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Value investors may be dissuaded by the 2012 stock market rally and the Federal Reserve's open-ended quantitative easing announcement. They might worry that the upside of investing in the stock market is outweighed by the downside as price multiple expansion has ruined many buying opportunities.

Fortunately, the volatility of the S&P500 is near five year lows, which suggests that there may be an opportunity to take long positions in attractively-priced companies using long-dated call options. A long call strategy allows investors to participate in the upside of stock while limiting its downside to the premium paid.

Who cares about value?

Stocks that sell at the deepest discounts below accounting values of their equity (the lowest price to book ratio) have enjoyed higher returns than stocks that sell at the highest price to book ratios. On the basis of overwhelming empirical evidence, the price to book ratio is a useful starting point for long-term value investing.

However, stocks with low price to book multiples are vulnerable to tremendous risks. Many of these stocks are on the verge of bankruptcy or are in terrible industries. Since the price-to-book ratio has been connected to long-term returns, is there a long-term measure of risk we can use? Are there methods that can protect us from value traps?

Screening Long Call Candidates

Two techniques can aid value investors: the use of affordable long-dated call options to take long positions, reducing the money risked in individual investments and the use of the Altman Z-score* to assess the threat of a company going bankrupt. Stocks were screened according to the following criteria:

1) There must be a January 2014 or later expiration call option for the stock.

2) The Altman Z-score must score the stock as safe.

3) The stock's price-to-book ratio must be below 2, the average P/B ratio for the S&P 500.

4) The return on equity over reported in the last ten 10-K filings must be over 5%.

5) For affordable call options, stocks were screened for volatility at or below 2.5%

The results follow:

 

 

Ticker

Company

Industry

10-Year Average ROE

Altman Z-score

Volatility (Month)

ADM

Archer Daniels Midland

Farm Products

12.1%

3.58

1.5%

AMAT

Applied Materials

Semiconductor Equipment & Materials

11.4%

4.52

2.0%

BG

Bunge Limited

Farm Products

14.7%

3.58

1.4%

BHI

Baker Hughes Inc.

Oil & Gas Equipment & Services

16.4%

3.29

2.1%

CVS

CVS Caremark

Drug Stores

12.8%

4.02

1.3%

CVX

Chevron Corporation

Major Integrated Oil & Gas

20.2%

4.54

1.1%

DELL

Dell Inc.

Personal Computers

48.7%

3.19

2.1%

FDX

FedEx Corporation

Air Delivery & Freight Services

11.1%

3.85

1.3%

FRX

Forest Laboratories

Drug Manufacturers - Other

23.0%

6.34

1.4%

HUM

Humana Inc.

Health Care Plans

15.2%

3.21

1.8%

MUR

Murphy Oil

Oil & Gas Refining & Marketing

19.0%

4.21

2.0%

NOV

National Oilwell Varco

Oil & Gas Equipment & Services

12.7%

4.52

1.9%

NUE

Nucor Corporation

Steel & Iron

17.1%

3.83

1.8%

SFD

Smithfield Foods Inc.

Meat Products

7.5%

3.33

2.3%

SWY

Safeway Inc.

Grocery Stores

5.5%

4.06

2.4%

TIE

Titanium Metals

Industrial Metals & Minerals

5.2%

5.52

2.4%

TSO

Tesoro Corporation

Oil & Gas Refining & Marketing

11.6%

4.59

2.4%

UNH

Unitedhealth Group

Health Care Plans

24.4%

3.13

1.6%

VLO

Valero Energy

Oil & Gas Refining & Marketing

12.5%

4.25

2.5%

YHOO

Yahoo! Inc.

Internet Information Providers

7.5%

5.93

1.4%

These screening results generally trade at attractive valuations:

Ticker

Company

P/E

P/S

P/B

P/FCF

BG

Bunge Limited

14.02

0.16

0.87

N/A

SFD

Smithfield Foods Inc.

9.76

0.24

0.94

7.46

ADM

Archer Daniels Midland

14.86

0.2

1

18.6

VLO

Valero Energy

11.6

0.13

1.12

18.73

MUR

Murphy Oil Corporation

13.55

0.39

1.17

N/A

BHI

Baker Hughes Inc.

11.97

1.04

1.33

N/A

HUM

Humana Inc.

9.44

0.3

1.36

3.19

TSO

Tesoro Corporation

8.78

0.18

1.39

6.38

YHOO

Yahoo! Inc.

17.72

3.75

1.51

21.1

SWY

Safeway Inc.

9.11

0.09

1.56

N/A

CVS

CVS Caremark

16.6

0.51

1.58

14.69

FRX

Forest Laboratories Inc.

12.11

2.18

1.63

14.41

NUE

Nucor Corporation

22.51

0.64

1.71

115.92

CVX

Chevron Corporation

8.73

0.93

1.77

42.95

AMAT

Applied Materials

14.51

1.61

1.79

9.84

UNH

Unitedhealth Group

11

0.53

1.89

6.53

NOV

National Oilwell Varco

15.59

2.12

1.92

185.5

DELL

Dell Inc.

6.41

0.31

1.93

7.38

FDX

FedEx Corporation

14.06

0.66

1.94

42.63

TIE

Titanium Metals

22.31

2.24

1.99

N/A

Consider Bunge Limited. It BG shares recently traded at $66.89 per share and has a book value of about $76.89 per share. An investor could buy a Jan-2014 call with a strike price of $50.00 at the bid price of $19.60. This allows an investor to have a long position on $26.89 ($76.89 book minus the $50 strike) in book value for $19.60, which is a deeper price to book ratio of 0.73. An investor could create a call spread with an even deeper price-to-book discount by selling a January 2014 call with a strike price of $80 for a $2.75 bid price. The overall position would be a call spread which cost $16.85 ($19.60-$2.75) for a book value of $26.89, an even deeper price to book ratio of 0.62.

A call spread using January 2014 expiration calls can also be used to create a price-to-book discount for Archer Daniels Midland. ADM shares recently traded for $27.19 with a roughly equivalent book value. An investor can purchase a $20-strike call for $7.85 and sell a $27-strike call for $3.10. The resulting position would cost $4.75 for $7 in book value, a price to book multiple of 0.68.

Conclusion

In value investing there is always something to do. Even after a dramatic run up in price, call options are presenting value investors attractive opportunities to take positions in these stocks at a discount to book value. Value investors should consider these studying these stocks as potential long call candidates.

Please read the article disclaimer.

Source: Long Call Candidates: P/B Ratio And Altman Z-Score