If anyone tells you what Federal Reserve Chairman Ben Bernanke is going to discuss during Friday’s speech in Jackson Hole, WY, they’re lying. And to say it’s a highly anticipated speech is an obvious understatement.

Frankly, I’m terrified of anything Mr. Bernanke utters these days and see two possible scenarios for how the market reacts after his comments. If the Fed communicates that another round of quantitative easing is imminent, we’ll likely see the market hit the rockets as we did last year. Thank you for playing, please pass “GO” multiple times and please keep collecting your $200 in printed greenbacks as additional liquidity floods the system. Alternatively, after the small market recovery during the last couple of trading sessions, anything seen as hesitancy on the part of the Fed to apply further stimulus could be calamitous for the market.

Because of that I did some selling today of two companies in my portfolio to protect some gains and raise cash. Both of these stocks have been hard-hit, at least from their recent highs. I did this with stock replacement trades in both Electronic Arts (ERTS) as well as Gamestop (GME).

Stock replacement involves selling your shares and buying some form of call options to replace your position. This is usually done with an outright call purchase or a call spread. When buying calls, investors typically use in-the-money (ITM) or at-the-money (ATM) calls as the position will begin to appreciate immediately when the stock moves higher.

In both cases, I used call spreads for ERTS and GME:

ERTS – $20/$25 Jan 2013 call spread with ERTS @ $20.34.

GME – $25/$30 Jan 2013 call spread with GME @ $23.35

GME lacked a $22.50 call strike, so I opted for the cheaper $25 call. As the stock’s high back in late May was almost $29, there’s upside in this position if the stock returns to its recent heights.

I’m worried about a negative market reaction to the Jackson Hole speech and with these two trades I’m raising cash and protecting what’s left of my gains in two stocks that have proven fairly volatile in the last 60 days (what hasn’t been?). If I’m wrong and Mr. Bernanke gives the all clear for the “risk-on” trade supported by additional easy money and more liquidity, stocks will move higher and my spread positions will increase in value.

I’m still fine with both companies in that the new Star Wars online game for ERTS has blockbuster potential and GME remains undervalued on a cash flow basis as well as a possible buyout candidate. I’ll still participate in any upside – at least to the level of my sold call – at a fraction of the cost of owning the shares. The caveat is that I’ve turned over the hourglass to begin counting down the 513 days until expiration.

This is more tea leaf reading than I usually worry about. But the market has made such volatile sharp moves of late, that a little more caution is warranted around major events like Friday’s Jackson Hole speech.

Positions: Long GME call spread, Long ERTS call spread (details above)

“Looks like I picked the wrong week to quit sniffing glue.” Lloyd Bridges as Steve McCroskey in Airplane!

Last week really makes investors sympathize with Steve McCroskey. Landing doomed airplanes or losing 5-6% in the market in a couple of hours can feel the same.

Long time readers know I’ve used put selling as a strategy for the past three years. I’ve been successful with this strategy, as I’ve used limit orders to purchase stocks in the past. To me, selling puts is like a limit order you get paid for. The strategy is straightforward as I typically sell puts on stocks I want to eventually own, at strike prices I’m fine buying at if the stock declines. Since I sell out-of-the money puts, the share price has to typically decline between 10-15%.

But there’s one big caveat. Unlike a limit order, when the stock falls you have to buy the stock or buy back a really expensive put at a loss. There’s NO free lunch. So when the market decides to take a one way trip down the crapper like it did last week, sold puts get expensive quickly.

Autodesk (ADSK) was a long time holding until a year ago when I collared my position – write a call / use proceeds to buy a put –  expecting a decline.  However, Mr. Bernanke instituted a second round of money prin…quantitative easing and the market took off, taking ADSK with it as my shares were called away. I waited patiently until the stock came back to the $41-$42 range and wrote a string of puts at the $38-$39 level over the next couple of months. It was the August $39 put that was the real Achilles slicer though. Taking a quick glance at the current quote of at $29 and change, you can guess this one was a big, juicy loser in the portfolio.

While ADSK was plummeting, I had also sold puts on Activision Blizzard (ATVI) and Microsoft (MSFT). Looking back, I violated a rule of mine with these three positions. They were all August maturities. I’ve been careful in the past about bunching together expirations, but lack an excuse for why all three were on in August. However, I was able to roll both the ATVI and MSFT puts out to later months and lower strikes at no cost (ATVI was a slight profit, MSFT a slight loss).

One benefit of the volatility is that options get more expensive. If you have existing options that are close to maturity and still around your strike price, you’ll likely have choices in terms of rolling them out to later months if you want.

One thing I did correctly was to have cash on hand when I put these positions on, making these cash-secured puts. In other words, I left cash in reserve in my account to cover these positions in full if I was assigned. This is probably the most important thing of all, especially to those new to selling puts. Having cash on hand allows you to avoid panicking as you don’t have to contemplate margin requirements and forced selling of positions to cover your cash needs.

And if Airplane! taught us anything, it’s that no one wins when they panic. Sniffing glue doesn’t help either.

Positions: Long ATVI, MSFT stock and calls, ADSK // Short MSFT put, ATVI puts

This won’t be a popular post.

Criticizing industry titans is never fashionable.

Bruce Berkowitz has made me a lot of money. As a shareholder of the Fairholme Fund (FAIRX) since 2004, it’s been a long rollercoaster ride through the 2007-2008 crash and I’m a grateful former shareholder. However, I recently sold all of my shares as the current version of FAIRX is a much different animal than in the past.

I’m a longtime follower of Berkowitz. I’ve used his analogy of “counting the cash in the register” in both casual and professional settings to explain the concepts of free cash flow. Free cash flow is not an easy concept for people who’ve been spoon-fed earnings per share for year by CNBC. But Berkowitz’s analogy of the grocery store cash register – cash in, expenses out and whatever you have let at the end of the day is your free cash – is a powerful one. And Berkowitz and his team have used free cash flow as the core concept of their investing philosophy for decades.

But a review of FAIRX’s recent Top 10 holding list gave me heartburn. FAIRX top 10 holdings consist of 9 financial companies – Sears Holdings (SHLD) excluded – meaning that a large portion of the fund is directly tied to insurance and banking. And other than a meaningful position in Brookfield Asset Management (BAM), I don’t like any of them.

And I’m surprised Berkowitz likes any of them. Less than two years ago he indicated that financial companies were difficult to evaluate. But with the help of consultants hired to disprove / prove his investment thesis on each of his financial holdings, he’s “grown more comfortable” over time.

But how do you measure free cash flow at banks and insurance companies? Much of a bank’s earnings are determined by a bank’s reserve policies, with cash flows highly variable. Insurance companies are an even greater “black box” when it comes to reserving, as cash received today is paid out far in the future. We’re not talking about widget makers here; we’re discussing huge global organizations with enormous derivative exposure and very complicated accounting.

Part of the investment thesis is Berkowitz’s dependence on government largesse to continue to provide a supportive investment environment for FAIRX’s holdings. But as we’ve seen in the past two weeks, the government’s ability to support the financial industry may be limited in the future. And now that a double dip recession is back on the table as well as a downgrade of U.S. Treasury debt, higher interest rates and a tougher economy are real possibilities going forward.

Financials aren’t new to Berkowitz. He made a killing on Wells Fargo back in the 90’s after the last Savings and Loan crisis. And he recently made a second killing when General Motors (GM) – probably THE biggest beneficiary of government support – bought FAIRX’s large holding in Americredit, which put to rest any questions about why he might have penned a thank-you letter to the “thousands of patriots in civil service who rescued the global financial system”.

My original investment thesis for the FAIRX fund was that I was getting a manager who invested from the framework of free cash flow, finding values and waiting for the rest of the market to catch on. I have no interest in a focused fund of financials and insurance companies in this political environment. My guess would be that Berkowitz does just fine from here with his current crop of holdings if the economy stabilizes and eventually recovers. But if there’s another financial hiccup in the system, we may find the government’s willingness and capacity to keep the financial sector strong much different than in the past. In that scenario, I want to be as far away as possible from much of FAIRX’s top 10 holdings.

Positions:  Long BAM

We should be thankful we get a barometer check on the state of the banking system every couple of years or so. And by barometer check, I mean a reporter who checks in with billionaire banker Andrew Beal wanting to do an article about Beal Financial in Dallas, Texas. This forces Beal to grant an interview – he’s notoriously private – and provide the rest of the investing public an update on where he stands in regards to the banking cycle and lending in general. The latest assessment from Bloomberg doesn’t disappoint.

When I last wrote about Beal in 2009, he was expanding his bank’s balance sheet by buying up distressed assets – loans, bonds and other securities – at rock-bottom prices and profiting wildly. As these opportunities began to dry up, Beal turned to another avenue for distressed assets, purchasing failed banks from the FDIC. But remaining true to his contrarian nature, Beal turned away from buying assets after early 2010, due to a lack of sellers and after the government’s economic stimulus began to stabilize asset prices.

Beal runs a tight and profitable ship at Beal Finanical and Beal Bank Nevada, a subsidiary bank. Beal Financial has over $3.2 billion in total equity with Beal Bank Nevada’s equity to capital ratio standing at 35%. As the article states, this is over 3 times the regular equity-to-asset ratio for the average U.S. bank. And operations are wildly profitable. Beal Bank Nevada’s ROE of 27.4 percent vs. 5.9 percent for all U.S. banks is incredible.

So what is Beal seeing now? He’s moving to the sidelines again, a place he presciently inhabited from 2004-2007.

“Today’s markets are being supported by a flood of money,” he says. “There are so many lenders in a race to the bottom when things are good. We don’t participate in that.”
Beal’s indicating that assets are mispriced for the real amount of risk they contain, and the Federal Reserve’s monetary strategies have flooded the markets with so much money, it has to find a home. This is a common refrain from bankers I talk to. Banks that spent much of the last three years getting back on their feet are beginning to lend again.

But the banks’ reinvestment choices are so minimal, that the consensus strategy seems to be to buy business again through lower lending rates, which can be offered as a result of the Fed’s zero interest rate policy and prevailing prime rates at 3.25%. When your reinvestment options are long term bonds paying next to nothing, even making the choice to lend on a riskier commercial line of credit for twelve months or 3-5 year real estate term loan will start to gain appeal.

It’s noteworthy that Beal’s seen as an outsider in his own industry. Simply put, he chooses not to play his competition at their game, competing on price alone. He’s found a better method of buying those assets at discounts when there are no other sellers and the holders are desperate to unload.

The rest of us should take heed when he’s telling us the industry is back “in a race to the bottom”.

Barron’s released its Mid-Year roundtable update a couple weeks ago and the article contained a brief snippet from Fred Hickey on Microsoft (MSFT). Mr. Hickey’s published The High-Tech Strategist since 1987, and has had a seat on the Barron’s Roundtable for a number of years. Notably, over the past couple of roundtable meetings, Hickey’s picked gold and gold mining shares rather than technology companies.

What’s noteworthy is when a guy who follows and knows the technology sector inside and out – just read an issue of The High Tech Strategist if you doubt that statement –  is bearish on tech stocks and is primarily picking gold and mining shares in which to invest. But what’s even more notable is when someone with Hickey’s knowledge is so bearish on the tech sector and yet still likes a tech stock. That’s when I pay attention.

Hickey recommended MSFT earlier this year in the initial Barron’s Roundtable. And while he backed up his thesis in the mid-year edition, he noted that it’d be hard for the company to win in the next few months as he believes the tech sector is in for second-half slowdown. To show the market has no allegiances to experts, MSFT has rebounded sharply upwards over the past two weeks, closing Thursday at $26.77.

So how did I play it wrong? I shared Mr. Hickey’s thoughts on the immediate prospects for MSFT and sold a $26 call on MSFT. The price was wallowing just above $24 when I made the trade, and the premium I took in looked like easy money as the market was extremely soft. I’m obviously giving up some gains at the current quote and ended up making a poor trade.

But I’m not looking for sympathy. I doubled down on some additional MSFT LEAPS (long-dated call options) when the stock hit its lows and the profits from those have more than made up for the gains I’ve foregone with my misplaced covered call. Also, I’d dipped below my normal cash levels over the past couple of months, so the additional liquidity when my shares are called away can be used for other opportunities.

The biggest lesson learned from this position is that I’m done with covered calls for awhile. There’s likely a behavioral finance lesson in here somewhere as giving up the additional upside on positions hurts me far more than getting assigned on written puts, another options strategy I use frequently. I’m sticking to put writing in the future if I’m looking for additional income.

Long MSFT, Short MSFT $26 Jul Call, Long MSFT Jan 13 Calls

Hoping I can catch the stock at lower levels from where it’s currently trading, I’m back poking around Adobe Systems (ADBE). And by poking around, I’m referring to my oft-used strategy of selling puts.

After reviewing the last couple of quarterly reports, shares outstanding are declining while cash is heading higher, and free cash flow remains very strong. The ongoing recurring revenues from Omniture are providing a nice balance to Adobe’s more economically sensitive software offerings.

My numbers indicate ADBE’s selling at a trailing twelve month free cash flow to enterprise value ratio of 16x. Looking at the July puts, the $29 strike is selling for $0.90, giving us a breakeven price of $29.10. This put is only 26 days out, so if it expires worthless without getting the stock, we’ll have a nice annualized return for our time and effort.

One issue right now with selling or buying options is the low volatility that’s priced into the market. But this is changing. With a VIX (CBOE Volatility Index) at 22, the market is finally starting to price in some volatility. ADBE’s July options have an implied volatility in the high 40’s (%) – up from the high 30’s only a week ago – which means that while our chances of getting assigned are higher, we get paid more premium.

As with any sale of puts, you need to be prepared to take assignment – be put the shares – and have cash (or margin) available in your account to do so. Selling puts is a good way to generate income in a sideways or up market, but represents more risk in a downward market like the one we’re currently in.

If you’ve been looking to add ADBE to your portfolio, this is a way to do it at a discount from the current quote or generate income in the next 26 days before July expiration.

Position: Short ADBE $29 July Put

With volatility the name of the game in the markets this year, no investment has had more movement than silver. After trying unsuccessfully in April to take out the $50 high last set by the Hunt brothers cornering of the market in January 1980, “gold’s poor cousin” has had a swift decline closing at $37.12 on Friday.

With the Federal Reserve’s bond buying program – aka QE2…don’t call it money printing – coming to an end in June, the market has taken a somewhat apathetic view towards gold and silver, although gold’s stoically hung in there relative to silver. With Fed Chairman Ben Bernanke not providing any indication that another round of quantitative easing is imminent; investors have cooled on gold and silver.

However, little if nothing has changed with regards to the current macroeconomic situation. Europe is still a god-awful mess with Greece teetering on the edge of default, debt restructuring or exit from the Euro. Our own budget and ongoing deficit is a slow-motion train wreck with no movement whatsoever on our own “debt ceiling”, a running joke ever since it was established. Add in issues in the Middle East and worldwide inflationary concerns and we have a good base for continued investment in the metals at some point.

My play here is a call spread using the January 2013 LEAPS in iShares Silver Trust (SLV). Specifically, I’m looking to the $40-$45 call spread, which using Friday’s closing prices, would cost $1.35 ($135). For those unfamiliar with call spreads, you buy the $40 call for $5.25 and sell the $45 call for $3.90 for a $1.35 net debit. With a breakeven price of $41.35, we’re essentially paying $1.35 to make $3.65, for an almost 1:2 return ratio. The drawback to this strategy is that with a current price of $35.25, SLV has to rise over 17% for this trade to be profitable. However, in the last silver run-up, SLV made up this gap in just over a month. Also, we don’t need SLV to make a new high, just move towards previous highs again.

We have multiple ways to win. Metals could rise due to a further breakdown in negotiations over Greece (or Ireland, Portgual etc.) in the Euro zone. Should our own domestic economy continue to weaken, the Fed may be forced to go back to the well and print…sorry…quantitatively ease, increasing inflation fears yet again. As we’ve seen, silver’s a volatile metal on the upside as well as the downside. After the recent severe downdraft, SLV may have to trade within a range for awhile, but that’s why I like using the Jan 13 LEAPS, as it provides us some time for the trade to work.

Position: None (I’ll be putting this trade on sometime in the next couple of days.)

On a completely unrelated note, a severe storm knocked out our TV this weekend, and after 24 hours or so of actually getting some things accomplished around the house, I’m left wondering just productive I’d be without regular TV. It’s a completely unrealistic hope though as I’m anxiously awaiting Season 4 of Breaking Bad from AMC in July! Who says summer TV is dead?

Gamestop (GME) reported another solid quarter, with record 1^st quarter sales and profits. And while the results were good, management provided a glimpse into how the company’s digital strategy is helping to build and solidify the customer base on its conference call.

The strong pull from GME’s in-house customer reward program – PowerUp Rewards – is increasing the “stickiness” factor of shopping at GME. The ability to trade in games and then purchase downloadable content (DLC) with GME currency is more lucrative than I suspected. GME’s customer base may at times be currency constrained, but they have ”liquid assets” in the form of used games. GME allows a player to “monetize” these assets and get something they really want, whether that’s a new game or an addition to an existing game via DLC. And a lot of gamers are still trading in games at GME, with over 30 million trades in the prior quarter alone, part of which was then used to download DLC at stores. That’s high margin revenue for everyone involved, including GME, the game developers, as well as Microsoft (MSFT) and Sony (SNE).

Despite the results, the haters are still out in force. I saw a recent Morningstar article that noted a fair value of $20 for the stock. This would imply an obscenely low FCF multiple on the stock, much lower than the current market. At that valuation, the nuclear winter scenario is in effect whereby everyone stops going to GME immediately. It’s not warranted.  However, with a lack of big name titles in the next two upcoming quarters, I don’t expect much movement from these levels. But the end of the year promises a big slate of games, including Madden 2011, Gears of War 3, a sequel in the Batman Arkham franchise, Assassin’s Creed, and the next Call of Duty: Modern Warfare release from Activision Blizzard (ATVI).  On top of the release schedule, all of these games will have downloadable content as well.

Since management didn’t feel it worthwhile to provide a cash flow statement with its earnings release, I’ll circle back and update the numbers when the 10-Q’s released. Looking at the balance sheet, it looks like the company had some working capital moves that will impact free cash flow. Until then, I’ll continue to hold my shares.  The stock is up almost 40% since my purchase and it’s still cheap, with a management team that’s buying back shares – another 5.9 million retired this quarter – and repaying debt.

Long GME

Hiding in plain sight is hard to pull off in the stock market. After all, there’s an entire marketplace sniffing out the minutest mispricings in the market in the hopes of exploiting them for an edge. After struggling to understand the market’s apathy towards Activision Blizzard’s (ATVI) latest results, I’m going to speculate that most investors are like those poor overmatched Stormtroopers on Tantooine in the original Star Wars. It’s staring right at the cheap stock it’s constantly looking for and doesn’t even realize it. Why? The market is paying too much attention to quarterly GAAP earnings and not enough to free cash flow.

ATVI consistently generates lots of free cash flow. As opposed to its competitors in the industry, ATVI actually does some shareholder friendly things with this cash, like paying dividends and buying back stock. And yet the stock goes nowhere, even though the company is currently selling for only 9 times free cash flow to total enterprise value.

I have to assume that either no one is calculating free cash flow for ATVI or if they are, they aren’t paying attention to the numbers. Maybe everyone’s going to the quote screen on Yahoo! (YHOO), looking at the 26 PE and turning off the computer?

I understand the risks. Much of ATVI’s success comes from two franchises, World of Warcraft and Call of Duty. And there’s a risk of a franchise simply failing. Cough. Guitar Hero. But the rest of the industry would kill for these two franchises, as both have been wildly successful and still have legs. The rest of the cupboard isn’t exactly bare. Starcraft and Diablo 3 (whenever it comes out) are huge franchises in their own right and ATVI’s distribution deal with Bungee – the maker of the Halo series – promises to be an important contributor to earnings going forward.

My strategy for ATVI remains the same. I continue to write puts at the $10 / $11 levels to add additional shares. If the shares get to the $10 level as they did back in early 2010, I’ll look to purchase another synthetic long using LEAPS – selling a put and using the proceeds to finance the purchase of a call – to leverage my capital.

ATVI’s an industry leader selling at a below market valuation. With $3.4 billion in cash and no debt, the balance sheet presents minimal risk. Management is shareholder friendly. Jedi mind tricks aren’t going to stop me from loading up.

Long ATVI, Short Aug $11 ATVI Puts

After the whirlwind of news surrounding Microsoft’s (MSFT) purchase of Skype, there’s little left to add.  But since I recently added Microsoft to my portfolio on the grounds that’s it cheap – and getting cheaper – I’ll comment anyway. Heck, everyone else already has!

Let’s break the deal down into pros and cons.

Cons:

-          Microsoft’s lousy history of acquisitions is not a great indicator for eventual success here. Solid deal execution is not a trademark of Microsoft.

-          The price. $8.5 billion for a company with revenues of $860 million and losses of $7 million? Yuck.

-          The network carriers are not going to look at a huge rollout of Skype to the masses favorably. No one wants scratchy, interrupted internet video conferencing or voice calls and all that bandwidth has to come from somewhere.

Pros:

-          That $8.5 billion purchase price is being paid out of international funds, which if brought back to the United States would be taxed at 30%. We need to discount $8.5 billion by 30% to arrive at a real deal cost. Does this make $8.5 billion more reasonable? Maybe, but not much.

-          The deal gives Microsoft the ability to broaden Skype with Facebook, in which Microsoft owns a stake (purchased at far cheaper multiples than Facebook is currently selling shares for, a fact that Microsoft gets little credit for) and keeps it out of the hands of Google (GOOG).

-          The deals allows for the possible integration of Skype into Microsoft products, including Office and other enterprise software, competing with Cisco’s (CSCO) WebEx and Adobe (ADBE) Connect. This is a big market, which a company of Microsoft’s size has to address in order to keep growing in a meaningful way.

There are a couple reasons I’m invested in MSFT. The PC business, even if no/low growth, will continue to generate gobs of cash. The Xbox Live platform continues to grow and the Kinect is a bonafide hit. The deal with Nokia (NOK) gives them a legitimate shot – though admittedly long – to get back in the mobile game. There’s no balance sheet risk and free cash flow remains strong. Seriously strong, as the Skype purchase is four months of operating cash flow for MSFT.

I’d doubled down on MSFT shortly before the deal was announced and added LEAPS options after the market gave the purchase a thumbs down. The stock continues to get cheaper, but MSFT is being dismissed by the market for all the things it’s not, rather than the business that it is.

Long MSFT, MSFT Jan 13 Calls