This article contains only my opinions based on facts and research that I have put together. It is mainly for educational purpose and not a recommendation to buy/sell/hold any form of securities. Please exercise your own independent thinking. We can be wrong too.
P/S: This article also requires you to have good knowledge about options. Should I cover more about options? Let me know in the comments :)
So after the previous article I have written about investing in Chinese companies, I have received many questions from many of you. In fact I have been actively discussing with many of you through social media.
P/S: Feel free to ask me questions through my social media channel:
So, back to Chinese stocks. In this example, I am going to share our little discussion/agreement on Alibaba together with some of my thoughts and opinions
As we can see, Alibaba has experienced a steady decline from its previous high of $320 to $160. That is a 50% decline in stock price. On top of that, we can see that it is trading at a P/S ratio below 4x. The average P/S ratio for Alibaba was about 7x over the past 2 years. It is very hard for me to deny that it is undervalued.
Even after comparing them to their peers in the industry on financial apps like TIKR, we can see that Alibaba’s valuation multiples are currently the lowest.
Then I was presented with Alibaba’s quarterly financials so far, they are still chugging along without too much negative changes. Revenues grew by 46% in the latest quarter. Return on equity is at 18.9%, gross profit margins at nearly 20% and EBIT (Operating Profit) margin is at 15%. The company is even generating free cash flow!
By the way, in case you are asking, the financial app that I am using in this article is TIKR. You can use it for stocks around the world. Do check it out, its FREE anyways.
Back to the topic at hand, with the company doing quite decently and still growing, what is the justification for the sell down? Is there an opportunity here?
That depends - how much are you willing to invest?
Before I go on, I need to share my context again. One of the key selection criteria for a stock to be in my portfolio is how much am I willing to invest. If I am not convicted to allocate/budget at least 15% of my portfolio, then I will not invest in the stock at all.
Lets assume that I invested only 5% of my portfolio in Alibaba at $160 and it recovers to its previous high of $320, then my portfolio would have only gained 5%. I would rather focus my effort following and understanding stocks that can grow and provide way higher returns when I am right.
And as of now, my concerns are not with the company, but with the politics of China. The Chinese government have the ability to quickly alter the fundamentals of any businesses under their jurisdiction and that is too unpredictable for me especially looking at how frequently they are doing it. I don’t want to wake up one morning realising that they have forced Alibaba to separate from Alipay for example. There are of course many other reasons I have mentioned in my previous article. You can check them out here.
But I know that even if you are fully aware of the risks and the likelihood of them materialising, you have this feeling in your ‘gut’ saying that Alibaba will go ‘up’!
The worst part is that you can’t get rid of the thought no matter how hard you try. If that is the case, then in this article, I will highlight what I would do in your situation.
I remembered mentioning that I watched the movie, “The Big Short” for more than 30 times. The main reason why I did that was because the movie was highly entertaining. But the silver lining was I managed to pick up many different investing methods and strategies from it as wells. Some of which I researched upon to develop the investment strategy I use today.
There was a scene in the movie where I was introduced to Charlie Geller and Jamie Shipley who manages a private fund called “Brownfield Capital”. Apparently, they started with a fund size of $110,000 and turned it into $12 million in just 2 years. Their investment principle was very simple, they invested only in highly asymmetrical investment opportunities. When they were wrong, they were wrong small. But when they were right, they were right BIG. Using the same investment method, they turned the $12 million fund into a $130 million fund by the time the market crashed in 2008.
So how do we create asymmetric investment opportunities? - we use call options.
I shall show it to you through an example below:
Lets assume that you have a $100,000 portfolio and wanted to invest 4% of it into Facebook when it corrected to $150 in March 2020.
4% of $100,000 means that you have a $4,000 budget to invest. You can use that money to either buy 25 shares at $157 each or use it to buy a single call option which will cost you $4,000.
I have done both and you can see the results below:
Investing in the stocks only yielded you a $3,918 or 99% profit. That means that your portfolio will grow from $100,000 to $103,918 or 3.92%. But investing in the option gave you $11,979.50 or 300% in profits. This means that your portfolio will grow from $100,000 to $111,979.50 or 11.98%. In both situations, you risked 4% of your capital. But if you invested using options, you can clearly see the leverage that options provide. By investing very small amounts of money, you can grow your portfolio very meaningfully even if stock price did not appreciate tremendously.
However, for those of you who know me, you know that I do not advocate using call options unnecessarily. This is because the risk of an option compared to a stock is that you are 10x more likely to lose 100% of your investment with option than with stocks if your investment thesis is wrong. I have seen countless investors got greedy and focused on buying mostly call options in their portfolio. When the correction came, they will see their portfolio evaporate overnight and as time runs out, the losses becomes permanent. You can read more about the risks of options from this article I have written in the past.
Options are very delicate tools, you see. Use them correctly and it can create unbelievable wealth for you. Use them wrongly, and they destroy your wealth faster than you can blink your eyes.
Have An Investment Thesis
This part is crucial. You must first have an investment thesis that can guide you through the investment process. For example, Alibaba is a buy. Why?
Because revenues are growing, cash flow is growing, company has certain competitive advantage etc. List down all the reasons to buy Alibaba.
Have a target price or valuation. How much is Alibaba worth? $100? $200? $300? For this example, let’s assume that I believe Alibaba will recover to its original high of $320.
And lastly, for options you need to have a time frame. When will Alibaba likely recover to its original high of $320? This is probably the hardest part to estimate because no one can really tell the future. If I cannot estimate the time frame, then I will want to buy the call option with the longest possible expiry date to give myself the highest possibility of success.
Having a thesis is extremely important. The way I invest is that as long as my thesis holds true, I will stay with the investment until the end. If the thesis is no longer true, then I will proceed to cut my losses and exit the investment. If you do not have an investment thesis, then you are about to go into the investment blind.
For the purpose of this example, I am going to assume that my investment thesis is as follows:
Alibaba will recover to its original high of $320 within 2 years.
Stocks Vs Options
Imagine again that I have a $100,000 portfolio and would like to invest a maximum of 5% into Alibaba. Should I purchase the stock at $160 each now and the stock recovers to $320, the investment will only produce a 100% return and my portfolio would have only gained 5%. To make my portfolio grow by more than 10%, I will need to be willing to invest more than 10%. But knowing the risks, I am not willing to risk more than 5%.
Now, let’s observe the potential results for different call options:
19 Jan 2024 Call Option @ Strike $160
Let’s assume I chose a call option at strike $160 priced at $44.75. That will cost me $4,475 (100 shares per contract) or 4.475% of my portfolio. If my investment thesis is right and Alibaba recovers to $320 within 2 years, the call option will be priced at a minimum of $160. Meaning my call options will be worth at least $16,000. Compare that to my total investment of $4,475, my capital has grown by 3.57 times. That means that my portfolio would have grown from $100,000 to $116,000 or 16% by just investing 4.475% of my money.
19 Jan 2024 Call Option @ Strike $200
This time, let’s assume that this time I chose a call option at strike 200 priced at $28. This will cost me $2,800 per contract or 2.8% of my portfolio. If Alibaba recovers to $320 within 2 years as predicted, then the call option will be priced minimum at $120, making my call options worth at least $12,000. Compare that to the investment of $2,800, the value of the investment has grown by 4.28 times. My portfolio would then grow from $100,000 to $112,000, a 12% gain by just risking less than 3% of the portfolio.
So you see, I can risk very small % of my portfolio yet grow my portfolio very meaningfully. This, my dear readers, is what I mean by asymmetric returns. Some of you are probably tempted now. Why am I buying stocks? I should be investing only with options.
STOP! Remember that the high returns your are seeing - 3.57x or 4.28x, only materialises if the investment thesis materialises and Alibaba recovers to $320. If it goes beyond that, then the returns will definitely be higher. But if your investment thesis is wrong and Alibaba does not recover within 2 years, then you will probably lose close to 100% of your investment and it CANNOT BE UNDONE. Because of this, I will never risk more than 5% of my portfolio on a single call option position. There should also be proper assessment whether your investment thesis is sound or not. If you frequently spend even just $1 on the lottery, do it long enough and the total will add up to a significant amount.
Remember, you have to accept that there are times when your investment thesis is wrong. Most importantly, when you are wrong, make sure you are wrong small. But when you are right, make sure that you are right BIG.
Last question, are all these worth it? I don’t know, you tell me:
Disclosure: I have no positions in Alibaba nor am I considering to initiate one in the near future.
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