Thursday, March 26, 2009

Green Mountain Coffee Roasters, Inc. (GMCR)

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Peter Lynch deserves a lot of credit for getting people interested in investing. Whether or not he intended to do so, he convinced many people to buy stocks in companies whose goods and/or services they knew and liked. However, indiscriminately buying stocks in companies whose goods and services you like isn't necessarily a good approach to investment management. Just ask anyone who ever bought stock in Boston Chicken or Crocs.

Green Mountain has enjoyed incredible growth in revenue and income over the past several years. From 2006 to 2008, their revenue more than doubled. The Keurig machine is a huge hit and everyone loves their K-cups. I have one. I love it.

But that doesn't mean the stock is a good buy, at least not at these levels. As impressive as their growth to date has been, the market for high-end coffee machines and supplies is saturated. And at 35x earnings and 32x net tangible assets, the stock is richly priced. The stock may continue to move higher, but I expect it to underperform relative to the S&P. I'm initiating a small, short position this morning and will add to that short position if the stock trades over $52 in the coming weeks.

This is a crowded trade. The short interest in the stock is extremely high (over 40%). As such, it's subject to manipulation. If you can hold your short position through any price spikes, you should do well as the enthusiasm for Keurig products levels off.

Tuesday, March 24, 2009

Dialing Down Leverage After a Rally

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Market events of the past three weeks underscore the incredible gains that can be enjoyed with just a dab of leverage. If you were long the S&P at 700, your portfolio would be up at least 14% now. However, if you had increased your exposure to 1.5x the S&P, you'd be up over 20% for that same period.

I remain convinced that a long-term recovery is in progress. And yet, it's times like these where you dial back your leverage after a rally. If you swapped some index shares to buy the $25 LEAP calls I mentioned in my last blog (symbol: OBMLE), you might want to consider swapping them back. You don't have to go from 1.5x leverage back to 1.0x (unleveraged, but still long), but you might want to at least consider going to 1.2x the index or less.

Stock market recoveries almost never occur in a straight line. You might not get another opportunity to buy at 700 again, but 100 to 120% long the S&P is still a good place to be to enjoy future gains.

Thursday, March 5, 2009

Should you use leverage?

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"Leveraging" is nothing more than the act of structuring a portfolio to move faster than some underlying benchmark. You can achieve that effect in multiple ways... by buying on margin, using derivatives like call options, or holding futures contracts. All of these strategies entail a different, and greater, level of risk that merely buying and holding an index product. Be certain you understand those risks before you engage in this kind of behavior.

If anything, the events of the past six months may serve as a lesson for why you should not use leverage. Leverage is a wonderful thing when markets move in the direction you anticipate. Leverage magnifies gains. But when the market moves against you? It's a real bitch. Leverage magnifies losses. As painful as a 50% drop from the market highs of 2007 has been, if you were just holding onto an index fund, you're still in the game and your portfolio should recover over time. Plenty of people who were leveraged over the past year and a half are now wiped out.

Now that you've been warned of the potentially devastating effects of a leveraged portfolio, you need to consider the benefits of taking on some leverage now. One attractive alternative at your disposal is the LEAP call option and the prices for these products right now are very intriguing. A call option is a financial product that gives you the right, but not the obligation, to buy the underlying asset at a certain price [the "strike price"] on or before a certain date [the "expiration date"]. "LEAP" ["Long-term Equity AnticiPation"] merely designates an option with a longer duration. The vast majority of options trading is done in contracts that expire within a few weeks or months. When LEAP's are originally listed, their expirations are typically several years into the future.

I think current market conditions justify a look at the December 2011 LEAP calls on the S&P 500 Depository Receipts [root symbol: "SPY"]. Someone who is currently long SPY could moderately leverage their position with the right SPY LEAP calls. Yesterday, with SPY closing at 71.73, the $25 LEAP calls on SPY for December 2011 [symbol: "OBMLE"] could be had for around $47. An investor who swaps his "SPY" dollar-for-dollar into an "OBMLE" position would end up with a leveraged position of around 1.5. A $1 move in the old "SPY" position would result in a $1.50 move in the new "OBMLE" position. Using the December 2011 contracts affords you over 2 1/2 years to catch a recovery in the markets.

You must have a stomach for risk if you're going to try this. If the S&P (currently around 700) is at or below 250 in December 2011, you will be wiped out. If the S&P is significantly below 700 in December 2011, you will endure severe losses. Your portfolio will be even more volatile if you're holding LEAP call options instead of a plain old index fund. However, if, as I suspect, we enjoy a modest recovery over the next two years, this leveraged position will reward you well for the risk you've undertaken.

Wednesday, March 4, 2009

Portfolio Management Tasks

I've closed out a portion (less than a third) of my short position in US Treasury futures. There is still plenty of downside on the 30-Year, but the sell off in the S&P has become too tempting. I'm adding more to my S&P positions. Two years from now, people will look back at the first week of March as having been an excellent buying opportunity for stock.

Unfortunately, with the S&P under 710, most will probably fail to take advantage of it.