37 lines
2.6 KiB
Plaintext
37 lines
2.6 KiB
Plaintext
Gaining Exposure • 197
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sauce to make the main course more interesting and flavorful. Y ou can
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layer ITM options onto the stock to increase leverage to a level with which
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you feel comfortable. This does not have to be Buffett’s 1.8:1 leverage of
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course. Levering more lightly will provide less of a kick when a company
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performs according to your best-case scenario, but also carries less risk
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of a severe loss if the company’s performance is mediocre or worse. OTM
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option positions (and “long diagonals” to be discussed in Chapter 11) can
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be thought of as a spicy side dish to the main meal. They can be added
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opportunistically (when and if the firm in which you are investing has a
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bad quarter and its stock price drops for temporary reasons involving sen-
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timent rather than substance) for extra flavor. OTM options can also be
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used as a snack to be nibbled on between proper meals. Snack, in this case,
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means a smaller sized position in firms that have a small but real upside
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potential but a greater chance that it is fairly valued as is, or in a company
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in which you don’t have the conviction in its ability to create much value
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for you, the owner.
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Another consideration regarding the appropriate level of investment
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leverage one should apply to a given position is how much operational
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and financial leverage (both are discussed in detail in Appendix B) a firm
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has. A firm that is highly levered will have a much wider valuation range
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and will be much more likely to be affected by macroeconomic considera-
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tions that are out of the control of the management team and inscrutable
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to the investor. In these cases, I think the best response is to adjust one’s
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investment leverage according to the principles of “margin of safety” and
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contrarianism.
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By creating a valuation range, rather than thinking only of a single point-
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estimate for the value of the firm, we have unwittingly allowed ourselves to
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become very skillful at picking appropriate margins of safety. For example, I
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recently looked at the value of a company whose stock was trading for around
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$16 per share. The company had very high operational and financial lever-
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age, so my valuation range was also very large—from around $6 per share
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worst case to around $37 per share best case with a most likely value of around
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$25 per share. The margin of safety is 36 percent (= ($25 − $16)/ $25).
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While some might think this is a reasonable margin of safety to take a bold,
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concentrated position, I elected instead to take a small, unlevered one because
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to me, the $9 margin of safety for this stock is still not wide enough. The best |