Protect the Value of Your Stock Options

More than a year ago, I wrote an article about the importance of protecting your financial well-being by diversifying your employee stock options. I described this scenario: "Suppose Microsoft (MSFT - Cramer's Take - Stockpickr) is broken up, a la AT&T (T - Cramer's Take - Stockpickr), in a settlement with the Justice Department. Does the stock price plunge by half? In that case, the value of your options would decline by 67%."

That was my way of demonstrating the risk facing Microsoft employees with most of their wealth tied to the company. Now that scenario has, for the most part, come true. Microsoft stock is down 45% from its high, and I suspect that there are a few long faces in Redmond these days.

After April's mini-crash, the consternation spreads far beyond Microsoft. Many individuals now find the value of their options sharply reduced or even erased. What can be done now? What strategy should be pursued going forward?

Why Diversify At All?

The bottom line is that you are sacrificing some upside (and you will be paying a lot of taxes) in return for protection on the downside. We can't predict how much any individual stock will appreciate over the next five years. We can't predict a sustainable drawdown rate for a single stock portfolio. But we can predict with high confidence that the S&P 500 will be 60% to 75% higher five years from now (assuming the S&P 500 reverts to its long-term annual appreciation rate of 10% to 12% a year.) And we can predict that you can draw 5% to 8% out of a diversified portfolio every year for the rest of your life and never run out of money.

Evaluate Your Risks

In managing our clients' portfolios, we automatically sell half of any position that exceeds 10% of the portfolio's total value, regardless of how much we like the actual company. It only takes an earnings warning these days to trim 50% or 75% from a company's stock price. (Take a look at the charts for Procter & Gamble (PG - Cramer's Take - Stockpickr) or Novell (NOVL - Cramer's Take - Stockpickr).) With no more than 5% exposure to any one stock, we take no more than a 2.5% hit if indeed one of our companies takes a 50% tumble. We are astounded by how many inquiries we get from individuals who have 95% of their net worth tied to a single company. Imagine being 65 years old, coming home from work one day and saying, "Honey, I can't retire after all, our retirement nest egg just got cut in half."

Sun Microsystems (SUNW - Cramer's Take - Stockpickr) is an example of a company where everything seems to be going OK. The stock is up 225% over the last year and only 17% off its high. The company has positive earnings, positive operating cash flow of about $560 million per quarter and about $1.3 billion in cash on the balance sheet. However, with a price-to-earnings ratio three times that of the S&P 500 and a price-to-book ratio four times that of the index, Sun could fall quite a way on any disappointment. If you work for a company like Sun, you should be proactively addressing diversification now.

MicroStrategy (MSTR - Cramer's Take - Stockpickr) is an example of a company that may be beyond salvation. The stock is down 92% from its high, earnings are negative, operating cash flow is negative and worst of all, the company is the subject of both shareholder lawsuits and a Securities and Exchange Commission investigation over its accounting practices. If you work there, your best strategy may be looking for a new job.

Until last year, employees of companies whose stock had fallen sharply could hope that their options would be repriced. However, the tax laws were changed in 1999, forcing companies that reprice employee stock options to take a charge to earnings. That should make options repricings less common, though barnesandnoble.com (BNBN - Cramer's Take - Stockpickr) announced this week that it had reduced the price on options for 5.99 million shares to $8 from $16.15. Microsoft took a different approach, offering an unscheduled options grant to all its employees on April 25, priced at the previous day's closing price of 66 5/8.

You may able to effect a personal repricing by jumping from one company to another. For example, the share prices of eBay (EBAY - Cramer's Take - Stockpickr) and Amazon.com (AMZN - Cramer's Take - Stockpickr) have both fallen 45% to 50% from their highs. As an employee of eBay, you may find that your options are well underwater. By jumping to Amazon.com, you may get a new package of options pegged to the current price.

Microsoft is an example of a company where the bad news is mostly reflected in the stock price. With positive earnings, huge operating cash flow, a cash hoard of about $22 billion and financial ratios just 40% of Sun Microsystems', we would buy this stock with both hands if Microsoft's management could work out an accommodation with the Feds. Analysts' estimates of the break-up value of Microsoft range from $50 to $130 per share (it has been trading around 70 lately). If you work for a company with generally sound financials and a knocked-down stock price, you may want to plan a diversification strategy in anticipation of a rising stock price.

Rules of Thumb for Diversifying

• Keep careful track of your options in a spread sheet. Include grant date, strike price, vesting date, whether they're incentive stock options (ISOs) or nonqualified options. Also keep track of company stock, whether from a 401(k) plan or an employee stock ownership plan (ESOP).

• If vested options are at least 100% in the money (the market price is twice the strike price), consider exercising 20%. If the vested options are at least 200% (the market price is three times the strike price) in the money, it's irresponsible not to exercise at least 25%.

• Keep careful track of tax lots and holding periods. A prudent strategy is to pay for an option exercise by selling ESOP stock you've held at least one year (to avoid paying short-term capital gains taxes). The stock you receive from exercising the options can then be held for a year and sold to pay for the next option exercise.

• Make sure your accountant knows what you're doing -- the exercise of incentive stock options can, under certain circumstances, trigger alternative minimum tax (AMT). Your accountant should estimate your tax liabilities before you act. I'll address tax issues in my next column.

• Invest the resulting cash in a diversified (by company, industry and sector) portfolio of 30 to 40 stocks or in diversified stock mutual funds.