When I think about Kohl's (NYSE:KSS) I keep the idea of a "second tier" type of investment in mind. If you had to come up with a list of 50 firms that were of the highest quality, Kohl's probably wouldn't be on that list. It's not that's it's a bad business - indeed its quite profitable year-after-year - it just doesn't have that staying power feeling to it that Coca-Cola's (NYSE:KO), Johnson & Johnson's (NYSE:JNJ) or Colgate-Palmolive's (NYSE:CL) tend to have. Retail can be a rather finicky business.
So when you look a prospective investment like Kohl's, I think there are three basic things that you have to consider. The first is whether you want to limit yourself to only the highest quality businesses, or determine if you're willing to go beyond that to find some other solid companies. Either way can work out well, so this part is about being true to your investing ambitions.
If you're comfortable with adding a company like Kohl's to your portfolio, with the above caveat in mind, there are two more things to consider. Next, when you're developing your expectations you probably want to remain somewhat cautious. It can be easy to get caught up in growth expectations. Granted this idea holds for any potential investment, but I find it even more practical when you're moving down the quality ladder.
Finally, you'd like to find a price that reflects the value proposition. One again, obviously this is the case for every investment, but there's a bit of difference between "paying up for" for something like Visa versus Kohl's. If Visa underperforms, the company might still grow by 8% for quite some time. If Kohl's does worse than expected, you could be looking at the potential for negative growth.
Incidentally, in the "second tier" link above I have previously outlined what some cautious assumptions and the current value proposition could look like for Kohl's. If the company can grow by 1.5% or so, a shareholder could see annualized gains on the magnitude of 8% to 10%, as a result of the share repurchase program, valuation and above-average starting yield.
That's what I mean by "cautious" assumptions - especially when you consider that analysts are calling for 6%+ intermediate-term growth. If things go marginally, investors still stand to do well. If things go as expected or better, the investment could work out quite well.
So with the above in mind, let's suppose that you'd be comfortable with owning shares of Kohl's around today's price (a bit above $43). You could simply buy shares, or you could make an agreement to buy at an even lower price. Let's explore that second option, in this case literally.
As I write this the last bid for the January 20th 2017 put option with a $42.50 strike price was about $4.40. This means that if you set aside $4,250 to buy 100 shares of Kohl's, you would receive an upfront premium of $440 for doing so; let's make it simple and call it $425 after fees and fluctuations.
Now there are two basic outcomes if you were to make this agreement: either the option is exercised or it is not. If the option is not exercised, as would likely be the case should the share price remain above $42.50, you would keep your upfront option premium of $425 and the $4,250 you set aside would once again be "released" - or able to be redeployed once more. In this scenario your return is 10% in just 9 months.
The upside is clear: while the option premium may be taxed at a different rate than dividends or long-term capital gains, that's a very solid return in that amount of time. If you were able to generate that sort of gain consistently, you'd have no problem creating substantial wealth over the years.
The downside is that you may not get to own shares in a company that you'd like to partner with. Should shares of Kohl's jump to $50 or $60, you're "stuck" with a 10% gain when you could have simply bought shares and had a much better result. That's a very real risk. If you find a company that you'd like to own and a price you like, the easiest way to ensure that "you're on board" is by buying shares.
If the option were to be exercised - as would be the case with a share price lower than $42.50 - you would still have your option premium and also have 100 shares of Kohl's. If you truly want to own shares, which I believe is key in this process, this is a favorable outcome.
The upside is that you get to own shares at a lower cost basis than simply buying outright. If the option is exercised, you'll always be ahead of simply buying today as a result of the option premium that you received. (Note, you would have to net out the potential for missed dividend payments, but in this case the option premium more than makes up for this.)
The downside is that you could still have a negative return - but as indicated, this shouldn't concern you if you planned to hold for the long-term anyway. If you were willing to buy at $43 and hold should shares drop to $30, there's no reason to be disconcerted about having a lower cost basis and watching the same thing. Here again it's important to make sure that you'd be happy to hold in such a circumstance.
Of course that certainly is not to suggest that this is the only option out there. There are all types of different strike prices, but let's move with time instead.
If you made an agreement to buy at $42.50 anytime between now and May 20th, the option premium would provide a 2.7% upfront cash flow - not bad for a month, keeping in mind the caveat of wanting to own shares anyway. The July put option - 3 months out - would provide an upfront cash flow yield of about 4.8%. The October option with the same strike offers a 7.6% starting option premium. And if you want to go really far out, the January 2018 option would provide an upfront option premium of about 14%.
In short, working through your options, in this case literally, can help you think about the process. The first thing you want to do is figure out if you'd be happy to partner with the company and if so, at what price. Without this piece anything related to selecting investments or making potential agreements turns into mere speculation. With this piece, you can approach the process with some rational thought. It's not going to be perfect, but it at least provides a psychological and investing baseline.
In the above example, Kohl's doesn't have to do anything spectacular to provide reasonable returns moving forward. You could think about owning shares outright, or agreeing to buy shares around (or a bit below) today's price. It's not talked about as often, but if you're content with either side of the agreement it's possible to generate a double-digit cash flow in a relatively short amount of time.
Disclosure: I am/we are long JNJ, KO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.