Four Classic Hedges

"Hedge your bets," say the wise.

In the beginning, "hedge funds" actually hedged, meaning that they would make money in both rising or falling markets. Nowadays, the "hedge" in "hedge fund" has lost all meaning. Hedge funds simply invest in risky investments and/or use leverage (borrowed money). Most hedge funds these days do not hedge at all.

So what does it mean, exactly? What is hedging?

Hedging, in simple terms, is a method for taking precautions against financial risk. The goal of hedging is not to make money; rather, it is to prevent losing money.

As an example, if you are worried about a stock market crash, you can buy put options against the stock market, which gain in value if the market drops. Of course, if the stock market goes up, the value of your put options goes down – and the outcome is neutral. If you are a baker and are worried about the rising cost of grain, you can buy wheat futures that gain in value if the price of grain increases. If the price of grain declines, you will lose money on your wheat futures, but also pay less for the wheat you need – again, a neutral outcome.

The financially sophisticated investor has almost unlimited choices for hedging. But, this article is not about these sophisticated hedging choices. It is about simple hedging for the layman.

Hedge #1, Insurance
Say, for example, that you are a married father of two. If you were to pass away, your spouse would be left with the mortgage payments, the costs of raising two children, etc. Therefore, the wise person buys life insurance. If you pass away, your income to the family is gone forever; however, the life insurance pays off the mortgage, with hopefully enough money left over to see the children through college. Thus, life insurance is your “hedge” against possible financial ruin caused by your premature death. Virtually everyone should have life insurance, disability insurance, home insurance, and home content insurance (the building and its contents are usually insured separately). The goal of insurance is not to have so much as to guard against any possible occurrence – it is to buy just enough to prevent extreme financial hardship.

Hedge #2, Gas and Oil
If you drive, consider buying stocks of a large oil company, or an energy mutual fund. As the price of oil (and gasoline) goes up, you can be compensated by an increase in the value of your oil company stock, and also an increase in the amount of dividends it pays you. If the price of oil goes down, your oil stock may decline in value, but so will the price you pay at the pump – this is classic hedging.

Hedge #3, Real Estate (for current non-owners)
If you rent, consider buying a real estate investment trust (REIT), a form of stock market real estate investment. If real estate values increase (along with your rent), the income provided by the REIT will also increase. If real estate values decline, your rent will likely not decline (unless you change buildings), but it won’t go up, either – a 3/4 hedge.

Hedge #4, Household Energy
Almost everyone pays for electricity and heating supplied by a utility company. Utility companies are not only some of the safest investments around, but they also pay regular dividends. The more money they make, the larger the dividends. Utilities can be bought through utility ETFs or utility mutual funds.

The first hedge (insurance) can save you from ruin and protect your family. The final three are long-term inflation killers. Together, and for a minimal outlay of cash, they protect you from both unforeseen circumstances and unexpected costs.
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"(Gold) gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head."

Warren Buffett

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Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.

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A Barrel of Reality

BP, formerly British Petroleum, has been making headlines for weeks with its outrageous 35,000+ barrel per day ocean-based spill. With President Obama calling for revenge (at least publicly), and congressmen berating BP executives while vainly attempting to maneuver them into admitting guilt, some say that the offshore oil market is finished. Others add that the rise of alternative energy vehicles is now assured. Still others say that BP is a great buy. This article is a dose of reality all around.

I am a big fan of alternative energy. Wind and solar power have come of age, and can successfully compete with traditional sources like coal and hydroelectric power for electricity generation. Alternative energy vehicles, however, are simply not at the same level.

Despite all the hype about alternative energy vehicles, how many recharging stations do you actually see on your way home from work? How many people do you know who run electric vehicles for personal use (not just for corporate image)? Major alternatives to electric, such as fuel-cell cars, have been “in the works” and “soon affordable” since I visited Ballard Power’s (BLDP) office 11 years ago.

Although fuel cell and electric vehicles hold great promise, they simply aren't ready. No one wants to wait 20 minutes to "refuel" their car. No one wants a low-cost commuter vehicle that goes 35 miles per hour. Nor does anyone want to pay a year’s salary for a car that goes the same speed as their existing car.

Like personal computers, alternative energy vehicles will truly take off once cost and functionality reach reasonable levels, and once the infrastructure to maintain them is in place. Until then, oil and its producers maintain a bright future.

As for BP, should you buy or sell? Although BP looks tempting at these levels, I should remind everyone that the inglorious well is still leaking thousands of barrels per day. Until it’s actually capped, my money is going into more reliable opportunities; like, for example, this disaster's beneficiaries, Chevron (CVX) and ConocoPhillips (COP).
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“Already those who have seen this new model are acclaiming it the finest car of any type yet produced for city and suburban use. You, too, will be delighted with it.”
Advertisement for the Detroit Electric Car Company, 1920.

Two Stocks I Like – Alternative Energy

Although people continue to debate the existence of global warming, good investors should leave the debates aside and focus on reality: demand for alternative energy has risen significantly in recent years, and will likely continue to do so. Clean energy solutions are more practical and cost effective than ever before, and industry is embracing the savings and public relations improvements that clean energy offers.

Two companies that stand to gain large amounts of new business as demand for alternative energy increases are the well-known companies General Electric and Dow Chemical (I own both).

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General Electric (GE) is one of the largest companies in the world, and the only remaining original component of the DOW 30 Index. It is a technologically sophisticated company with diverse fields of business, giving it an annual GDP larger than the entire country of Israel. GE is a leader in (among other things) nuclear power generation, wind turbines, hydroelectric power, and components for many sources of alternative energy.

GE suffered during the credit crisis of 2008 (especially due to the investment arm GE Capital), and although the stock has come back 100% from its lows it is, in my opinion, still selling well below its true value.

GE Statistics (at time of writing):
Price $18.30 USD
P/E 18.15
Return on Equity 10.11
Dividend Yield 2.19%

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Dow Chemical (DOW) was incorporated in 1897 and now employs over 52,000 people. DOW is already a huge supplier of residential and commercial insulation and weatherization products (including the ubiquitous Styrofoam®), and is always working on new and innovative energy-saving solutions. In 2009, Dow introduced solar shingles. Dow is also currently developing advanced Carbon Dioxide scrubbers for commercial use.

Dow stock has tripled since its low in 2009 in anticipation of the return of substantial revenue, giving it a ridiculously expensive-looking P/E ratio of 93. Nevertheless, DOW has incredible revenue generating capabilities, and I believe that in a few years today’s price will look like it was a bargain.

DOW Statistics (at time of writing):
Price $18.30 USD
P/E 93.2
Return on Equity 3.16
Dividend Yield 2.00%

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Disclosure
Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.

Alternative Energy – Cap and Trade

You’ve heard about Cap and Trade, but what is it?

Before talking about Cap and Trade, one first has to understand pollution control. Note that I am using the term “pollution control” (a tangible, measurable phenomenon) as opposed to “climate change” (a debatable, difficult-to-measure phenomenon).

When talking about pollution control, one has to be sensible. Americans are not going to park their cars and start cycling to work any time soon. On the other hand, it doesn’t make sense to drive your SUV two blocks to buy milk, either. Any good economist will tell you that to control pollution you have to control behavior. This means either putting incentives on green, putting disincentives on brown, or both. And you have to do it without killing the economy.

Say that you own a company that produces 1 tonne of pollutants per day of production. If you were to build infrastructure to reduce that pollution, it would cost you $50/tonne. Since there is a cost with no equivalent savings, there is no inventive to implement pollution control measures. But, if the Government were to start fining you $60 per tonne of pollutants, suddenly there is an incentive not to pollute: your company saves $10/tonne to build the anti-pollution infrastructure. The point is, while free market economics takes care of most issues of industrial production, pollution is rarely one of them. Pollution control has to be mandated.

Measures that have been already been used to control pollution include taxes on gasoline, emissions taxes for corporations, tax credits for buying low-energy home appliances, banning polluting substances (such as DDT and CFCs), and rebates to convert gasoline vehicles to natural gas. So how about Cap and Trade?

Cap and Trade -- also known as cap-and-tax by those who oppose it -- is the name given to a system where a central authority (ex. Government) sets a limit on the amount of pollution that can be emitted. Companies are issued credits, giving them the right to produce a specific amount of pollution (that is reasonably low). If they are efficient (pollute less than their allowance), they can sell their excess credits to other companies for cash. If they are inefficient (pollute more), they need to buy credits from other companies to avoid heavy fines. In other words, there is an economic incentive to meet pollution targets and become more efficient. In theory, it’s a good idea.

The problem with Cap and Trade is that it is complicated and easy to manipulate. If a company manufactures energy-efficient camp stoves, for example, and sells them to African villagers to replace their dung-burning stoves, should they be able to claim credits? If they plant a forest of trees, should they get credits? If a fire destroys the forest, should the credits be taken away? It’s all very opaque. This is not to mention the potential for corruption when big businesses trade credits for cash. And, who decides how many credits to give out, anyway? Will the amount of credits issued rise during an economic crisis, so that businesses can save money?

In my opinion, the best solution is to keep doing what we are already doing. When I visited California as a kid, the smog was so thick it literally made my eyes water. After California passed a law requiring low-emission mufflers, the smog cleared up. When I visited England as a child, households burned coal for heat and buildings looked filthy. Since the government expanded the infrastructure for natural gas and gave incentives to switch, the same buildings now look pristine. When my mother was a child, DDT was a common pesticide. After it was determined to be dangerous, DDT was banned.

The American Clean Energy and Security Act, now in Congress, includes many elements similar to those that have already proven successful; for example, increasing standards of energy efficiency for buildings, modernizing the electrical grid, giving incentives for energy efficient appliances, and requiring large utility companies to obtain some of their energy from renewable sources. But Cap and Trade is also a primary element of the bill.

Cap and Trade isn’t a terrible idea, I just don’t believe it is the best idea. Contrary to some news reports, most major companies support pollution control: it is good for public relations as well as the environment. But they want the playing field to be fair. Existing pollution control measures work and should be expanded. The Cap and Trade portion should be removed and replaced with carbon control measures, tailored to local areas and individual industries.