The market moves in mysterious ways. After months of a bullish run, signs of a pullback are showing up everywhere – the most obvious being the move from momentum stocks into defensive stocks.
Portfolio managers rarely make large shifts in their core holdings, but they adjust the bias inside of a portfolio fairly frequently. That is, they shift the percentage of the fund's holding to prioritize growth or value weighting or momentum stocks and defensive stocks.
Basically, the "risk on" trade is rotating into a "risk off" trade. Fund managers are preparing, and investors should be as well. If you're not, a good way to start would be to pick up a stock like Cisco Systems Inc. (Nasdaq: CSCO).
Cisco makes switches, routers, and other necessary equipment to build out and deploy the routing of electronic information. In other words, it builds the core equipment for the high-speed Internet that you may be using to read this article.
Founded in 1984, Cisco has grown into a company that today has a market cap of $120 billion. It has an enterprise value of $94 billion after net cash has been deducted from the market cap. The company has $15 billion in debt, and currently holds $38.9 billion in gross cash, giving it $23 billion in net cash. This is what you call defensive posturing.
Cisco generated more than $41 billion in revenue in the last year, and $10.75 billion in revenue in its first fiscal quarter of 2011.
In the trailing 12 months, Cisco has reported a profit margin of 19.8% with an operating margin of 22.5%. However, while Cisco generated $25 billion in profit last year, its stock posted a negative return.
In the last 52 weeks, Cisco stock has tumbled 7% while the Standard & Poor's 500 Index is up nearly 18%. In that time, the stock has traded between $19 and $27 per share and built what appears to be a multi-month base at lower levels. Now it's breaking out to the upside during a period of market weakness.
This is a sign that fund managers are starting to rotate into Cisco as a defensive heavy weighting in their portfolios. The ample liquidity, options market, and bond offerings make Cisco an institutional investor's dream stock during market inflexion points.
Better yet, the company finally has agreed to start paying a dividend. That will give long-term investors a reason to stay in the stock. It also gives dividend mutual funds a reason to buy a company they'd previously been unable to add to their portfolio. This will help put some hustle behind Cisco stock.
Bottom Line: Cisco has more than $20 billion in net cash on its balance sheet, a liquid options market to hedge against risk, and shareholders this year will begin to reap the benefits of a 1% -2% dividend payout.
The market is showing signs of becoming worried about future returns. This is a warning sign that stock prices could be lower in the weeks and months ahead. The market appears to be rotating into defensive positions, which is driving up Cisco's share price. That, in turn, is lowering the cost of put insurance on the company's stock. This gives us a chance to hedge our position through the purchase of cheap puts.
Cisco is one of the most liquid stocks available. So let's take advantage of that liquidity by picking up 99% of our position at market. Use the other 1% of the position to purchase a LEAP put on Cisco to hedge against any major market volatility.
Let's pick up 1% of our position in CSCO Jan 2012 puts with a strike of $15 to help hedge our downside risk in case of a major market correction in 2011. This strike already has over 87,000 open interest puts available. They trade currently for a bid of 45 cents and an ask of 47 cents.
(**) Special Note of Disclosure: Jack Barnes holds no interest in CSCO.
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"Buy, Sell or Hold" columnist Jack Barnes started his career at Franklin Templeton in 1997, working in the company's fund-information department – just as the Asian contagion infected the Asian tiger countries. He launched his own RIA shop in 2003, just as the second Gulf War was breaking out. In early 2006, after logging a one-year return of nearly 83%, Forbes named Barnes the top stock picker in its "Armchair Investors Who Beat the Pros" competition. His two audited hedge funds generated double-digit returns in 2008. Barnes – the author of the popular blog, "Confessions of a Macro Contrarian" – retired to the beach in the summer of 2009, and continues to write from there now.]
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