By Mark Bern, CPA CFA
Oracle (ORCL) is a major technology company which develops and sells software and hardware primarily for the business community. The company derived 57% of revenue from outside the U.S. in 2010. The company's ability to thrive in all market conditions is uncanny. Consider the earnings per share record of the company during the past two major recessions.
Year | 2000 | 2001 | 2002 | 2003 | 2004 |
Earnings per Share | $.35 | $.46 | $.39 | $.43 | $.50 |
Year | 2007 | 2008 | 2009 | 2010 | 2011 |
Earnings per Share | $1.01 | $1.30 | $1.44 | $1.67 | $2.22 |
Even after the tech bubble burst, earnings only dipped a little and then rose to new highs within two years. And during this last recession, earnings per share hardly skipped a beat rising in every year. Results from 2011 were spectacular on a year-over-year comparison basis with earnings per share up 33%. That's not bad growth for a stodgy tech giant. Earnings per share comparisons in fiscal 2012 will not be so good .. positive growth but nothing to write home about. It is my contention that years like this create opportunities.
The company is still capable of average growth in the neighborhood of 12% a year going forward. This year won't be one of those years, but next year will have easier comparisons, so I'd be surprised (assuming the world economy doesn't fall apart in the meantime) if 2013 doesn't turn out to be another strong year for Oracle stock. The stock is currently trading at $28.34, well below its 52-week high of $36.50. Even with that discount, until the earnings growth rate picks up, I suspect the shares to remain range bound between $26 and $30. But that also could spell opportunity for the investor who has some cash sitting on the sidelines in a money market account earning less than 1%.
If an investor would like to own Oracle stock, but really doesn't want to pay more than say $27 for the stock (closer to the bottom of the range) I have a strategy that could provide a good chance of that happening. If we don't get the stock we make close to an annualized return of 20% for trying. And it's simple to apply.
For my method to work efficiently, an investor will need to use a discount broker to keep commissions costs low. It is also best to use a tax deferred account to keep from having the tax consequences eat into your profit. Let me begin by saying that this strategy should not be used on stocks unless the investor really wants to own the stock and is preferably a long-term investor. I'll explain why in a few moments.
The basis of this strategy is simple: About 80% of all options contracts expire worthless. What this means is that the buyers of 80% of options contracts lose their investment. We don't want to buy any options. What we want to do is play the other side of the transaction and sell put options. Selling a put option obligates the seller to purchase the stock at a specified price at some date in the future if the option is exercised. This is a method that allows investors who want to own the stock an opportunity to accomplish one of two outcomes: Own the stock at a discount to the current price or earn as much as 20% annualized return on their money while they wait. If you want to own the stock, why not buy it at a discount? If you don't get the stock, why not earn a great yield on your cash? Let me give an example step by step so you can understand how it works.
Oracle stock closed today, January 18, 2012, at $28.34 a share. What if we could buy that share for less than $27? I'm going to give you two examples, the first one with more detail and the second to provide an idea of what choices there are available.
My favorite put option contract on Oracle is the June 2012 option with a strike price of $29 and a premium of $2.43 per share. Each option contract equals 100 shares. If you sell one put option at a premium of $2.43, you collect $243 less the commission. This is where the discount broker becomes important. Many discount brokers charge less than $10 for the first contract (and usually less for additional contracts, like $1.50 per contract, so two contracts would cost $11.50) while some banks and full service brokers can charge many times that amount. I will use $10 in my example for simplicity.
You may be thinking, "Why am I paying $29 per share?" You aren't. You received the $2.43 per share up front which reduces your cost basis to $26.57 ($29 - $2.43). Your actual cost per share is $26.87 due to the commissions ($0.10 per share) and an exercise fee that only gets charged if the option is exercised (usually less than $0.20 per share). You will only get to buy the stock if the option is exercised. There are generally two instances in which a put option contract gets exercised: First, if the price is below the strike price at the time of contract expiration, in this case $29 on June 15, 2012; or, second, if the price drops below the price before the expiration date and buyers decide to sell and take their profits. In the latter case you may or may not be assigned since the process is random. The exchange randomly assigns exercised options to brokers whose clients have open sold positions and then the brokers randomly assign those exercised option to some of their clients. I am using an in-the-money put option because it is assumed that the seller of the put wants to own the shares but would like to get in at a better price.
The other reason to use in-the-money puts is to boost the return in case you don't get put the stock. In this case, if the price rises between now and June 15th (at least a 50% chance) then the option will expire worthless and the seller of the put gets to keep the premium of $2.43 (net of commissions) or $233. That is a return on your cash of 8% in just five months, or over 19.2% if you annualize it. If you like the return and also like the stock, turn around and try again. If you never get the stock is there any harm in making 19% a year on your cash for trying to buy the stock?
Another example is the March put option with a strike price of $28 and a premium of $1.04 (as of the close on January 18, 2012). The premium would net an investor $94 (after commission) for a return of 3.36% in just two months. That is equal to an annualized rate of return of 20.1%. Your cost basis, should the option be exercised, would be $26.96 ($28 - $1.04), for IRS purposes. Your actual cost basis would be $27.26 ($28 - $1.04 + $0.10 plus $0.20). You need to include the commission ($0.10 per share) and the exercise fee ($0.20 per share) to be accurate. But, still this is better than the current price of $28.34 and gives you a good shot and owning the stock at a discount. And if you don't get the stock, you still keep the premium for a nice return on your cash.
Now, earlier in the article I said I would explain why it is important to only use this strategy with stocks that you really want to own and so here is my explanation. Obviously, you could end up owning the stock. And if the price of the stock drops precipitously, you will own the stock. So you must take care in selecting the stocks you use this strategy on. I am comfortable with Oracle because the company is not going out of business and it is still able to grow earnings at a healthy pace.
Earnings are the basis of the value of a stock. If earnings continue to increase the stock price will eventually reflect the strength of earnings. The economy, headlines, temporary setbacks, and market activity can all affect the price of an individual stock in the short term, but earnings will determine the price in the long term. If earnings continue to rise even as the price of the stock tumbles with the rest of the market due to external factors beyond the control of management, the stock price will rebound once whatever caused the market turmoil dissipates and investors recognize the true value of the company.
A second caution I want investors to be aware of is that when selling options you must have the same type of exit strategy that you would if you were buying a stock. In other words, if you ride out the storm as a long-term investor who buys and holds, you have no plans to make. But if you are prone to sell a position in stock if the market takes a bad turn in order limit your losses, treat options the same way. If the stock drops and the world economy is falling into recession and you believe that the market will drop considerably more, you can buy the option back to close the position any time and limit your loss.
I can't tell each investor what they should do. We all have to make those decisions that suit our dispositions. But consider this: Those who sell after months of falling stock prices often lose more than those who hold long-term. If you choose quality stocks to begin with, you will be OK in the end. It's when we, as investors, speculate on stocks that are not prepared to weather the economic storms that we make the biggest mistakes. Always start with quality and you'll be better off in the end because you'll end up making far fewer mistakes. There is no such thing as mistake free investing just as there are very few perfect games in sports. Usually, the team that makes the fewest mistakes wins.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
