Excerpt:
By Scott Phillips - August 7, 2013
"Members might be aware that some of the betting agencies are offering juicy odds of a Labor victory. We believe option 3 would see McMillan Shakespeare's share price recover to near pre-announcement levels, but there might be some (imperfect) insurance available to members who placed a bet on a Labor victory.
Hedging your bets in a good way
Let's assume a couple of completely hypothetical outcomes (please note these aren't guaranteed outcomes!):
1. If the changes are passed, McMillan Shakespeare shares fall from around $9.20 today to, say, $4.50
2. If the changes aren't passed, McMillan Shakespeare shares rise from around $9.20 today to, say, $16.00
3. You can get odds of $4.50 for $1 on a Labor victory through a major betting agency
On a purely hypothetical level, the maths suggests the best return would come from just buying the shares and letting the probabilities play out. But there's still around 1 chance in 3 that our thesis won't play out.
In short using the above hypotheticals, if a McMillan shareholder put a $750 bet on Labor (at $4.50) for every $5,000 of McMillan shares they owned (at today's price):
1. The chances of a negative outcome halve from 1 in 3 to 1 in 6;
2. The upside of a Coalition victory will be slightly less
3. The downside of a Labor victory will be eliminated; but
4. The downside of a Coalition victory that resulted in the FBT changes still being passed would be slightly worse the shares would likely fall and you'd lose the bet
Put through the probability model, the result is that this 'hedged' strategy delivers a slightly lower weighted return but with a much lower chance of a negative outcome. Trading off a small amount of upside for a much lower chance of a negative result sounds like a good deal to Joe and I.
Let's flash back to our original assumptions. If the changes go through, that McMillan Shakespeare shares would fall to $4.50. And if they don't, they return to their pre-drama price near $18. Based on the stock's current price and the odds ahead of us, we think McMillan Shakespeare's shares should sell for more than $13 a 50% gain from today's price.
If you applied a $750 hedge against a $5,000 investment in McMillan Shakespeare's shares, though, your expected payoff is around 44%. That's only a small turn lower than your unhedged payoff but substantially less risky."
