My investment strategy is extremely simple: I buy 50-cent dollars -- ideally, with a catalyst. In other words, I buy stocks I think are worth at least twice their current share price, with one or more events on the horizon that might trigger the market to value the company properly, at intrinsic value.

But what happens when these 50-cent dollar stocks rise and become, say, 80-cent dollars? This is not an academic issue. After a big run-up in the past 18 months, nearly all categories of stocks are fully valued, if not substantially overvalued. So my portfolio -- and likely those of nearly all U.S. equity investors -- holds many 80-cent dollars.

I'm not happy about this. Holding stocks with only a 20% margin of safety is risky, because if the market were to fall sharply, which worries me these days, then these positions, as a group, could fall by a similar amount. I hate round-tripping -- buying a 50-cent dollar, seeing it rise to become an 80-cent dollar, and then watching it plunge back to a 50-cent dollar. Alas, I speak from experience and have the scars to prove it.

One obvious solution to this dilemma is simply to sell stocks quickly, before they reach my price target, a conservative estimate of intrinsic value. But to me, that's crazy. I have no interest in excessive trading, getting hit with more short-term capital gains taxes, and, most important, dumping the stocks of great companies such as McDonald's (NYSE:MCD), Yum! Brands (NYSE:YUM), and Home Depot (NYSE:HD), which I recommended in twocolumns 18 months ago. This is especially true when I believe the companies are only halfway through remarkable turnarounds and, this is key, the stocks remain approximately 20% undervalued. If they reach full value, I would sell them, as I've done with many other positions over the past year, such as E*Trade (NYSE:ET), Office Depot (NYSE:ODP), and Jack in the Box (NYSE:JBX). (If only I were clever enough to nail the top when selling.)

Hedging my long positions
Instead of selling my 80-cent dollars, I've bought insurance. Let me explain. Generally speaking, there are two types of risks in owning a stock: external risk and company risk. Regarding the former, a stock can go down because the economy tanks, interest rates soar, consumer spending weakens, terrorists attack, and so forth. Or a stock can decline because something bad happens uniquely to the company: new competitors emerge, growth or margins unexpectedly decline, management makes a dumb acquisition, and so on.

I'm quite comfortable with company risks because they are reasonably knowable for many firms -- certainly all of those I invest in -- with enough analysis and scuttlebutt research. In contrast, I'm not comfortable with external risks because I have little ability to predict them (and am skeptical of the many soothsayers who pretend to have such an ability).

When I'm certain that I own a 50-cent dollar, I tend not to worry much about external risks for two reasons:

  • When a stock is so cheap, it often does not correlate with the market, even in a period of declining prices.

  • I don't mind if an extremely cheap stock falls because of external factors, because I'd like to buy more at a lower price.

But neither of these reasons apply in the case of 80-cent dollars, so I seek to hedge in this situation. There are many ways to do this, some massively complex, but I try to keep it simple. What I have done is taken all of my large-cap stocks (Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), McDonald's, Home Depot) -- which I believe will, as a group, track the S&P 500 index in a period of sharp market decline -- and purchased an equivalent notional dollar amount of the longest dated (December 2006) S&P 500 puts available. I've also done the same with my small-cap stocks (CKE Restaurants (NYSE:CKR), Huttig Building Products (NYSE:HBP), and Universal Stainless & Alloy (NASDAQ:USAP)), using Russell 2000 puts. I believe that this strategy achieves my objective of largely removing external risks from my portfolio, which I've validated by stress-testing it.

My approach is especially compelling when puts are so cheap because of today's low volatility. For example, I recently purchased at-the-money December 2006 puts on the S&P 500 for $103 (the index is at roughly 1,100). This means that for 9.4% of the notional value, I profit dollar for dollar from any decline in the S&P 500 for the next two and a half years. (The Russell 2000 puts are nearly as cheap.) Expressed another way, it costs me less than 4% of the amount insured per year to, I believe, hedge my long exposure against external risks. (For more on puts, see Bearish Options Strategies.)

This hedging, of course, does not protect me if I'm wrong about the individual companies I own (i.e., if the turnaround at McDonald's sputters, the stock will surely decline). Still, these are risks that I have evaluated carefully and am comfortable with.

Why own puts?
Let me briefly digress with a quick discussion of why I'm comfortable owning puts, given their high bid-ask spreads, illiquidity, and the fact that time is working against me. In short, I'm convinced that there are major market inefficiencies in the pricing of long-dated options -- both puts and calls. This is especially true during times like today, when investor complacency translates into low volatility, a major input into the Black-Scholes option-pricing model, resulting in very low prices for buyers of options. My view is that while the Black-Scholes model is a reasonable tool for valuing short-term options, it is a truly insane way to value long-term ones.

Think about it. Who has the advantage in pricing a security, the value of which depends on the long-term movement of a stock? Would it be someone who knows nothing about the company underlying the stock and who depends solely on statistical inputs to a static mathematical formula, or someone (like me) who knows the company intimately and has assessed its intrinsic value?

Final thoughts
When stocks are richly priced and insurance, in the form of put options, is extremely cheap, then investors might want to consider buying long-dated puts, both as insurance and also to make money.

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Longtime Fool columnist Whitney Tilson was long McDonald's and Home Depot stock and calls, Yum! Brands calls, the stock of CKE Restaurants, Huttig Building Products, and Universal Stainless & Alloy, and owned puts on the S&P 500 and Russell 2000 indexes at press time, though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. To read his previous columns for The Motley Fool and other writings, visit The Fool is investors writing for investors.