From Frontwater Capital’s Options Desk:

In a matter of weeks, Apple (AAPL) stock has fallen 25% from its September 2012 high of $704. Investors are now questioning if Apple has lost its magic touch. Just what has changed in only a few months.

Has Apple Lost Its Magic Touch?

Apple is no longer the underdog, the contender; they are now the company to beat – the ones with the target on their back. And while Apple continues to be known for its excellence, innovation and quality, life at the top is much more rigorous, and pressure bound than being second in command.

Factories are demanding higher wages and better working conditions that are putting pressure on margins. Competitors like Samsung are constantly improving their own phones, tablets and computers. Furthermore, we are starting to see limited sales of the iPhone 5 due to supply chain issues. And finally, the newly released mini Ipad was only warmly received by analysts who noted marginal, insignificant upgrades with the mini.

That said, Apple’s stock looks to be in bargain basement territory. Even with competitive pressures Apple’s gross margin remains above 40%. Most important is that Apple has an ecosystem that few others can rival. Apple users link and connect their Mac laptops, iPhone, and iPad so that, for example, a library of itunes can be automatically distributed to each gadget. This convenience factor makes it extremely difficult for users to switch to a new platform.

Finally, much of the sell off in Apple stock can be explained by the approaching ‘fiscal cliff’. Investors who have held Apple stock for some time are likely sitting on large capital gains and are wishing to realize their capital gains in 2012 prior to potential tax hikes in 2013. This is creating downward pressure on the stock. Yet the company remains intact.

Here are some different ways to play Apple in today’s sell off:

1. Go Long!

Apple has been the trade of the year and up until recently, momentum and speculation had taken the price sky high. Now, with the momentum going against Apple, we think it is an attractive entry point. Even if we forget about ANY growth, this company seems like a bargain — valued at 12.5 times earnings; with more than $120B in the bank; and zero debt.

2. Sell a Put

The panic in Apple today has created a great opportunity if you are willing to take on exposure to Apple if it continues to drop. The options market will pay you $19 between now and December if the stock were to drop below $525 and you sold a put. Your downside risk here is that you own Apple with an effective price of $506. On the other hand, if Apple stock trades above $525, you effectively pocket $19 in option premium.

3. Buy a Collar

If you were willing to take the on additional Apple shares with an effective cost of $506 from the above example, you could turn around and purchase a March 605 Call using the $19 dollars that you received from selling the put. This will give you upside on Apple and enable you to profit in the event that Apple’s stock rises above $605.

Bottom line is that if you believe in the company’s long term value, there are a bunch of different and creative ways to play Apple using option

As an options trader and as a specialist in risk management, I often get annoyed when I read about risk mitigation strategies in any number of business newspapers and magazines. Rare is the case where I read an insightful article on the use of options strategies, particularly the protective put, to manage volatility within one’s portfolio.

All too often, authors focus on asset allocation as the primary mechanism for managing risk. In order to preserve capital, low risk investors should overweight fixed income products like GICs, government bonds, investment grade bonds, and underweight equities.

To further this argument, authors often display historical chart information to graphically illustrate the steadiness and consistent returns from bonds over the last twenty, even thirty years.

Problems With Relying On Asset Allocation

There are a number of problems I have in relying on asset allocation as a risk mitigation tool. First, only two years ago, we laid witness to the fact that all asset classes were hit hard. It did not matter if you held investment grade bonds, junk bonds, small cap stocks, preferred shares, or blue chip stocks in your portfolio, everything took a beating. Asset allocation did not turn out to be the safe haven that many thought and counted on.

Is Fixed Income Really A Safer Haven?

The second issue that I find bothersome is the assumption that fixed income is a steady eddy asset class over the long run. Many investors are oblivious to the fact that we have been in a declining interest rate environment for the last thirty years. Interest rates have dropped from twenty percent to one or two percent. So is it any wonder that bonds have done so well – it is simply a function of falling interest rates — as interest rates go down, bond prices go up.

On that note, one has to question a historical bond chart, even one with thirty years of history, if it is statistically representative.
Now that interest rates are slowly creeping up from their all-time lows, it could get very ugly, very quickly for bond holders. Unfortunately, I foresee a lot of seniors taking it on the chin once this bond bear market kicks in — especially those seniors being advised by their bank mutual fund salesperson to buy into bond mutual funds.

Capital Preservation At The Risk of Inflation

Finally, the third issue I have with the ‘bond safe haven’ argument is that few advisors make mention of the risk of inflation. And in today’s high commodity price environment, I fear too many investors are exposed to inflation risk – specifically the loss of purchasing power.

It does an investor little good to earn 3 percent on a long term government bond if inflation is running at 4 percent. True, the investor is almost certain to see his initial cash outlay returned as the bond matures, but the investor will have lost in real purchasing power. Unfortunately, too many investors associate capital preservation with the likelihood that cash is returned all the while ignoring the risk of inflation.

Problem With Laddered Bond Strategies:

That brings us to the next type of business news article which discusses the benefits of a laddered bond strategy. In a laddered bond strategy, an investor owns a number of different bonds, each with various maturities. Some bonds mature earlier and some mature later. Presumably, if interest rates rise, the bonds that mature earlier can be re-invested in potentially higher yielding bonds. Thus the exposure to inflation and higher interest rates is diminished.

On paper, the strategy sounds great. One problem though: in this low interest rate environment, the returns from this strategy are lousy.

The Protective Put

All of which brings me to the protective put strategy.

The concept of an index put is very simple. It is very much like insurance with the added benefit that it trades on an exchange. Unlike ‘asset allocation’ which did little to shelter portfolios against an outright collapse in the financial markets, puts most certainly protect investors against extreme market events.

Furthermore, puts give conservative investors much more leeway in bumping up the equity portion of their portfolios. Generally, it would be unheard of for a conservative investor to assign more than 65% of his portfolio towards equities. But with put protection in place, an investor has the flexibility to increase the equity portion towards even 80% with the knowledge that an effective hedge is in place should the market collapse.

Puts: The Concept Of Insurance

As mentioned, puts are equivalent to insurance. Like insurance, there is a cost to a put. A buyer of a put pays cash to the seller in what is known as the option premium. What is kind of neat is that the put premium is liquid and trades on an exchange. Investors can buy and sell put premiums exactly in the same manner that they buy stocks (eg. enter a ticker symbol, enter a price, and click ‘buy’ or ‘sell’)

Like many types of insurance, there is an expiration date associated with a put. After the expiration date, the put no longer trades and is considered terminated.

Put premiums appreciate in value when the market drops and decrease when the market goes up. But, put premiums cannot go below zero. Upon expiration, the put will be “in-the-money” and have monetary value, or it will be worthless.  Keep in mind, that the maximum amount that a buyer can lose is the put premium. The buyer cannot lose more than what he paid for the premium.

One More Feature: The Strike Price

In addition to an expiration date, puts are described by a strike price. The strike price enables investors to further customize the level of protection.

For example, if the TSX is trading at 14,000, an investor may choose a put with a strike price of 14,000. That particular put protects the investors against a market drop below 14,000.  Another investor, however, may choose to insure his equity portfolio at a lower strike price, say 13,000. Here, the investor has protection but only if the index falls below 13,000.

Why would an investor choose a strike price of 13,000 versus 14,000, one might ask?  The answer is cost. A put with a lower strike price costs less than one with a higher strike.

Having the ability to buy insurance at various strike prices gives investors a tremendous amount of flexibility in tailoring a risk strategy.  Some investors may be fine with a marginal drop in the market but want protection to kick in only in the event of a catastrophic event. Those investors are more likely to choose a strike price below current market levels – say 13,000. Other investors may want a higher amount of protection and choose a higher strike price that is more in line with the current market – say 14,000.

Volatility and Put Premiums

While both expiration dates and strike prices affect put premiums, volatility is the most important factor in determining relative value.  This is why many option traders track a volatility index called the VIX in order to assess the relative value of options.
When volatility is low, option traders know the cost of the put premium is relatively cheap. Likewise, the reverse is true. If volatility is high, put premiums become relatively more expensive.

Intuitively, this makes sense. Investors are more fearful in highly volatile markets and are therefore willing to pay more for insurance in order to protect their portfolios.

With investor sentiment bullish and the VIX trading at near lows in Jan & Feb 2011, Frontwater loaded up on 2012 protective put options on the TSX, DJIA, and S&P 500. This week we were rewarded. As stocks dropped, the index puts that we bought increased in value and our portfolios only suffered marginal paper losses. With insurance in place, not only were we able to avoid knee jerk reactions but we were positioned to take advantage of the first weekly drop in several months and added to our equity positions at depressed levels.

Admittedly, we bought the puts from a purely risk management perspective and not because we had a crystal ball that could possibly forecast the political unrest that would break out in the Middle East or that a terrible natural disaster would hit Japan.

That said, we complement ourselves for recognizing the most cost efficient way of managing risk at the time was through the use of put options. The protective puts offered great value, enabled us to comfortably maintain a higher level of equity allocation (close to 80%), and then positioned us to further take advantage of a market drop.

Option strategies can be a powerful risk management tool within one’s portfolio. All too often they get dismissed as being ‘too sophisticated’ for the average investor which draws my ire. True there are many complex option strategies but buying a put is a very simple investment strategy and insurance policy at the same time.

Jeff Kaminker

President, Frontwater Capital

Long term shareholders of George Weston cannot be happy right now. No matter how the company window dresses today’s announcement of it special one-time $1 billion dividend, shareholders know there was a huge missed opportunity.

Back in January 2009, at the height of the credit crisis and stock market crash, George Weston Limited was the envy of capital markets. The financial world was collapsing, banks were teetering, IPO filings were shelved, mergers and acquisitions terminated, and liquidity all but vanished overnight. Companies were on life support, and were it not for the emergency assistance of central bankers pumping trillions of dollars into the economy, many companies would have indeed gone bankrupt.

But George Weston stood out as the exception. It was flush with cash as it had just sold its US bakery business for $2.3 billion to Mexico’s largest bakery, Grupo Bimbo. Not in a hundred years could a company be better positioned to feast on such famine.

Even back then, the company could have decided to conservatively pay out a large shareholder dividend while maintaining the remaining cash flow to make a strategic purchase that would have produced synergies for the Weston family of holdings. This was one of those rare times when you get to have your cake and eat it too.

Saks (ticker symbol: SKS) was one company that looked ripe for the picking and would have fit nicely with the Weston family’s portfolio of luxury retailers around the world including Holt Renfrew (Canada), Selfridges (UK), and Brown Thomas (Ireland). And while it is unrealistic to fault Weston for not buying at the March 2009 low when the stock hit $1.79, certainly one could have made a strong business case to buy in around the 2009 average price of $5.00 which would have valued Saks at around $800 million USD – a valuation that was well within Weston’s financial reach. Today, stock in Saks has more than doubled as America’s wealthiest fashionistas are back. Profitability is up and Saks now trades near $12 with a market cap close to $1.8 billion USD.

Another strategic fit would have had George Weston pursue investment opportunities within the real estate sector, given that the company indirectly owns a huge real estate portfolio though its 60% holding in Loblaws. Loblaws is estimated to own somewhere between $8 to $10 billion of real estate alone so Weston and its portfolio of companies are no strangers to executing large real estate transactions. In fact, with some creative ingenuity, Weston might have further thought about teaming up with any number of large players including REITS, pension funds, and private equity players in lending its expertise in property management.

But instead of leading the charge in acquiring highly desirable real estate at fire sale prices south of the border or building an equity stake in any plethora of US retailers, the company chose the worst of all alternatives – ‘the do nothing’ approach.

For blown opportunities, this will certainly go down as one. Of course, George Weston Limited is attempting to put a favourable spin on a decision that was long overdue. In all likelihood, the company has missed the boat and it would be surprising to see George Weston make a foray into any familiar or new industries.

In fact, we view this dividend payout as the first step in a major re-structuring by the George Weston parent company. While ten years ago, George Weston owned a diversified set of businesses ranging from bakery to dairy to grocery to pulp and paper; today the company owns two significant yet straightforward businesses: Canada’s largest bakery and Canada’s largest grocer.

We, at Frontwater Capital, believe that this is the end of the parent company, George Weston Limited, as the market knows it. By spinning out the bakery business into a public company while distributing pro rata shares of Loblaws to its existing shareholders, the company could easily do away with the additional overhead of having a parent company oversee two businesses that can operate just as well as standalone companies. Furthermore, any excess cash could then be paid out via an additional special dividend.

Given that the parent has proven itself to be a conservative, no risk taker, it just makes good business practice to break the company up into individual pieces. Doing so would likely unlock at least another 15% or $13 of shareholder value.

Regards,

Jeff Kaminker
President, Frontwater Capital

Long-only portfolio managers traditionally manage risk through asset allocation strategies that concentrate on finding a balance between equity, fixed income, and cash. Portfolio managers wanting to minimize volatility generally do so by increasing exposure to fixed income products while simultaneously underweighting equities.

But what happens when demand for seemingly safe fixed income investments, such as government and investment grade bonds, drives prices up to ‘bubble’ territory. Shifting assets out of equities and into an inflated asset class such as bonds does little to minimize risk.

Here, long-only portfolio managers are handcuffed – constrained by the fact that the fixed income alternative is in fact no alternative at all. That leaves cash as the only substitute for equities. Of course, cash tends to be dead weight. And while there may be times that sitting on cash makes sense, investors simply do not need to pay professional money managers to hold onto cash.

This is where option licensed portfolio managers outperform their long-only counterparts – not only in higher returns but in managing the overall risk profile of the investment portfolio. Suitably designed options strategies can add considerable value to a tactical asset allocation program.

Rather than change asset allocations in order to modify risk profiles, option licensed portfolio managers can use puts and calls to preserve capital, enhance income, and reduce market volatility without having to sell equities outright.

Many unsophisticated investors see derivatives and options as instruments used to increase, rather than to reduce risk. Nothing could be further from the truth. Investors interested in prudent risk management strategies should be looking at option instruments including puts and calls.

Buying plain vanilla puts are similar to buying portfolio insurance and protect investors against a market fall. These type of instruments are great for conservative investors who want capital preservation. Not only do puts provide a floor in the event that the market falls, but they allow investors to enjoy all the benefits of a rising market as well as any dividend payouts. In this environment, where fixed income instruments are overpriced and bond yields offer next to nothing, maintaining equity exposures with put protection is the way to go.

In addition to buying puts, income oriented investors can also consider option strategies including covered calls and collars. These strategies are a tad more complicated than simply buying puts. That said, they are not beyond the reach of ordinary investors who have been brainwashed to think that risk profiles are based on asset allocation.

Make no mistake, there’s a real bond bubble forming and unfortunately many conservative investors are on the verge of a rude awakening. Whereas the stock market crash of 2007 punished greedy, risk seeking investors, this time around it will be conservative, risk-averse investors who take the hit. Protect your portfolio with options.

Jeff Kaminker
Frontwater Capital

Lake Shore Gold (TSX: LSG), a Canadian junior gold company (JGC), is no longer on our watch list. We originally liked Lake Shore Gold for its position as a takeover target. However, Hochschild Mining plc (a mid tier gold producer listed on the London Stock Exchange) has reduced their stake in the company.

Hochschild originally owned 36% of the company, but on Thursday, Oct 14th 2010, it reduced it’s stake to 5.7%, offloading more than $392 million in common stock. Lake Shore Gold has fallen approximately 4.6% to $3.53 since Hoschild’s announcement and we believe LSG will continue to fall due to the elimination of any takeover premium.

Lake Shore Gold is a rapidly growing mining company, aiming to become one of North America’s mid-tier gold producer through successful exploration, development, and operation of three wholly owned mines in Timmins, Ontario. The company plans to grow from 65,000 oz of gold in 2010 to mid tier levels of 350,000 oz of gold in 2013. Lake Shore plans to achieve its growth through the acquisition and development of high-grade gold projects within the Canadian Shield.

Lake Shore is still doing well, but some ratios seem rich when compared to competitors, as well as the industry in general. Lake Shore Gold’s estimated EBITDA for 2011 is 10.6 which almost double the average of 5.5 for other junior gold companies. Likewise, the company’s P/E ratio of 18.2 for 2011 is higher than the sector average of 12.3.

We will continue to have our eye on Lake Shore Gold, but for now, we no longer consider this stock a ‘Good Buy’ opportunity.

Last week, the Nasdaq dropped convincingly below the Common Sense buying threshold, which is a 10% decline from the most recent high reached on April 23. The S&P 500 also dropped more than 10% from its peak, putting both major averages into an official correction, the first since the bull market began its rise on March 10, 2009. The Dow Jones Industrial Average dropped below the 10% correction threshold Thursday, returned above the line Friday and fell back below it again Monday. The Common Sense approach calls for buying on corrections of 10%, and selling after rallies of 25%.

Just two weeks ago I fretted that a buying opportunity had come and gone so fast. The $1 trillion rescue plan unveiled by the European Union and the International Monetary Fund had triggered a huge rally, and it looked like the bull market was back. I needn’t have worried. European sovereign worries have returned with a vengeance. Not only did the market’s plunge renew a buying opportunity, but indexes fell so rapidly last week that the Nasdaq Composite was well below the 10% threshold on Thursday.

This is yet another reminder to remain focused on the long term and not get caught up in the minute-by-minute or even daily gyrations of the stock market.

As usual, I’m making no short-term predictions about the direction of the market. My goal is simply to be prepared when opportunities present themselves, as they did last week.

Frontwater Capital Watch List

Date: March 17, 2010
Author: Jeff Kaminker PM, CFA, MBA, P.Eng

Lake Shore Gold Corporation (LSG – TSX)

Lake Shore Gold is a Canadian junior gold company that is focused on bringing its 100% owned Timmins Mine in Timmins, Ontario, into commercial production by the fourth quarter of 2010. Lake Shore also carries out advanced exploration at its portfolio of properties in the Timmins camp.

Lake Shore Gold trades at a discount relative to other junior development gold companies and mid tier producers. We believe that Lake Shore should trade at higher multiples given the expected rapid growth in production at an attractive mining jurisdiction. The company plans to grow from 65,000 oz of gold in 2010 to mid tier levels of 350,000 oz of gold in 2013. Lake Shore plans to achieve its growth through the acquisition and development of high-grade gold projects within the Canadian Shield. Lake Shore has been actively consolidating the Timmins mining camp and has done several acquisitions in recent months.

Although Lake Shore recently guided to lower production in 2010 (down to 65,000 oz of gold from 100,000 oz of gold), the revised 2010 production estimate reflects a change in priorities focusing on the preparation of 43-101 compliant resource estimates at Thunder Creek and at Bell Creek where the company confirmed the presence of a large new gold system.

Lake Shore is carrying out advanced underground exploration programs at its 100% owned Bell Creek Complex and Thunder Creek properties and continues to invest aggressively on exploration with plans to spend approximately C$31 million in 2010. Lake Shore expects that the additional development and infrastructure work will position the Company to maximize and sustain annual gold production at both Thunder Creek and Bell Creek. As of December 31, 2009, Lake Shore had C$132.9 million in cash and no debt and is in good position to finance its planned expenditures.

In addition, Lake Shore is likely a take-over target. Hochschild Mining plc (a mid tier gold producer listed on the London Stock Exchange) owns 36% of Lake Shore. Hochschild’s ownership in Lake Shore remains limited to 40% of until the expiration of a stand-still agreement on November 22, 2010. We anticipate that Hochschild will likely increase its stake in Lake Shore or buy the entire company at that point.

We believe this is a good buy opportunity as we believe Lake Shore will either get taken over or get re-rated as it continues to increase production and reach mid tier status.

Osisko Mining Corporation (OSK – TSX)

Osisko Mining Corp. is a Canadian gold exploration and development company. Its primary focus is advancing its flagship 100% owned Canadian Malartic property, located in Val D’Or Quebec.

In recent years, there have been few large gold deposit discoveries making it hard for senior gold producers to replace and add resources. Furthermore, the senior gold producers are interested in large scale deposits that can add significant production to make an impact to their bottom line and that are located in safe jurisdictions. In our view, Osisko’s Malartic gold deposit which is located in an attractive mining jurisdiction and has significant scale makes the company an attractive take-over target. We believe the company will ultimately get acquired by Goldcorp or another senior gold producer. Goldcorp already owns approximately 12.9% of Osisko, effectively signalling to the market their potential interest in acquiring Osisko.

Osisko trades at a premium to other junior development companies and mid tier producers. We believe a premium is justified to account for the company’s flagship project which is located in an attractive mining jurisdiction and to account for the expected large scale gold production which is in the higher end of the mid tier gold producers. With its mine scheduled to start production in 2011, Osisko is benefiting from a re-rating to a level indicative of upper mid tier gold producers operating in an attractive geopolitical mining jurisdictions.

Osisko’s Malartic gold project is the biggest gold reserve deposit in Canada. In a recent update by the company of its reserve estimate and mine schedule, total reserves increased by 43% to 8.97 million ounces gold. This resulted in Osisko increasing its average annual production forecast from 620,000 ounces of gold to 630,000 over its 12.2 year mine life. This level of gold production positions Osisko in the higher end of the mid tier gold producers.

With permitting and financial risk now minimal, Osisko is well positioned to advance development towards full operation, expected by the company to begin in Q2 2011.

Frontwater Capital is actively following the stock.

Health insurer UnitedHealth Group Inc (NYSE:UNH – News) posted better-than-expected quarterly profit on Thursday, helped by moderating flu costs and growth in its businesses serving the elderly and low-income Americans.

The largest health insurer by market value also backed its 2010 forecast. UnitedHealth continues to project 2010 profit of $2.90 to $3.10 per share, down from $3.24 reported for 2009. Analysts expect $3.06 for 2010.

UnitedHealth’s fourth-quarter net income rose 30 percent to $944 million, or 81 cents per share, from $726 million, or 60 cents per share, a year earlier, when the company took a big litigation charge.

Analysts on average expected 73 cents per share, according to Thomson Reuters I/B/E/S.

Revenue rose 6.5 percent to $21.78 billion. Analysts looked for $21.72 billion.

Its unit for Medicare plans serving the elderly saw revenue growth of 14 percent to $7.8 billion, while its unit for Medicaid plans for low-income Americans grew 34 percent to $2.3 billion. Enrollment rose in both businesses.

Other positive news includes Tuesday’s stunning election of a Republican to the U.S. Senate by voters in Massachusetts. This unforeseen victory has thrown the reform process into uncertainty…

On the side of caution, keep in mind that UnitedHealth, like its rivals, is being hurt by the weak economy, because fewer people employed means fewer with health coverage. For its UnitedHealthcare plans serving employers, the company reported a decline of 130,000 members from the end of the third quarter, to 24.63 million, but said the plans would have seen growth of 40,000 members if not for job cuts at continuing clients. Total membership stood at 32 million at the end of December.

For those who prefer diversification and would rather own the index, take a look at the S&P Managed Health Care index (^GSPHMO – News). This is the index for large health insurers.