions
Of course, all these stocks have something else in common -- they trade at tiny fractions of their 2000 prices. Dynegy traded near $60 a share in the bubble days of 2000 before crashing to a low of 49 cents a share. Corning’s high was near $113, and its low $1.10. PMC-Sierra peaked near $250 a share and bottomed near $2.70.
So what’s going on? Are these former leaders of the bubble market about to finally lead the current market out of the clutches of the bear? And what should you do as an investor with this group of stocks?
Frankly, it’s the performance of this group of former bubble stocks that makes me most nervous about the stock market’s move off its October lows.
These stocks tell me this market remains range-bound with good trading profits to be made as stocks move between the top and bottom of the range. But they also tell me that the market still doesn’t have the strong leadership it needs to break out of the bear market and start a sustainable move upward.
Look at Corning. When the company announced its latest round of charges -- $800 million to $824 million for the fourth quarter -- it said that it didn’t expect to see a turnaround in the telecommunications segment of its business until late 2004. A report in late October from Lehman Brothers, which noted the company had enough telecommunications goodwill to write off to endanger its bank credit lines, said Corning’s liquidity position was more tenuous than that of Lucent Technologies (US:LU, news) or Nortel Networks (US:NT, news) but that the company was more profitable than either.
Do you see a fundamental turnaround in the company’s business that would justify a 200% increase in stock price? I don’t.
Heavily shorted
Instead, I see a heavily shorted stock that started to look less and less attractive to short-sellers -- those folks who sell borrowed shares of a stock in the belief that’s its price will fall further, so that they can replace those borrowed shares by buying cheaper shares.
You can see how the interaction between short positions and stock price plays out in detail by watching PMC-Sierra. On July 15, 2002, when the stock hit a near-term peak of $10.39 a share, short interest in the stock also soared to 24 million shares. That’s how many shares short-sellers had borrowed and needed to buy to close out their positions. That was up 18% from the previous month. As the price of PMC-Sierra climbed, the potential reward from shorting the stock also climbed.
August and September didn’t see much of a change in short interest in the stock. It rose 1% in August and dropped 1% in September.
But October brought a huge shift. With the stock at just $2.72 a share (at its Oct. 9 low) short-sellers were closing positions and taking profits. Short interest fell to 19 million shares, a drop of 22%). The decline in short interest continued as short-sellers took profits in November -- short interest dropped 7% that month -- and took profits or closed unprofitable positions in December. That month, short interest fell to 15 million shares, a decline of another 15% and a drop of 9 million shares from the July levels.
In other words, the rise in PMC-Sierra’s stock in the rally that began in October had nothing to do with changed fundamentals, and very little to do with a desire to buy the stock on the part of investors. It was largely fueled by profit-taking by investors who thought that at $10.39 the stock was overpriced and offered them more reward than risk and who at $2.72 thought the balance had shifted too far toward risk.
Price channels
This kind of interaction between price and short-sellers can clearly define a price channel for investors interested in trading these swings on market emotion, but the domination of short-term prices by short-term emotion and the lack of fundamental improvement in these stocks makes it very hard to set long-term price targets or to know when to buy and hold.
Many of these companies aren’t expecting real change in their markets until 2004 or 2005. That leaves investors with very few intermediate signs of improvement in a company’s fortunes. Balance-sheet problems that could still derail many of these companies also aren’t likely to be resolved until 2004.
So what is a stock like AES worth? When margins, market share, market growth, revenue growth and earnings growth are guesswork over the next year or two, it’s extremely difficult to value a company on its growth prospects. And when assets are clearly not worth the values listed on the balance sheet, it is difficult to use standard tools to set a price.
Honest valuation
It’s more honest -- and safer for an investor’s portfolio -- to admit this valuation problem from the beginning. Anybody who is not trading these stocks on technical indicators or sentiment, but is instead buying them for a long-term investment, is really buying an option on the company’s long-term prospects and should think of the price of the stock in those terms.
This way of thinking about these stocks is useful even if you know almost nothing about options. It gives an investor a benchmark for figuring out how much to risk on one of these extremely risky stocks.
At the risk of oversimplifying, options give the buyer a right to buy or sell a specific stock at a specific price on a specific date in the future. For our purposes, we’re interested in call options, which give the option holder the right to buy in the future. (“Puts” give the right to sell.)
For example, I can buy a call option on IBM that gives me the right to buy 100 shares of that stock at $85 a share up until the expiration of that option in July. With IBM recently trading at $84.37, the options market thinks there’s a good chance that IBM will trade above $85 before July. So this contract is priced at a premium of $8.60 a share or $860 for a 100-share contract.
Options for the kind of stock that have soared recently sell at much lower premiums -- which tells you something about the market’s read on the stock’s prospects. For example, a contract to buy 100 shares of JDS Uniphase (US:JDSU, news) at $5 up to the option’s expiration in June sells at a premium of just $20 for a 100-share contract. With the stock at $2.91 at the moment, the options market is saying that investors don’t think there’s much value to the right to buy the stock at $5. The only way to make money on this option is for the shares to run above $5 by June.
Options expire, and if they aren’t exercised, they expire worthless. If JDSU never gets above $2.50 as June nears, the owner of the option has lost the $20 paid for the right to buy at $5.
So logically, the longer an option has to run, the more valuable it is and the greater premium it fetches. So while the premium on a contract to buy JDS Uniphase at $5 in June costs just $20, the right to buy the stock at $5 until January 2004 carries a premium of $60, and the right to buy 100 shares at $5 up until January 2005 costs $95.
Think of the current price of $2.96 a share for JDS Uniphase in this context. For that price ($296 for 100 shares), an investor is buying not an option for two years (current premium $95) but an option that never expires. And that has a strike price not of $5 a share but of $2.96.
4 reasons to call these stocks options
Thinking this way about these risky stocks as perpetual options has a couple of advantages. First, it should remind an investor that this is an investment than can go to zero -- just as options can expire worthless. Second, options are a risky asset class -- one that many investors who are ready to seriously think about buying Nortel Networks would never consider. An investor who would never buy an option on Nortel shouldn’t be buying shares of Nortel that are -- in effect -- options on the stock.
Third, by comparing the price of shares and the price of options on those shares, an investor can put a kind of value on the shares. If you want to buy an option on Corning, you need to ask yourself if it is better to buy the $5 call on Corning that’s good until January 2005 at a premium of $145, or the shares at a recent price of $401 per hundred?
And fourth, by thinking about these stocks as options, an investor is more likely to remember that they are among the riskiest assets in any portfolio (and not the least risky simply because they have a low price per share). Remembering the extreme risk in this kind of stock is an important step in keeping any investor’s exposure to the class under control.
New developments on past columnsTax-free dividends have consequences
Maybe the Bush administration’s proposal to eliminate personal income taxes on dividends should be called “The tax accountant employment act of 2003.” The details that have started to emerge on what dividends would be eligible for tax-exempt status show a system of stunning complexity. For example, dividends issued by companies that themselves paid no income tax in a year -- either because the company ran a loss or because it sheltered income -- would be taxed. Dividends from preferred stocks that were structured as hybrids of debt and equity would be taxable if the company was deducting the payouts from its income tax. Merrill Lynch estimates that more than 70% of existing preferred stocks would be taxable under these rules. And the proposal would also create something called a “deemed” dividend. A company that chose to reinvest in its business rather than pay a dividend could declare a deemed dividend that would give an investor a tax break when the shares were sold. In general, not all dividends would be free of taxes and not even all the dividend paid by any single company would get the same tax treatment. I can’t imagine that this complexity is going to encourage investors to buy dividend-bearing stocks to the degree that the Bush administration’s initial calculations indicate.
By Jim Jubak
Quiz time.
What has been the best-performing stock in the Standard & Poor’s 500 index ($INX) since the stock market low on Oct. 9?
Need a hint? I’ll tell you which stocks it wasn’t. Not Xilinx (US:XLNX, news) , the chip maker that scored a technological breakthrough in partnership with IBM (US:IBM, news) . No, Xilinx was up just 75% from Oct. 9, 2002 through the close on Jan. 8, 2003. It wasn’t Yahoo! (US:YHOO, news) , even though that Internet survivor climbed 88% on the strength of growing revenue. It wasn’t retail turnaround story JC Penney (US:JCP, news) , up 62% for the period, or perennial market laggard Eastman Kodak (US:EK, news) , which finally got its act together and rose 53%.
Nope, the correct answer is Dynegy (US
YN, news) . The independent power company rose an astounding 224% from the market low.And if you go looking for runners up to that performance, you’ll start to pull up strikingly familiar names from that same bubble and bust. AES Corp. (US:AES, news) , another independent power producer, was up 206% -- a gain exactly matched by optical fiber and components maker Corning (US:GLW, news) . Ciena (US:CIEN, news) , another former communications equipment star, was up 144%, and PMC-Sierra (US
MCS, news) , a chip maker for that market, climbed 132%.Tiny fractions
Of course, all these stocks have something else in common -- they trade at tiny fractions of their 2000 prices. Dynegy traded near $60 a share in the bubble days of 2000 before crashing to a low of 49 cents a share. Corning’s high was near $113, and its low $1.10. PMC-Sierra peaked near $250 a share and bottomed near $2.70.
So what’s going on? Are these former leaders of the bubble market about to finally lead the current market out of the clutches of the bear? And what should you do as an investor with this group of stocks?
Frankly, it’s the performance of this group of former bubble stocks that makes me most nervous about the stock market’s move off its October lows.
These stocks tell me this market remains range-bound with good trading profits to be made as stocks move between the top and bottom of the range. But they also tell me that the market still doesn’t have the strong leadership it needs to break out of the bear market and start a sustainable move upward.
Look at Corning. When the company announced its latest round of charges -- $800 million to $824 million for the fourth quarter -- it said that it didn’t expect to see a turnaround in the telecommunications segment of its business until late 2004. A report in late October from Lehman Brothers, which noted the company had enough telecommunications goodwill to write off to endanger its bank credit lines, said Corning’s liquidity position was more tenuous than that of Lucent Technologies (US:LU, news) or Nortel Networks (US:NT, news) but that the company was more profitable than either.
Do you see a fundamental turnaround in the company’s business that would justify a 200% increase in stock price? I don’t.
Heavily shorted
Instead, I see a heavily shorted stock that started to look less and less attractive to short-sellers -- those folks who sell borrowed shares of a stock in the belief that’s its price will fall further, so that they can replace those borrowed shares by buying cheaper shares.
You can see how the interaction between short positions and stock price plays out in detail by watching PMC-Sierra. On July 15, 2002, when the stock hit a near-term peak of $10.39 a share, short interest in the stock also soared to 24 million shares. That’s how many shares short-sellers had borrowed and needed to buy to close out their positions. That was up 18% from the previous month. As the price of PMC-Sierra climbed, the potential reward from shorting the stock also climbed.
August and September didn’t see much of a change in short interest in the stock. It rose 1% in August and dropped 1% in September.
But October brought a huge shift. With the stock at just $2.72 a share (at its Oct. 9 low) short-sellers were closing positions and taking profits. Short interest fell to 19 million shares, a drop of 22%). The decline in short interest continued as short-sellers took profits in November -- short interest dropped 7% that month -- and took profits or closed unprofitable positions in December. That month, short interest fell to 15 million shares, a decline of another 15% and a drop of 9 million shares from the July levels.
In other words, the rise in PMC-Sierra’s stock in the rally that began in October had nothing to do with changed fundamentals, and very little to do with a desire to buy the stock on the part of investors. It was largely fueled by profit-taking by investors who thought that at $10.39 the stock was overpriced and offered them more reward than risk and who at $2.72 thought the balance had shifted too far toward risk.
Price channels
This kind of interaction between price and short-sellers can clearly define a price channel for investors interested in trading these swings on market emotion, but the domination of short-term prices by short-term emotion and the lack of fundamental improvement in these stocks makes it very hard to set long-term price targets or to know when to buy and hold.
Many of these companies aren’t expecting real change in their markets until 2004 or 2005. That leaves investors with very few intermediate signs of improvement in a company’s fortunes. Balance-sheet problems that could still derail many of these companies also aren’t likely to be resolved until 2004.
So what is a stock like AES worth? When margins, market share, market growth, revenue growth and earnings growth are guesswork over the next year or two, it’s extremely difficult to value a company on its growth prospects. And when assets are clearly not worth the values listed on the balance sheet, it is difficult to use standard tools to set a price.
Honest valuation
It’s more honest -- and safer for an investor’s portfolio -- to admit this valuation problem from the beginning. Anybody who is not trading these stocks on technical indicators or sentiment, but is instead buying them for a long-term investment, is really buying an option on the company’s long-term prospects and should think of the price of the stock in those terms.
This way of thinking about these stocks is useful even if you know almost nothing about options. It gives an investor a benchmark for figuring out how much to risk on one of these extremely risky stocks.
At the risk of oversimplifying, options give the buyer a right to buy or sell a specific stock at a specific price on a specific date in the future. For our purposes, we’re interested in call options, which give the option holder the right to buy in the future. (“Puts” give the right to sell.)
For example, I can buy a call option on IBM that gives me the right to buy 100 shares of that stock at $85 a share up until the expiration of that option in July. With IBM recently trading at $84.37, the options market thinks there’s a good chance that IBM will trade above $85 before July. So this contract is priced at a premium of $8.60 a share or $860 for a 100-share contract.
Options for the kind of stock that have soared recently sell at much lower premiums -- which tells you something about the market’s read on the stock’s prospects. For example, a contract to buy 100 shares of JDS Uniphase (US:JDSU, news) at $5 up to the option’s expiration in June sells at a premium of just $20 for a 100-share contract. With the stock at $2.91 at the moment, the options market is saying that investors don’t think there’s much value to the right to buy the stock at $5. The only way to make money on this option is for the shares to run above $5 by June.
Options expire, and if they aren’t exercised, they expire worthless. If JDSU never gets above $2.50 as June nears, the owner of the option has lost the $20 paid for the right to buy at $5.
So logically, the longer an option has to run, the more valuable it is and the greater premium it fetches. So while the premium on a contract to buy JDS Uniphase at $5 in June costs just $20, the right to buy the stock at $5 until January 2004 carries a premium of $60, and the right to buy 100 shares at $5 up until January 2005 costs $95.
Think of the current price of $2.96 a share for JDS Uniphase in this context. For that price ($296 for 100 shares), an investor is buying not an option for two years (current premium $95) but an option that never expires. And that has a strike price not of $5 a share but of $2.96.
4 reasons to call these stocks options
Thinking this way about these risky stocks as perpetual options has a couple of advantages. First, it should remind an investor that this is an investment than can go to zero -- just as options can expire worthless. Second, options are a risky asset class -- one that many investors who are ready to seriously think about buying Nortel Networks would never consider. An investor who would never buy an option on Nortel shouldn’t be buying shares of Nortel that are -- in effect -- options on the stock.
Third, by comparing the price of shares and the price of options on those shares, an investor can put a kind of value on the shares. If you want to buy an option on Corning, you need to ask yourself if it is better to buy the $5 call on Corning that’s good until January 2005 at a premium of $145, or the shares at a recent price of $401 per hundred?
And fourth, by thinking about these stocks as options, an investor is more likely to remember that they are among the riskiest assets in any portfolio (and not the least risky simply because they have a low price per share). Remembering the extreme risk in this kind of stock is an important step in keeping any investor’s exposure to the class under control.
New developments on past columnsTax-free dividends have consequences
Maybe the Bush administration’s proposal to eliminate personal income taxes on dividends should be called “The tax accountant employment act of 2003.” The details that have started to emerge on what dividends would be eligible for tax-exempt status show a system of stunning complexity. For example, dividends issued by companies that themselves paid no income tax in a year -- either because the company ran a loss or because it sheltered income -- would be taxed. Dividends from preferred stocks that were structured as hybrids of debt and equity would be taxable if the company was deducting the payouts from its income tax. Merrill Lynch estimates that more than 70% of existing preferred stocks would be taxable under these rules. And the proposal would also create something called a “deemed” dividend. A company that chose to reinvest in its business rather than pay a dividend could declare a deemed dividend that would give an investor a tax break when the shares were sold. In general, not all dividends would be free of taxes and not even all the dividend paid by any single company would get the same tax treatment. I can’t imagine that this complexity is going to encourage investors to buy dividend-bearing stocks to the degree that the Bush administration’s initial calculations indicate.
