Scott is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
We have all heard the stories about employees making fortunes through company stock participation. Tales of millionaires traversing the isles of HomeDepot in their orange aprons make participating in company stock an enticing option. It suggests you don't have to make it to the board room to be rewarded for your service. It may be tempting to take advantage of such incentives, but whether it is prudent depends upon the risks of the industry and the type of plan being offered. An ESOP is a type of plan where the employer gives employees the stock; in that case the employee isn't diverting personal savings. However, a stock-matching plan within a 401k involves a personal investment decision, and that's where caution should be used.
You don't have to work for Enron or Worldcom to be hurt by allocating savings to your employer's stock. Your employer may be profitable, growing and executing brilliantly, but it is important to consider more than the traditional metrics before participating in that equity plan. If you work in an industry that carries a great degree of risk, it may not matter how well your employer runs the business. Some sectors carry risk that cannot be eliminated internally. The sectors change, but there are always a few at the forefront that carry high external risks. In the early 2000's the tobacco industry was public enemy #1. At present, the sector the shorts love to hate is for-profit education.
With many universities competing for dollars, most of them are feeling the revenue pinch. Considering that most of their customers pay with money that comes from a government running a trillion dollar deficit, $16 trillion dollars in debt, and a student default rate running over a trillion dollars,these companies are in a precarious position they can do little to mitigate regardless of pristine balance sheets.
I do have a professional relationship with a for-profit university and recently was asked by a colleague at the university whether this would be a good time to buy shares. By traditional standards, everything about the sector screams value. Not only are all of the universities trading at lows, they are trading at multiples to earnings about half the S&P, dividend yields eclipsing junk bonds, strong balance sheets, and respectable profit margins.
My answer was that anyone working in this industry might be better off -shorting- the sector. The reason is the same logical thought process that goes into asset allocation when constructing a stock portfolio. The portfolio allocation varies depending on the individual for whom it is being designed.
A fundamental planning concept is to select sectors with different correlations in order to offset volatility that can be harmful to the investor. An employee who supports a family with a salary primarily earned from any sector already has a substantial investment in that sector.
Employees of Johnson&Johnson or GeneralElectric work for a company so diversified that they are practically mutual funds. They can afford to have a different approach than employees of publicly traded universities.
A few weeks after I made that "shorting the sector" comment to my colleague, ApolloGroup(NASDAQ: APOL), the largest for-profit education holding company, announced they are slashing jobs and closing 25 campuses. In one day the shares dropped a substantial 18% as a result. From the perspective of an employee at one of these companies, shorting the sector may provide a viable hedge against the increasing possibility they may be joining the ranks of the unemployed.
The entire sector, including Kaplan University (NYSE: WPO) and StrayerEducation(NASDAQ: STRA), has been moving together. An employee of one of these companies concerned about the -external risks- could hedge by shorting any one of the majors without having to short their own employer, which could be unsavory (and subject to "black out dates").
In the case of Apollo Group, Put options can be purchased all the way out to 2015, giving them plenty of time on their "insurance policy." At Apollo's current market price of $19.72 per share (as of Oct. 28), an employee in this sector might want to purchase a slightly "in of the money" Put option on Apollo that doesn't expire until January 2014 for a premium of approximately $400 per contract. Each contract gives the option holder the right to sell 100 shares of APOL at $20.00 per share until the third week of January, 2014. In this unique situation, the rationale of the Put buyer should be that they would prefer that the catastrophic scenario does not happen and the industry rebounds from here. In that case, hopefully their job is secure and they only lose the $400 per contract they paid.
In the event that the government doesn't cut or eliminate Pell grants and doesn't dramatically change the availability of student loans, shares of these for-profit education companies might level off or rebound from here. However, a dramatic change in those programs could drastically affect the revenues and earnings of these companies. In a cataclysmic scenario, those options with a $20 strike price could be trading "in the money" at 200%-300% higher premiums. The possible return could serve as a home-made "severance package."
The same principles can be applied with employees of companies in the maligned coal industry, or the latest cash rich sector defending against plunder - "Big Fast Food." Many are aware, including executives at McDonald's(NYSE: MCD), that the cash-strapped governments of states like California are seeking whom they may devour in order to support spending while tax receipts are declining. As we witnessed with "Big Tobacco", there is a viral effect from state to state. If I were an employee in the fast food sector, when given the choice in my 401(k), I would not load up on my employer's stock in this environment.
Thurston3 has no positions in the stocks mentioned above. The Motley Fool owns shares of General Electric Company, Johnson & Johnson, McDonald's, and Strayer Education. Motley Fool newsletter services recommend The Home Depot, Johnson & Johnson, Lorillard, McDonald's, and Strayer Education. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.