How A Structured Note Can Save Value Investors From A Bad Trade
Back in December 2012 I started geting interested in Apple (AAPL). The stock had fallen from $705 down to the low $500s as investors began to sour on its margins, the CEO, and the competitive landscape with Samsung launching a 5″ smartphone called the Galaxy S4.
One simple investing screen I use to find ideas is to see what stocks have fallen at least 20% in a six month period. From there I identify names to research for potential catalysts that will hopefully prove the market wrong. My thoughts on Apple were simply that they couldn’t ignore the market’s appetite for a large screen iPhone. I also thought they’d begin returning more money to shareholders given their $150 billion war chest. At then 12X earnings with double digit earnings growth and an S&P 500 at over 14X earnings, I thought Apple provided a good risk reward in the low $500s.
After dumping a good chunk of change into the markets in June of 2012, I regrettably let a remaining $40,000 sit in a low yielding money market account waiting for opportunity as the markets kept on rising. I figured keeping some money liquid would be prudent because one never knows what opportunities may arise. Apple looked enticing, but I wasn’t willing to “catch a falling knife.” There had to be an option where I could invest in Apple with lower risk, but with a decent return. Enter the Apple ELKs structured note (the link goes into more detail of how a structured note works).
THE NOT SO SAFE TRADE
My base case annual financial target continues to be 3X the risk free rate. The 10-year yield hovered around 1.8% in December 2012 with an expectation that it wouldn’t rise much higher than 2% in 2013. Hence, my 2013 financial benchmark was a conservative 5.4-6%. I’d aggressively seek all investment opportunities that provided greater than a 6% return if the risk was reasonable.
The Apple ELKs offered a 20% downside barrier and a guaranteed 3.5% return over six months if Apple closed higher than the 20% downside barrier. With the stock at $520 I thought there would be no way Apple would close below $415 come June 2013. I remember thinking to myself I wish I had $400,000 to invest for a low risk 7% annualized return instead of just $40,000. 7 year CDs were only yielding 2% for goodness sake.
Apple actually ended up declining by more than 20% during this six month time period to my dismay. On April 18th while I was on vacation in Hawaii no less, Apple broke $400 to hit a low of $390. If Apple closed below $415 on the June 17 closing date I would lose the exact percentage decline! In other words, if Apple closed at $414.99, instead of getting my full $40,000 back, I would get only $31,990 back + the monthly dividend payments based on 3.5% over 6 months.
All of a sudden, making a lousy $1,400 coupon spread out over 6 equal payments vs. losing $8,000 or more minus the $1,400 coupon didn’t sound that great at all.
STRUCTURED NOTES PROVIDE DOWNSIDE PROTECTION
If I owned $40,000 in Apple outright at $520/share I’m not sure what I would do after the initial drop to the mid-$400s. I may still be holding on for hope, cursing my ill-timed investment. Or maybe I’d double down to $80,000 and hope the second half of 2013 and all of 2014 will bring about incredible new product offerings to get the stock moving again. What I do know is that my happiness meter would tick down a notch and that’s not good.
Because I’ve gone through so many downturns since the 1997 Asian Financial crisis, I’m very wary of investing in anything without protection. There are a lot of hot shots out there who think they can do no wrong because they began investing in 2008 and beyond with insignificant amounts of money, having never experienced a bear market. I can unequivocally tell you that their feelings of invincibility will change once a large correction hits again. It won’t be just their investments they are worried about, but their jobs and future as well.
If you’re willing to give up some upside in exchange for some downside protection, structured notes are a viable solution. The returns as stated in the prospectus bake in the fees. In other words, what you see is what you get, much like the “no cost” mortgage refinances. It’s important to accept that banks are making a spread off of you. That’s the price of doing business.
Sometimes you might not be really giving up any upside since the upside is already above your annual financial target (5.4% vs. 7% in this case). I thought there was a good chance Apple would continue to falter at $520, hence the structured note investment rather than the outright purchase of underlying shares. However, I thought there was no way in hell Apple would lose another 20% after already losing 30% unless management was completely tone deaf to the market.
It turns out that I was wrong, but ultimately right. Although the experience was somewhat worrisome, I maximized the features of the structured note to the fullest. It would have been ironically more annoying if Apple rebounded to $700 after I purchased the structured note at $520. Instead of making $15,000+ I would be stuck only making $1,400.
Structured notes are one of many ways to invest and manage your financial nut. The question is now where to invest the $41,400 to try and get a 6.6% lower risk return now that the 10-year yield has moved to 2.2%. Happy hunting!
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