Let me begin with the following quote:
The man who begins to speculate in stocks with the intention to make a fortune usually goes broke, whereas the man who trades with a view of getting good interest on his money sometimes gets rich. -- Charles Dow
I try to keep the latter part of this quote in my mind whenever I search for a stock to buy. It forces to me to find companies with significantly undervalued stock prices so that I embed a relative margin of safety into my whole investing premise. Whenever I find a candidate, I conduct an extensive research of the future prospects of the business, so as to minimize the risk of buying a value trap, or even worse, a company on the path to bankruptcy. While nothing in this word is certain but death and taxes, I seek to put as many variables as possible on my side.
I've been following Skechers for a long while. The company engages in the design, development, marketing and distribution of footwear for men, women, and children in the United States and internationally. This company has a wide brand recognition, and for a while it enjoyed the fruits of the toning shoes frenzy. By any measurable ratio, this company is amidst a "molting" process. They are getting rid of their toning shoes excess inventory and introducing new, promising footwear lines, aided by significant marketing campaigns.
The purpose of this article is not to explain the mishaps that this company has been through in the last 12 months. You only need to look at the 1-year stock chart to get a clear picture of the pain that Skechers and its investors have been experiencing. Furthermore, an analysis and prospects of this company's near and mid-term future are very well documented by Gregory Lemelson in this article.
But when I see a company with 20 years of successful operation and high growth trading at 0.70x Price-to-Book-Value ratio and 0.09 LT Debt-to-Equity ratio, I pay attention. A lot of attention. The problem is no investor can ever time the market, and while I personally believe that this stock will be significantly higher at some point in the future, there's no way to know when exactly Mr. Market will begin to give Skechers the value it purposedly deserves.
To avoid this market timing problem, maximize my potential gain and reduce risk as much as possible, I rely on a combination of stocks and options to invest in this company. If you are a long-term investor, you might care less about the technicalities and somewhat high level of complexity discussed in this article. You can just buy the stock, scale-in your full position and wait, wait and wait until Mr. Market awakens from his dormant state.
But if at its current depressed price, I can tell you that you can make an almost-guaranteed profit of 21.5% by just waiting it out for 6 months (43% annualized), without the need for the stock to appreciate one single cent during that time, you can keep on reading. Worst-case scenario you end up with an open position in Skechers at an average price that is almost 20% less than the current stock price. Now allow me to get into the math so I can you show how the magic works.
For purposes of this article, let's assume that my intended full position would be 200 shares. The current price of the stock (as of January 13th) is $13.25, and the longest-traded options are from July 2012. It's important to realize that you are already willing to own this stock at its current price for the long-term, otherwise the whole premise is futile. The trade would then be to buy 100 shares of Skechers at $13.25 ($1,325 excluding commissions) and to short one July 2012 13C/11P strangle (the simultaneous sale of one contract, equivalent to 100 shares, of the July 2012 $11 Put and one contract of the July 2012 $13 Call) for $3.10 in credit. Credit means that you will, at this very moment, receive $310 in cash in your account. This is like getting paid already your potential profit, and all you have to do is wait 6 months to record this gain in your book.
How does this work? What you are inherently doing with this trade is not only buying 100 shares at the current price, but also making a commitment, depending on the final price of the stock at expiration in July 2012. On one side, you are willing to buy an additional lot of 100 shares at $11 dollars ($1,100) if the stock ends at $11 or lower come July. On the other, you are willing to sell your current position (100 shares acquired at $13.25) at $13 if the stock ends at $13 or higher at the expiration date. So let's analyze the two possible scenarios:
Skechers ends at $13 or higher come July 2012. The Call contract of the strangle would be exercised and you would sell your existing shares at $13 ($1,300) which is less than what you originally paid for them ($1,325). The Put contract expires worthless. Where's then my guaranteed profit? It's in the payment that you already received at the very beginning from the sale of the strangle. The math would be $1,300 + $310 - $1,325 = $285 profit. This is a 21.5% investment return over your capital allocation of $1,325. The beauty of this is that the stock could have stayed at the exact same price it's today for 6 months, and you will still have your profit guaranteed. Granted, you are capped in the maximum gains, but you are giving this up in exchange for further protection. Isn't 21.5% (43% annualized) in 6 months already a good return on your money? There's no need to be greedy, slow and steady always wins the race.
Skechers ends at $11 or lower come July 2012. The put contract of the strangle would be exercised and you would buy an additional 100 shares at $11 ($1,100 excluding commissions), which brings your total position to 200 shares at an average price of $10.58. The call contract expires worthless. This is a 20% discount on the current price. You initially had made the decision to own this stock at $13.25 for the long-term because it's already undervalued, so under this scheme, not only you are saving $225 of additional capital to open your full position, but also lowering your average cost price. Granted, the stock could go lower even before July 2012, but you would have faced the same risk by just investing in Skechers at this point in time. Heck, the company could even go bankrupt, and nothing can protect you from that. Again, few things in this world are certain.
One drawback of this whole trade is that you would need to separate $1,100 of capital for the duration of the strangle contract (6 months), but the same would have happened had you opened your entire position at the very beginning (except you would need $1,325 as opposed to $1,100). This is only if you want to avoid playing with margin, which is a way to leverage your money.
I particularly don't like to use margin, so I have no problem in putting this money aside while the investment plays out. If you want to go old school about it, you can throw into your investment equation the fact that you are constraining $1,100 of additional capital. So if the scenario 1 plays out, your profit would then be an 11.7% return on your capital ($285 / ($1,325 + $1,100)). I would still be quite happy with such return. After all, the long-term average return of a broad market index is less than 9%, so you are receiving 2.7 percentage points of additional return for incurring the risk of investing in one single company, which by the way happens to provide a significant margin of safety based on our due diligence.
Disclaimer: This article is intended to be informative and should not be construed as personalized advice, as it does not take into account your specific situation or objectives.