From Espoo to Oulu to Salo, the Finns know first-hand how far Nokia has fallen.
In 2007 the phone manufacturer paid €1.3bn in corporation tax, last year it paid just €66m. There will be many rueful suomalaiset that once expected more brand loyalty to come from selling more than three billion handsets.
This time can be described as Bi – Before iPhone. When Apple’s game-changing device was unveiled on 9 January 2007, Nokia’s share price was €13.14. Today NOK1V.FH languishes at €3.92. At 33% (from near 50%), market share is back at 1997 levels.
Our interest, however, lies not in the share price, but the strength of Nokia’s balance sheet between now and January 2012. It’s a trade that could return 233%. If it doesn’t and I’m wrong – well, we’ll come to that.
The more futures and options attached to a single name, the more opportunities there will be to profit from mispricing. When news flow hits the underlying share, the fallout tends to be inconsistent across asset classes.
In Nokia, we have both the requisite scale and news flow. NOK1V has more than 3,000 equity-related securities, let’s take a look at two of them.
Models, as with most derivatives, dictate dividend prices. In this instance the model is Black 76. I contend that this theory, co-opted from the bond market, holds no ground in the single-stock dividend market. Dividend payment, at the single stock level, is the subjective decision of the chief financial officer (in this instance Timo Ihamuotila) and the board of directors.
No one knows what dividend Nokia will pay next year. However, the market’s best guesses look pessimistic. Pessimistic in reference to the best guesses of the analysts, last year’s pay out and in reference to Nokia’s rather plump balance sheet.
Why is the dividend expectation so low?
It’s index rebalancing sandwiched by weak bottom-up and top-down sentiment.
On 19 September Nokia was booted out of EURO STOXX 50. The SX5E, as you’ll well know, is the most liquid equity index for derivative trades in Europe. Typical clip size in index dividend trades is some €100k versus €23k in FTSE index dividend futures. When a stock is no longer a constituent of this index there is a pronounced effect on open interest across the board. And selling begets selling. Particularly as we’ve discussed above, as Nokia’s relegation was well earned.
Since the beginning of the year the share price has fallen 44%. In that time, the 2012 dividend future has fallen from €0.33 to €0.09, despite Bloomberg consensus at €0.20 The liquidity, as reported by Societe Generale, has worsened from “medium” to “low” in this time. The spread is six basis points of a trade worth twelve. Even a market maker in Kenya, the world’s least liquid bourse, would be embarrassed to quote a spread like that.
Top-down, the bear market completes this veritable feast. Taking the example of the Flash Crash, in times of distress, exacerbated by structured product flow, dividends fall farther than do the underlying equities. We’ve got a situation more troubling than the Flash Crash on our hands here. The MSCI All- Country World Index of 45 nations fell 20% for the first time in more than two years as investors baulked at Bernanke’s Operation Twist. As Barclays Capital tells it, “current 2013 dividends trade at a similar fundamental premium as the 2012 dividends during the May-10 crisis.”
It seems bleak, but there saving graces.
Firstly, the scurrilous rumour I was hearing – namely that once a stock is ejected from the SX5E, its dividend futures are cancelled, was just that. I spoke with Stuart Heath at Eurex who confirmed that where there is open interest – currently 11,695 in the 2012 – market makers are obliged to continue trading.
Secondly, while the spread is objectionable today, it’s important to understand the nature of the beast. Dividend futures are seasonal and cash settled. As the January decision nears, we’ll have a clearer picture about Nokia’s dividend. And, for investors with no mark-to-market issues to worry about, one can just hold until the position turns cash – sans any bid ask spread.
Another explanation is simply that I/B/E/S forecasts have been lowered, so the futures followed suit. This would not alone account for the overshoot, however. If the price rises to the low consensus, it would engender a 100% gain in the first leg of the trade.
That’s right, first leg. Nokia is a company with a knack of responding aptly to bad news. Hence, to cover some of the risk in this trade, we should introduce a second leg, an out-of-the-money put on the underlying share.
Either the dividend future trades higher or Nokia has to announce to a cynical investor base that it’s scrapping its dividend. And to make such an announcement, taking the last dividend downgrade, from €0.53 to €0.40 as a case study in 2009, engendered a 10% fall in share price. One can only imagine the effect if it now falls from €0.40 to €0.00.
So, we’re golden. Or maybe we’re not.
The aforementioned bear market has made entry for the second leg rather tricky. As I once overheard at a conference, the only thing harder than selling puts is buying them. And right now, Nokia volatility is high and rising. Vol across the market (using VSTOXX as a benchmark) shows there are few avenues to cheap volatility right now.
Now would represent a tough time to leg into the trade particularly as Nokia is unlikely to announce its dividend policy any time soon. However, the upside potential, well-hedged, gives an opportunity to strangle value out of Nokia either way the decision goes.
Theo Casey is editor-at-large at Smart Investor.
Disclosure: The author holds long positions in dividend futures at the time of publication.