The Cisco Setup

The Indispensable Infrastructure Investment You Have to Own

Over the years, I've made hundreds of trades. Some are fantastic, exciting stories, and some would make you sick, as they did me.

But instead of making you queasy, I'd like to share a trade setup from a few months ago that turned out particularly well for me. It introduces some new concepts, terms, and strategies that you probably have never heard before, or even tried. My hope is to show you the potential there is in using oft-misunderstood strategies to produce safe, solid gains in your investments in the long and short-term.

Let me introduce the idea by starting with a little story from my life...

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I grew up in a small dairy town on the Oregon coast. It was a rainy, uneventful day during the summer after my seventh grade year. My parents dropped me off at a friend’s house to spend the day, and we went into his room to listen to some music.

My buddy was always a music fanatic. In fact, he was actually pretty talented in his own right, and later dropped out of high school to pursue his own “rock star” dream.” Unfortunately, he never really made it like he wanted to. He’s homeless today, but that’s beside the point.

My buddy dropped a “burned” CD into his 5-CD changer. Back then, these CD changers were a huge luxury. You could buy stereos with buy 5- 10- or 60 CD changing capabilities if you wanted to back in the 90’s.  You could store and cycle through all your music in one "device" and never have to change anything out. How novel, how convenient. And it was all about to go out of style (within a decade or so, thanks to digital storage).

Today, everyone stores their music collections on the computer, but that wasn’t always the case. In 1999, digital music collections were a new concept. Most folks had migrated their music collections to CD’s at this point from cassettes, but relatively few had their music collections stored on their computer. You had to be somewhat tech-savvy to know how to do this.

I sat down with my friend, and he asked if I had ever heard the song Bohemian Rhapsody. About the time Queen started singing "Galileo, Galileo," my friend mentioned he had just downloaded this song using something called Napster, a kind of file-sharing program—again, a new concept. Someone on the other side of the world had the song stored on their computer, and through Napster’s interface, via the internet, my friend searched for the song title, found the file, and was able to directly download the song to his computer. For free.

For a young kid with no job, who owned maybe a dozen random CD’s ranging from Smash Mouth to Britney Spears, this was like a gold mine. “The Napster” was my new best friend.

Of course, being so young, I was completely ignorant of the moral and legal implications of using the software to obtain copyrighted material without paying for it.

I went home that day and fired up my family’s home computer. I connected to the internet using my squelching 56K modem (which actually ran at a speed closer to an unbelievable 3 kilobytes per second due to the quality of the phone lines on my road), and installed the Napster software. I downloaded a handful of songs later that day, and each one took about an hour to complete.

And I never could have done it without a boy named Shawn Fanning.

Online, Fanning went by the alias “napster”, a moniker derived from his “nappy” close-cropped hairstyle. Fanning was a young, early-college age kid interested in software programming. Like all other poor college kids, he liked music, and he liked free stuff.

Fanning had the idea of developing a piece of software which would allow internet users to index music files on their computers which other users could easily and reliably locate and download. Before Napster, you could get music online for free, but it wasn’t easy to do, and sources were unreliable.

Fanning secured collaboration for the project from his uncle, John Fanning, and another interested entrepreneur, Sean Parker, whom he had met in a chatroom.

Parker managed to garner a small amount of seed money from investors. Fanning, meanwhile, spent days at a time cooped up in a small office in Massachusetts working on a borrowed PC to work on the programming. Once the work was complete, Fanning’s username “Napster” was carried over as the name for the flagship software being developed by the budding entrepreneurs.

Around the time of its launch, the pair eventually moved to California with their venture. After the software’s launch in early 1999, Napster quickly began rising in popularity. Within one year, over 4 million songs were available through Napster’s fun, user-friendly interface.

The software was little more than an “index service,” much in the way the Google functions today as a search provider. Napster didn’t have a central server to store the files, nor did it distribute the copyrighted material directly. It simply provided a way for users to find and obtain something they wanted, legal or not.

Fast forward about a year into Napster’s nascent life. At this point, my personal digital library had grown substantially. So had the notoriety of Napster, whom just about every college student in the country was using, consequently bogging down their dorm room internet connections. Many campuses had, in fact, blocked access to the service to preserve limited bandwidth for more legitimate uses of the internet.

Napster, Inc. was facing massive growing pains at this point. The company was now embroiled in a copyright infringement case filed by several high-profile artists such as Metallica and Madonna, along with other members of the Recording Industry Association of America, whose copyrighted music works were being flagrantly and illicitly pirated for free, often available on Napster months before their official release. “Stump the Napster” was the name of the game in the music industry—if your song wasn’t on Napster, it meant you just weren’t cool anymore.

The music industry clearly had legal grounds in the suit. The judgment was handed down in court to Napster to either cease and desist streaming the illegal content, or start charging for it, and hand over revenue to the copyright owners. Due to a Napster’s inability to market itself as a paid subscription service, along with other court orders demanding the blocking of content which was confirmed to be illicit, the company was forced into bankruptcy.

Napster sold off its assets, and its network was finally shut down in July 2001. The name and service still exist today, though the allure and function of the service have drastically changed and faded into virtual obscurity.

There were numerous copycat iterations to Napster over the subsequent years as digital music and video collections became the norm. P2P data and file sharing networks such as these subsided, but illegal content can still be had today in the dark corners of the internet through the usage of torrents and other methods of high-speed and anonymous data transfer. High profile cases of illegal content sharing, accomplished through sites such as Megaupload and the like show up in the news every once in a while.

Napster was significant because it attracted a broad foray of internet users into a realm previously unknown, one where digital content could be streamed into users’ homes at the touch of a mouse click. Since that time, the volume of digital content streaming into everyday users’ homes has essentially exploded—not only music, but especially video, with content streamers like Netflix and YouTube alone now accounting for over half of all bandwidth (data usage) worldwide.

Throughout the 1990’s and leading up to the Napster period, one company had ridden the rising internet wave and positioned itself as the industry leader in providing devices which allow users to physically distribute internet connection signals to computers and other devices in their homes. For a time, this company was the most valuable business on the planet.

The company was Cisco Systems (CSCO). To this day, Cisco remains one of the most valuable businesses in the world, and one of the safest and most reliable investments.

One of Cisco’s core businesses is to provide the hardware which allows users to distribute, or “route” internet signals directly to every one of their connected devices in the home. Without this hardware, internet users would have no way to stream music or video, check their email, or look at funny pictures of cats on Facebook.

By hardware, I’m referring to the boxes (“Routers”) , networking cards, as well as software you use to transmit internet signals (“Wi-Fi”) throughout your home, workplace, or in public places every time you send an email, stream a television show, or listen to digital radio, among other things. Cisco also has a wide variety of products in telephony, data, and server applications for homes and businesses.

Cisco has not only allowed users across the world access to the wealth of the internet, but has also been one of the most valuable and profitable companies I’ve held over the last few years in my personal portfolio.

In my investing career, I’ve held a variety of securities, but CSCO has proved to be one of the most consistently profitable and predictable. I like predictable, and I love profitable.

The best companies in the world to invest in are ones you can hold forever without having to feel like you need to check your brokerage account every half hour. These are the companies whose stock you can buy then take a trip to Timbuktu, without an internet connection, and without losing any sleep at night.

Cisco is this kind of company.

Below are what I believe to be the biggest factors to consider when making a long-term investment:

• Does the company own and manager a great product and business that you understand, is tangible, and isn’t going to disappear tomorrow or go out of style? Is it a business and product that people can’t do without?
• Does the company have strong financials? There should be no doubt in your mind about whether or not the company will go bankrupt tomorrow.
• From a technical perspective, Is the price and timing right? Or would it be best to sit on cash and wait?
• Will my wealth grow over time with this company?

The Product – A No-Brainer

The first question I ask myself with an investment is: What is this company selling? Do I understand this product and this business?

I’ve outlined above briefly some of the products CSCO specializes in. Essentially, data management and access, and networking products are CSCO’s focus. I can walk into McDonald’s, a coffee shop, or a library and see CSCO’s routers at work streaming internet content to hundreds of devices simultaneously. I can remotely access my home server and files from anywhere in the world and know that this was made possible by the fact that my server is connected to the internet using CSCO’s router switch in my basement. And it works beautifully. I can sit at work and know that the financial data managed by my bank is likely stored on a physical data center manufactured by CSCO or at the very least, systems architecture base on CSCO protocols.

CSCO’s products are so ubiquitous and commonplace, there’s no way the networking device marketplace would be the same without them. It would be like Starbucks getting out of the hot flavored-water business.

Financials

An established market, predictable demand for its product, and strong, competent management give Cisco’s financials almost unmatched strength among its peers. The financials are nothing if not rock-solid. Here are the metrics we use to make this determination:

Let’s outline a few of these key indicators, and why they are important.

• Intrinsic Value – Book Value and Share Price
• Price Considerations – Is CSCO a Buy at the current price?
• Resources to tap when needed – “Cash flow”
• Great Income Generator – Reliable and Growing Dividend policy
• Steadily increasing shareholder equity – Share buybacks
• Profitability – Steady earnings

Intrinsic Value

First, intrinsic value. Currently CSCO trades at around $25.80. But market price does little for us in terms of showing the true value of a company. We get a better idea of value by looking at the balance sheet and subtracting all liabilities the company has from its assets, arriving at the company’s net worth. We divide that number by the amount of shares outstanding to arrive at Book Value per Share.  We use this number to compare what the company is actually worth, with what it is trading for.

CSCO trades at Book Value of $10.90 per share, meaning each share’s intrinsic value is $10.90. We want to see where this stands in comparison to other companies in the market. To do this, we find out its Price per Book ratio. Divide share price by Book Value Per Share. And we get 2.366.

To put this figure in perspective, the S&P is trading at a P/B ratio around 2.8. So, CSCO is trading at a 16% discount to the average large-cap name in the US stock market.

                                                                                    

Price

From the perspective of value, CSCO is trading at a respectable discount to the general market. But how does current price compare with historical performance? CSCO is trading only 10% off its 52-week low, and is in a strong uptrend. From a technical perspective alone, CSCO’s price denotes a buy.

What about current price in relation to earnings? The favorite indicator of Wall Street is the P/E ratio. This metric indicates the multiple of the current share price compared with the company’s net earnings per share on the market. The lower the ratio, the cheaper the stock.

CSCO trades right now at a ratio of around 17.41. To put this in perspective, the S&P, and index of the 100 biggest stocks on the market, trades for a P/E ratio of 19.54. Meaning, CSCO beats the average price of the S&P index by around 11%.

Also, CSCO is the cheapest stock among its direct competitors on both a trailing and forwards earnings basis. Competitors include Alcatel-Lucent, Juniper Networks, and Ericsson.

Resources to Tap

Let’s address CSCO’s cash situation. The firm currently has over $50 billion in cash and other short-term investments. Current liabilities and short-term debt are just $22 billion.  There is no situation in which CSCO could find itself in need of external cash infusion in the form of debt issuance of share offerings. It has gobs of cash it can use for R&D, growth, share buybacks, dividends—you name it. It could even take a decade of losses and drastic decreases in cash flow before it would be in any kind of financial trouble.

And if that ever happened, we would know about it and take action accordingly.

Income (for us as investors)

Next, income considerations. For the most part, CSCO’s growth years are behind it. Most investors buy CSCO today for the income considerations, meaning dividends. The company began paying a dividend in 2011, and currently pays a respectable dividend of 3.1%, which, from the graphs below, you can see has been consistently growing for the past several years, and is projected to grow larger still.

Source: SeekingAlpha

Steadily Increasing Ownership For Free

Not only are dividends growing, but CSCO consistently grows the share of the earnings “pie” that you get, because it has a consistent policy of share buybacks.

When a company buys back its shares, it decreases the total number of shares that exist on the open market. This is great for current shareholders, because it increases the earnings per share the company generates, which translates to cash back in their pocket at dividend time. If a company buys back shares that you own, it gives you cash in exchange, which is like receiving an extra dividend.

CSCO consistently buys back shares and thus increases shareholder returns. Some investors may criticize CSCO’s buyback program as being less than it seems, because while CSCO does consistently decrease its share count, the company also dilutes shareholders by issuing tons of shares and stock options to employees. Generally, I don’t like share dilution in this way, but since CSCO cleans up its dilution by buying back more shares than it hands out to employees, overall I’m not concerned. Below is a graph outlining the decrease in shares over the past 20 years.

Source: SeekingAlpha

CSCO has decreased its share count by roughly 22% over the past decade. That’s a steadily increasing bigger piece of the pie which investors can enjoy.

History of Profitability

The final consideration is: how consistently profitable is CSCO? Earnings Per Share can answer this question for us, and the following graph illustrates this consistency.

GRAPH

CSCO has never missed a quarter when it comes to increasing profitability. So far, we have no reason to believe that the trend will not continue. CSCO is the dominant player in the industry, and barriers to entry are very high for competitors.

Summary

I’ve shown that CSCO is undervalued, fair-priced, has upside potential, financially stable, provides steady income to investors, and consistently increases shareholder equity. In summary, these things all added together should underscore why the trade opportunity I recently saw close on CSCO made perfect sense.

Crank Up the Alpha

To be clear, I don’t actually own CSCO right now. The main reason is that, I would love to own CSCO long-term, but at a cheaper price than it now trades. Still, since I think the stock has further to go in the current bull run, I’m willing to pay up to a certain price for the company. This forms the basis for my strategy.

I was looking to buy more CSCO stock in January. I decided I would be willing to buy CSCO anywhere between $23 and $25 within the next 6 months when or if I have more cash available. The question I asked myself was, what is the best approach to execute my bullish view on the stock? And how can I capture the highest gains available?

Ideally, I would use an arbitrage strategy if I can find one.

In general, arbitrage means that I’m going to buy and sell a certain asset in order to take advantage of what I believe is a mispricing of that asset, in order to receive a net gain on the transaction, risk-free.

If you look at the chart of CSCO, you can see that the stock tends to trade in a relatively predictable range ever since the dot-com era. This makes it easy for us to identify a trading range for the stock.

ENTER another graph from Ameritrade that has a moving average. Show the LT average is where we are, and that we are reverting to the mean.

The stock has traded strictly between $10 and $32 over the past 10 years. Our price range sticks right in the middle, giving us a little upside potential, and safely ensuring that our downside is limited for the short-term horizon of our trade execution.

Low-Risk, High-Reward Setup

Most of Wall Street, as well as the vast majority of people in this world with a PhD in finance will tell you that, in order to capture above-average gains, you have to take above-average risks. I can understand their reasoning, but I also tend to think the market isn’t always as rational or balanced as economists and Wall Street analysts think it is. Low-risk, high-reward setups happen all the time, and the average investor doesn’t need a PhD or high-tech software to spot these opportunities, at least all the time.

I’ll prove this with and example trade I saw play out earlier in the year which recently closed.

I was looking to own CSCO anywhere between $23 and $25 within the next six months. On January 30 of this year, CSCO was trading at $22.15, outside the lower end of this range. Given the market environment in general and its steady march upward, and considering the Fed’s continuing commitment to provide liquidity to the market in the form of QE through at least September of this year, I was confident that within a few short months, CSCO shares could appreciate anywhere from 5-10%. Not a bad gain to shoot for over a few months’ time.

The average investor would buy the stock at $22.15, and if they are looking to hold the shares short-term, sell within a few months for a modest gain.

The savvy investor can use a conservative option strategy to decrease the cash he needs to put on the trade, and increase the magnitude of his gains—generate what is referred to on Wall Street as alpha, or gains in excess of the average market return. The strategy I prefer is to buy or sell a set of options, collect a net premium, which would lower my entry price if I am put the stock on a decline, and offer myself the potential to capture magnified upside gains.

The trade I executed involved selling a put option which is in-the-money with the strike at the lower end of my range, $23, and buying a call option at the upper end of the range--$25.

Buying a naked call option carries high risk. For that reason, I don’t generally do it. When you own just a call option, if the stock goes nowhere, or decreases in price, you lose your shirt—100% of the money you put in.

I don’t like betting the “rent money” or doing anything even close to that. In other words, while I don’t make bets I can’t afford to win, I also don’t make bets I don’t have a high degree of winning. And let’s face it: using options is little more than a bet. But, if you are the Casino instead of the Gambler, you win much more often and in greater magnitude. With this trade, we become the Casino.

So instead of simply buying a call and being a gambler, I offset my cost of the call, and the majority of my risk, by selling a put option on CSCO and collecting some upfront premium.

My broker basically paid me to put on this trade. It was as easy and painless as collecting a dividend.

On January 30, the July 2014 $23 put was selling for $2.36. The July 2014 $25 CSCO call was selling for $0.285. 

Buying the call option would allow me to buy 100 shares of CSCO at $25 if the stock was trading above $25 on expiration, and I would have to pay $0.285 for that right. By selling the put, I agreed to buy 100 shares of CSCO at $23 even if the stock was trading below $23 on July 18, 2014. In return for me taking on this obligation and risk, the broker would pay me $2.36 per contract.

On the combined position, I was agreeing to buy CSCO if the stock traded outside of the $23-$25 range(either above or below) on expiration, and I got $2.075 per share ($207.50 per contract) deposited immediately into my trading account.

My idea was that within a few short months, before Wall Street cools off for the summer and all the traders go on vacation, I could earn a respectable gain on CSCO which is significantly above what I would get by holding the shares outright.

Here are the possible scenarios for how the trade could have played out.

#1 Stock price increases and stays between $23 and $25. As the stock price goes up from $22.15, my call option will become worth more, and the put will become worth less. I can close the positions whenever I feel is advantageous and want to lock in the gains on these options. Or, I can hold them through expiry and they will expire worthless.

#2 Stock price increases to above $25. The call option would exercise, and I would end up owning shares of CSCO at $25. My breakeven price if the option exercises is $25.285. The put would expire worthless. I keep the upfront net premium I collected on the put, and can either turn around and sell my new shares at market or continue to hold them.

#3 Stock price goes nowhere, stays below $23. I get assigned the stock at $23. Since I received a net premium for entering the trade of 2.075, my entry price on the trade is actually $20.925. This is a 5.6% discount off the current share price. I am break even on the trade down to this point.

Scenario 1 results in a gain, potential upside is basically unlimited.

Scenario 2 results in a modest gain, equal at least to the premium of $207 I received. The closer to $25 the stock price is, the higher my gain will be due to the call value appreciation.

Scenario 3 results in a gain down to a breakeven price of $20.925. However, potential downside is unlimited.

How the Trade Played Out

I ended up holding the options positions through expiry. On July 18, the stock was trading for $25.90.

The stock had risen so much, the put was basically worthless, and expired, and I ended up keeping the premium I received originally. The call on the other hand, had substantially increased in price as it approached the $25 strike and above.

Since the call was above the strike, I had the shares assigned to me at $25. I decided to turn around and sell the shares outright to free up some cash in my account. I sold them on July 22 for $26.05, another $1.05 gain per share, or $105.

All told, my gain came to $207 + $105 = $312. The amount of margin I was required to put up with the broker was $1150, 25% of the capital at risk for the two options positions.

My total return on the position was 27% in 173 days, or annualized gain of 57%. Not too shabby.

How would I have done if I just held the shares outright with an equivalent capital amount ($1150)?

With $1150 in capital, I could have bought about 52 shares of CSCO on January 30. Those 52 shares went from $22.18 to $26.06, a gain of $3.87 per share, total return of $201, 17.5% in a little over 5 months, or 37% annualized.

By using the options strategy, I realized an extra 20% in gains on this trade.

Not bad for a “value” stock.