June 2, 2006                                     Strengthen Returns as Dollar Weakens    Equity Derivatives               ...
Equity Derivatives Strategy | Strengthen Returns as Dollar Weakens                           Since Q2 Began, Dollar Deprec...
Equity Derivatives Strategy | Strengthen Returns as Dollar WeakensFigure 2: Top 25 S&P 500 Firms With Highest % of Foreign...
Equity Derivatives Strategy | Strengthen Returns as Dollar Weakens                           Cheap Options for Stocks Expo...
Equity Derivatives Strategy | Strengthen Returns as Dollar WeakensAnalyst Certification:The respective research analysts r...
Equity Derivatives Strategy | Strengthen Returns as Dollar WeakensDisclosure Legend:C: Lehman Brothers Inc. and/or an affi...
Equity Derivatives Strategy | Strengthen Returns as Dollar Weakensby Lehman Brothers Australia Pty Limited, and in Singapo...
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How to Strengthen Portfolio Returns as the Dollar Weakens!

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Actionable trade ideas for stock market investors and traders seeking alpha by overlaying their portfolios with options, other derivatives, ETFs, and disciplined and applied Game Theory for hedge fund managers and other active fund managers worldwide. Ryan Renicker, CFA

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Transcript of "How to Strengthen Portfolio Returns as the Dollar Weakens!"

  1. 1. June 2, 2006 Strengthen Returns as Dollar Weakens Equity Derivatives • The U.S. dollar has depreciated nearly 6% since Q2 began. This is substantial; during the past Strategy 134 quarters (since Q1 1973), the dollar has depreciated more on only 11 other occasions. In Ryan Renicker, CFA addition, the degree of depreciation during those periods was only about 1% more than what has 1.212.526.9425 transpired thus far this quarter.ryan.renicker@lehman.com Devapriya Mallick 1.212.526.5429 • Naturally, a weakening dollar is expected to benefit U.S. exporters, particularly relative to U.S. dmallik@lehman.com importers or domestic companies generating a relatively small percentage of their revenues overseas. • With earnings pre-announcement season approaching, we believe there is a relatively strong probability that companies having exposure to fluctuations in the dollar could pre-announce prior to their expected earnings report date, resulting in potentially high volatility for these names. • Lehman’s U.S. Strategy team has identified the top 25 S&P 500 companies having the highest percentage of foreign revenue share as well as the top 25 S&P 500 firms having the highest proportion of foreign operating income share in 2005. • We screen the stocks within these lists to identify those having relatively cheap short-dated options, and thus being attractive long-volatility candidates, particularly given the heightened possibility of an active currency-related earnings pre-announcement season. • Options we identify as cheap include those on PFE, LLY, CL, CVX and NVDA. Lehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Customers of Lehman Brothers in the United States can receive independent, third- party research on the compan y or companies covered in this report, at no cost to them, where such research is available. Customers can access this independent research at www.lehmanlive.com or can call 1-800-2LEHMAN to request a copy of this research. Investors should consider this report as only a single factor in making their investment decision. PLEASE SEE ANALYST(S) CERTIFICATION AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 5.
  2. 2. Equity Derivatives Strategy | Strengthen Returns as Dollar Weakens Since Q2 Began, Dollar Depreciation Significant The U.S. dollar has depreciated nearly 6% since Q2 began. This is substantial; during the past 134 quarters (since Q1 1973), the dollar has depreciated more on only 11 other occasions (full quarters). In addition, the degree of depreciation during those periods was only about 1% more than what has transpired thus far this quarter. Below we plot the quarter-over-quarter percentage changes in the U.S. Trade-Weighted Major Currency Index Bloomberg ticker: USTW$ Index). Note the substantial ( depreciation in the dollar since this quarter began two months ago. Figure 1: Quarterly Percentage Change s in the U.S. Trade -Weighted Major Currency Index (1973 – Present) 10% 8% 6% % Change in Dollar Index 4% 2% 0% -2% -4% -6% Dollar depreciated substantially -8% since quarter began -10% Mar-74 Mar-77 Mar-80 Mar-83 Mar-86 Mar-89 Mar-92 Mar-95 Mar-98 Mar-01 Mar-04 Jun-73 Jun-76 Jun-79 Jun-82 Jun-85 Jun-88 Jun-91 Jun-94 Jun-97 Jun-00 Jun-03 Jun-06 Dec-74 Dec-77 Dec-80 Dec-83 Dec-86 Dec-89 Dec-92 Dec-95 Dec-98 Dec-01 Dec-04 Sep-75 Sep-78 Sep-81 Sep-84 Sep-87 Sep-90 Sep-93 Sep-96 Sep-99 Sep-02 Sep-05 Source: Lehman Brothers, Bloomberg. Company Exposure to Declining Dollar Naturally, one would expect a weakening dollar should benefit U.S. exporters, particularly relative to U.S. importers or firms generating a relatively small percentage of their revenues outside of the U.S., depending of course on the degree to which each firm employs internal currency hedging strategies to mitigate this exposure. Lehman’s U.S. Strategy team has identified 1) the top 25 S&P 500 companies having the highest percentage of foreign revenue share and 2) the top 25 S&P 500 firms having the highest proportion of foreign operating income share in 2005 (Figures 2 and 3 on the following page). Please see A Weaker Dollar’s Impact on U.S. Equities, Chip Dickson (5/8/06) for further details. June 2, 2006 2
  3. 3. Equity Derivatives Strategy | Strengthen Returns as Dollar WeakensFigure 2: Top 25 S&P 500 Firms With Highest % of Foreign Figure 3: Top 25 S&P 500 Firms with Highest % of Foreign Pre-TaxRevenue Share in 2005 Income Share in 2005 % Foreign % Foreign Ticker Name Sector Ticker Name Sector Pretax Revenue IncomeFCX FREEPORT-MCMORAN COPPER-B Materials 100% JBL JABIL CIRCUIT INC Information Technology 98%MOLX MOLEX INC Information Technology 90% MAT MATTEL INC Consumer Discretionary 96%NVDA NVIDIA CORP Information Technology 86% ANDW ANDREW CORP Information Technology 93%SLR SOLECTRON CORP Information Technology 86% MOLX MOLEX INC Information Technology 91%INTC INTEL CORP Information Technology 85% FLR FLUOR CORP Industrials 91%TXN TEXAS INSTRUMENTS INC Information Technology 84% AA ALCOA INC Materials 91%QCOM QUALCOMM INC Information Technology 82% PFE PFIZER INC Health Care 89%NSM NATIONAL SEMICONDUCTOR CORP Information Technology 80% WFT WEATHERFORD INTL LTD Energy 85%MO ALTRIA GROUP INC Consumer Staples 80% NVDA NVIDIA CORP Information Technology 85%AMD ADVANCED MICRO DEVICES Information Technology 79% ADI ANALOG DEVICES Information Technology 84%AMAT APPLIED MATERIALS INC Information Technology 79% BMY BRISTOL-MYERS SQUIBB CO Health Care 82%AES AES CORP Utilities 79% AVP AVON PRODUCTS INC Consumer Staples 82%RIG TRANSOCEAN INC Energy 78% WWY WRIGLEY WM JR CO Consumer Staples 81%TER TERADYNE INC Information Technology 78% WAT WATERS CORP Health Care 80%NE NOBLE CORP Energy 77% PLL PALL CORP Industrials 79%SANM SANMINA-SCI CORP Information Technology 76% ETN EATON CORP Industrials 79%KLAC KLA-TENCOR CORPORATION Information Technology 76% CBE COOPER INDUSTRIES LTD-CL A Industrials 79%XOM EXXON MOBIL CORP Energy 76% LLY ELI LILLY & CO Health Care 77%ALTR ALTERA CORPORATION Information Technology 76% BAX BAXTER INTERNATIONAL INC Health Care 76%ADI ANALOG DEVICES Information Technology 75% MMC MARSH & MCLENNAN COS Financials 75% CTXS CITRIX SYSTEMS INC Information Technology 74%AVP AVON PRODUCTS INC Consumer Staples 75% CVX CHEVRON CORP Energy 73%CL COLGATE-PALMOLIVE CO Consumer Staples 74% CL COLGATE-PALMOLIVE CO Consumer Staples 73%MXIM MAXIM INTEGRATED PRODUCTS Information Technology 74%HAL HALLIBURTON CO Energy 73% IR INGERSOLL-RAND CO LTD-CL A Industrials 73% PX PRAXAIR INC Materials 73%SLB SCHLUMBERGER LTD Energy 73%Source: Lehman Br others, FactSet, A Weaker Dollar ’s Impact on U.S. Equities, Chip Source: Lehman Br others, FactSet, A Weaker Dollar ’s Impact on U.S. Equities, ChipDickson (5/8/06) Dickson (5/8/06) Although individual firms included in Figures 2 and 3 may employ currency hedging techniques to reduce potential FX exposure, we find both groups – on an aggregate basis – have tended to outperform (underperform) the S&P 500 Index during periods of dollar weakness (strength). Specifically, we plot the relative performance of each basket (Figure 2 basket, Figure 3 basket) versus the S&P 500 Index during the past year. For simplicity purposes, each basket is calculated on an equal-weighted basis. In addition, we scale the value of each basket to 100 as of one year ago. Furthermore, we scale the value of the U.S. Trade Weighted Major Currency Index to 100 as of one year ago (for comparative purposes). We label the relative performance of the basket of stocks having the top 25 S&P 500 firms with the highest percentage of foreign revenue share in 2005 versus the S&P 500 Index as “% Revenue Relative Performance”. We label the relative performance of the basket of stocks including the top 25 S&P 500 firms with the highest percentage of foreign pre-tax income share in 2005 versus the S&P 500 as “% Pretax Relative Performance”.Figure 4: % Revenue Relative Performance vs. Currency Index Figure 5: % Pretax Relative Performance vs. Currency Index 114 104 106 104 112 103 103 104 102 102 110 102 RelativePerformance 101 101 Relative Performance 108 CurrencyIndex Currency Index 100 100 106 100 99 99 104 98 98 98 102 97 Appreciating Dollar 97 Depreciating Dollar 96 100 96 96 % Revenue Relative Performance 94 % Pretax Relative Performance 98 95 95 US Trade-Weighted Major Currency US Trade-Weighted Major Currency 96 94 92 94 Nov-05 May-06 Mar-06 Jun-05 Jan-06 Jul-05 May-06 Aug-05 Sep-05 Dec-05 Feb-06 Oct-05 Apr-06 Aug-05 Sep-05 Nov-05 Dec-05 Jun-05 Jan-06 Jul-05 Feb-06 Mar-06 Oct-05 Apr-06Source: Lehman Brothers, Bloomberg Source: Lehman Brothers, Bloomberg June 2, 2006 3
  4. 4. Equity Derivatives Strategy | Strengthen Returns as Dollar Weakens Cheap Options for Stocks Exposed to Cheap Dollar With earnings pre-announcement season approaching, we believe there is a relatively high probability that companies having exposure to fluctuations in the dollar could pre-announce prior to their expected earnings report date, which would likely result in relatively high realized volatility for such names. We list the stocks within each basket identified as potentially having exposure to the declining dollar that also have relatively inexpensive 1 month implied volatility versus both1) their 22-day realized volatility and 2) S&P 500 1-month implied volatility (versus each spread’s trailing 12-month history). In addition, we believe the names presented below also have relatively cheap 2 month implied volatility versus both 1) their 44-day realized volatility and 2) S&P 500 2-month implied volatility (again, versus each spread’s trailing 12-month history). Figure 6: Stocks Having Relatively Cheap Options and Likely Exposure to Declining Dollar Expected Ticker Name Sector Earnings Date PFE PFIZER INC Health Care 07/20/06 LLY ELI LILLY & CO Health Care 07/21/06 CL COLGATE-PALMOLIVE CO Consumer Staples 07/27/06 CVX CHEVRON CORP Energy 07/28/06 NVDA NVIDIA CORP Information Technology 08/11/06 Source: Lehman Brothers, OptionMetrics, Bloomberg We believe investors should consider expressing directional views or going long volatility in these names by purchasing short-dated options (1 or 2 month expiry), ahead of a potentially volatile, currency-related earnings pre-announcement season. Please call for details. June 2, 2006 4
  5. 5. Equity Derivatives Strategy | Strengthen Returns as Dollar WeakensAnalyst Certification:The respective research analysts responsible for the fundamental ratings hereby certify (1) that the views expressed in this research email accurately reflect ourpersonal views about any or all of the subject securities or issuers referred to in this email and (2) no part of our compensation was, is or will be directly or indirectlyrelated to the specific recommendations or views expressed in this email.I, Ryan Renicker, hereby certify (1) that the views expressed in this research email accurately reflect my personal views about any or all of the subject securities orissuers referred to in this email and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressedin this email.To the extent that any of the conclusions are based on a quantitative model, Lehman Brothers hereby certifies (1) that the views expressed in this research emailaccurately reflect the firms quantitative research model (2) no part of the firms compensation was, is or will be directly or indirectly related to the specificrecommendations or views expressed in this research report.Important DisclosuresLehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have aconflict of interest that could affect the objectivity of this email communication.Customers of Lehman Brothers in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost tothem, where such research is available. Customers can access this independent research at www.lehmanlive.com or can call 1-800-2-LEHMAN to request a copy ofthis research.Investors should consider this communication as only a single factor in making their investment decision.The analysts responsible for preparing this report have received compensation based upon various factors including the Firm’s total revenues, a portion of which isgenerated by investment banking activities.Stock price and ratings histor y charts along with other important disclosures are available on our disclosure website at www.lehman.com/disclosuresAnd may also be obtained by sending a written request to: LEHMAN BROTHERS CONTROL ROOM , 745 SEVENTH AVENUE, 19TH FLOOR NEW YORK, NY10019Mentioned StocksColgate Palmolive (CL - USD60.77) 1-Overweight / Neutral JRisks Which May Impede the Achievement of the Price Target: Various risk factors which could affect our rating and price target include raw material cost inflation(among others: plastics, paper/ packaging, chemicals, and tallow), geo-political & economic instability (developing markets are estimated to contribute 40%+ ofColgates sales), foreign currency translation (roughly 75% of Colgates sales are in non-US $ currencies), acquisition integration, competitive pricing environment,marketing/advertising effectiveness, consumer acceptance of new products, ongoing retailer consolidation / retail shelf space rationalization (Colgate derivesroughly 45% of sales from mature retail markets) and fixed asset utilization levels.Chevron Corporation (CVX - USD59.98) 1-Overweight / Neutral D/J/LRisks Which May Impede the Achievement of the Price Target: Our earnings estimates are based on Lehman Brothers current commodity price assumption on oil &gas, refining and marketing margins as well as chemical produc margins. Thus, results could be subject to changes due to fluctuations in the macro commodity tmarket environment.Lilly, Eli (LLY - USD51.99) 2-Equal weight / Positive E/J/LRisks Which May Impede the Achievement of the Price Target: Lilly is currently in litigation with Ivax over the exclusivity of Zyprexa. Losing the case would open upthe possibility of generics for their top product. Lilly also faces risk from the Deparment of Justice investigation of marketing practices of some products. Risksassociated with the pharmaceutical industry include pipeline product delays due to discouraging clinical trial results and FDA conflicts. The pharmaceutical industry isalso at risk towards FDA/regulatory conflicts, patent disputes, loss of patent exclusivity, and competitive pressure from other drugs. Lastly, a Medicare drug benefitcould be enacted in a form which would give the Federal Government some purchasing power over the industry, leading to potential downward pressure on margins.NVIDIA Corp. (NVDA - USD24.18) 1-Overweight / Positive C/JRisks Which May Impede the Achievement of the Price Target: (a) dependence on short product cycles (b) dependence on PC industry (c) dependence on externalfoundries (d) dependence on the cycli cal semiconductor industryPfizer Inc (PFE - USD23.90) 1-Overweight / Positive G/J/K/MRisks Which May Impede the Achievement of the Price Target: Competitive threats to Lipitor through AZNs Crestor and MRK/SGPs Vytorin (SGP/MRK), and Zoloft(LLYs Cymbalta). Exclusivity for Diflucan, Zithromax, Zoloft, Accupril, and others will be lost in the next few years. Risks associated with the pharmaceutical industryinclude pipeline product delays due to discouraging clinical trial results and FDA conflicts. The pharmaceutical industry is also at risk towards FDA/regulatoryconflicts, patent disputes, loss of patent exclusivity, and competitive pressure from other drugs. Lastly, a Medicare drug benefit could be enacted in a form whichwould give the Federal G overnment some purchasing power over the industry, leading to potential downward pressure on margins. June 2, 2006 5
  6. 6. Equity Derivatives Strategy | Strengthen Returns as Dollar WeakensDisclosure Legend:C: Lehman Brothers Inc. and/or an affiliate makes a market in the securities of this company.D: Lehman Brothers Inc. or an affiliate has received compensation for investment banking services from the subject company within the past 12 months.E: Lehman Brothers Inc. or an affiliate expects to receive or intends to seek compensation for investment banking services from the subject company within the nextthree months.G: One of the analysts on the coverage team (or a member of his or her household) owns shares of the common stock of the subject company.J: Lehman Brothers Inc. or an affiliate trade(s) regularly in the shares of the subject company.K: Lehman Brothers Inc. has received non-investment banking related compensation from the subject company within the last 12 months.L: The subject company is or during the past 12 months has been an investment banking client of Lehman Brothers Inc. and/or an affiliate.M: The subject company is or during the last 12 months has been a non-investment banking client (securities related services) of Lehman Brothers Inc.Options are not suitable for all investors and the risks of option trading should be weighed against the potential rewards.Supporting documents that form the basis of the recommendations are available on request. Please note that the trade ideas withinthis report in no way relate to the fundamental ratings applied to European stocks by Lehman Brothers Equity Research.Guide to Lehman Brothers Equity Research Rating SystemOur coverage analysts use a relative rating system in which they rate stocks as 1-Overweight, 2- Equal weight or 3-Underweight (see defi nitions below) relative to othercompanies covered by the analyst or a team of analysts that are deemed to be in the same industry sector (“the sector coverage universe”). To see a list of companies thatcomprise a particular sector coverage universe, please go to www.lehman.com/disclosures.In addition to the stock rating, we provide sector views which rate the outlook for the sector coverage universe as 1-Positive, 2-Neutral or 3-Negative (see definitions below).A rating system using terms such as buy, hold and sell is not the equivalent of our rating system. Investors should carefully read the entire research report including thedefinitions of all ratings and not infer its contents from ratings alone.Stock Rating1-Overweight - The stock is expected to outperform the unweighted expected total return of the sector coverage universe over a 12-month investment horizon.2-Equal weight - The stock is expected to perform in line with the unweighted expected total return of the sector coverage universe over a 12-month investment horizon.3-Underweight - The stock is expected to underperform the unweighted expected total return of the sector coverage universe over a 12-month investment horizon.RS-Rating Suspended - The rating and target price have been suspended temporarily to comply with applicable regulations and/or firm policies in certain circumstancesincluding when Lehman Brothers is acting in an advisory capacity on a merger or strategic transaction involving the company.Sector View1-Positive - sector coverage universe fundamentals are improving.2-Neutral - sector coverage universe fundamentals are steady, neither improving nor deteriorating.3-Negative - sector coverage universe fundamentals are deteriorating.Distribution of Ratings:Lehman Brothers Equity Research has 1838 companies under coverage.43% have been assigned a 1-Overweight rating which, for purposes of mandatory disclosures, i s classified as a Buy rating, 32% of companies with this rating are investmentbanking clients of the Firm.39% have been assigned a 2-Equal weight rating which, for purposes of mandatory disclosures, is classified as a Hold rating, 6% of companies with this rating areinvestment banking clients of the Firm.18% have been assigned a 3 -Underweight rating which, for purposes of mandatory disclosures, is classified as a Sell rating, 62% of companies with this rating areinvestment banking clients of the Firm.This material has been prepared and/or issued by Lehm an Brothers Inc., member SIPC, and/or one of its affiliates (“Lehman Brothers”) and has been approved byLehman Brothers International (Europe), authorized and regulated by the Financial Services Authority, in connection with its distribution in the Europe an EconomicArea. This material is distributed in Japan by Lehman Brothers Japan Inc., and in Hong Kong by Lehman Brothers Asia Limited. This material is distributed in Australia June 2, 2006 6
  7. 7. Equity Derivatives Strategy | Strengthen Returns as Dollar Weakensby Lehman Brothers Australia Pty Limited, and in Singapore by Lehman Brothers Inc., Singapore Branch. (“LBIS”). Where this material is distributed by LBIS, pleasenote that it is intended for general circulation only and the recommendations contained herein does not take into account the specific investment objectives, financialsituation or particular needs of any particular person. An investor should consult his Lehman Brothers’ representative regarding the suitability of the product and takeinto account his specific investment objectives, financial situation or particular needs before he makes a commitment to purchase the investment product. This materialis distributed in Korea by Lehman Brothers International (Europe) Seoul Branch. This document is for information purposes only and it should not be regarded as anoffer to sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it. No part of this document may be reproduced in any mannerwithout the written permission of Lehman Brothers. With the exception of disclosures relating to Lehman Brothers, this research report is based on current publicinformation that Lehman Brothers considers reliable, but we make no representation that it is accurate or complete, and it should not be relied on as such. In the caseof any disclosure to the effect that Lehman Brothers Inc. or its affiliates beneficially own 1% or more of any class of common equity securities of the subject company,the computation of beneficial ownership of securities is based upon the methodology used to compute ownership under Sec tion 13(d) of the United States SecuritiesExchange Act of 1934. In the case of any disclosure to the effect that Lehman Brothers Inc. and/or its affiliates hold a short position of at least 1% of the outstandingshare capital of a particular company, such disclosure relates solely to the ordinary share capital of the company. Accordingly, while such calculation representsLehman Brothers’ holdings net of any long position in the ordinary share capital of the company, such calculation excludes any rights or obligations that LehmanBrothers may otherwise have, or which may accrue in the future, with respect to such ordinary share capital. Similarly such calculation does not include any sharesheld or owned by Lehman Brothers where such shares are held under a wider agreement or arrangement (be it with a client or a counterparty) concerning the sharesof such company (e.g. prime broking and/or stock lending activity). Any such disclosure represents the position of Lehman Brothers as of the last business day of thecalendar month preceding the date of this report.This material is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity. Opinions expressed herein reflect the opinion of LehmanBrothers and are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, and they may notbe suitable for all types of investors. If an investor has any doubts about product suitability, he should consult his Lehman Brothers representative. The value of and theincome produced by products may fluctuate, so that an investor may get back less than he invested. Value and income may be adversely affected by exchange rates,interest rates, or other factors. Past performance is not necessarily indicative of future results. If a product is income producing, part of the capital invested may beused to pay that income. © 2006 Lehman Brothers. All rights reserved. Additional information is available on request. Please contact a Lehman Brothers entity in yourhome jurisdiction.Lehman Brothers policy for managing conflicts of interest in connection with investment research is available at www.lehman.com/researchconflictspolicy. Ratings,earnings per share forecasts and price tar gets contained in the Firms equity research reports covering U.S. companies are available atwww.lehman.com/disclosures.Complete disclosure information on companies covered by Lehman Brothers Equity Research is available atwww.lehman.com/disclosures. June 2, 2006 7

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