Well Managed Investing Risks Bring Rewards!

Someone who reads the blog sent me this email:

Dear Geoff,

in your article "Should you Buy Microsoft?" on GuruFocus, you said, that it makes sense for some investors to use LEAPS instead of the stock.

After thinking long about that, I came to the conclusion, that LEAPS can be viewed as a form of leveraged investment with an insurance against a falling stock price included...So LEAPS would make sense, if you want to leverage your portfolio with relatively low risk.

I'm not endorsing LEAPS.

I think they make sense only in situations where there is a level of catastrophic risk in the underlying stock that is not priced into the option. In general, this means low volatility stocks that nonetheless can fail catastrophically if infrequently.

Like banks.

I would use LEAPS to buy a bank because there is always the risk that a bank will go to zero. In that sense, LEAPS leverage your investment and provide protection - basically an involuntary surrender - where you cut down a huge loss while still betting on a favorable outcome.

The problem with LEAPS is that they aren't long enough dated. 5-year LEAPS would be good. 10-Year LEAPS would be virtually indistinguishable from a stock in terms of a correct analysis resulting in profit. But 2 years is not long enough for a value investor. If Warren Buffett had bought Washington Post 2-year LEAPS instead of Washington Post stock in the 1970s he would have lost his entire investment. By buying the underlying stock, he had a return of 30% a year compounded over the first 10 years.

I’ve had stocks that didn’t work out for 2 years. But, boy, did they work out over 5 years. I would've lost money on the LEAPS. 

Any bet that depends on the market recognizing something within 3 years is a bet where a value investor can be completely right in terms of analysis and yet lose everything simply because the clock runs out.

Value investing is largely based on being able to hold a position until the market changes its mind. I'd say it's very unreliable to assume mean reversion in the market mood on a stock within 3 years.

The exception to this is when you're diversifying both across a group of separate bets and across a period of time. For example, if you buy one stock a month every month and turn over the portfolio every year (by swapping out one stock each month), you may average an acceptable result because you're actually making a dozen different bets on a dozen different stocks that depend on prices at a dozen different future moments in time.

That's not what you're talking about. You're talking about making one bet on one stock that will succeed or fail based on whether or not the stock reaches a certain price fast enough.

Personally, I'm not interested in LEAPS.

And I really don't think it makes sense to buy LEAPS on a stock like Microsoft. It makes much more sense to simply put a huge part of your portfolio into the stock if you believe in it so much.

This is something people overlook. The best way for most investors to leverage a good idea is simply to bet big on it. If you look at Microsoft and then you look at the S&P 500 - it's very clear that right now you're not giving up much by putting a lot of your portfolio into Microsoft because the opportunity cost is very, very low.

The risk/reward on the S&P 500 specifically - and stocks generally - is lousy right now.

I don't really get why someone would want to put 5% of their portfolio into Microsoft LEAPS instead of putting 25% of their portfolio into Microsoft shares.

I'm not exactly drowning in good ideas over here.

But different people see these things differently.

Personally, I'd opt for 25% in Microsoft shares rather than 5% in LEAPS.

I don't own any of either. And have no plans to buy Microsoft in any form.

As far as LEAPS themselves, it’s probably best to look at LEAPS as offering you the ability to do two things:

• Surrender
• Buy something else

Putting less money down only offers two real benefits.

You get to have your cake and eat it too. Or, rather, you get a return on your capital without putting all of that capital out there. And you get the chance to lose only a portion of the capital that would be necessary to buy the underlying stock.

But that’s really all leverage offers. The idea that leverage is attractive when you don’t have more ideas than money is kind of silly. Leverage only works in situations where you wish you had more cash to buy stocks than you have now.  

Looking at the opportunity cost of using capital, I’d say LEAPS don’t make much sense for most investors given today’s stock prices. They’re high. Future returns will be low. By holding cash you may have the chance to invest more in the future when stock prices are lower and returns on your investment will be higher.

So there’s strong logic behind the idea of holding cash right now (simply because there aren't better places to put it). And there might be strong logic to holding Microsoft shares right now.

But where’s the logic behind buying Microsoft without using a full serving of your own cash?

I don’t see it. There’s a big gap between the opportunity Microsoft offers and the opportunity most stocks offer right now. Since the opportunity offered by most stocks is so low, why not just use cash (and forfeit those bad options) to buy Microsoft stock outright?

If you’re buying LEAPS instead of buying the stock itself, you need to ask yourself what exactly you intend to do with the capital you’ve saved. Do you really have good uses for it? Uses that are worth the risk you are taking by greatly increasing the chance of permanently losing all the capital you put into the LEAPS?

I don’t think it makes sense to use leverage of any kind when the price of the assets you like to buy is high. It makes the most sense to borrow when the general price level of the assets you tend to own – presumably stocks – is especially low.

That’s when you’re likely to get the most bang for the bucks you invest. It’s also when the opportunity costs are highest because capital is scarce relative to opportunities.

I don’t see that right now. Capital is plentiful. Ideas are scarce.

So, if you find a good idea – like Microsoft – why not just load up on it with a big chunk of your own capital instead of making a leveraged bet?

I think most investors either have plenty of cash or plenty of fairly and – let’s be honest – overvalued shares lying around. Sell those to buy Microsoft.

Don’t buy LEAPS unless you’re sure you’ve got more good ideas that money.

You might.

I don’t.

So if I was buying Microsoft - I'd just buy a ton of the stock. I wouldn't buy the LEAPS.

Talk to Geoff about LEAPS