Naked (uncovered ) puts are a useful way to earn some money with low risk if you intend to purchase the stock anyway and don’t need to get in immediately.

You are “naked” when you sell a put (the put guarantees you will buy X shares on contract at the strike price if exercised) without a corresponding short position in the stock.

This scenario is exposed to “risk” because if the stock drops below the strike price and the option is exercised you will be forced to buy the stock. Therefore you would have to lay out capital on a stock that has decreased in price and could be a dog.  If the company has a catastrophe you would be stuck with shares that may never recover. 

But what if you want to buy the stock anyway?  Then being forced to buy at a lower price might not be a “risk” after all.

So here’s the deal:

If you’ve found a stock you want to buy at its current price and have done all of your homework, consider selling a front month naked put at an out of the money strike price.

You will have the premium deposited into your account and you have essentially agreed to purchase the shares at the strike price if the option is exercised.

You already have the desire to buy the shares and wouldn’t mind getting them a little cheaper.

Most major Canadian discount brokers will not let you trade uncovered.  After looking around, TD Waterhouse and ETRADE are your best bets for the discount brokers.

Here is an example:

You like the proposed infrastructure spending that the US has pledged to undertake.  Steel will be a significant component of the spending and commodity prices might be poised for a rebound next year.  So you’re thinking Nucor Corp (NUE), Andrew provided an overview back when they were really booming,  which is currently trading at $39.19 with a 52 week high of around $83 and a low of $25.

The March $37.50 put has a price of $2.50. 

1)You sell 5 puts (Total Potential Purchase of 500 shares x $37.50 = $18750 if exercised) and pay associated commissions (ETRADE will be a max of $19.95 per order plus $1.75 per contract) of $28.74.

2)$1250 is deposited to your account (500 shares x $2.50)

3) Waiting game begins. Do your best not to check Yahoo Finance every 5 minutes.

4a)It is getting close to March 20 and the stock price has stayed steady around $40. The option will not be exercised and you keep your premium. 

4b)The stock drops to $35 and you are required to buy 500 shares at $37.50 on or around March 20.  Keep in mind that you have collected $2.50 per share in premiums and paid $37.50. So unless you spent the $1200 on a gold-plated iPhone, your cost basis is $35.  You have then bought the shares at market price after an 11% drop in the stock price over a month.  If you bought before the drop you are now down 11%.

5a)Repeat the next month until you get exercised and keep the premiums while you wait.

5b)Hold the stock as per your bullish take on steel and infrastructure and you have now bought Nucor for $35 when you were ready to buy at $39.19.

There’s no time like now to find some great stocks you wouldn’t mind buying for below current levels.  Consider naked puts as a way to get into those positions when Mr. Market permits and be paid to wait in the process.

Risks are present, but if you like a stock and are ready to buy at current levels, go naked and sit around for a while instead!

So by now everyone is asking how they can open a TFSA and every financial institution is loving the attention. However, there are some important things to note before opening up your account.  

• Some banks charge fees for account transactions while others do not 
• It is more than just a “Savings” account
• Know the rules regarding deposit and withdrawal
• Know the tax benefits to assist in the RSP / TFSA debate

In my previous post I discussed the greatness of the TFSA but lacked the operational details because it was only March 2008.Now that the banks are unveiling the full set of info, its time to dive in.

1. Fees

The major banks are offering these accounts with varying fee structures. The fees consist of an annual administration charge because of the record keeping and such required for reporting purposes. Withdrawal fees are triggered when you withdraw money from the account.

For GIC’s, Savings Accounts, and Mutual Fund activity only major banks will not charge you for administration or withdrawal. In fact TD Canada Trust branches are the only ones that have a free withdrawal limit (1 per month, $5 per withdrawal after that). TD Mutual Funds do not have a withdrawal limit however.

For Stocks and activity requiring use of a brokerage (full service or discount) at the major banks the fee structure changes for the worse.

No Fees at all:RBC Direct Investing, Scotia McLeod Direct Investing, and HSBC Invest Direct.

Some Fees:BMO InvestorLine is a discount brokerage and charges a withdrawal fee of $25 per transaction and an admin fee of $50.  The admin fee is waived for the first year of an account and/or if you have over $100,000 in assets with BMO.BMO Nesbitt Burns is a full service entity and has an annual admin fee of $50 and a $15 withdrawal fee. TD Waterhouse has a $50 annual admin fee, waived if you have over $100,000 in total assets. You can also eliminate fees at TD if you use the electronic statement option for your billing.

Verdict: Watch out for the fee structures especially if you don’t bank at a major institution.  These admin fees are equal to 1% of the annual contribution limit, which is kicking you while you’re down if you’re also invested in mutual funds (and paying MERs). Ask about the fees and if you’re not happy go somewhere else.  It is easy to open up the accounts and transfer money, so this is no time for loyalty in the face of high fees!

2. Investment Options 

The name Tax Free Savings Account is being taken too literally.  Looking at CIBC offering the wonders of a “Tax Advantage Savings Account” with “a guaranteed high interest rate tax free” sounds like a dream doesn’t it! The truth is that banks are pushing high interest savings accounts and GIC’s really hard for the TFSA accounts (can’t blame them because they’re attractive in today’s market).  Some offer different accounts altogether depending on what you want. However, you can invest in the same things as your RSP. Tim Cestnick, who writes for the Globe, offers a great outline of the more specific ones outside of funds, bonds, and stocks. For instance, you can hold options, shorts, and private company shares (this one is detailed further by Tim).  The highest taxed forms of investment income are a sure bet to go into your TFSA. These include interest generating investments, foreign dividends, and options and shorts whose gains may be treated as regular income. 

3. Deposit and Withdrawal  

It looks like you can deposit up to $5000 per year, yeah, “we knew that already”. But many banks are offering a monthly contribution plan, so it appears that you can contribute at any frequency until you reach the $5000.

Withdrawal is the same.  You can withdraw money at any time. Money taken out of your TFSA frees up that amount of “room” so it can be put back in later. 

Example: You deposit $5000 on Jan 15, 2009.  You withdraw $1000 in Dec, 2009.  You now have $1000 of cap room you can use in 2010 on top of the $5000 annual limit.  So you would now be able to put $6000 in during 2010.

4. Tax benefits

 This is a critical factor.  The decision of RSP / TFSA, if you have to decide, comes down to what you predict your income tax rate will be upon retirement.  Because your RSP money is taxed at retirement age, it is most advantageous to contribute now if you think your annual income will be lower than your current level.

If you expect your annual income to be higher than current levels, the TFSA offers an advantage. You would be giving up the tax benefit of the RSP now and putting the money into your TFSA.  Upon retirement, you could withdraw from the TFSA tax free and at a higher marginal tax rate this represents substantial savings.  In this situation, if you had your money in an RSP, the annual withdrawal would be taxed at the full marginal rate.

In the event that you can maximize both TFSA and RSP contributions, by all means.

If you’re unsure about your future tax situation, it might be best to straddle the line and put a similar amount in your TFSA and RSP. Tim Cestnick provides a similar, yet more detailed, analysis.

Overall, the TFSA presents a new investment opportunity with substantial benefits.  Just make sure you ask a few questions before you open one.

I’ve decided to start a new segment of posts on the site called “On the Radar”. When I come across a stock that catches my interest i’ll outline the story in post form so you can see my justification for why I like the stock. This will help me perform thorough research on my stock picks and hopefully give you some ideas in the process. The first stock in the segment is Nucor Corp. (NUE).

Nucor is a steel company operating in the United States with customers across North America. Last year Nucor produced 22 million tons of steel and steel products, including hot-rolled steel, cold-rolled steel, metal buildings and steel joists. It is also North America’s largest recycler of scrap metal. Nucor controls about 20% of the US market and about 60% of sales are to the construction industry with automotive making up another large portion. The U.S. steel stocks have been on fire lately as a decline in finished steel imports to the United States has increased demand for locally manufactured steel. The weak dollar, high shipping rates, and strong overseas demand has kept imports from reaching American shores. This limits the supply locally which forces U.S. steel companies to run at full production capacity and allows them to raise spot prices on steel. As long as demand remains strong these companies should continue to have great pricing power. According to the International Iron and Steel Institute global production remains below historic trends and likely will lag global consumption, despite rapidly rising steel prices.

Nucor is up 20% over the past year but has underperformed compared to competitors U.S. Steel (up 55%) and AK Steel (up 100%). Nucor is only 8 points off its 52 week high and is cheap on a valuation basis trading at 15x trailing earnings and 10.4x forward compared to U.S. Steel at nearly 25x trailing and AK Steel at 18.5x trailing. Nucor recently increased guidance for its second quarter earnings due to strong shipments and higher margins. The company now expects Q2 earnings in the range of $1.75 to $1.80 per share compared to their previous forcast of $1.55 to $1.60 per share and well above consensus analyst estimates of $1.69 per share. That represents an increase of nearly 54% over Q2 2007 on the low end of the estimate. This bullish outlook likely means that analyst estimates for the full year are on the low end meaning Nucor is undervalued and has significant room to the upside. The earnings increase even reflects the dilution of outstanding shares of more than 3% due to Nucor’s common stock offering of 27.7 million shares that closed on May 29th, 2008. On the news shares of NUE jumped nearly 9% to $80.54 but pulled back all the way to $74 and currently sits at $75.50 per share. I’ve been watching this one for a while and I jumped on the opportunity to buy in on the pullback below $75 per share. I expect global demand to remain strong through 2008 and into 2009 and Nucor should perform exceptionally well in this environment.

A key component Nucor’s long term growth strategy includes pursuing strategic acquisitions of downstream steel products. Execution of this strategy has resulted in annual capacity more than doubling over the past year to 4 million tons. Recent acquisitions include Verco in steel decking, Harris Steel Group in rebar fabrication, cold finished bars, & metal grating, LMP Steel in cold finished bars, Magnatrax in metal buildings, and Nelson Wire in wire mesh. Continuing this strategy Nucor announced last week the acquisition of Ambassador Steel, one of the largest independent fabricators and distributors of rebar in the United States. With its strong growth strategy Nucor should continue to increase its footprint in the U.S. steel market.

I think this is a great stock with great potential over the next two years. I think you can get into this one anywhere near $75 per share with a lot of room to the upside.

(Disclosure: Long Nucor)

Lately I have been trying to implement the deep-in-the-money calls options strategy that I explain in a recent post through my paper trading account at Investopedia. On April 22nd I outlined our first success with Microsoft calls and a second idea with Corning Inc. With the stock trading at $25.73 I bought 10 of the August $20 calls for a premium of $5.91 per share for a total capital investment of $5910. Sometime last week the premium on the calls hit our target of $6.91 per share and the position was sold for a gain of $1000. Good for 17% in less than two weeks. The move was thanks to a solid earnings report by Corning where both earnings and revenue saw strong double digit growth. In addition, guidance was raised for the upcoming quarter and full year. In the same time-span the stock price increased approximately 5%, again illustrating the leverage of options.

In a comment on the previous post Jeff from Blue Moat illustrated a potential downfall of this strategy. Essentially his point was, the strategy is great when it works but if you pick a bad stock you can end up down 95%. The leverage of options is great when it works for you but when it goes the other way it can translate into serious losses. One way to get around this may be to put in a stop loss order after the calls are purchased. In the same way we limit our gains to $1000 we can limit our losses to $1000 as well. As long as you are smart about your stock picks you should be able to stay on the winning end of the trade the majority of the time. Stay tuned for more potential stock ideas for this strategy.

On April 4th I wrote a post on implementing the deep-in-the-money calls strategy with Microsoft calls. To recap I bought 10 of the July 2008 $24.00 calls for $5.15 on March 26th. Sometime last week the July calls reached our target of $6.15 and the good-till-canceled limit order executed to lock in our $1000 gain. This means that in three weeks we made nearly 20% by carefully implementing the deep-in-the-money calls strategy. The best part of this is that in the same time frame the stock price moved less than 2%. A great example of the leverage of options.

So lets try and repeat this success. Corning Inc. makes the specialty glassware that goes into LCD screens and has a new technology for bendable fibre optic cable for fibre-to-the-home internet connections. They are cheap on a valuation basis, trading at 19x trailing and 13.5x forward earnings. The have been trading fairly flat for the past year but, based on the fundamentals and the company’s performance, could be due for a breakout. The stock is currently trading at $25.73. Looking out to the August 2008 calls will give us four months to get the required move in the stock. The August 2008 $20 calls (GLWHD.X) at a current cost of $5.91 per share fit the bill for this strategy (strike price $20 + option premium $5.91 – stock price $25.73 = $0.18; which is well under our threshold of $1.00). Therefore, we will place a limit order to purchase 10 of the August 2008 $20 calls at a cost of $5.91 per share. Once the order fills we will immediately place a good-till-canceled limit order to sell the calls $1.00 above our purchase price (~$6.91). This will insure that if we get the required move in the stock price our gains will be locked in.

Once again I will keep you posted on the progress.

In a recent post I commented on the Visa (V) IPO and how I thought you should play it. The post was also published on Seeking Alpha, which is a financial site that publishes stock related posts from various blog sites and individual contributors. On the Seeking Alpha post a number of readers have left comments giving their two cents on Visa as a stock purchase. As you can expect the overwhelming majority of these comments are bullish. Considering that Visa was one of the most sought after IPOs in US history, this isn’t surprising. What was surprising was the over-the-top blind faith by some readers that Visa stock would do nothing but rise in value. Take a look at some of these comments…

“If you have a 3 year or longer horizon, this is a great entry point! It will trade at $200 in 3 years or less. If you are a trader, you will see choppy waters short term; after all, all the banks in deep capital need will sell to raise capital.”

Alright, so I agree with this reader, you probably will see choppy trading in the short term and with a 3+ year horizon this may be a very good entry point. But considering the hype around the IPO why not wait for this one to come in a bit before building your position? And the $200 price target is completely baseless. This next one is even better…

“i am 18 and bought about 1200 dollars worth at 59.5 and i think by the end of the year this stock will have a fair value of $80. with VERY little risk and a lot of upside earnings growth and the possibility that down the road visa europe will join the company there is too much upside to be had not to get in now.”

I’m not sure where this reader comes up with the $80 valuation or the upside earnings growth considering at this point we have very minimal visibility into the financials or growth projections at the company. And saying that there is VERY little risk in a market as uncertain as this one is dangerous thinking to say the least. Here’s my favorite…

“This is definitely a great stock to invest in… It might go up and down for a few days, but in the matter of a few months, maybe a few years, it will definitely be well over $200.00″

Again the $200 price target, and possibly in a matter of a few months none the less. Maybe the reason that these readers are throwing around the 200 handle is because MasterCard (MA) is currently trading around $220. Just because these two companies have the same business model does not mean that Visa is going to follow what MA did post-IPO. There are a lot of other factors that investors must consider and I don’t think the casual, first-timers realize this. When investors make investment decisions based on sentiment and blind statements like these, essentially what they are doing is gambling. Investments must be made on sound homework into the fundamentals of a company; anything else is downright dangerous. I’m not knocking Visa here, these readers may very well be right. But if you are going to pitch a bullish outlook in a stock you better be able to back it up with logical arguments. Do your homework before you put any money down and make sure you understand the whole story. Because the risk that comes with making decisions based on a lack of information can turn the VERY little risk that our reader talks about into a poor investment in a hurry.

The Dow was down nearly 300 points today lead by commodities with Gold making its biggest drop since June of 2006 and Crude Oil down nearly 5%. Yet Wall Street still managed to pull off the Largest IPO in US history. Late Tuesday Visa (V) priced the 406 million shares of their Initial Public Offering at $44 per share, raising $17.9 billion in the process. This morning the stock made its market debut at $69 before trading a whopping 177 million shares on the day. The stock cooled off slightly as the day went on but still closed up an impressive 28% at $56.50. Great news for the lucky few who were able to get in on the IPO, but for the majority average Joe investor how do you play this. Well, you could have bought in this morning and then lost 18% on your position…probably not the best strategy. Or you can sit back on the sidelines for a while until you can evaluate this company in more depth and figure out what direction the market is going to take this stock. Everyone wanted a piece of this IPO today hoping that they were getting a piece of the next MasterCard (MA), which is up over 350% since its IPO in May 2006. There was no way that it was going to be able to hold up the highs from this morning trading 177 million shares, especially in the tape we saw today. If you want to play Visa, wait for the stock to come in a bit before you start to build a position. And buy in small blocks so you can lower your cost basis if the market gives you the opportunity. At this point there isn’t much data on the stock in terms of revenue, income, cash flow, or prospective top and bottom line growth. As with any stock you should do your homework and evaluate the fundamentals before making a final decision.

Visa makes money through transaction fees which are cashed in every time a cardholder makes a purchase. And with more and more people paying for non-discretionary staples such as gas, groceries and household bills with their credit cards, Visa has been able reap the benefits. Throw in the steady growth in online shopping, which almost always requires a card, and you’ve got the makings of a winning stock. Unlike the lenders that issue the cards, Visa is well insulated from credit problems because they don’t carry any consumer debt on their books. Visa posted revenue of $5.2 billion last year as it handled more than more than 44 billion transactions (far ahead of rival MasterCard). For the Q1 2008 Visa grew earnings by 70% compared to the previous year and management anticipates year-over-year earnings growth of at least 20 percent for the next two years. I’ll be interested to see what valuation the market is going to give this stock once more data is made public. I’m guessing the P/E ratio will be fairly steep due to the hype surrounding the IPO and this business model in general.

As a side note, this IPO is also extremely bullish for the investment banks that brought Visa public. The team, lead by JP Morgan (JPM) and Goldman Sachs & Co. (GS), is expected to collect more than $500 million in fees from the IPO. JP Morgan is a double winner as Visa biggest customer and shareholder. Look for both of these investment firms to generate huge payoffs from this massive deal.

Disclosure: None

In my last post I disclosed a holding in Sandvine Corp. (SVC.TO) and had promised a full fundamental analysis on the company. Well it was a rough week last week for shareholders of Sandvine. On Thursday Sandvine announced that they were cutting their 2008 revenue forecast to $80-85 million from the previous $100-110 million. The stock has fallen 62% since, closing today just over $1 per share. The adjustment came less than three months after Sandvine originally issued 2008 guidance ($100-110 million) which fell below consensus analyst estimates. The original announcement caused a significant decrease in the share price and, in my opinion, created a great entry point into the stock. But now after the most recent development I’m on the hook for a 70% decline in my position relative to where I bought in. Obviously my great entry point wasn’t so great after all. In my defense, my sentiment on the stock being cheap around $3 was echoed by a number of other individual investors including Justin, our friend Jeff McLarty over at Blue Moat, and a number of people we spoke to at Sandvine. Most of the analysts covering the company held similar bullish views including Scotia Capital who upgraded SVC to 1-Sector Outperform on March 3rd and Canaccord Adams who reiterated their buy on weakness on March 5th (the day before the revenue cut). I’m not stating this to justify my mistake. However, I am confident in saying that not many people saw this coming.

If you think about the reasons Sandvine stated for the adjustment it does seem logical and maybe that means that we should have seen it coming and been more cautious. In the announcement Dave Caputo, the CEO of Sandvine, stated that customers are taking longer to make decisions due to weakening economic conditions. Basically what he is saying is that the the credit crisis and subsequent slowdown in the US and global economy is starting to affect them being able to do business. In today’s market even hinting at the fact that your business is going to be negatively impacted by the weakening US economy is essentially the kiss of death. It is widely accepted that the US is probably already in the middle of a recession and there is a huge surge away from the ‘recession-affected’ and into the so called ‘recession-proof’ stocks. The equipment that Sandvine sells to Internet and wireless providers is a purely discretionary product at this point; it is a proven great technology but not essential for everyday business. So when things slow down and these providers are looking for ways to trim their budgets, spending $25 million on non-essential equipment probably isn’t at the top of their lists. Add to that the whole Net Neutrality issue and you’ve got the makings of a true battleground stock.

SVC is currently trading at a P/E multiple of just 7.6x trailing earnings. If the company can keep earnings relatively flat in 2008 and then continue growth in 2009, assuming the US economy has turned the corner by that point, the shares are very cheap purely on a valuation basis here. The company expects to do $8.2 million in revenue in Q1. To hit their estimates they will have to make up the remaining $72+ million in the final three quarters of 2008. This means they expect business to ramp towards the end of the year. Going into the slowdown Sandvine was well positioned to be the industry leader when it came to Deep Packet Inspection (DPI) technology. I believe that when the economy turns around and more providers adopt this technology, which they will eventually, Sandvine will still be positioned to be the industry leader. I remain bullish, albeit a bit more cautious now, on the stock and will probably add to my position to bring my cost basis down. I do believe that the most recent development is very negative for the stock in the short term. However, I believe the long term story remains intact. If you want to be long this stock I think you need to update your timeline from a 2-3 year timeline to a 3-5 year timeline at least. If nothing else, at these levels I have to believe that some of the major players in the Internet networking industry (Cisco anyone?) will be taking a close look at Sandvine as a potential takeover target to get a foot in the door of this emerging technology.

So that’s all for now on Sandvine. I’ll keep you posted on any new purchases or changes in the story.

Disclosure: Long Sandvine

Its been a while since my last stock purchase update, so I wanted to bring everyone up to speed on my current holdings. I’ll state the number of shares, the purchase price of the stock, and a brief justification for the purchase.

1. 50 shares of Research in Motion (RIMM) @ $87.03

This holding was actually a gift I recieved at Christmas this year (thanks Grandma!!). I took control of the shares in my TradeKing account on January 17th, 2008. The $87.03 per share was the price at the close on the 17th, which is kind of arbitrary since the stock was a gift and technically is 100% profit. I’m still not completely sure how I handle this stock for tax purposes if I were to sell.

The Waterloo, ON based company sells the wildely popular BlackBerry smartphone, which has become the industry standard mobile phone, email and internet access device for corporate North America. They are starting to gain market share in the personal-use wireless space and recently signed a deal with Alcatel-Lucent to sell the BlackBerry in China. The mobile phone market in China is enormous and RIM has the potential to eat up a boatload of that market share once the BlackBerry starts shipping. On a valuation basis RIM is actually pretty expensive, trading at 57 times trailing earnings. However, they have earned this rich valuation due to their rapid rate of growth. Revenues are growing at 40% year-over-year and their expected 3-5 year EPS growth rate is an unbelievable 70%. The company recently announced that they expect to sign 10-15% more subscribers in the current quarter than originally expected. As long as RIM continues to exhibit strong domestic and international growth I believe that they have the potential to generate some great returns.

2. 20 shares of ConocoPhillips (COP) @ $75.35

In today’s market no portfollio is complete without some type of energy stock. ConocoPhillips is an integrated oil and gas company that operates in six different segments: Exploration and Production, Midstream, Refining and Marketing, LUKOIL Investment, Chemicals, and Emerging Businesses. They are a diversified energy company with exposure to all segments of the oil and gas industry from exploration to marketing. In addition, their exposure to natural gas helps insulate them from being tied to the price of crude oil. ConocoPhillips is very cheap on a valuation basis, trading at less than 9x trailing EPS and 7.8x forward earnings, compared to an industry average of 11x and 24x trailing and foward earnings, respectively. Even if the demand for oil slows in the US (which I have my doubts about), the worldwide demand, especially in the developing nations, is just too great not to have some type of oil and gas company in your portfollio.

3. 25 shares of Biogen Idec (BIIB) @ $60.00

Biogen Idec is a biotechnology company which engages in the development, manufacture, and commercialization of novel therapies in the areas of oncology, neurology, immunology, and cardiology. The companies comercial drugs include AVONEX and TYSABRI for the treatment of multiple sclerosis, RITUXAN for the treatment of non-Hodgkin’s lymphomas, and FUMADERM for the treatment of psoriasis. In addition, the company has a very solid pipline with 5 Phase III and 1 Phase II clinical trials for drugs under development, as well as a number of preclinical stage projects. The difference between Biogen and most other biotech companies is that Biogen is actually making money. Biogen has shown strong double diget year-over-year revenue and EPS growth and trades at a modest 22x earnings. In October, Biogen announced that it was putting itself up for sale to the highest bidder. The news sent the stock soaring nearly 20%. Two weeks later Biogen called off their search for a potential suitor saying that they didn’t generate any serious interest. In a classic market overreaction, investors pumbled the stock sending it 20% lower than where it was trading before going up for sale. This created a great entry point into an undervalued stock. Nothing had changed at Biogen Idec in the two weeks that it was up for sale but the stock was trading at a 20% discount. And with Big Pharma looking for ways to bolster their lagging piplines and activist investor Carl Icahn increasing his stake in the company, Biogen remains a potential takeover target. The stock is still trading about 10% lower than where it was at the beginning of October, and is still undervalued in my opinion.

4. 560 shares of Sandvine Corp. (SVC.TO) @ $3.53

Sandvine Corporation is a Waterloo, Ontario based company that develops and markets broadband network management equipment and solutions for broadband service providers. The Company’s network management equipment and software solutions help broadband service providers identify, monitor and apply policies on network traffic. Sandvine is a local Waterloo company that Justin and I first started following through a number of friends who work there. We’ve both owned stock since shortly after they went public and have followed it fairly closely, including going to a shareholder’s meeting. I’m planning on doing a full analysis of Sandvine in an upcoming post, so I write any more on that here. But check back soon for my Sandvine post.

Unless you have been living under a rock for the past 2 weeks you probably have heard about the Microsoft offer for Yahoo!. After what has seemed like endless speculation, Microsoft finally announced that they are officially pursuing a deal for internet conglomerate. The unsolicited offers has Microsoft paying $42 billion dollars or approximately $31 per share for Yahoo!, representing a 62% premium to Yahoo’s previous day closing price. Since the news Yahoo’s share price has risen over 50% to almost $30 while Microsoft’s has fallen nearly 13% to $28.50, Google chimed in playing the anti-competitive card, Yahoo! officially rejected the offer saying that they are being grossly undervalued, and there has been speculation that other potential suitors may want to join in on the party.

In my opinion this has created an excellent buying opportunity in Microsoft. This was a $37 dollar stock as recently as the end of December. At $28 Microsoft is trading at 16x trailing earnings and just 13.5x forward earnings. People seem to forgot that the company absolutely destroyed earnings the previous two quarters. The knock on the proposed merger is that Microsoft may have issues consolidating Yahoo! into its business. Microsoft has been down this road before, maybe not on such a large scale but they know what they are doing. This is what everyone has been expecting them to do…make a move to challenge Google in the internet/search business. The 62% premium may be large but let’s not forget that Yahoo! was trading nearly 40% off its highs from last year. So its not like they swooped in when Yahoo! was at an all time high. Microsoft saw a great, yet poorly managed, franchise at a discounted price and identified an opportunity for them to get into a market that they’ve wanted to get in for a while now. I think this is a great move for Microsoft. When this all gets done, Yahoo! will add a great deal of value to the Microsoft franchise that already is doing very well.

I have been hearing a lot of people recommend buying Yahoo! even after the news of the deal. I don’t agree. To me it seems that an investment in Yahoo! comes with a capped upside and quite a bit of downside. Let’s think about the potential scenarios. The first and most likely scenario is that the deal gets done at somewhere between $34 and $36 per share. In this case your upside is limited between 13 and 20%. Even if the deal gets pushed up to $40, which I think is very unlikely because Yahoo! doesn’t have much leverage in these discussions, the upside is capped at 33%. Now don’t get me wrong, 20% is a great return in a short period of time but this is assuming the deal gets done. If Yahoo! decides to play hard ball and Microsoft walks away, Yahoo! stock falls back to $20 or possibly lower. Same thing if the deal runs into problems with regulatory approval. With Microsoft trading at a 13% discount from when they announced the offer and 23% from the high at the end of December, I think the buy is Microsoft. Even if they walk away from the deal Microsoft is still the company knocked earnings out of the park the past two quarters. When the deal does get done and the Yahoo! synergies start to hit Microsoft’s top and bottom line their share price should follow.

Disclosure: None