*An interesting alternative trade on the financial markets and an important investing principle*
Welcome back to the blog, I hope you had a great weekend! In this blog post I am going to take a look at an alternative trade that has come good in recent weeks and an interesting point of analysis that I have seen recently. I find these types of trades interesting because they are normally either more complex in structure than I would personally trade or they are “bets” that a normal retail/professional trader might not have access to. I have kept things simple and tried to only explain the basics of each topic in this post in order to keep reading easy and not too stressful.
PizzaExpress (PIZ) – CDS Trade.
Yes, that is correct, the first trade I am going to show you involves our beloved pizza restaurant chain that makes the best starter ever… Garlic butter dough balls!
The first PizzaExpress was opened in Soho in 1965 by Peter Boizot, a young entrepreneur who had worked in Italy and missed good pizza when he got back to London. PizzaExpress first floated on the London Stock Exchange in 1993 and lasted 10 years before being bought out by a private equity (PE) group in 2003. It went public again but was bought out once more by a different PE. PizzaExpress then changed hands once more and is now under the ownership of Hony Capital who paid £900m for the company in 2014.
What are CDS?
CDS stands for Credit Default Swaps are a financial derivative product that allows an investor to offset (or “swap”) his credit risk for an investment with another investor. The original purpose for this type of contract was for a lender to offset the risk of the loan he made to a borrower by buying a CDS. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse the lender in the case the borrower defaults. Most CDS will require an ongoing premium payment to maintain the contract, which is therefore why CDS are much like an insurance policy.
However, as with most financial products, speculators and traders soon get involved because there are ways to use Credit Default Swaps to profit from market events. This is the case for traders involving PizzaExpress in recent months.
As you can see on the chart above, the price of 5-yr CDS for PizzaExpress has increased massively in the past 12 months with price increasing by approximately 900% since the beginning of 2020. Even before the coronavirus pandemic hit, PizzaExpress was heavily laden with debt owing more than £1.1 billion at the end of 2019 and this meant that when global lockdowns started, they were already on the back foot.
From Bloomberg – Hedge funds that bought credit insurance are receiving a payout Thursday from an auction to settle credit-default swaps. The initial auction set the value of the payout just shy of 100%, amounting to compensation of $142 million.
The chart shows how the value of CDS on PizzaExpress, effectively insurance betting on the companies failure, as increased weekly since the beginning of the coronavirus pandemic at the end of February 2020. The increasing price of the CDs protection represents the increasing certainty of failure for the company because protection on the companies debt is therefore more costly to purchase. The idea behind making a profitable trade using Credit Default Swaps is to make sure that your total premiums paid for the swaps (insurance) does not exceed the total potential payout on the swaps. Timing is therefore a key component of this trade if you are a speculator looking to make a quick profit on a failing company like PizzaExpress.
You might recognise the term CDS from the famous film The Big Short as this product was created back in 2007 prior to the financial crisis as a way to profit from defaults on mortgages by home owners.
In late February 2020, famous fund manager Bill Ackman used CDS type products to protection on $71 billion worth of corporate debt with monthly premiums of $40 million as a hedge for his existing portfolio of stocks. When the full extent of the coronavirus pandemic hit the stock markets a few weeks later, he received a huge payout. At the point he exited his positions and sold on his protection, he had only paid $27 million in premiums. It was almost perfect timing because stocks then began to climb again and recover all losses in his existing stock portfolio whilst maintaining the large profits from the CDS trade.
You can read more about this trade by clicking on the following link https://www.marketwatch.com/story/how-the-single-best-trade-of-all-time-netted-one-investor-a-26-billion-profit-2020-04-29
European Stocks – The importance of dividends.
I don’t talk much about individual stocks on this blog because it is not my specialty. However, I do talk a lot about stock market indices as you will all know I am currently short the FTSE100 index. When trading stocks and even Indices that are made up of of stocks, you should be aware of the dividend history of the stock and a metric called the dividend yield.
What are dividends?
A dividend is the distribution of the profits of a company to its shareholders. It is a reward for investing in a company and an important metric to consider when evaluating the performance and long term returns of a stock.
Dividend Yield % = Annual Dividend Per Share / Price Per Share *100
There are 3 main types of stocks when you are evaluating performance via price performance and dividend income. A stock that has seen historically strong price increases but has a low or zero dividend yield is considered a growth stock. This is because the returns on your investment come from the increase in value of the stock overtime and when you sell the stock you make your profit.
A stock that typically has a lower price performance but pays a high dividend yield is called an income stock. This is because the longer term returns come from annual dividend payments as income and these payments accumulated overtime and even reinvested can add up to significant returns on investment.
A stock that typically has a low increase in price over time and has a low dividend yield is called a rubbish investment.
A lot of new tech stocks that are currently seeing huge growth in value are actually non dividend paying stocks. This is because, as an industry, technology moves so rapidly that profits have to constantly be reinvested in to research and development (R&D) in order to maintain growth and stay ahead of the curve. Amazon and Tesla are famous tech stocks that have a 0% dividend yield.
Despite the times we live in where tech stocks are seeing huge increases in price over the last 12 months and even longer, it is still very good to remember the importance of dividends. In particular, in European stocks which is outside of the US (where the majority of the tech giants are trading).
The chart above shows 2 lines, the black line is the STOXX600 price index for the past 20 years, normalised as of 01/01/2000. As you can see, the returns of this index are now back below it’s starting price at the begging of this century which means that without dividend income you would have lost money by investing in this basket of stocks.
On the contrary, the STOXX600 index does pay a dividend income to shareholders of the stocks within the index at a rate of approximately 3.5% per year. Although this isn’t a huge amount, when accumulated and reinvested into the stock index itself, these returns add up to something great.
The red line shown on the chart above shows the STOXX600 total return index where dividend income has been included and reinvested, the 20 year performance is around 90% which is more than 90% more than the price growth of the index. This shows the importance of dividends in long term investing where you simply cannot predict the potential “boom stocks” in that time period.
I hope you enjoyed this different style of blog content. I wanted to bring you something interesting and out of the ordinary compared to my normal content that is primarily focussed on you expanding your own trading skills. This week I plan to publish TWO more blog posts on the topics of trading education and live financial markets analysis.
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