Calculated Risk: An Options Play On Oversold Jefferies Group

Nov.15.11 | About: Leucadia National (LUK)

Every now and again you find a stock that offers a compelling valuation but carries risk that is hard to determine. One such stock right now is Jefferies Group (JEF), which has been hit hard by the fallout from the bankruptcy of MF Global (OTC:MFGLQ). My opinion is it is being unfairly punished and the shares hold significant value over the longer term. In these circumstances, I prefer to employ an option strategy to make money while limiting risk.

My Strategy on Jefferies

Sell the April 12 10 puts and buy the April 12 7 puts via a bull market put spread for a net credit of $1.

Scenario 1: Jefferies holds the $10 level or rises from current price level when the option spread expires in April. In this likely scenario, I make my $1 a share spread while only tying up $2 of collateral in my brokerage account.

Scenario 2: Jefferies continues to decline, but the company survives. In this situation, I get Jefferies for a price-adjusted $9 a share while limiting my maximum loss during the time of the option spread to $2 a share. I can then reassess the value of Jefferies when the stock is “put” to me.

Scenario 3: Jefferies follows MF Global down the drain and declares bankruptcy. I consider this possibility as exceedingly remote, but in this case I am only out $2 a share.

Jefferies Group, together with its subsidiaries, operates as a securities and investment banking company in the Americas, Europe, and Asia. It operates in two segments, Capital Markets and Asset Management.” (Business description from Yahoo Finance).

5 reasons why JEF is a solid long-term value at $11 a share:

  1. It is selling at the very bottom of its five-year valuation range based on P/S, P/B, P/E and P/CF.
  2. Insiders certainly believe in the long-term viability of Jefferies, as they have bought approximately $150M in shares over the last few months.
  3. Jefferies has a forward PE of under 7.5, which is a huge 70% discount to its five-year average.
  4. JEF is selling significantly under analysts’ price targets. The mean analysts’ price target on Jefferies is $18, and Keefe, Bruyette & Woods has a target of $17.
  5. The stock has a five-year projected PEG of just 0.53, which is an approximate 75% discount to its five-year average.

Disclosure: I am long JEF via the option call spread described in article.