December 2007 Archives
It turns out that Apple, Inc.'s stock (ticker: AAPL) was a stellar performer in 2007. It also performed really well in 2006:
Perhaps surprisingly, the purpose of this entry isn't to pump AAPL. Instead I'm going to explain how buying and selling stocks in increments is one of the most powerful money-making (and money-preserving) tools you can utilize as a stock investor.
Increments? I want BIG gains!
What do I mean by "buying and selling stocks in increments?" Have a seat on my hypothetical stock sofa. Ask yourself, "What is my stock investing dream?" If you're like me, it involves something along the lines of: buy 1,000,000 shares low and sell 1,000,000 shares high. I'm a king! Hooray... hooray... feed me grapes, dammit ... HOORAY! er... ah hem.
Let me clarify; that used to be something like my stock dream.
Reality kicked in and I learned the hard way that I'm not very good at predicting what will happen to a stock price tomorrow or next week or even a month from now. Ultimately I figured out that when I do thorough homework on a company/stock, my odds of making profit over the long term are a lot better. Over the short term, forget about it.
Given that tomorrow my favorite stock could trade at a discount compared to how it's trading today, why not snap up that bargain tomorrow? Then again, it could sky-rocket on a buy-out rumor, too. Face it: without [probably illegal] insider trading information, you never really know what's going to happen to a stock price in the future.
Accept it, learn it, live it. Come up with trading strategies that embrace this philosophy. Don't worry; I'm not going Plato on you, but check out the following scenarios that illustrate the advantages of buying in increments. Small pieces... not big chunks.
Let's assume you have $300k to "play" with (ha!).
Example 1: The quickly skyrocketing stock
Suppose you buy 1,000 shares of a stock that's trading for $85 / share. Within a few weeks the stock is trading around $98 / share. Sweet!You sell all and catch a net gain of $13k or 15%. Yeah, you could have bought 3,500 shares and made a bunch more money... but you just made $13k in a few weeks! If you're sad about making $13k in a few weeks, you may have other problems.
Example 2: The tanking stock
Suppose you buy 4,000 shares of a stock that's trading for $75 / share. You're sure that conditions haven't changed, but the stock drops immediately after your purchase. The next month it hits $60 / share. The next month it hits $50 / share.Ouch. Now you're down $100k or 33%. If only you had the power to see the future and had waited those two months... or realistically, what if you had purchased 1,000 shares at $75 / share. You'd still be down 33%, but that 33% would translate into a loss of a more manageable $25k instead $100k. I don't know about you, but if I absolutely had to choose between losing $25k or $100k then first I'd click my heels together three times and then I'd pick the $25k loss.
Example 3: The tanking stock that recovers
You buy another 1,250 shares at $60 / share; same total cost of $75k, but this time you get more shares. Good deal! You've spent $150k so far and have another $150k in cash.
A month passes and the "impossible" happens: your stock sinks to $50 / share. You're nervous, angry, and you've begun to consume your daily share of Top-Ramen noodles... but you're confident that your research and evaluation of economic conditions are spot on. This time $75k buys you 1,500 shares. You somehow remain calm. You're left with $75k in cash and you've spent $225k purchasing stock.
Incredibly positive news comes out and within a month your stock shoots back up toward $75/share. Nice! If you had invested all your $300k @ $75 / share initially, you'd be breaking even and back to $300k.
Since instead you invested wisely and broke your purchase into three increments, your 3,750 shares are now worth $281k for a 25% gain. Add that to your $75k cash and your portfolio has grown from $300k to $356k ($281k stock + $75k cash). Again, you could have broken even but instead you're up $50k+. Winner!
Conclusion
As you can see, buying in increments has its definite advantages while the disadvantages are few. Yeah, yeah ... in Example 1 you could have made more money, but let's not be greedy. Profit is profit is profit.
In a future entry I'll go through some examples to illustrate how selling in increments can also be very advantageous. Sure, there are some situations where experts advise dumping all (for example when there's an abrupt executive management change), but even in those cases you never know beforehand if it's the most profitable thing to do.
In general if you sell in increments you can lock in gains while also giving your stock the chance to climb higher (while also shielding yourself from potentially more severe losses). Craziness, a free lunch, the best of both worlds, and so on. Woohoo!
If you can tell the future, disregard everything I've written in this entry today. If you're like me and can't tell the future (go Packers!), consider buying stock in increments instead of in one big chunk (this process is also known as dollar cost averaging). You just might thank yourself later.
Oh, by the way... all the above three examples track AAPL stock movement over some period in the last two years. Check it out:
Full disclosure: I do not have any position, long or short, in AAPL at the time of writing.
What are options, anyway? A stock option represents the right, but not the obligation, to buy or sell stock at a specified price by a certain date. In other words, with stock options you can choose to buy or sell stock at a given strike price, but you don't have to.
Individual companies grant stock options
I first became aware of stock options during the Internet Boom of the late 1990s / early 2000s. I would read in the news that Wealthy McCEO and many other company executives were getting crazy rich thanks to stock options. Companies can grant stock options to employees, which often encourages employees to stick with the company for an extended period of time.
How employee stock option plans benefit the company and the employee
How would stock options entice an employee to stay at a company? Here’s an example. Suppose Company XYZ is a public company and XYZ stock trades for $10/share. Upon hiring a top-level manager (let's call the manager by Smarty Pants), XYZ might grant Smarty Pants the option to buy 10,000 shares of XYZ @ $10/share.
With shares of XYZ trading for $10/share, Smarty Pants probably wouldn't want to do anything with those options. Why bother, since she could buy shares for the same price on the open market? Typically companies don't allow the option holder to exercise the option (i.e., perform the purchase prescribed by the option contract) right away, anyways.
Companies control when the employee stock options become vested (i.e., eligible for exercise). XYZ might tell Smarty Pants that her options become 50% vested after two years and 100% vested after four years. This would mean that after being with the company for two years, Smarty Pants could exercise the option to buy 5k of those 10k shares @ $10/share. After four years she could exercise the option to buy the remaining 5k shares, still @ $10/share.
Suppose a year passes and XYZ stock becomes an increasingly attractive investment. Shares of XYZ now trade at $20/share. Ho, ho, ho - Santa Claus just came to town. Just for sticking with the company, Smarty Pants could -- in a single transaction -- realize a gain of $10/share. But wait… her options aren’t vested yet. They become 50% vested two years (not one year) after the initial grant. Bummer. Now she’ll have to stick around for another year to realize that potentially saucy gain.
Suppose yet another year passes, and XYZ now trades for $25/share. Hot dog! Smarty Pants can buy 5k shares @ $10/share only to turn around and sell them on the open market for $25/share. Putting this transaction into the numbers:
Purchase price = $10/share * 5,000 shares = $50,000
Sale price = $25/share * 5,000 shares = $125,000
Net gain = Sale price - purchase price = $125,000 - $50,000 = $75,000
Smarty Pants was rewarded for sticking with the company as the company's stock performed well. During that time period, Smarty Pants also had incentive to help the company perform well. If she were to help the company to perform better, in theory XYZ stock might trade at a higher price per share and she could end up with more dough for herself.
Employees won’t always make a profit on stock options
Of course, if investors had viewed XYZ stock as a decreasingly attractive investment then the share price might have dropped over that two-year initial vesting period. If the stock performed so poorly then Smarty Pants’ options might have expired before she got a chance to exercise them in a profitable transaction.
What do I mean by expire? Just as companies control stock options vesting periods, companies also control when that contract expires. Like I mentioned above, stock options represent the right -- but not the obligation -- to purchase shares by a certain date. If XYZ stock traded at no higher than $8/share between the time the options were vested and when they expired, then there would be no reason for Smarty Pants to exercise the options. If she were to go through with it, she’d lose $2/share on the transaction (since her option was to purchase shares at $10/share, whereas the market was paying up to $8/share). That sounds like a bogus deal because it is a bogus deal.
Impact of employee stock option plans on share price
Although employee stock option plans can be good for the company and good for the employee, investors should be aware of a company’s stock option granting practices. These practices can add downward pressure to a company’s share price. Thinking in terms of supply and demand, when an employee buys shares through a stock option plan then more shares all of a sudden become available for trading (and therefore supply increases). More supply means more pieces to the same size pie, so each piece has to be a little smaller. Following an employee stock option exercise, each outstanding share is worth some fraction less than it was before.
Companies can offset the dilutive effects of option exercises by buying back shares on the open market. If a company buys back more shares than are issued into the trading pool, the number of outstanding shares decreases and so each share -- in theory -- becomes worth a little more. Something to consider!
Insider activity
When employees of a public company buy or sell shares of that company, that’s commonly referred to as insider activity. Insider activity is completely normal, and you can investigate insider transactions yourself. This information is available online, and one site I visit to obtain information on insider transactions is Yahoo!’s insider activity area like this one. On that page we can see that on 25 October 2007, a Yahoo! Directory named Terry Semel exercised options to net more than $8 million in a single swoop. Not too shabby.
Some people take into account insider activity when constructing opinions on a company or a company’s share price. People buy and sell shares all day, but presumably directors know more about the company than the average investor does. If a director buys shares on the open market, that’s often interpreted that the director has faith in the company.
When an insider dumps a lot of shares, some believe that demonstrates lack of faith in the company. While that may end up being the case sometimes, remember that insiders are individual people. Insiders have their own financial wellbeing to consider, and sound principles like diversification apply to them, too. Just because an insider sells shares or exercises options, that doesn’t necessarily imply upcoming problems. Some insiders participate in stock option exercise plans that force regular, periodic exercising of options and selling of shares at predetermined time intervals. This allows insiders to sell stock in a way that some consider less predictive.
Insider activity is interesting to look at, but it doesn’t necessarily imply anything. It can be a useful piece of information when evaluating a stock, but I strongly would advise against using it as the sole indicator of whether to buy or sell shares.
Summary
Stock options can be good for the company, good for the employee, and good for the investor (for example, if the company ultimately spends less on hiring since their employees stick around). Stock options can also be a negative for a stock, so be aware of what's going on and you'll have a more informed and complete view of a company and that company's valuation.
Long story short, I hope you and I get rich off of stock options ... Cha-ching!
- The price of oil escalated to nearly $100/barrel
- The US dollar reached an all time low vs. the Euro
- Major financial institutions announced write-down after write-down, due to losses from mortgage-backed securities
- The media spread stories on the "credit crunch" and the "housing slowdown"
Today the S&P 500 reached a high of just over 1508. What's different between now and then and why did we see a 100 point recovery in the S&P 500 from 26 Nov to 6 Dec? The recovery might have to do with the following:
- Oil is trading for less than $90/barrel, with perhaps more downside since I figure some of the price increase was directly related to perceived risk of an American invasion of Iran (said risk has decreased after the much-discussed National Intelligence Estimate [NIE] was released earlier in the week)
- The dollar has recovered somewhat vs. the Euro
- The value of the write-downs may have been priced into the shares of financial institutions during the "correction"
- The media has been spreading word of a 25-50 basis-point rate cut at the upcoming Fed meeting on 11 December 2007
- President Bush outlined a plan to reduce the number of potential foreclosures by freezing some interest rates for certain mortgage holders
Let's talk about the interest rate freeze for a moment. What short-term effects will that produce?
- Fewer people will lose their homes to foreclosure, but some are still out of luck. These folks may have to negotiate to refinance at [ideally] lower rates*.
- More home-owners will feel better about their financial situations.
Also, since the holiday season often produces a large proportion of annual sales for retailers, it's logical to assume that if people feel better about their home situations, they're more likely to spend more $ during this holiday season. The macro-conditions listed above may have led to reduced expectations for retailers, and so if people spend more money than was anticipated, Bush's announcement may precede slightly higher-than-expected sales for retailers. It might be a good time to look into buying some of your favorite retailer...
All in all, to me it seems economic conditions look much better than they did a couple of weeks ago. Although the plan to freeze some mortgage interest rates may delay but not solve the mortgage "problem," perhaps a recession is farther away than many have predicted. Whether a recession is around the corner or far off in the distance, people are buying stocks and life's looking good for bulls.
I don't know about you, but I'm ready to dig my heels in and make $ome money. I hope you do the same. Good luck!
