Saturday, January 22, 2011

Another Break that can make you rich - Options

In a previous blog we discussed that many corporate employees have the opportunity to participate in a company savings plan. This is one of the opportunities that constitute a 'break' that can not only make you financially secure, it can make you rich. Another break that is even more powerful is employee stock options.

When discussing the company savings plan, we mentioned that many of these plans encourage that you invest your savings in the company's publicly traded shares. If you do your stock market research you know which companies are the best stock market performers in your line of work. So aim to work for them, this is not only good for your career but it also gives you the opportunity to participate in its company savings plan were you buy its stock in the favoured 'cost averaging way'. Every month you buy a little bit of stock for a fixed amount of money. Thus, you buy more when the share price is relatively low and you buy fewer shares when they are expensive. This is the next best thing to buying a stock at the 'right price' – the way we advocate so often on this blog.

Since you not only buy shares using the cost averaging method, but you buy stock of a company that is the best in your field of work. Your shares will outperform over the long term the competition. There is one added advantage that may sound strange coming on a blog that wants you to diversify your portfolio. You know that Bill Gates and many others did NOT get rich by diversifying. Rather they put all their eggs in one basket – in Bill's case the eggs were all in the Microsoft basket. The difference between 'day-to-day' investing and Bill's investment is that he knew Microsoft better than any other company. This is quite different than investing in some publicly traded company where as shareholder you probably know nothing more than what's published in the annual report and what senior management tells you on BNN. When you work with your employer, you know a lot more about your company and your management than the typical retail investor. You yourself may even have a significant impact on corporate performance. In fact, many would consider you an 'insider' and you have restrictions when selling your savings plan's stock. Your company will announce 'black-out' periods when you are not allowed to sell your shares. Typically just around the time that your employer will publish its quarterly financial report or when a take-over announcement is coming.

Just like Bill, you have much more control/knowledge over your employer's company performance than a typical investor and thus you run less risk losing money than such a typical investor. For you it is O.K. to invest a higher proportion of your net worth in your employer's company stock – maybe as much as 30%. 'How much' depends also on your personal situation. If you are just out of school working for such a company, your entire portfolio may be comprised of your savings plan. Don't worry – first of all there is nothing you can do to alter this and because you're young it is sometimes O.K. to take on a lot of this kind of risk (note the careful wording?). But as soon as your savings plan's worth becomes substantial (say the size of a 20-30% down payment towards the purchase of your first residence), it will be time to start taking some of the profits and accumulate cash. Once you build up enough cash for a down payment or another investment then make that investment and then you are more diversified. Note, I did not say, sell all your stock, just a significant portion – say 50% - after all your company shares are the best investment you have up to now. So don't shoot the chicken that lays the golden eggs!

As said in an earlier post, you may get even a better break than a company savings plan. You may have the chance to borrow from your company a large number of shares interest free! Even better, if the shares lose value, you cannot lose money you only give the shares back to the company! How does that sound? Pretty sweet he? We call those loans, employee stock options! Now you see how important it is to choose your employer with care and don't just grab any job offer that comes your way! Be an action taker and pursue a job with the company you want, not the other way around!
When you have stock options don't ever loose eyes on how your company is performing – operationally, financial and… on the stock market. As you may soon realize, over the short term, there is often a disconnect between stock market performance and your company's true performance. If this disconnect gets out of hand, you may see real company insiders buying company stock or the company itself may do 'share buy backs' – this may be an opportunity to buy more shares or it may give you the confidence to holding on to your shares. When insiders are selling, this can be for many reasons, but if you feel that the stock is overpriced (and you are becoming an expert on that stock by now yourself), or if you see a lot of insider selling, that may be a signal to take some profits. NOT TO GO ON VACATION TO DISNEY LAND!!!! But to use the cash to diversify – to put it into another investment. These days, even Bill Gates does not only own Microsoft stock! Selling consumption items such as that BMW is the sure fire way to waste your Break. Instead of ending up with a nice nest egg you will end up with a pile of rust!

There are a lot of exclamation marks in the last paragraph but then this is a break that can make you ultimately rich. So it is critical that you manage it well. Too many examples of embittered employees who sold off their options for a boat on the lake and then they saw their company stock double and they literally missed the boat. They only have themselves to blame

An option is a share that the company lends you typically for five years. All the value increase of the shares from the moment they lend you the share until you sell it is yours! So say you work for the Bank of Montreal and when you start working, they give you 1000 options (i.e. they lend you 1000 shares) which trade at that time at $40.00 per share (the strike price). Two months later the shares trade at $50.00, a single option is them worth $50 minus the $40 strike price or $10.00. Wow! You got how many of those things? 1000 options! So in two months you made 1000 x $10= $10,000! That is more than your entire salary plus savings plan included! Sell, sell, sell!

Eh… not so fast. Many employers are good but they are not crazy. What would happen if you sold your options within 2 months and then you quit to go work for another company that gives its employees shares as well? So, although your own the options, you don't have the right to sell them right away. If you quit you lose your options. Talk about retention bonus. Well how can you cash in on your windfall?

Typically, you will earn the right to sell your options over time. Your options expire – i.e. you have to sell them before the expiry date; typically 5 years from when the options were given to you. You also get the right to sell a portion of your options – typically 20% of your options 'vest' every year. In other words, you earn the right to sell 20% of your 1000 options or 200 options. After five years all your options are vested. To stop you from quitting after five years, your sly employer gives you as part of the year-end bonus also some more options which expire five years later. So you will always have just enough options in your inventory to keep you from quitting! The more they like your work the more options they will give you with that year's bonus. Of course, it also depends on how the economy and the company overall is doing. But there is usually a connection/recognition with how good you're doing from the company's perspective.

What happens if the company shares don't go up? Well simple. Say your BMO option strike price is $40.00 and the shares trade at $30 per share. Then your option would put you theoretically in debt by $10 a share! That would be the risk of leverage and of your underperformance along with the rest of the company. "Oh… wait a minute, I don't feel so well! You mean I would owe $10,000 to my company for the borrowed shares? Eh… Eh…"

No, not really. You borrowed shares not money! So in the worst case you just let the options expire since nobody will buy your $30 dollar borrowed share for $40 or more. So the option is worthless and you won't exercise the option (i.e. sell the underlying share). The borrowed share is returned free of charge to your company. Pfff!

There are a lot of different strategies you can follow with options. Too many to discuss on this blog. Point is options are the road to becoming truly wealthy, maybe not as rich as Bill Gates but rich enough. Thank you Mr. Employer! However, I would like to discuss one major pitfall.

Many people prefer to work with at small corporations rather than large ones. The logic is that those small companies will grow much faster and so will the value of their options. This is not quite true as many found out the hard way. First of all, small companies are very risky – their growth is very dependent on the quality of the company and, of course, the state of the economy. But say you're lucky and the company doubles over five years in value and you hung on to all your one thousand small company options.

How much did you make as compared to working at larger company? Say, you got the options at a strike price of $1 dollar and now the shares have doubled to $2. Your profit is $2000 minus $1000 (1000 x strike price) or a whopping $1000.

What would have happened if you had worked at the large company which only grew at an incredible snail's pace of 10% over 5 years. What would those options be worth? Well, say the (strike) price of a company's share was $100. So now five years later they are worth $110 and each option is $10 worth. 1000x $10 is $10,000.

Where would you have done better? At the small or the large company? So don't fall for misconceptions, do your numbers. An opportunity such as getting employee stock options should be considered very carefully because it can be your ticket to become wealthy.

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