Only swing at soft pitches

I've been working on a model for pricing options that does not rely on volatility as an input. (I know: I might as well try to design an airplane without wings.) Testing it out on real prices, I've found that it give vastly different answers for most options. But when the stock price is fairly close to the strike price and the expiration date is only a few months in the future, my estimate doesn't stray too far from the market quote. So as a general options pricing model, this one pretty much fails.

But today I realized that I really don't care. The vast majority of options are ones I don't really care to sell in the first place. For the most part, I want to sell options with strike prices near the price I would value a company. And options longer than a few months in duration are not interesting either since it would be hard to value the underlying shares. Further, I don't really plan on selling options that are less than 50 or 60¢ because commissions eat up too much of the premium. In essence, my model pins a value on the options I'd really like to sell and I don't care what it does to options I want nothing to do with.

Now I'm interested in selling a January $22.50 option on Oracle that currently trades for 50¢. It's pretty far out of the money, so my model does a rotten job of evaluating its price. It comes up with a negative price, which obviously won't work. On the other hand, my model values the $20 option at about $1.32 while the market says the option is worth $1.50. If I were interested in selling Oracle at $20, I'd take that price, which would amount to selling Oracle at $21.50 with a 67% probability.

As it turns out, if Oracle where trading at $22.50 today, I estimate that the $22.50 option would be worth about $1.24. Now there isn't much chance that Oracle will jump from $20.21 to $22.50 in one day, but it does exist. And if it did happen, I'd gladly sell an option on my Oracle shares for that price. It would be a pitch I'd know what to do with.

Why I won't be rolling my Oracle call options

The November call option I wrote will be expiring this weekend and the December option is likely to expire too (35% chance). But instead of rolling them forward, I now plan on hanging on to my Oracle shares for a bit longer. I listened to the recent OpenWorld keynotes and also the analyst meeting and I think I've ignored some significant real options that Oracle might exploit.

According to my discount cash flow models, Oracle is well within the low range of its fair value. The market is assuming 10% growth for 10 years or 14% growth for 5 years. Safra Catz, Oracle's CFO, has set 20% as the goal and hinted at 26% as a possibility. Normally, there would be reasons to be skeptical of these claims, but Oracle has some unique attributes that make this sort of growth possible and even likely.

To begin with, much of Oracle's revenues are incompressible. In other words, once a client begins to depend on HR, accounting, CRM or other software as a critical element in their business, it isn't possible to reduce the licensing stream going to Oracle without shutting down altogether. As a result, there is a floor on how much revenues can fall. Also, the natural tendency is for margins to increase over time rather than decrease. Continuing licenses are nearly cost free to Oracle because of scale.

Now assuming there is a recession this year and next, Oracle will have a harder time growing organically. But the revenue stream shouldn't fall too much and it will have an opportunity to either lower costs or buy up other companies cheaply. If the recession doesn't occur or is mild, Oracle has the option to expand its offerings organically in addition. So because of the nature of its business, Oracle has more flexibility than most companies to deal with downturns. That flexibility represents a real option that I hadn't accounted for in the past. Being able to grow earnings in the face of economic headwinds could be a huge advantage.

I know I've flip-flopped on Oracle lately. Part of the reason is that its share price has been jumping around my lower edge of my value estimates. It hasn't gotten so expensive that I feel the need to sell right away, and it isn't so cheap I'm interested in buying more.

Oracle's offer to BEA

It looks like I won't sell Oracle for $22.50 this week (1 chance in 5). I plan to continue trying to write $22.50 call options on my shares because they continue to be fully-valued. I mentioned last month, that it is nice to have more than one reason to own a stock and the income from writing options is a good reason. Besides that, if the option is exercised, I feel I'm getting a fair price.

The big news for Oracle was their offer last week to buy BEA. I've learned a bit about how to evaluate mergers and I think the offer is pretty good, but is likely too be raised before all is said and done. If the premium offered is less than the expected value of the synergies produced, a transaction my be considered successful. In this case, the premium is at least $1.3 billion. Before the announcement, BEAS was priced at $13.62 a share and the offer price is $17—a premium of $3.38 a share times 392 million shares. Oracle hinted it considers the premium to be even higher: "Our proposed price is a substantial premium to an already-inflated stock price that reflected speculation of the potential sale of BEA and represents a more than 40% premium to BEA's stock price before the appearance of activist shareholders in mid-August of this year." Carl Icahn is, of course, the "activist shareholders" the letter refers to. I'm not going to factor that in, however, since the stock traded higher than $14 as recently as July 19 of this year and has been in the general range for most of the last twelve months.

Synergies are a bit harder to calculate. The market clearly thinks Oracle will need to raise its price since BEAS is trading at $18.55 a share (a $1.9 billion premium). An obvious source of synergy stems from Oracle's high operating margin (33%) compared to BEA's (14%). If Oracle simply trimmed BEA costs to match its own, it would earn an extra $205 million a year in synergies. Using an 11% cost of capital, that works out to about $1.9 billion. Further benefits, such as the ability to cross-sell products to BEA customers and technological improvements, are not included but are also less certain and harder to calculate. I'd assume they are a counter-balanced by integration costs, but they probably do exist.

I just read the chapter on Mergers and Acquisitions in Expectations Investing. One important concept it presents is Shareholder Value at Risk (SVAR), which quantifies how much of current shareholder's value the company is betting on an acquisition. For an all-cash offer, the math is pretty easy and works out to 1.2%. If the offer goes up to $18.55, as the market currently predicts, the SVAR is 1.7%. The highest offer I've seen speculated is $21 a share, which would risk 2.5% of shareholders current value. Any way you slice it, this offer will not have a huge impact on Oracle's long-term performance.

So to sum up, I like Oracle's prospects and the current offer to BEA, but I'm still trying to sell call options so that I can earn some extra income on this fairly-valued position. Got it?

Why I'm selling Oracle

I'm now in the process of writing in-the-money call options on my remaining Oracle shares with the intention of closing my position soon. Today I sold a $22.50 October call for 60¢ when Oracle was selling for about $22.85. By my calculations, there is about a 63% chance the option would be exercised. Oracle ended the day at $22.92, which boosts the odds a couple of percentage points. After commission, I'll be selling Oracle for the equivalent of $23 a share in about 9 days. I'm also trying to sell November options to cover the rest of my Oracle position.

In my opinion, Oracle is no longer a good value. A conservative growth assumption of 10% a year for the next 5 years would come out to about $21 a share. Using more aggressive growth rates will produce higher estimates, of course, but we are now firmly in the range of reasonable valuations. That makes Oracle less attractive to hold and unattractive to buy. If there was a dividend, especially if there was a good chance it would be raised, I'd have more reason to hang on. But the share buybacks Oracle currently uses to return value to shareholders don't excite me at these prices.

I should note that Oracle will continue to be on my radar over the next few years because it is a business that is not well understood. Earlier this week, SAP made an offer to buy Business Objects, which was widely reported as a change in course to Oracle's acquisition strategy. The trouble with that statement is that Oracle's strategy isn't to just buy up competitors, but to get the best software even if it has to buy whole companies to do so. SAP might be doing the right thing, but only if Business Objects to improves SAP's own suite of products and doesn't cost too much. SAP's action doesn't "validate Oracle's strategy"—it merely increases the cost for Oracle to buy good businesses. So it's been odd to see Oracle's price going up this week rather than down.

Having multiple reasons to own

Looking at my overall portfolio performance, I feel pretty good, but two of my biggest positions are way down against the market (as defined by the S&P 500). First Marblehead doesn't bother me too much because I just bought shares and I can't believe how cheap they are. The first and primary reason to own a company for a value investor is that shares are worth far more than the price assigned them by the market. It's sort of the litmus test of value investing.

Select Comfort is a different story. Since I doubled-down, at the end of 2006, the price has gone down, but so has the value. Based on 85¢ EPS last year and 20% projected growth, a fair value would have been about $34 a share. But this year, 87¢ EPS seems pretty optimistic and 15% is a better guess for growth, which makes my best guess for Select Comfort's value to be $24 1/2. I wouldn't argue against a valuation as low as $20 or so. Even so, this is still less than the $18 I paid last year or the $13.30 (adjusted for a 3:2 split) I paid in 2005.

The other reason First Marblehead is easier to own is that it pays a regular dividend. I cheer for low prices since they mean I'm reinvesting at low prices. But Select Comfort doesn't pay a dividend. They do have a buyback program, which I expect is taking full advantage of the low prices the market is offering. I still prefer a dividend, however, since it is more certain and reliable. First Marblehead is buying back shares as well, so I'm doubly pleased.

One lesson I've learned from Select Comfort over the last year is that as a stock price approaches parity with its value, there needs to be another reason to own the stock. You can't force a company to pay a dividend and share buybacks become less worthwhile, so selling becomes a reasonable option even for a company that is operating on all cylinders. As I have done with Select Comfort and Oracle, you don't have to place a sell order in order to sell a stock—writing a call option works nearly as well. I missed that chance a year ago when Select Comfort was trading near $25, but I won't miss it next time.

I've already started practicing sell discipline with Oracle. Improving, rather than worsening, financial conditions make a company easier to own. But stock prices tend to peak around the time that performance peaks. If price are getting close to value, there has to be another reason to keep the company. At the moment, Oracle is priced to grow earnings at 14.5%. Though this is possible, I'm afraid there is a real possibility Oracle's business could falter like Select Comfort's did. I don't see any reason to take that risk when there are other investments that trade well under their current value.

Why I sold Oracle and how I wiped out my option profit

So the Oracle September call option I sold is going to be exercised this weekend since Oracle finished the day at $21.98 a share. Using the rules I established for accounting option gains and losses, selling the option cost me $1.98 a share. Since I only received 55¢ a share of premium and also paid a commission, I took a pretty ugly accounting loss on the transaction. In fact, this single loss would nearly wipe out all the premiums I've earned since I began selling call options this year. When adding in costs, my combined ratio is an abysmal 121.92%.

Without this single transaction, my combined ratio was an amazing 24.74%. I don't really have a large enough sample to measure myself yet, but this tells me that I'm settling for too little premium when I write call options. In fact, I was pretty surprised to see that Oracle's price had jumped from $19.36 to $20.13 on the day I sold the option. Rather than a 35% chance of losing, I sold a option that was nearly a coin-flip. If options were my full time job, I would have noticed the price change and adjusted my limit order to capture more premium. Options are so much more volatile than the underlying stock that the full-time trader has a distinct advantage.

But even if I had written the call for a reasonable price, I would certainly have lost this particular bet. Oracle's stellar earnings release, that came on Thursday, assured that the option would be exercised at a loss. The market's response to lower rates didn't help either. Now, I don't really mind too much because I still have plenty of Oracle shares that are worth more than when I sold the option. Part of the reason I sold in the first place was because Oracle was a bit overweight in my portfolio.

Why I sold a $20 September call option on Oracle

Yesterday I sold a $20 September call option part of my Oracle shares for 55¢ a share. As of this afternoon, they are selling for 65¢. Last year, I sold an option that was not exercised for these shares at 70¢, so I've created a synthetic dividend of $1.25 on a stock that earned 81¢. Now there's a risk (50.6% or so) that I will lose a percentage of that premium in accounting terms when the option expires. This option likely to be exercised, so it might be better to think of this as a sale of Oracle. I think Oracle is still undervalued, but I'm willing to sell because First Marblehead is even more undervalued.

Select Comfort option expired

So Select Comfort ended last week under $17.50, so the call option I sold expired worthless. As I mentioned previously, I'll be on the lookout for a chance to sell another option soon. One issue is that the company releases 2^nd Quarter earnings on Wednesday afternoon. Selling a call option before then is at least partially a bet on there being no upside surprises in that release. I don't like to speculate on what is basically unknowable, so I will likely pass on the premium until Thursday at the soonest. If by some chance, the news on Wednesday exceeds my expectations, I might look at a higher strike price on later dated options.

One problem with selling call options on Select Comfort is that roughly a quarter of the outstanding shares are sold short. That's a lot of buying potential if relatively good news causes short sellers to unwind their positions. Paradoxically, extreme short interest tends to be a positive sign for companies that aren't scams or on the way to bankruptcy. All those short-sellers are going to need to buy back shares sooner or later, which means extra demand at some point down the road.

Option expiration tomorrow

The call option against my Select Comfort shares expires tomorrow. Since the stock ended at $17.20, it must gain 1.7% tomorrow. Of the 1,685 trading days in my database, a little over a 1/4 have resulted in 1.7% or greater gain. So I must face the possibility that my shares will be called away. If so, the proceeds ought to be reinvested, though probably not in Select Comfort. My original thesis on selling the option remains intact and First Marblehead has gotten even cheaper.

The July option ended the day at 5¢ or essentially worthless. August $17.50 options ended at 70¢, so I may collect another nice premium next week if the shares are not called away. At this point Select Comfort is on a short leash for me, so I plan to continue selling options until the business improves.

Why I sold a call option on Select Comfort

I already mentioned my intension to sell a covered call option at $17.50 a share and today the order was filled at 45¢ a share. I sold July contracts and the underlying stock ended the day at $16.68. Over the next 31 days, there is a 42% or so chance the option will be exercised.

The odds that I will break even are approximately 62%.

It's important to note that I've only written an option for a portion of my holdings, which means I can still profit from price increases over the next month. I might sell another option at a higher strike or an option that expires later in the year. It's also possible that I will sell shares outright if their price jumps unexpectedly. On the other hand, I could have sold options more cheaply if I'd sold more contracts.

Is seems to me that Select Comfort is undervalued because of a convergence of events that management has some control over. At a recent Analyst Conference, CEO Bill McLaughlin pointed out that the current marketing campaign does a good job addressing the "need" portion of Select Comfort's message, but not the "solution" portion. He mentioned at least twice that consumers don't always know where to buy the Sleep Number bed, which I found a bit surprising. He also said that the housing downturn has had an effect on sales since Labor Day last year because people tend to buy beds when they move into a new house and because the "wealth effect" has been reduced. He also revealed that Select Comfort has seen significantly more cannibalization than expected when it expand from 100 Retail Partner Doors last year to 800 this year.

Fortunately, management has committed to fixing these problems and to borrowing cash to buyback shares. They have a significant amount of control over the marketing and distribution of their own product. Also, there was an announcement today of upgraded products, which gives me encouragement that R&D efforts are starting to pay off.

Why I sold Alberto-Culver

A few weeks ago, I sold a call option against Alberto-Culver and on Friday, the option was exercised. I can't think of a better way to sell my shares: I sold for $22.50, the price on Friday was $22.51, and I got paid 30¢ for the privilege. As a result, my total combined ratio (after taking a penny a share loss) is 25.92%.

I still have a few shares left, but I got out of the bulk of my position in Alberto, because my original thesis is no longer valid—Sally Beauty was spun off. As it happens, I estimate that I earned 17.47% (38.90% annualized) on the first purchase and 16.32% (46.72% annualized) on the second purchase. "New Alberto" did better than I prediced, so I'm quite pleased with the overall transaction.

I still think Alberto will outperform the market over the next 5 to 10 years, but I don't think it will be a dramatic overachiever. I'll maintain a minimal stake in the company for a long time, if only because it isn't cost-effective to sell. Based on the dividend discount model, I guesstimate the shares are worth closer to $25 apiece, but I'm happy to sell in order to free up cash for an even better opportunity that I hope to buy into within a few weeks.

Odds of my ACV option getting exercised

As of the market close today, Alberto-Culver stands exactly at $22.50—my option's strike price. I would expect the option to be exercised if the price ends a penny or two higher on Friday. This graph shows that (if the past is any guide) there is a better-than-even chance I'll be selling my shares.

The horizontal axis shows the range of gains and losses experienced by ACV shares over any two day period. The vertical axis is the odds that the price will increase by a certain percentage or greater in two days. So for a 0% or greater increase, the odds are 56% or so. Actually due to rounding errors there are more 0% gains in my data then there ought to be. (You will notice that the curve becomes vertical on the 0% line. That's not an optical illusion, but an artifact in the data.)

If the increase is 0.89% or greater, my option will lose money compared to simply selling the underlying stock on Friday. This graph shows that the odds are roughly 34% of taking a "loss" on the transaction.

Ideally, the shares will end somewhere between $22.50 and $22.70 so that I will sell the shares at a gain (odds ~ 22%). If that happens, I am ready to roll the proceeds into a new investment. If the option is not assigned, I might sell outright or (more likely) sell another covered call for April.

Why I doubled-down on Oracle

I've been planning on buying more Oracle off and on ever since I sold a portion a few years ago. Lately, I've held off because of price or because I had better ideas for the cash. As recently as last November, I was willing to sell another portion of my holdings. But since then, the price has fallen off far (15.97%) enough for me to switch back to buy mode.

I've borrowed some key ratios from Reuters:

Ratio                    Oracle  Industry*
-----                    ------  --------
P/E (TTM)                 24.02    31.08
Price to Sales (TTM)       5.39     5.96
Price to Cash Flow (TTM)  18.54    26.05
Price/FCF (TTM)           19.70    31.53
Operating Margin (TTM)    32.40    24.49
Net Profit Margin (TTM)   23.03    19.17
Return on Equity (TTM)    26.79    22.22

* Software & Programming 

The point is, Oracle is cheap compared to other software companies. But none of these ratios consider Oracle's superior growth. Year over year, Oracle has increased sales by 24.72% compared to 18.66% for the industry as a whole. Now much of the growth has come from the purchase of Siebel systems in January 2006, so we can't expect that growth to be repeated this year. But it's also becoming clear that the acquisition strategy is working. In particular, when a customer decides to buy one portion of the Oracle Suite, there is a strong incentive to buy all of their enterprise software from Oracle. Oracle the platform company is an even better business than Oracle the database company.

I also must admit that part of the reason I bought more Oracle was to round up an odd lot. Since Oracle doesn't currently pay a dividend, I intend to sell call options against my position. Of course, that requires Oracle to increase in price to where it is overvalued. That might take a few years, however.

Odds of successful call writing

Earlier today, I wrote a call option on my ACV stake. At the time, I was more concerned about getting paid to sell than loosing out on gains. This afternoon, I took a look the odds of exceeding my break-even price at the end of the two weeks. I calculated that if miss out on any increase of beyond 1.89%. First, I grabbed all the closing prices for ACV and loaded them into an SQLite database. Then I counted the total number of two week periods in my dataset:

sqlite> select count(*)
   ...> from (select * from acv_prices a
   ...>       join acv_prices b
   ...>            on (julianday(b.date) = julianday(a.date) - 14));

5503

Next I counted the number of those periods in which the closing price increased by 1.89% or more:

sqlite> select count(*)
   ...> from (select (a.close-b.close)/b.close increase
   ...>       from acv_prices a 
   ...>       join acv_prices b
   ...>            on (julianday(b.date) = julianday(a.date) - 14))
   ...> where increase > 0.0189;

2088

Therefore, if the past is any indication of the future, there is a 38% (2088/5503) chance my option will be called for a loss.

One of my goals in writing the option was that I would like to sell my Alberto-Culver shares. It's likely that a 1% increase will result in my option being assigned, so I also took a look at the number of fortnights in which the stock increased by that percentage or more. I won't show the code, but it turns out that 2551, or 46% of the periods resulted in greater than 1% increases. And just for kicks, I looked at the odds ACV will loose value over the fortnight, which is 43%.

Overall, the odds for each scenario shakes out like this:

ACV	Option	Odds
Down	Expire	43%
Up	Expire	11%
Up	Excerised for gain	8%
Up	Excerised for loss	38%
Total		100%

Why I sold an Alberto-Culver call option

Today I sold a call option on part of my Alberto-Culver position. Between now and March 16, I may be required to sell shares at $22.50. I'd be happy with a higher price, obviously, but I'm getting eager to use that cash to pick up shares of other companies that I have more confidence in. My current combined ratio is 24.92%.

Look-through earnings

"Merry Christmas!" At least that's what I feel like saying every year around this time. Warren Buffett likes to publish his annual report to shareholders on a Saturday, but we get Christmas a few days early thanks to new SEC regulations. Needless to say, Berkshire's actual results were almost as good as its Chairman's commentary and advice.

This year, I thought it would be fun to present my investment's results using one of Mr. Buffett's favorite tools—look-through earnings. Essentially, I calculate my share of each companies earnings by multiplying the quarterly earnings per share by the number of shares I hold each quarter. Then I aggregate four quarters into a year and divide by the number of "shares" in my IRA. (For an explanation, see this article). This way, I can focus on the economic value the various businesses have added as if I owned each one outright. All 2007 numbers exist only in the imagination of analysts; I use them as placeholders to get an idea of what the future holds.

Earnings         2007*   2006    2005    2004    2003    2002
Oracle           0.19    0.13    0.21    0.30    0.44    0.34
Canon            0.31    0.28    0.49    0.34    0.08 
Select Comfort   0.26    0.19    0.27   
Berkshire        0.19    0.25    
Alberto-Culver   0.12    0.08    
Sally Beauty     0.04    0.00    
Look-through     1.12    0.93    0.97    0.64    0.52    0.34

* 2007 numbers are consensus analyst estimates.

The 2006 results are down in part to my purchase of Alberto-Culver and its spun-off subsidiary, Sally Beauty. I bought these shares more for the value I hoped would be unlocked by the spin-off and for the large special dividend (see below). Oracle has slowly been losing its share in my personal look-through earnings because it is a smaller part of my overall portfolio. On an absolute basis, its earnings have increased smartly.

Last year was the first in which I made more than 2 trades. Besides three new positions, I added to one of my old positions, executed three going-private, arbitrage transactions, initiated two more and sold one option. Plus I left substantial (relatively speaking) sums in cash. So my non-look-through earnings and costs were significant for the first time. In the following chart, I've included actual year-to-date results in the 2007 column.

Interest         0.01    0.16    0.01    0.03    0.02    0.00
Costs           (0.05)  (0.19)  (0.04)  (0.06)  (0.22)  (0.12)
Arbitrage        0.39    0.41    
Options          0.06     
Operating        1.47    1.32    0.94    0.61    0.32    0.23
Gain            11.28%  40.94%  52.78%  89.99%  41.50% 

My "operating" earnings are more impressive, smooth and meaningful when presented this way. The market value of my IRA is substantially more lumpy due to market fluctuations. Note that while the arbitrage earnings are quite significant for last year's results (not to mention this year's), they would be partially offset by a tax cost if this were a taxable account. I'm also batting 1.000 with a pitifully small sample size. One day I will experience a setback and the loss may very well wipe out significant gains.

Finally, if you add in my sale of Oracle a few years ago and the large special dividend from Sally Beauty, you will arrive at some very lumpy net earnings. Once again, these earnings benefit greatly from the tax-deferred status of the traditional IRA.

   
Realized Gain                                    1.79 
Special dividend         2.99    
Net              1.47    4.31    0.94    0.61    2.11    0.23
Gain           -65.97% 360.84%  52.78% -71.01% 827.21% 

The fun part about looking at results this way, is that it's easy to imagine being at the helm of a large conglomerate controlling an array of subsidiaries. But this approach ought to also aid an investor's thinking about the businesses he partially owns. Clearly, I will need to consider eliminating my Alberto-Culver and Sally Beauty stakes in the next few years if they do not improve performance. I might want to increase my investment in Oracle instead. Arbitrage and option activities have added considerably to my bottom line.

Buying Alberto-Culver (and trying to sell it too)

I can't say I know very much about Alberto-Culver. It's a consumer products company that mostly caters to women, and my wife doesn't use their products. My original thesis was that the spin-off of Sally Beauty would unlock value in Alberto-Culver. As far as I'm concerned that has already happened.

But, as it turns out, I just bought a faction of a share of ACV. Why? Because I've instructed my broker to reinvest dividends. If your broker offers dividend reinvestment as a free option on your account, there's no good reason not to buy some fractional shares of a company you already hold. Alberto-Culver's earnings yield is about 4.22% versus 4.85% that cash would earn. But remember, companies have the potential to increase earnings over time.

Meanwhile, I'm attempting to write a call option on the bulk of my holdings. I've got better ideas than Alberto-Culver at this point and I'm overexposed on this particular stock at roughly 11% of my IRA. But I'm not quite ready to sell outright. I like the dividend I'm getting, management seems very shareholder friendly, and I think a few acquisitions combined with cost-savings could push earnings up over the next year or two. So the middle ground for me is to write slightly out of the money call options until something drastic changes.

My stock option insurance business

Back in November, I wrote my very first covered call option. Since then I've been struggling to understand how I ought to evaluate these transactions—especially when the option expires worthless.

Oracle slid from $19.48 to $17, so there was no possibility that the option would be exercised. On the one hand, I certainly didn't lose any upside. On the other, if I had sold my shares instead of the call option, I would have avoided a worse than 11% loss. I'm not terribly upset about the "loss", however, since I wasn't committed to selling Oracle. $20 is at the low end of the stock's intrinsic value, and I'm interested in becoming at buyer again now that Oracle is priced under $17. From the perspective of the option buyer, the option was well worth its price. Instead of out-right buying Oracle and taking an immediate loss, the buyer has the luxury of buying at much cheaper price or taking a pass altogether. So who won and who lost in this transaction?

If you think of an option as an insurance transaction, it becomes more obvious that there don't need to be losers (though often there are). Although the option buyer lost the premium paid to me, their bigger concern was to avoid the sell-off that did, in fact, occur. And although I suffered a big, unrealized loss, I would have suffered it whether or not I'd sold a call option. So like an insurance contract, the party (me) that could afford a sudden price drop sold protection to the other party that couldn't afford it.

Insurance writing is usually evaluated with a metric called the combined ratio. It takes any losses, costs or dividends to policy holders and divides by total premiums. Ratios greater than 100% indicate underwriting loss. Insurance companies prefer to operate at the lowest possible combined ratio, but can still be profitable thanks to investment gains on the premium float, which is the money that has been paid in and has not yet been paid out in claims. Based on a single option, my combined ratio is 21.37%, so I'm currently making an underwriting profit.

The paper loss on the underlying asset (Oracle) is unfortunate, but not really relevant to the activity of writing call options. Think of the underlying asset as a reserve that is required to ensure that I can pay out a loss. When my reserve shrinks, it is the result of an investment decision to not sell not because I wrote a call option against it.

I expect that in the future, I will make a small profit on covered call options. Thankfully, USAA lowered my commissions, which will lower my cost. But I will also probably suffer some loses when options I write are exercised and I imagine I will accept smaller premiums than I did with Oracle.

January performance

I haven't written in a while, but my IRA portfolio turned in a spectacular January:

Date      S&P 500  Delta   IRA    Delta  BRK A  S&P 500   NAV    BRK A
01/31/07  1.41%    1.07%   2.47%  2.42%  0.05%  1,438.24  24.44  110,050.00

Here are a few highlights:

• Sold Pegasus Communications for $3.25 a share.
• Bought Eupa for 35¢ a share.
• Sold Meritage Hospitality for $5.50(!) a share. (That works out to a 295.71% annualized return.)
• My Oracle call option expired. The good news is that I was not forced to sell my Oracle shares. The bad news is that Oracle lost more than 12% of its value in that time. Fortunately, I didn't want to sell anyway.
• Select Comfort gained nearly 6% for the month. I guess the shock of bad news in December wore off.
• Sally Beauty gained 9% for the month. I guess the shock of bad news in December wore off.
• Alberto-Culver gained nearly 5% for the month based, I suppose, on a 5.5¢ a share quarterly dividend.
• Oracle and Canon had poor Januaries based on being large companies with little real news.
• Berkshire Hathaway, as you can see above, ended flat.
• Earned 4.85% (annualized) on any cash I had lying around.

All of this is to say that my stock prices bounced around randomly. I'd say the going-private transactions that I've participated in show true skill since they've worked exactly as I expected. My other investments have did well in January mostly due to luck. Long term, I expect to have more good months than bad ones and make more good decisions than bad, but one month isn't a big enough sample.

February is turning out to be my best month yet. My IRA balance right now is over $5 million. That easily surpasses the half million dollars I "had" back in September. But I expect my balance will return to earth shortly when my Eupa are cashed in.

2006 in review

2006 was a great year for my IRA portfolio (up 28.50%). Not only did I outperform both the S&P 500 (13.62%) and Berkshire Hathaway (24.11%), I also posted my best calendar year performance. After 4 1/2 years of out-performance, I feel confident that my results so far are not a fluke.

Date      S&P 500  Delta     IRA   Delta BRK A  S&P 500   NAV    BRK A
06/23/02                                         992.72 10.00  72,200.00
12/31/02   -11.37% 42.32%  30.95% 30.18%  0.76%  879.82 13.09  72,750.00
12/31/03    26.38% -1.49%  24.89%  9.08% 15.81% 1111.92 16.35  84,250.00
12/31/04     8.99% -2.16%   6.84%  2.49%  4.34% 1211.92 17.47  87,910.00
12/31/05     3.00%  3.23%   6.23%  5.42%  0.81% 1248.29 18.56  88,620.00
12/31/06    13.62% 14.88%  28.50%  4.39% 24.11% 1418.30 23.85 109,990.00
Total Gain  42.87% 95.63% 138.50% 86.16% 52.34%    
Annualized   8.20% 12.97%  21.17% 11.43%  9.75%    

A significant factor in my success this year was that my patience with Oracle finally paid off. I bought at a ridiculously low price and Oracle proceeded to perform quite well and account for nearly all of my IRA's gain for the second half of 2002 and all of 2003. 2004 and 2005 represented a fair amount of uncertainty for Wall Street, which refused to believe that "tech mergers" worked. This year, the various acquisitions started contributing to the bottom line and Oracle's shares followed (up 40%). The interesting thing is that Wall Street still undervalues Oracle. Too many analysts focus on new database licenses to the exclusion of higher margin renewals. Also, I think the Oracle database is under-appreciated as a platform for other businesses to develop new products on. It's nice that Oracle the company is standing in the wings to buy startups that succeed.

Canon, at 23% of my portfolio, is tied for my largest holding in large part due to its exceptional performance during 2006 (up 44%). Once again digital cameras and printer-related consumables continue to be the mainstays of Canon's business. The digital camera revolution is nearly over in my opinion—most people have a digital that meets their needs. Canon is going to have to have a new product boom in the next year or so to keep up their revenue growth. Perhaps YouTube will do for digital camcorders what Flickr did for still cameras. I think Canon's management is counting on its new flat-screen TV product to drive revenue growth.

Select Comfort endured a rocky ride this year and ended down 4.6%. Operationally, nothing much changed in my opinion. They are still the same company with the same management operating in the same business as when I first bought shares nearly two years ago. It's entirely possible that macro factors such as the slowing housing market and credit tightening will make 2007 a disappointment, but over the next ten years Select Comfort ought to do very well. After buying more shares, it is now tied for my largest holding.

Berkshire Hathaway is up 23.5% since I bought it. 2006 was a spectacular year to be a reinsurer since claims were low and premiums high. (The catastrophes of 2005 are largely to blame so its possible premiums will head down in 2007.) Auto insurance continues to be a good business since cars continue to be built safer. Berkshire's other lines of business seemed to perform well during the year. From now on, a portion of my portfolio will match Berkshire's results, which is something to keep in mind when I compare my results to it.

The year end spin-off math for Alberto-Culver is Alberto-Culver ($21.47) + Sally Beauty ($7.86) + the special dividend ($25) = $54.33. Given that I bought at a dollar-weighted average of $49.34 a share, I've made nearly $5 a share or 10% on the spin-off. Alberto-Culver and Sally Beauty together make up 15% of my portfolio, which is fairly significant. But I haven't yet decided if they will become core positions. Both companies have now released initial 10-K reports, which I hope to have a chance to read in-depth soon. But I think I'll have a better idea of how the new companies operate after a quarter or two. Also, I'd like to know what Alberto's dividend will be.

The rest of my portfolio is a smattering of going-private transactions and cash. I'm also short January 2007 options on Oracle at $20, which should expire without value. In some ways, this "short-term" portion of my portfolio is the least important. By their nature, going-private transactions are very profitable, but also very small. Last year I completed 3 and initiated 2. But if they were to make a significant impact on my portfolio, I would have had to have completed something like 10. This year, I'll need to complete even more, since my total portfolio has grown considerably. On the other hand, since they require little in the way of effort, risk or capital, I see no reason not to continue attempting to make a little profit there.