Joe Ackerman, a Ph. D candidate at the University of Manitoba, sees gold in the unlikeliest of places.
Studying biosystems engineering, Ackerman is working on a way to extract phosphorus from hog manure. It could be a profitable venture, as demand for fertilizer worldwide is high. But he also has found profit recently in the volatile stock market, making wagers, albeit educated ones, on companies that most of us would turn up our noses at and say "no way."
With the help of his father, Jerry Ackerman, an outspoken, off-beat former U of M finance professor, Joe focused on U.S. companies, making advanced investment purchases -- put options and short-sales -- he made through his online investment account with a Canadian financial institution.
"In November, we looked at how much debt they had," he says, adding they honed in on U.S. banks overextended in the collapsing subprime housing market. "We looked at total debt per dollar invested. If you could put a dollar into this industry, how much debt would you be getting back? The numbers we came out with were staggeringly high."
Together, they ranked 20 banks and financial institutions on the basis of their equity-to-debt ratios.
"In a down market, you focus on the unmanageable debt, the phony accounting, the overpaid executives ("pirates in the till") and the lack of exit options -- a very different scenario (from an up market)," his father states in an e-mail.
After a lot of research, Joe decided to put his knowledge to the test. He bought a put option on Bear Stearns. This meant he paid about 10 per cent premium on its stock, which was at $90 a share in January. It gave him the right to sell the stock at $90 over a period of time -- one year, for instance. If the stock goes up during that time, the option is worthless and he loses the money invested in the premium. If it goes down, though, the option becomes worth whatever the difference in value is between $90 and the actual price -- say $75.
So, if you were to sell the option for 100 shares at $90, your profit would be about $1,500 less brokerage fees.
To make a long story short, Joe sold Bear Stearns at his strike price of $75, only to see its stock fall to below $10 two weeks later. JP Morgan Chase, another big investment bank, and other investors eventually bought all of Bear Stearns stock for $10, after originally offering two dollars a share.
"I had the right position at the right time, and I just didn't hold it long enough," he says. "It's not like I didn't make any money, but it's more like, 'Wow! If I had only been a bit more patient, I would have made 40 times the money had I waited four weeks."
Joe didn't stop there. In fact, he wandered into even more precarious investment territory, short selling Ford shares after analyzing the profitability of U.S. automakers.
"It became really clear that Ford was in the worst position of these companies. It had $12 debt per dollar invested, whereas GM had only four dollars," he says.
With a short sell, he borrowed Ford shares at five dollars, sold them and eventually bought them back at $4.30. Then, he returned them to the original owner, making a profit of 70 cents a share, minus any dividend payments he had to cover or trading fees.
Though he came out on top in both scenarios, these strategies are risky and require a firm understanding of the companies that you are essentially betting against.
"What this individual has done rates a little high on the sophistication level even amongst money managers," says Tony Demarin, president of BCV Asset Management Inc. in Winnipeg.
"Most investment managers are what we call long-only managers. Most mutual fund managers don't have the ability to use options, nor are they allowed to short sell."
With a short sell, the upside is limited, he explains. You can only make from the price you borrowed the stock at to zero -- if the company were to go bankrupt.
"If you are wrong, the downside is unlimited because when you short a stock, what you are doing is you are borrowing a stock from somebody else and selling it," Demarin says, adding that stock has to be returned to the owner eventually.
"You are on the hook for the value between what you sold it at to what you ultimately have to buy it back at."
It could in theory keep rising infinitely.
It's an unlikely scenario since, by definition, you are holding the stock for a short period of time. Unlike long-term investments, where you hold on through volatility, you are best advised not to ride out a surging stock price. Cut your losses before they get even bigger.
A put option is less risky because all that's exposed for losses is the premium you've paid for the right to sell the stock at a certain price.
"Using puts and calls is a very smart strategy in a bear market," he says, adding Canada, thanks to resource stocks, isn't quite there yet. Unlike Joe's strategy, which was a naked put, most investors use puts as a hedge against their long-term investments.
"It's like buying house insurance against fire," Demarin says. "If your stock falls to zero, the stock is now worthless, but your put will have increased in value by an equivalent amount."
Maybe this all sounds a little too sophisticated, and it is. Diligence is required, and for those of us who like the concept but not the risk, options do exist.
Some exchanged traded funds (ETFs) now use bear market strategies, which can be used to hedge against losses in a long-term portfolio.
"We make shorting very easy to implement by all investors," says Howard Atkinson, president of BetaPro Management in Toronto, which runs the only bear-oriented ETF of its kind in Canada.
Instead of using the techniques yourself, a fund manager does it for you with a group of stocks or other investments that follow a particular sector, like the S&P/TSX 60 index. BetaPro bear ETFs promise two times the inverse value of the underlying index's movement. If it goes down three per cent, your bear ETF rises in value six per cent. Keep in mind, it can also do the opposite. Your losses can be double too, which really sums up these strategies' upsides and downsides -- quick, big profit or quick, big losses.
Perhaps even more fitting is the not-so-average Joe's take on it:
"My friend says that options are the crack cocaine of investment because they represent such a large bang for your buck. However, if you have bought the stock instead, you still own it at the end of the year," he says. "Whereas, if you are wrong on an option, it's worth nothing."
Of course, this makes one wonder: If put options are crack, then what's a short sell -- the crystal meth of investing?
Quick facts:
Bear market: It's when market conditions are in a prolonged downturn cycle, marked by falling stock values ¬ -- or bonds, currencies and commodities -- and a general sense of pessimism amongst investors, which leads to sell-offs and further market drops. Definitions vary, but a 20-per-cent fall in value across multiple indexes (i.e.: Dow Jones, NASDAQ, S&P 500, S&P/TSX Composite) over a period of two months makes for bear market conditions. It's called a bear because when bears are on the offensive, they swipe downward with their paws.
Bull market: It's when market conditions are in a prolonged upturn cycle, marked by rising stock values and other tradable investments. Investors are upbeat and willing to invest, which means stock prices and other exchangeable goods rise in value. It's called a bull because bulls thrust upward with their horns when on the offensive.
-- Source: Investopedia.com
Bear market investment strategies:
1. Invest in stable companies that pay good dividends: BVC Asset Management Inc. president Tony Demarin says blue chip companies -- stable corporations that have been around for a long time and have no extensive debt -- are often not as adversely affected in a bear market. They also often pay dividends, so the stock value may drop, but you are still being paid some money regardless. Having said that, Bear Stearns was once considered a blue chip stock.
2. Invest in companies that provide goods and services people always need: The economy may be depressed, but people still need to brush their teeth.
"Wal-Mart is actually performing quite well because a lot of consumers have lost purchasing power to higher energy prices and instead of shopping at a higher-price retailer, they've come down to shop at more of a discount retailer," Demarin says. Stay away from discretionary spending industries, such as homebuilders, automakers and luxury goods manufacturers. People put off big or extravagant purchases in hard times.
3. Invest in bonds: Bonds are a stable investment for your money. You won't lose the principal amount invested unless the company goes broke. If you put $10,000 into 10-year bond paying five per cent interest, you are very likely to get that amount back at the end and earn interest along the way. Watch out for investing in bonds in a rising interest rate environment. Their value as an exchangeable security falls when interest rates rise. They do the opposite when interest rates fall. Another drawback is inflation. In conditions where inflation is high, the principal invested has less buying power. In an environment with five per cent inflation, the $10 you invest today will buy fewer goodies one year from now, Demarin says.
4. Short selling: Most investing is for the long-term. You buy; you hold and you sell years later at a profit. Short-selling is the opposite. You only hold the stock for a short time. More precisely, you borrow the stock that you think is over-valued from someone else through a broker (this can be an online trade account too, but it must be a special account). You sell the shares and hope the stock falls in value. When it does fall to a point where you've made your desired profit, you buy it back and return it to the lender. Your profit is the difference in the price at which you initially borrowed and the price you purchased the stock to return it.
The upside is you can make a lot of money without really investing a lot of money. The downsides are huge. If the stock goes up in price, it could keep going up. There's no out point. You have to buy it back, cut your losses and return it before it becomes too expensive. You are also responsible for any dividends that are paid to the holder from whom you've borrowed the stock. You also need a margin account, which allows you to borrow an additional amount of the short-sell price to ensure you can cover your losses if you are wrong. The margin account is collateral. If the stock goes up, your broker has the right to return the assets before it's so high you can no longer pay.
5. Put options: If you think a stock is over-valued, a holder of that stock may not agree with you. So you negotiate to pay a premium for the right to sell the stock at a certain value during a defined time period. A longer period requires a higher premium price , although this fee is usually about 10 per cent of the actual cost of the share price. If the stock goes down, the option is worth more money. It's worth the amount by which the share price has fallen. For instance, a put option on a stock at $60 that has now fallen to $40 is now worth $20. You can either exercise your option to sell the stock at $60 or you can sell the option to someone else. You could theoretically trade the option at a profit even if the stock has gone up or remains flat if a potential buyer still believes the share price will fall. However, that is only a likely scenario at the beginning of the term period for an option.
It's a risky venture because you are gambling on falling stock prices, but it's not as risky as short selling because you are only out the premium if you are wrong and the option expires.
Other sources: Investopedia.com
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