By Mark Bern, CPA CFA
This article will focus on General Electric (NYSE:GE) and includes information on two other conglomerates I also like for the long term toward the end. GE has underachieved and underperformed for more than a decade. The former engine of growth, GE Capital, is coming back to life. Preferred shares previously held by Berkshire Hathaway, which when issued were needed to hold the company together, have been redeemed, which will add 3 cents per share to earnings annually hereafter. Both the Energy Infrastructure and Transportation segments have experienced growth in sales year over year. The company is not yet hitting on all cylinders but much progress has been made of late. It may be too early to declare victory as the margins for Aviation and Healthcare have fallen under pressure and appliance sales are soft.
Having said all that, it would appear that though the company may not thrive, per se, it seems to be on the right path. The company has operations spanning the globe and is very well-positioned to take advantage of economy growth wherever it appears. It is doing very well in the emerging BRIC countries with sales growth in those areas increasing by 25% in the latest quarter. The earnings release earlier today (January 20, 2012) took the stock down temporarily, but I liked the resilience it showed by regaining the level at which the stock had closed on the previous day. There is good support for the stock by investors. That's a good sign.
Overall, the future looks brighter than it has in some time. The shares are still trading at less than half of the 2007 high over $41 and the current yield is 3.6%. However, for those who are hesitant to purchase GE at the current price because it is also well off its low near $14, I have a simple strategy that could potentially reduce the cost basis of new purchases. Let me explain how in detail on GE and then I'll add a short note on how to deploy the strategy on a couple my other favorite conglomerates.
I'll start by saying that I always like the odds in my favor. In this case the odds are stacked about 4 to 1 in our favor to earn nearly 14% on our money in the next year. And in the fifth case we end up buying the stock at a discount of about 10% below today's price. Let me explain how.
Historically, 80% of all options contracts expire worthless. So we don't want to be on the losing side of that statistic. What this means is that 80% of all options buyers lose all their money. So, why not be a seller of options and win 80% of the time? Stick with me a bit and I'll explain how this works and how the trade works. I'll also explain the risks and provide guidance to mitigate that risk at the end of the article.
First, I'll explain a little about options nomenclature. A writer of an option is the seller. I rarely, if ever, buy options because the odds are terrible as I pointed out above. But selling options is a different story. In this article I will stick to my strategy for buying stocks using puts. If you've ever placed a limit buy order you've done almost the same thing. The difference is that with a limit buy order you either get the stock or end up with nothing and when selling a put you either end up with the stock or you get paid for trying. I'd rather get paid for trying than end up with nothing, thank you very much. Generally, brokers require that the investor sell only cash-secured puts which means that the brokers require that the amount needed to purchase the stock at the strike price should the option be exercised be held in the account for the duration of the contract or as long as the position is open.
The seller of a put option is obligated to purchase 100 shares of a stock at a specified price, called the strike price, on or before a specified date, the expiration date. When an investor sells a put option contract he/she is paid a premium from the buyer who, in turn, has the right to exercise the option on or before the expiration date at the predetermined price. If the buyer decides to exercise the option contract, the seller is obligated to purchase the stock represented by the contract (1 option contract equals 100 shares of stock). To sell an option an investor will sell to open an option position and will collect the premium paid by the buyer. The seller keeps the premium no matter what happens.
Put options premiums increase as the price of the underlying stock decreases; just the opposite as with a call option. Generally there are two instances in which a put option will be exercised. The first instance occurs when the price of the underlying stock drops well below the strike price prior to the exercise price resulting in a significant increase in the premium. The buyer may own the stock and, if so, probably bought the put as protection in case the stock price dropped. In this case the option buyer would exercise the option early to get out of the stock without taking any more of a loss. The other instance is when the price is below the strike price on the day of expiration. In either case the seller, as pointed out earlier, is obligated to buy the stock at the strike price.
You may be wondering what happens if the option is not exercised. The answer is simple: The option expires worthless and the seller keeps the premium. And in the case of GE I'll show you how that premium can add up to 13.2% return over one year. If I can earn over 13%, do I really need the stock?
At this point I need to make one thing perfectly clear: Never sell a put on a stock unless you really want to own the stock because you may just end up owning the stock. You need to use this strategy only on stocks that you feel quite certain will rebound in the case of a recession or other cause of a stock market crash. I'll speak to this a little more from a different angle again later because it is very important.
But now I'll explain the example I like for GE. I often tend toward shorter duration puts but I first look for the expiration and strike combination that meets my two primary goals. Those goals are to find the balance between the best discount from the current price if the option is exercised and the best return of the stock if it is not exercised. My minimums generally are a 10% discounted cost from the current price and at least an 8% annualized return on the cash I hold in my account to secure the put. So, I scoured the put options available near the close on January 20, 2012, and found three that met both goals. One provided a discount of 10% and an annualized return of 10%, while another provided a discount of 10% and an annualized return of 8.6%, while yet another provided a discount of 10% and an annualized return of 13.2%. I selected the third contract because I really don't expect the option to be exercised in either case and want the higher return. On the other hand, if the contract is exercised I wouldn't mind buying the stock at a 10% discount to the current price.
My favorite of the bunch turned out to be selling the January 2013 put option with a strike price of $20 and a premium of $2.75 per share. The seller would collect $275 less commissions (with a discount broker this cost is usually below $10 per contract) to net $265 and a return of 13.2%. On the other hand, if the option were to be exercised sometime in the next year the seller would be obligated to purchase 100 shares of GE stock at the strike price of $20 but would have a cost basis of $17.25 ($20 - $2.75 premium collected) providing a 10% discount for tax purposes and an actual cost basis of $17.55 (the taxable cost basis plus commission and exercise fee which is usually under $20 per contract or a total of $30 for both fees). Now the discount on the actual cost basis is down to only 8.36%, but that is still the best discount available today. One may want to use patience to pick up a better premium and discount, but the yield is very tempting.
For United Technologies (NYSE:UTX) the results are similar but the return is somewhat lower. I own UTX and wouldn't mind adding to my position if I could get it at a bargain price. The only contract that offers a discount of 10% or more is the January 2013 put with a strike price of $75 and a premium of $7.40. The annualized return works out to be 9.7% but I would get the price down to $68 from the current price of $76.74 near the close on January 20, 2012. I wouldn't get the stock for another year, but that would be fine as I am a long-term holder of UTX. Actually, I probably wouldn't get the stock because I don't expect it to drop and remain low enough for that long. But I don't mind getting nearly 10% on my cash while I wait.
The third company is Northrup Grumman (NYSE:NOC) which is selling at $61.75 near the close on January 20, 2012. I like the January 2013 put option on NOC with a strike price of $60 and a premium of $5.90. This one results in a return of 9.7% if the option expires worthless and a discount of 11.9% from the current price. The company also pays a nice dividend that yields 3.4%.
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 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 am long UTX.