Welcome to part 4 of Investing In Video Games. In parts 1 through 3, we covered the 5 basic investment rules, a few pointers on portfolio management, how to select a discount broker for trading, and some basic strategies for valuating stocks. We did not cover the section on options because the subject is somewhat complex. There are many professionals working in the financial industry that still do not understand option contracts, so do not feel discouraged if the concepts do not sink in right away after reading this article. That said, to succeed at making a lot of money, it is important to learn how to use the tools available, and options are a useful tool. Learning how to use them effectively (not just for gambling), will result in significantly more successful long term performance. Since this particular lesson is more complex than others, we will keep this article 'on point' to give the reader time to digest the information.
Lets recall the "Investment Valuation Rules" from last article:
Investment Valuation Rules
- Invest as though you are buying the business.
- Income and Income Growth are the most important measures to consider.
- Money in your pocket is the ultimate hedge against incompetence and market volatility (aka crashes). Dividends are your best friend.
- Do not use DRIP (automatic Dividend Re-Investment Plans). Let the money accumulate and deploy it yourself.
- Stock buybacks can be better than dividends... sometimes.
- Options are your 2nd best friend.
- Most of the time, a lot of debt sucks but a little bit of debt is good.
- Big companies are usually safer than small companies.
- Hard assets are better than imaginary assets (aka "intangible assets").
Options are your 2nd best friend. Once again, options are a powerful, albeit complex, tools. Do not feel down if you don't get it right away and remember that even business grads and professionals run away from the subject due to lack of understanding. My goal is to make it easy so her we go; An Option is a contract that allows the holder of the contract to buy or sell exactly 100 shares of a stock, at an agreed upon price, at a later time for a fee paid to the writer of the option. Okay that is a long compound sentence, and it sound complex, but it really is not. Here is an example; you can buy an option contract that gives you the right to buy 100 shares of Microsoft, 3 months from today, at the current stock price, for a fee (aka premium) to the issuer of the option who is taking the risk of writing the option and selling it to you. Not too bad right? But you might be asking yourself, why would anyone want to do that instead of just buying the stock outright? Wouldn't that be much simpler? Yes it would be simpler, however this is not the most common usage of options.
Options are normally used for risk mitigation and income generation, not just gambling for huge gains based on a whim. The 1st thing you need to understand is that options usually cost a lot less than the stock they represent. Think about it for a second. If a stock is selling at $10 and an option allows you to buy the stock at $10, then the option itself cannot be $10 else you will be paying $10 for the option plus another $10 for the stock later for a total of $20... obviously that is not how options are priced else no one would ever buy an option. Rather, they are priced based on the difference between the agreed upon price and the current stock price plus the premium the options writer demands for the risk they are taking (also based on market demand). Thus in our example, since the stock is $10 and option allows you buy the stock for $10, there is no difference between the two so the value of the option is $0 but since the writer is taking a risk, they will want some sort of payment for that risk and they might charge you a $0.50 premium per stock for the risk they are undertaking. Remember, that each option represents the right to buy 100 stocks so the $0.50 premium is applied to 100 shares and the total cost of the option is actually $0.50 x 100 or $50 per options contract. As you can see, the option contract will cost you $50 for 100 shares whereas if you bought the shares outright from the market they would have cost you $10 x 100 = $1,000. That is a huge difference, however there is an obvious risk here. What happens if the price of the stock goes down to $9 the day your option expires?
Clearly, if you hold an option and the price of the underlying stock goes up, then you will make a lot of money because the option lets you buy the shares at a lower price. But if the stock falls, then you will not want to use the option since it is cheaper for you to buy it from the open market, and your option will expire worthless and you will lose the $50 premium you paid. Now, lets take a second to pause and consider the examples. What you should have noticed is that there is a huge risk involved with options because no one can tell what the exact price of a stock will be at any point in the future however your option always loses value over time due to the premium you paid for it. You should have realized that owning the stock is almost always better than owning the option because there is no premium to owning the stock. Here is another example, lets imagine that the price of the stock remains steady at $10 through expiration of your option. So in the case, the option is breaking even but since you paid a premium for the option, you still lost money whereas if you had just purchased the stock from the start, you actually would have broken even and lost nothing. This is why options are very dangerous and should not be used to gamble on price valuations. Again, we are not here to gamble, we are here to invest wisely. How do we use options in a wise manner? The answer is as insurance policies.
For our purposes, we will only need 1 type of option, and that is the "Put" option and we will be using this option as an insurance policy for our investments. The example used above was in the form of a "Call" option and there are many combinations of strategies that can be used with both "Put" and "Call" options but we will only look at "Puts" today. A "Put" option is an excellent protective contract. Unlike the "Call" option, it lets you SELL a stock at a agreed upon price at a later date. This sounds funny but it makes perfect sense if, for example, you already own the stock to begin with and you own the option at the same time. In such case, you will have the right to sell your stocks at a later date at the price you want, thanks to the "Put" option. This is basically how insurance works and that is precisely how we want to use options. Basically, you want to buy these "Put" options whenever you think your investments are in jeopardy, like when the S&P 500 hits a P/E of 25 or up, or if you know something bad is going to happen to your stock or its associated sector. If you own these options, you are fully covered for losses even if your stock moves down because you have the right to sell your stocks at a higher price. This is one of the hedges I used to plowed through the last market crash with huge gains while everyone else was running around like headless chickens.
So now that you have a primer on options, its important to note that buying "Puts" will cost you money just as buying insurance for your car costs you money. It really is up to you how much insurance to buy based on what you are willing to spend and how much you want to protect. There are many "put" options out there for most highly traded stocks, and this is where a lot of people start to get confused. The different options have differing expiration dates, and differing "strike" prices (the agreed upon selling price), and that is why you have to so many to chose from. The "strike" price is what determines your insurance coverage and it is the price you will be able to sell the stock for at or before expiration. Once again, the price of the option will change based on the difference between the current value of the stock and the agreed upon contract "strike" price. Here is what this means to you; if a stock is worth $100 and you had a choice between two put options, one that covers $90 and one that covers $100, which one will cost more? Obviously, the one with more coverage will cost more and you will have to pay more for it. In fact, the $90 "Put" option will probably be significantly cheaper since it is unusual for a stock to drop 10% within a short period of time. Remember most stocks, especially blue chips, go up over time and not down thus options that are far "out of money," or have a large gap between current stock price and the "strike" price, are much cheaper than ones that are closer to the current stock price.
As a side note, when you look at options you might notice that you can buy options that let you sell your stock for more than what it is currently worth. For instance, you might see a "Put" with a strike price of $110, which is $10 more than what our imaginary stock is currently worth. In this case, the price of the option will obviously climb by at least $10 to make up the difference between the current price and the strike price. You probably will never want to buy an option that is far above the current market value of the stock but sometimes your stock might be trading at fractions of a dollar so you may have no choice but to go up or down to the nearest rounded dollar value for options, since they usually trade in one dollar increments. Along with the price differences between stock price and contract "strike" price, options also offer differing duration's. Some are only good for a few weeks while others don't expire for a year or more (long term options are sometimes refereed to as "leaps"). So again, you will need to decide how much you want to protect and for how long and that will determine the price (premium) you have to pay for the "Put" option (insurance policy).
All this sounds like a lot of work, but it really is not so bad because once you hold an option, it usually does not need any management on your part, and that is because most brokers assign options automatically if they are "in the money." That means that if you own an option, and the option is profitable at the time of expiration, your broker will automatically assign (or execute) it to insure that you make your profit. They do this because they get a commission from the transaction, so it is in their best interest to assign "in the money" options automatically. This is good for the investor because it means they don't have to sit there and manually execute options at the expiration date. This seems to be the convention with every broker I have ever used but you will want to make sure of this when you start playing with options. Just call up your broker and they will be able to tell you very quickly if they auto-execute options on your behalf.
Also, and this is important, as the holder of an option contract, you actually have the right to use the contract any time before it expires! You do not need to wait until the expiration day to exercise a contract. During the 2008 crash I exercised contracts early to take the cash out immediately and use it to buy something else. Also, options are 100% transferable. In other words, instead of exercising an option, you could just outright sell it and keep your stocks, while making a profit on the option. I did this a lot in March 2009. Remember, a "Put" option gains value if the price of stock goes DOWN because they allow you to sell a stock at a higher price. It follows that if you have an option that is $10 "in the money" (lets you sell the stock for $10 more than its current value), that the option will be worth a lot and people will pay you at least its face value plus a premium if you sell it before expiration. You could also purchase extra new stocks and exercise the option at the same time to avoid selling your old stocks (you might need to do this if there are not a lot of buyers for your options). In other words, you have full control. If you don't want to sell your stock because of tax consideration you could just sell the option instead and keep the stock.
And that my friends is how you hedge with options. Remember this lesson if you notice that the markets are getting a bit overpriced. Many times, it is better to use options rather than sell your stock because selling your stock outright might result in huge capital gains taxes. You would also be taking the risk of being wrong about the market. What if, after you sell, the markets go up instead? You will have lost a lot of money. With options, you only risk the premium you pay upfront which is usually manageable. If the markets go down, then you can sell your options and you will have lost little to nothing overall. You can then take the cash you made from the options and use it to buy stocks on the cheap during a down market. Bottom line, options are wonderful tools.
- Each option represents 100 shares of a stock.
- When you see the options price, you must multiply it by 100 to get the total cost of the contract.
- Puts are like an insurance policy and give you the right to sell your stock at a later date, for the "strike" price.
- Calls allow you to buy a stock at a later date, for the "strike" price.
That's enough for today. Part 5 will be very important because I will discuss the free websites available to you for researching investments of all sorts:
- Part 1: Basic Investing Rules
- Part 2: How to Select a Broker Account
- Part 3: How to Determine Investment Value and Dividends
- Part 4: Hedging with Options
- Part 5: Best Websites for Researching Investments
- Part 6: Risks Associated With Video Game Stocks
- Part 7: tbd
Lets look at another game (related) company.
The Walt Disney Company
GTan Rating: 2/5 (avoid)
Morningstar Rating: 3 star (out of 5)
S&P Capital IQ Rating: 4 star (out of 5)
Reuters Rating: Positive
Smart Consensus Rating: Buy
Share Price: $89.55
Valuation: $155.45 billion
Cash on hand: $4.09 billion
Debt: $16.14 billion
Yearly Revenue: $48 billion
Yearly Net Profit: $7.4 billion
Earning Per Share: $4.17
Dividend Yield: 0.96%
3 Year Performance: Very Fast Growth (15.7% per year)
5 Year Performance: Fast Growth (6.75% per year)
10 Year Performance: Very Fast Growth (17.09% per year)
Earning Consistency: Very Reliability
Risk Level: Very Low
Total Executive Compensation (2012): $68.9m (1.12% of company profit)
Total Executive Compensation (2013): $59.4m (0.79% of company profit)
Disney needs no introduction. This company is currently the most valuable content creator and entertainment business in the world (I consider Facebook a marketing company). They are bigger than any casino company, bigger than Comcast, bigger than Pepsi, and bigger than EA, Activision, Take Two, Nintendo, Sony, Capcom, Square, Konomi, and Ubisoft COMBINED TIMES TWO. Yes, they are huge and their income comes from a diverse portfolio of products and services from theme parks, and toys, to movies, and video games. On top of that, they are worldwide thus their income comes from almost every nook and cranny of the populated world. This diversification makes them very stable financially and their net income growth has been nothing short of astounding the last 10 years. Their revenue growth has been more tame sitting at about 5.2% the last 10 years but they managed to squeeze more profit out of it over the last 7 years by improving their profit margins. There is a lot to like about Disney but like with all investments, one has to beware of valuation.
The 1st thing to note is their P/E which is unusually high for such a big company and higher than its 10 year average of about 18. This is mainly due to their huge recent successes at the box office which have led to increased toy and video game sales as well as more frequent park visits. The big question however is whether or not they can sustain the eye popping earnings growth while revenue climbs at a slower pace. In my opinion, this is unlikely because there has to be a breaking point at some time where margins cannot increase any farther without equivalent expenditure. This means that they must also increase the top line (revenue) to keep the growth going forward. Since their growth success is tied directly to their movies and associated products, we can extrapolate the near future by simply looking at what is coming out. Here are some notable mentions (big films) through December of 2015 (forgive me if I don't list some of your potential favorites):
- Big Hero 6
- Into the Woods (live action)
- McFarland, USA (live action)
- Cinderella (live action)
- Tomorrowland (live action)
- The Jungle Book (live action)
- The Good Dinosaur
- Star Wars Episode VII (December)
There are some big names up there and it would not surprise me if Disney were able to maintain their current growth through next year and early 2016 based on that list of movies. Several of the films are 'question marks' until released especially new intellectual properties (IP's) such as Big Hero 6, McFarland USA, and The Good Dinosaur however these movies have notably famous actors and the rest of the movies come from previously popular works, and are likely to do well even if the movies are not great. Overall, I think their current P/E is probably sustainable through next year however if you peak at their 2016 lineup you might get a little worried. There is not much announced for 2016 at this point however several of the films have not been revealed. By that time, their P/E, based on current valuation, will probably be down to around 19 but that is still higher than their historic average. If they maintain their current earnings growth and increase revenue at about 5%-6%, through 2015 and into 2016, it is reasonable to assume that they could maintain their current valuation level. That means that their stock price will probably climb to around $95 by next year and well over $100 into 2016... however maintaining the current blistering pace will not be easy given how many hits they had the last few years... Will the new movies match the performance of blockbusters like Frozen, Wreck it Ralph, all those Marvel movies, and Maleficent? That is a tall order indeed and if they cannot match that growth, their valuation will likely take a hit.
Here is one possible bad case scenario (not worst case); if 2015/2016 proves to be weaker than the last 2 years, it would not be surprising to see their valuation drop to the historic average of about 18 (or below) which means that their price might actually drop from its current price to about $85. If the market turn negative all around, then I can see them drop to a mid valuation of 15 P/E which would put them at about $75 (note that this is still not the worst case scenario based on historic P/E). This is not devastating, and Disney will most likely climb in the following two years as earnings climb, but it would be a waste of 2 years. Historically, Disney is not infallible. They have a long history of growth however they also have some periods of straight line stagnation due to spikes of over valuation. For instance, from the peak of 1998 to 2011, their stock was flat and made almost no gains at all. Further, their dividend * share buybacks are somewhat small (too low for me) and so investors, during that period, did not do well at all. Its important to not fall into a similar trap given Disney's current run up.
Next, I noticed that they have a lot of debt compared to cash on hand. This is usually a bad thing however in the case of Disney, you will note that the they make about $7b a year in income which means that they can cover that debt in less than two years, if all things just stay the same (without any growth at all). Sure, there is always the risk of the sky falling, but for the most part, their $16b debt seems to be well within their wheelhouse, so it is not that big of a worry for me.
Lastly and possibly most importantly, share buyback have been on the low side the last 10 years averaging about 1.5% per year while dividends are almost negligible. Combined, they average about 2.5% per year, which is much lower than I like. I generally do not invest in anything that does not give me at least 5% per year in combined dividend yield and stock buyback action. Thus this disqualifies Disney from my investment portfolio outright.
In my opinion, the risks are too high at the current price level. I would rather hold a secure 3% and growing dividend stock with minimal share buybacks, than Disney based on historic performance and future prospects. Remember, one of our primary rules to investing is that money in our pocket is the best hedge against incompetence, and market volatility. Unfortunately, Disney stock does not offer investors a lot of protection on those terms. Disney may still outperform and go beyond my expectations however it will be harder to do that going forward than it was in the past when expectations were much lower. I would avoid Disney stock at this time.
- Very low dividend and share buybacks for a blue chip stock.
- Running above historic average valuation with P/E of 21.48 (average is 18 the last 10 years).
- Extremely high expectations going forward.
+ Net earnings are growing at an unbelievable rate for a big company (despite average revenue growth).
+ Great diversity in products and locations.
+ Strongest portfolio of IP's of any company on the planet.
Disclaimer: I do not hold any DIS stock.
Thank you for reading part 4. See you in article #5.