Thursday, December 10, 2009

Bought Puts on Virgin Media

Virgin Media (Nasdaq: VMED) caught my eye on the Short Screen screener last night. In addition to having an Altman Z"-Score in the distress zone, the company has been losing money for the last four quarters (though those losses have narrowed somewhat over the last three), and has a fairly high debt load (about $9.5 billion in net debt, versus trailing revenue of $6.6 billion and a market cap of about $5.5 billion). Despite that, its share price has rocketed up from a low of $3.76 back in March, to $17 as of last night's close1. A quick search on Twitter showed several bullish tweets on the stock over the last few days, based on its technical trends.

Since Virgin Media has options traded on it, I figured I'd buy puts on it instead of shorting it to cap my downside risk. I bought a few of the Jun 10 put contracts with a $10 strike price (NUDRB.X) this morning for 30 cents each.

1The shares of a number of financially distressed companies have had similarly explosive run-ups from their March lows, including one we mentioned here previously, BAGL.

Update: Perennial contrarian "Commodity" makes the bullish case for VMED in this comment thread on GuruFocus. He could be right, so if you're thinking of going long or short VMED, you may want to check out his comments first.


Homer315 said...

Dave, a couple of things. First, I had considered joining Shortscreen, but haven't as yet because I've been jammed up working on some other investments this fall, and won't have more time until the new year. One thing that's bothered me though, is that the screen is looking at the TTM financials, right? Isn't that a problem when trying to extrapolate those figures to the future? Specifically, the screen is finding companies using financials for the worst economic environment in decades, meanwhile many of these companies could easily be on the upswing. It's sort of the opposite effect of cyclical companies having really low PEs because the cycle is about to turn and profits are about to fall. I'm not sure that the TTM financials for many companies are in any way indicative of what's going to happen to them in the next 12 months.

As for VMED in particular, the company has been losing money for like four years (at least, it's had negative EPS for that time period). Is there something else going on with the financials that make those figures misleading? They have huge depreciation and amortization figures, so perhaps that's hiding better cash flow. The stock was doing fine in the 2005-2008 time period, even though the EPS were largely negative. Did you look to see why the figures are so bad?

DaveinHackensack said...


The screener follows the Altman models, which do rely on past data (plus current market value of equity). More on how the models work, their accuracy, and how the screener uses them is available on Short Screen's About Page if you want to drill down further. The nut graf re accuracy is this:

In its initial test, the Altman Z-Score was found to be 72% accurate in predicting bankruptcy two years prior to the event, with a Type II error (classifying a firm as distressed when it does not go bankrupt) of 6%. In a series of subsequent tests covering three different time periods over the next 31 years (up until 1999), the model was found to be approximately 80-90% accurate in predicting bankruptcy one year prior to the event, with a Type II error of approximately 15-20%.

One comment based on my own observation is that the inclusion of items such as retained earnings gives the models a cumulative aspect, so an initially financially strong company can still have a strong score during an economic downturn. That was the case, for example, with AYSI earlier this year: its Z-score was in the healthy zone despite its earnings and share price falling off a cliff.

Re VMED, beyond the depreciation and amortization you mentioned I didn't drill down much further, to be honest. I might have, if I were shorting it, but since I am taking on less risk here by buying puts, I didn't. I looked at the negative earnings, the low current ratio, and the high net debt on the fundamental side. I also thought about the negative headwinds for media companies with the current weak economy and strapped consumers. Further, I feel like the current rally is getting a little long in the tooth and I think that this is the sort of stock that will fall faster than the market when the correction comes. As I winnow some long positions, I'll probably be opening more short positions (both shorting and buying puts).

Homer315 said...

Dave, I had already read the articles you cite to re the Altman models. My point regarding the TTM figures is that the last 12 months may not be representative of anything like a normal operating environment. Thus the model may (these days) produce a lot more false positives than it might in a normal economic environment. Frankly, I suspect the next four quarters will, for most companies, look very different than the last four quarters.

The only other quibble I have is with your comment re risk. I'm not sure that buying puts, which will go to zero if the stock price doesn't fall, is really any less risky than shorting the stock. Sure the stock could more than double in the next six months, but if you are just comparing the risk of loss of whatever your investment is (the money required to buy the puts or the money required to support a short) it seems to me that, especially over the short term, your risk with the puts is much larger.

And to be clear, I'm agnostic as to VMED -- I have no idea what will happen to it, I'm just a little wary of the Altman model in this particular environment.

DaveinHackensack said...


The models are more nuanced than they appear at first glance. Remember that market value of equity is one of the numerators, so there is a market-based element to the models as well. Then bear in mind that although the economy has been bad over the last year, we have also had a big equity rally. So while TTM income statement items and MRQ balance sheet items may have been negatively impacted by the recent economic environment, the market value of equity has been positively impacted by the market rally. E.g., all things being equal, VMED would have a much lower Z"-Score today if it were still trading at ~$4 per share.

That said, plenty of companies have made it through the last year without having their scores knocked down to the distress zone. Perhaps some that were in the gray area to begin with got knocked down to the distress zone by a few quarters of weak numbers, but as I mentioned in my previous comment, there's also a cumulative aspect to the models. This is just from my observations so far, but it appears that retained earnings, for example (another numerator in the model) are often impacted by events that go back more than one year (e.g., a big negative retained earnings number could have been swelled by more than one year of losses).

Re false positives, I suspect the opposite is the case, that there were more false positives before the crash than today, because of the greater availability of credit. I.e., a company that the models predicted would have gone bankrupt in, say, 2006, would have been more likely to get additional financing to avoid bankruptcy then than a company in similar straits today. This is just my speculation, but I wonder if it's not a coincidence that the rise in false positives from ~6% in the initial tests to ~20% in tests conducted over the next 30 years coincided with a massive expansion in credit over most of those 30 years.

Re risk WRT puts versus shorting, the biggest reason why I find it less risky is because I am putting less money at risk, without giving up much in potential upside, IMO. Consider this hypothetical example. I'm going to make up numbers here, but I think they are plausible. Let's compare shorting $10k worth of XYZ versus buying $1k worth of out of the money puts on it. If XYZ declines by 10% and you cover there, you've made $1k on your short, and you risked $10k to make that. Given the inherent leverage in options, a 10% decline in XYZ might lead to a 100% increase in the value of your puts. In that case, you would have made $1k while risking only $1k.

Now consider that example with XYZ going up 10%. Let's say you cover there on your $10k short. You're out $1k. Let's say you hold out with your put options and they expire worthless. You're out $1k.

FWIW, I'm not sure what's going to happen with VMED either. But consider this: those puts I bought today for 30 cents sold for 65 cents yesterday, while the stock price declined by 3% over the same time period. Time decay shouldn't be an issue here, since they don't expire until June. I'm no mathematician, but I suspect there's a little inefficiency there.

Homer315 said...

I'm not an expert in options, and I trade them pretty infrequently, but let me take a stab at a response to your comment about risk. First, shouldn't the comparison be between the risks of loss of each of your investments, irrespective of the amounts? By your logic, you could simply make your short less "risky" by merely shorting less of the stock. I'm not sure that's the best way of looking at the risk.

Your further explanation supports my point that I think options might be riskier. Look at the inefficiency you just described (if I read it correctly). The put price fell by 50% even though the stock price also fell (by 3%). Given the poor correlation, putting money on the puts seems more dangerous and prone to significant losses. As to your made up numbers of loss and gain, isn't the delta of the put what determines the change in price of the option? As for your particular June 10 put of VMED, I see the delta being about .12 right now. That means that for every dollar in stock price drop, the put should increase in value by only $0.12. Thus a 10% drop in the stock price (from $17 to $15.30)would result in an increase of the put price of $0.20, not a doubling. Maybe more importantly is the bid-ask spread of these low cost options. My broker right now shows the bid ask prices as $0.25 and $0.35 respectively. Imagine you have to buy at the ask price today ($0.35) and the stock price drops 10%, giving rise to a theoretical increase in the put value of $0.20. The problem is that when you go to sell the option, the bid ask might very well be $0.40-$0.50 for example (or $0.45-$0.55). Now suddenly you've had to buy the put at 35c and sell at 40 or 45c. This really wrecks your returns.

All these factors make me think that using options are riskier than shorting the stock as applied to any particular investment amount.

DaveinHackensack said...


shouldn't the comparison be between the risks of loss of each of your investments, irrespective of the amounts?

Sure, but as I said, I feel there is a better trade off between risk versus reward in this situation. I could be wrong.

My XYZ example was a simplified one, but you bring up some good points here. Re VMED, I strongly suspect the negative correlation the other day was simply an artifact of that particular contract being so thinly traded right now. Thinly traded options can also have the wide bid-ask spreads you mention, which as you note, can eat into returns if you're trading them. I suspect though that if the stock declines in the next few months, volume will pick up and spreads will narrow on the puts I bought*. I also suspect that if that happens, its movements will become more strongly (negatively) correlated with the share price. We'll see though.

There certainly are more variables to consider WRT options, which makes them trickier. I don't think it makes them riskier in this case, but I may have a somewhat idiosyncratic view of risk here, i.e., I know how much of this stock I would short if I were shorting it, and I think I have a better balance of risk versus reward doing it this way. Again, it's entirely possible I could be wrong here.