By Joseph Hogue, CFA
I won’t attempt to put a floor price on Bank of America (BAC) or to intrinsically value the company. There are so many unknowns from putbacks, litigation, and the general economy that any attempt to price the stock is useless without a crystal ball. Despite this, there are plenty of pundits and prognosticators out there willing to slap an exact number on the stock, so it shouldn’t be hard to find if that is what you want.
I am not going to get caught up on a finite price target because at this point, investing in the company is largely a belief that it will ultimately avoid a restructuring where equity holders are wiped out. Through all the potential risks and support to the company, of which we’ll look at some below, I believe there is an opportunity for investors to profit from the volatility in the stock.
The risks to the struggling bank, as mentioned above, are largely through three areas. Though the bank has reached a settlement for the robo-signing debacle, there is always the possibility of further litigation. The bank settled for $8.5 billion with the states and was sued by American International Group (AIG) last August for $10 billion in bad mortgage investments. The bank is also on the hook for further putbacks of bad mortgages. Though $28 billion has been set aside to fund continued claims, the company may have to reach further into its pockets. While the sluggish economy is a threat to the bank, it is not as specific or catastrophic as the other two risks.
Though it seems nearly impossible to find a reasonable intrinsic value for the company, the current stock price does make it attractive in anything short of a restructuring scenario. The stock currently trades for roughly half of the company’s tangible book value. The bank’s Tier I Capital, a measure of bank solvency, is at 8.2%. Under Basel III agreements, the bank must increase this to 9.5% but has until 2019 to do it. While it doesn’t need to raise capital now, management may want to decrease funding costs. This capital raising would hit the stock as shareholders are diluted but would stabilize the bank’s financial position.
Probably the biggest support behind the stock is Warren Buffett’s recent stake in the company. The Oracle was able to negotiate preferred shares at a 6% yield convertible to a price of $7.14 per share. Converting the shares to common stock gives Buffett a 7% stake in the bank, larger than any existing shareholder. Even if I, or most of the yahoos on Wall Street, are not be able to accurately pin down a value for Bank of America I would be willing to bet that the team at Berkshire has a decent idea.
While the majority of Bank of America supporters will want to go the traditional route and buy the company’s shares, I prefer a risk-reduced approach using options strategies. Yes, options strategies can reduce your risk in an investment if used correctly. Investors commonly use options to hedge their risk and buy ‘portfolio insurance’ against their shares. When volatility surges as high as it currently is in Bank of America, other cost-effective opportunities present themselves as well.
For comparison purposes, we’ll look at three option strategies against a straight stock investment of $2,500 for 375 shares at Monday’s price of $6.68 each. The stock has lost approximately 39.3% of its value over the last 12 months, falling from about $11 per share. We’ll be looking at our strategies from three scenarios for the one-year time horizon: additional loss of 39%, trading flat, or a gain of 39%. This brings the 12-month price to either $4.07, $6.68, or $9.29 per share. With a share purchase, the outcome of the three scenarios is a gain or loss of $975 or zero. We’ll be using January 2013 options within our strategies for two reasons.
First, it gives the bank and the economy a little time to stabilize. I have no idea what is going to happen in Europe over the next couple of months, but am more optimistic that the markets can stabilize and volatility will come down by the end of next year.
Secondly, using the long-term options means that capital gains for most strategies will be taxed at the 15% level instead of as income. Look into the specific tax consequences of options before placing a trade. Favorable tax treatment in some strategies will necessitate closing out the position before the expiration, but after the one-year time frame.
The first strategy is the most risky and my personal favorite, the bull-spread. This option strategy involves both buying and selling call options for the stock. We’ll run through the example which will help to clarify. Buying the January 2013 BAC call options with a strike of $4 gives you the right to buy the shares for that price on the expiration date. Selling the same date call options of $5 means the investor must sell the shares to someone for that price. With the price of the options as of Monday, we end up paying $0.65 for each spread option. We’ll buy 15 contracts representing 1,500 shares for a total expense of $975.
You can move the buy/sell points around depending on how risky you want to make the trade but $4/$5 leaves room for good return at lower risk. I’ve included a chart below showing the dollar payout of the three strategies and the share purchase. The max loss of the bull spread is $870 at our worst-case scenario and only $975 even if the stock goes to zero. Our break-even price is at $4.65 per share which is a nice 30% cushion from the current price. This strategy mitigates your downside risk and only underperforms the share purchase strategy if the stock rockets more than 21% by January 2013.
The next strategy is less risky and probably more familiar to most, the covered call. This involves buying the shares and then selling call options against them. By selling the options, you collect money upfront to defer some of the outlay for the shares. This lowers the effective price you paid for the shares. If we buy the same 375 shares for $6.68 but sell 3 call option contracts (representing 300 shares) for $2.75 each, we effectively lower the price paid to $4.48 per share. Here again we’ll use the $5 strike on the January 2013 options which gives the buyer the right to buy the shares from us at $5 on that date. If you’re more optimistic, you can sell the $7.5 strike price on the shares instead but will not collect as much upfront.
The strategy still leaves 75 shares uncovered and provides for a little more upside potential than a true covered call. You can see from the chart that both the downside risk and upside return are significantly reduced compared to our previous strategy. Despite this, the strategy still presents opportunities compared to the traditional share purchase scenario. As with the bull spread, the shares would have to rise by 21% for the share purchase to outperform the strategy.
This last strategy can be played a couple of different ways. We’ll look at what is called a ‘cash-secured put’ strategy where you put money aside to avoid a margin call even if the stock goes to zero. You can also try a ‘naked’ put-write which involves only putting enough in a margin account to cover the current stock price. A put-write involves selling put options on a stock which gives the buyer the right to sell you shares for the strike price. You collect the premium upfront and usually have to post some money in your trading account to cover margin. You effectively have no cost to the transaction and collect interest on your margin balance until the strategy expires. The strategy works best with shares of a company you are thinking about purchasing anyway.
We will sell five $5 put contracts (representing 500 shares) for $1.09 each and expiring January 2013. This means that you will collect the $1.09 now and have to buy the shares for $5 at expiration if they are below that price. Besides collecting the $1.09 per share, you’ll also have to deposit $1,955 in your account to make it a cash-secured put. If the shares are above $5 in a year, the buyer does nothing and you keep the premium collected.
Basically, you are lowering your cost per share to $3.91 if you end up having to buy them from the put buyer. At a discount of 41% to Monday’s price, this strategy provides the best downside protection of the three. Since we put all $2,500 in the margin account, including the $1,955 initial expense, our returns are reduced somewhat. The strategy’s breakeven with the share purchase strategy is a 27% increase in the shares. We could increase the returns by not depositing all the money in the account.
Volatility is a huge factor in options pricing. When the market or a stock jumps so violently that volatility surges, options strategies can offer the investor better risk-adjusted returns than a simple share purchase plan. You’ll want to read a little more on the idiosyncrasies of the strategies and tax consequences before you make a trade, but I believe investors can take a position and enjoy the upside potential in BAC without all the downside risk. As always, I welcome any comments.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.