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Me:

[Quoting Bob Warfield] “This one is self-referential because Thiel uses Bubble Logic to argue that you’ve got to bet on the next bubble. Why? Because the alternative is all-out Global War and nobody survives.”[/Quote]

There would seem to be an obvious third alternative (actually, there are additional alternatives, but let’s run with this one): bet on the bubble and hedge. This has the advantage that the bubbliest asset is often relatively cheap to hedge, since more folks thinks it’s going to keep going up.

For example, I just checked Portfolio Armor to see what the optimal put option contracts would be to hedge positions in, respectively, the ETF that tracks the S&P 500 (SPY) and the one that tracks gold (GLD), and what the cost of those optimal contracts would be. The cost of hedging against a greater-than-20% decline in the S&P 500 ETF over the next six months is 3.43% of the position value; the cost of hedging against the same percentage decline in the Gold ETF over the same time frame is .092% of position value. Gold may be a bubble — some would disagree — but it’s pretty cheap to hedge it at the moment.

So a simple investment strategy would seem to be to pile into GLD and hedge.

Howard Lindzon:

i love the idea of portfolio armor as a service. great idea. the gold example is a perfect sales pitch.

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Seems like the person who left that comment doesn’t really understand what Portfolio Armor is supposed to be doing (or option pricing models for that matter). The Black-Scholes formula is used to compute prices and hedge ratios for options. It will not tell you which contracts provide the optimal level of protection to preserve your wealth in a stock or ETF holding, given the market prices. An investor would use an option pricing formula (such as Black-Scholes) if he/she does not think the market quotes represent the “true” price of the option… so you put in the strike, the expiration, the stock price, the risk-free rate, and the volatility; then the model will spit out a price for the option assuming the model is “right” (if you believe markets are efficient then the model just serves as a check on the validity of the underlying assumptions).

Breaking up a block of text with the Porfolio Armor logo

Most option pricing models will also give you a “hedge ratio” which says how many shares of stock you would have to buy (sell short) for every 1 call option sold (or bought) so that the P&L on the option is canceled out by the P&L on the stock position. The problem with model-implied hedge ratios is that they will change every time the underlying asset price (stock or ETF price) changes; so in order to maintain a perfect hedge- where every $1 loss on the option is offset by a $1 gain in the stock- the investor/trader must “dynamically hedge” meaning he/she has to continuously buy and sell the stock and options to modify the ever-changing hedge ratio… while in theory this should work perfectly, the existence of transaction costs completely eats away at the benefits of attempting such dynamic hedge strategies.

Recall that Portfolio Armor, on the other hand, maintains a static hedge ratio of close to 1 giving them a more conservative position and the potential to make more money than they loose should the stock fall in price (remember the concept of “positive hedge error”… I think that’s what we called it? [We called it "positive hedging error"]).

So basically, the points are:

* Portfolio Armor gives you the optimal protection strategy (number of options and specific choice of contract) at the lowest possible cost, given current market prices
* Option pricing models say nothing about which contract is the optimal choice for a particular investor’s objective (i.e. cap losses at 20%, etc.)
* Option pricing models seek to find the “true” price conditional on the model assumptions
* Portfolio Armor is non-parametric and is not vulnerable to model error (resulting from flawed model assumptions)
* Option pricing models can give you a hedge ratio so that P&L gains in one position perfectly offset P&L losses in the other position, but they require continuous and dynamic re-balancing of the hedge portfolio
* Portfolio Armor maintains a static and conservative hedge ratio, and by taking the cost of the options into account, does so in the most economical (“cheapest”) way for the investor

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The Last Psychiatrist has good taste in TV. Here he blogs about a recent episode of the F/X show Louie, “Bully”. Below is the trailer for the episode. Incidentally, in addition to being a sharp writer, the way TLP breaks up his posts with roman numerals is a classy touch. It makes his blog posts look a little like Wallace Stevens poems with ads.

Update on the Thomson Reuters StreetApps Challenge

Thanks again to all of you who voted for the Portfolio Armor iPhone app in this contest. Public voting is over, but awards won’t be announced until later this month.

Elance FTW

Found a designer on Elance to do the iPhone app icon.

Why I’m buying more Alloy Steel Shares

That was the headline Seeking Alpha gave to the post of mine they published today. I picked up a few more shares of AYSI at .90 today.

A couple of items from Short Screen

I mentioned this in the comment thread of a previous post, but I piggybacked on one of Stockdoxc9999’s ideas and bought a few puts on WMG today. Also, I checked with the Options Clearing Corporation and found out that the May expiration options on ONP will come out after this month’s op/ex on September 20th.

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This is the logo of my company’s web app, Portfolio Armor:

What I need is a version of that logo to serve as the icon for the Portfolio Armor iPhone app. The icon should be photo-realistic and angled out toward the viewer like this image below,

But without that cash drawer in the side of the pig, and with a more metallic gold color for the pig, and with the design elements of the Portfolio Armor web app logo above, e.g., the armored border, the coin dropping into the slot (with the angle of the coin matching the angle of the piggy bank).

If you know of a designer who can do this well (preferably, one who works fairly quickly), please have him or her contact me.

Thanks.

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I had the pleasure of meeting Arnold Waldstein Tuesday evening at his local watering hole, Terroir. Nice place; don’t let the current iteration of their website throw you off. It was the first time I’d seen a bar have Riesling on tap, but I ended up having some Greek red, the name of which I forgot a few seconds after the barmaid mentioned it.

In addition to being a wine aficionado, Arnold is an expert on the social web and an experienced business and marketing consultant. He’s also a crackerjack writer. Worth checking out his blog for thoughts on wine; the intersection of technology, business, and the web; and occasional thoughts on other topics.

Dry powder

Tim Knight’s posts Wednesday evening (A Harrowing Session; Resilience) were only the latest examples of a veteran market participant writing about how difficult the market has been over the last few months. Tim is primarily a short seller, but I’ve read similar laments by folks on the long side as well. To me, that’s a signal to continue holding some cash. Currently, I’m about 50% in cash.

Holding some cash has made it easier to stomach the big recent decline in AYSI, and it has given me some dry powder to add a few more shares at .90 earlier this week (I tried to buy a few more at .80 Tuesday, but the order didn’t fill for some reason).

Alloy Steel thoughts

It looks like I overestimated how much the company would earn this year. My mistake. I thought it would earn over 30 cents this fiscal year, but that appears to have been unrealistic given the capacity constraints the company mentioned in our call earlier this week. Nevertheless, the company has already earned 17.2 cents in the first three quarters of this year, better than the 14.9 cents it earned in its previous best year (2008).

My general idea regarding small growth companies is that if I can buy shares at a single digit multiple to a conservative estimate of what the company will earn next year, that’s probably a good deal (conversely, if I can’t, I may consider that a sell signal, as I did with DSNY last year).

Imagine that AYSI earns in all of 2011 what it has earned so far in the first three quarters of this fiscal year (17.2 cents). That seems like a conservative estimate to me (absent macro headwinds from China, I would expect the company to add to its 2010 earnings next quarter, and grow earnings by a modest amount or more next year). If you estimate that the company will earn ~17 cents next year, at its closing price Wednesday (84 cents), the company was trading for about 5x that forward earnings estimate. That seems like an attractive valuation to me, even given the current secular bear market. At the end of the secular bear market that followed the Great Depression, the average stock traded at about 7x (trailing) earnings. So I have a limit order in to buy a few more shares around this level. My current average cost is about 95 cents per share, which I may get to lower a little here.

A short idea on my watch list

ONP, a Chinese company Hesperian brought to my attention on Short Screen. As this is below $5 (the minimum price for shorting at my brokerage), I had hoped to take advantage of the up day Wednesday to buy a few puts on it, but I was disappointed to see that there aren’t any March expiration puts available for this one. Since overall market action will have some impact on the the performance of the underlying stock (and, hence, the options), I’d like to stagger out the maturities of puts I hold on stocks in lieu of shorting them. I sent an e-mail to my brokerage to see if they know if there will be March options available for ONP soon.

A failure to take profits

Several months back I sold out of BPT for a 100% profit (including dividends, over 3 years) and bought puts on it in lieu of shorting it. I am going to lose money on those puts, which are set to expire this month, for a simple reason: I failed to take profits on them. I remember my project manager Matt asking me if I planned to sell those puts when they had about doubled from where I bought them, and I told him I planned to hold them as I expected them to gain in value as BPT declined further. Fortunately, I made more on the sale of BPT than I’ll lose on my puts on it, but an expensive lesson nonetheless.

Better late than never

The pool at the farm finally opens for the summer today. I might get a good day or two’s use out of it. It’ll be good to soak my bones after the 7 mile run Wednesday evening.

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Q: Can you offer independent verification of Arcoplate and Super Arcoplate’s superiority to other wear plates?

A: Many clients are reluctant to make testimonials. Third party testing (e.g., independent lab testing) is less meaningful in our industry as miners want to see how the product performs in their own local conditions. Client adoption demonstrates the product’s acceptance. Some of the largest mining companies in the world are using Alloy Steel’s wear plates and often end up using it in the majority of the equipment in their fleets. The best testimonial is a repeat sale.

Q: Why the departures of former CFO Alan Windus and director Alvin Tan (after one quarter, in his case)?

A: At this stage in the company’s growth, Alloy Steel needs a full time CFO and is reviewing its personnel requirements for its growth. Alan Windus was a part-time CFO. Barry Woodhouse is a full time CFO, which is the main reason he has replaced Alan Windus. Alvin Tan was a board nominee of Alan’s and the company elected to go with a clean slate.

The company is currently in the process of adding appropriately experienced board members (including an independent chairman) who have experience in the management of growing industrial companies, and have industry connections that will enable them to make introductions for the company that can lead to new client relationships.

Q: What is the status of the FINRA investigation and when do you expect it to be finished and the results made public?

A: As outlined in the recent quarterly, Alloy Steel conducted an internal investigation and provided the requested information to FINRA several months ago. The company has not received a response from FINRA yet, and has not been told if or when it will receive a response.

Q: What was the specific impact of the costs of new mill construction in this past quarter to profitability? How do you expect these costs to impact profitability going forward?

A: Costs of any new mill are carried in the balance sheet so there is no immediate impact to profitability, but to cash flow. Once commissioned, a new mill will be depreciated over its useful life. On the flip side, once a new mill is commissioned successfully, sales can commence. Subject to a decent margin, profitability then increases.

Q: Shareholder communication has been rough, at a minimum, over the past several years. Has any serious consideration been given to hiring a respectable investor relations firm to handle press releases and shareholder communication? It would at a minimum help return some confidence to shareholders and allow company executives more time to focus on what they do best, which is of course to run the company.

A: The company is reviewing the issue of shareholder communication broadly, and plans changes to increase communications in the future, including a revamp of the company’s website within the next few months.

Q: Does management care what the stock price is? If they do, why do they behave as if they don’t? If they don’t, why do they incur the considerable expense and management time associated with a public listing?

A: The company does care about the share price and is disappointed to see it so low. See the related comment below in relation to funding growth and review of strategy.

Q: What is happening in Costs of Goods Sold. AYSI’s Gross Margin has deteriorated markedly. (ii) What happened to a license agreement in Latin America (ie: sales to Vale)? (iii) Update on Indo mill as land is being acquired via installment payments.

Q: Work in progress increased from 124 th to > 1 M : does this imply we will have again record sales of > 5 M in the next quarter ? Why did work in progress increase so much ?

A: Cost of Goods Sold, W-I-P and stock-on can be a timing issue. The Gross Margin for the 9 months year to date (June 2010) was reported as 53.9% compared to 44% for the 3 month period (June 2010). In any quarter, revenue figures can be skewed by several factors including timing of shipments and customer delivery and the like.

The Company has distributor agreements in place for countries in South America. Those distributors have sold Arcoplate in South America, including to major miners who operate there.

Q: What is the capex to set up a new line ? Land expenditure versus equipment expenditure ? The 1 M investing activities: land or equipment investment ? => Idea is to get a clear idea what the company is investing its profits in … (if anyone knows about this please let me know).

A: The Company is investing some of its cash flow into firstly acquiring the Indonesian land (in monthly installments as announced) as well as further plant and equipment as appropriate.

Q: Will you need additional funds to accelerate the growth strategy of the company ?

A: The Company is reviewing its growth strategy and how to fund it. No decision as to method has been made as yet. If the company wanted to fund accelerated growth through an equity raising common sense suggests that a higher share price is required to ensure dilution is minimized.

Q: What is the growth strategy of the company ? (geographical expansion ? pricing strategy ? new products ?) = What is the main focus, main target within 1 year ?

A: The growth strategy of the company is to build credibility with large mining companies by offering a small amount of product and letting those companies see how well Alloy Steel’s wear plate performs. Selling to mining companies can be a long process, as miners generally assume that their local conditions are harsher than those anywhere else and want to see how product performs in their local area, which takes time for them to judge. Alloy Steel has successfully pursued this strategy in the United States and elsewhere, but sales results don’t follow in a linear fashion, i.e., it can take years of small deliveries of product to a particular company before they are followed by large orders once the target company has become confident in the product. Another aspect of Alloy Steel’s growth strategy is to leverage existing relationships with certain divisions of large mining company clients (e.g., the iron ore mining divisions) to introduce the product to other divisions (e.g., the uranium or copper mining divisions for example). Alloy Steel has now gained the credibility with its larger clients where it is positioned to present its product to other divisions.

Q: With the start-up of the second mill and the large backlog reported backlog, why are the total sales still below historical highs that were accomplished with a single mill?

A: Sales have grown steadily on an annual basis and for the 9 months ended 30 June 2010, reported sales are $15.7m compared to the best historical sales annual figure of $13.5m in 2008, prior to the GFC. We are dealing with new technology that has required numerous adjustments to our manufacturing process (to improve efficiencies and quality) which has led to downtime, limiting our capacity. Even with constant corrections, you can see quite clearly the increased sales effect of having a second producing mill on the current 9 month period.

We are wary of accepting large orders that we aren’t absolutely sure we can fill in a timely fashion, as committing to an order and failing to fill it on time would irreparably damage our credibility with our clients.

Q: What is the status of marketing and orders for Super Acroplate?

A: There is currently high demand for the product, but we are limited by capacity constraints.

Q: i. What is the current status of mill expansion? ii. Is the existing facility at maximum capacity?

A: i. Please see above. ii. No, please see above.

Q: Why isn’t the AYSI website used to provide updated product, marketing, and shareholder updates? This would seem to be a cost effective manner to share general information.

A: It will be, once the site has been revamped within the next few months.

Q: How many mills in Australia – in operation or being built?

A: There are currently 2 mills in production in Australia, but please note the comments above.

Q: What is the anticipated completion of the Indonesia complex – how many mills are planned?

A: We first have to complete payment for the land and then build the factory. These details will be part of the review of the growth strategy.

Q: Why were sales lower in the third quarter?

A: This may be a timing issue. In any quarter, revenue figures can be skewed by several factors including timing of shipments and customer delivery and the like.

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