Do you have a large single stockholding that you are concerned about the risk and would like to protect?
The technology boom over the last decade has created many multi-millionaire investors with large single stock portfolios. They can be founders or employees who joined sufficiently early enough to benefit from a skyrocketing stock price. Famous examples of company stock prices performance over the last 10 years include Apple up 285%, Netflix up 342%, Amazon up 415% or Tesla is up 584%. Incredible price gains that leave many investment analysts wondering where to next for these stocks?
Traditional advice would tell you to sell down large single stock holdings to diversify your portfolio but to counter, this it is by holding a single stock exposure you have created significant wealth or the opportunity to do so, returns that traditional investing may not achieve in a lifetime.
That said there is a clear logic to selling down or protect single stock holding that represents a significant portion of your wealth. There is a long history of financial collapse by previous high flying companies such as Kodak -95%, Peabody Energy -99% and Radioshack -100% as examples in the last 10 years. Or even periods of long market underperformance e.g bank stocks
If you wish to continue to hold your large single stockholding whether it is because you are bullish on the companies performance, disposal restrictions or do not wish to pay a large tax bill. What are your options?
Put option protection
A put option protection strategy entails buying a put option to protect the value of your stockholding (hedging). This gives you the right to sell the stock at a pre-determined price even if the stock price falls below this strike price. For example if company x has a stock price of 100c and if you wanted to protect the value from falling, buying a put option at a strike price of 95c would ensure that if the price fell to 95c your put would be exercised and the stock would be sold at 95c even if the price subsequently fell to 60c. A put option is typically for 3 months but can be up to 12-18 months. Once the option expires a new put has to be purchased if you wish to maintain protection.
The benefit of this approach is that you get guaranteed downside protection for the value of your stockholding and 100% of the upside. You also maintain ownership of the stock and can dispose of the stock and options at any stage (subject to the type of option). You may be able to borrow a percentage of the value of the stockholding as it is protected.
The drawback is that it is relatively expensive to purchase, at the time or writing a 3 month put option on apple stock would cost you 7% of its value. It is also an inflexible instrument, if the stock price only briefly dips below 95c you are forced to sell your stock even if it makes a dramatic recovery and doubles in value. So selecting the right protection price is important especially for volatile stocks.
Tactical hedging is a variation on the above strategy when put options are only purchased for periods that you perceive the stock is in danger of a sell off. Certainly a more cost effective option as you are only protected for specific periods but it exposes you the risk of missing a turning market, which most do.
Zero cost collars
To lessen the upfront cost of purchasing put options, some investors consider selling call options to partially or fully finance the purchase of the puts (with a strike price above the market price of the stock). The combination of long puts and short calls to hedge a single-stock position is commonly known as an “equity collar.” Similar to our first example of company x, if the current stock price is 100c and if you wanted to protect the value from falling, buying a put at a strike price of 95c would ensure that once the price fell to 95c your put would be exercised and stock would be sold at 95c. In addition if you sold a call option at a strike price of 105c, you would receive a payment that would offset the cost of the put; if the price reached 105c the call option would be exercised and the shareholding would be sold.
There is a lovely symmetry about this approach as you receive a significant level of protection without any additional cost. There may also be an option to borrow against the holding to further diversify your portfolio.
The drawback is that while your shareholding is protected you lose out on the up side if the price exceeds 105c (in our example). It may also mean having to sell your stocks at an inopportune time from a tax perspective.
This approach is not effective for long term hedging given you receive very little benefit from any price appreciation but it can be effective for specific protection strategies.
Stock protection Trusts
These are a relatively new option for investors and are currently available only for US listed stocks. It is based on the shared risk principle.
Typically 20 participants form a stock protection trust, each have invested in a different stocks and each stock is in a different industry. Each participant makes a one-time cash contribution of 10% of the value of the stock to be protected (e.g. each participant contributes $50,000 in cash to protect $500,000 of stock). This creates a cash pool that is invested in 5-year U.S. Government bonds.
After 5 years, the cash pool is disbursed to investors whose stock has lost value over the 5-year term – to eliminate or substantially reduce the decline in stock value. If cash remains after all losses have been covered, this cash is returned to the investors whose stock gained in value. In addition, these investors retain their stock’s full 5-year upside gain.
The benefit of this approach is that it is relatively cost effective circa, 2%pa over 5 years. The shared cash pool provides significant downside price protection and the risk is shared across a diversified portfolio. You can sell the shareholding at any time and you only pay for protection if required in the stock protection trust.
A drawback is that you will need to fund the 10% cash contribution at the beginning and in the event that the maximum losses exceed 10% across the fund, you will receive less than 100% price protection, if your stockholding has declined in value. You would need to ensure you get tax advice in relation to participating in the trust particularly if you live in Ireland/Europe.
An added feature is that public company executives and employees can use the fund to protect both stock and stock-linked compensation even if they have not fully vested.
Conclusion
A large single stockholding in a successful company is a blessing but it comes with its own risks. There are a number of options available to investors/employees with large single stock shareholdings that wish to maintain their holding. There are benefits/drawbacks to each option and suitability depends on your circumstances, investment objectives and timeframes.
Author: Frank Mulcahy, is the principal at Trinity Financial Management, he provides a specialised advisor service to families, to ensure they grow and build their wealth in line with their wishes.
If you would like to have a chat, contact me on 01 908 1236 or email me on frank@trinityfinancial.ie. Additional information can be found on www.trinityfinancial.ie
This article is provided on the strict understanding that it is for the reader’s general consideration only. Accordingly, no action must be taken or refrained from based on its contests alone.
