A huge electronics company is teetering on the edge of a sharp decline.
The company is so large that it accounts for 17% of its home country's entire GDP. Recently surpassing Apple (Nasdaq: AAPL) as the world's largest smartphone manufacturer, the company is constructing the world's biggest mobile phone factory in Vietnam.
However, this leading company is starting to show signs of being overvalued. In fact, it has warned about its upcoming earnings release, and the company's shares are down about 7% since the end of December.
If you haven't guessed, I'm talking about Samsung (OTC: SSNLF).
While Samsung is primarily traded on the Korea Exchange, there are ways for U.S.-based investors to capture profits from its decline.
One of the most compelling things about stocks is that profits can be made regardless of which direction the price moves. Although the majority of investors profit only when shares are rising, there is a subset of investors who specialize in trading the downward moves. I am not talking about waiting for a stock's pullback and buying the dip (as I have written about several times) -- I mean actually making money when shares decline in value.
This tactic is called shorting. Shorting entails borrowing shares from your broker at a certain price. The goal is to sell the shares back to your broker at a lower price, yielding you the difference between the lent (short) price and the price at which you sell the shares back to your broker.
Selling the shares back is called covering. To sell short, it's necessary to have a margin account and your broker's approval.
Investors can also profit from a stock's decline by using options. Buying put options or selling call options are the most basic ways. The primary issue with options is that you not only need to be correct with the direction of price, you also need to be correct with the timing of the move. This is why I like to use long-term equity anticipation securities (LEAPS) options when trying to ride long-term moves.
|Google has sharply lowered the price of its Motorola Moto X smartphone, forcing Samsung to start the painful process of lowering costs to maintain its leadership role.|
Rather than having monthly expirations like regular options, LEAPS expire between one and three years in the future. This provides a much longer timeframe for an investment thesis to work out. LEAPS can be either puts or calls, allowing them to be used for anticipated long-term moves in either direction. Although the premium cost is higher for LEAPS than regular options, their long-term nature more than makes up for the higher price, in my view.
LEAPS provide the perfect vehicle to capture a continued decline by Samsung, which recently warned investors that fourth-quarter operating profits will likely drop 8.4% from the same period the previous year. This is in sharp contrast to the 9% increase anticipated by analysts. The precipitous decline in profits is due to increasing strength in the Korean currency as well as an overall slowdown in smartphone sales.
Samsung is in a conundrum since its phones use Google's (Nasdaq: GOOG) Android operating system software, just like higher-end competitor HTC (OTC: HTCKF) and low-end rival Xiaomi. In other words, budget-conscious consumers can get essentially the same device at a lower price than Samsung offers -- while status-oriented consumers can easily pay more for a more prestigious device running the same operating system.
In addition, Google has sharply lowered the price of its Motorola Moto X smartphone, forcing Samsung to start the painful process of lowering costs to maintain its leadership role. Making matters worse, this month's International Consumer Electronics Show in Las Vegas has revealed Samsung's continued obsession with hardware design rather than improving the generic operating systems of its smartphones.
Change is very difficult for companies of Samsung's size, and until it creates its own revolutionary software, its glory days appear to be over.
Risks to Consider: There is always risk shorting stocks, which goes against the stock market's inherent upward trend. In addition, since upside gains are theoretically unlimited, shorts are exposed to theoretically unlimited losses. Stop-loss orders and a diversified portfolio are even more critical for investors shorting stocks.
Action to Take --> Since shares of Samsung are only available to U.S. investors as an over-the-counter stock, there are issues of volume and shorting (among others) to be considered, not to mention the stock's $1,300 price tag. I think the ideal way to short Samsung is through put LEAPS on the iShares MSCI South Korea Capped ETF (NYSE: EWY). Samsung makes up over 20% of this exchange-traded fund, making it an excellent proxy for the company. LEAPS provide low-cost and long-term exposure to Samsung. While investors can certainly short EWY directly, LEAPS are a much more cash-efficient way to play the short side.
I like the EWY Jan. 2015 60 put LEAP (EWY150117P00060000) to profit from Samsung's likely decline in 2014. Each contract is currently trading at $5.45, and buying when the ETF breaks support at the $60 level makes solid sense.