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) |
Archer Daniels Midland | Farm Products | 12.1% | 3.58 | 1.5% | |
Applied Materials | Semiconductor Equipment & Materials | 11.4% | 4.52 | 2.0% | |
Bunge Limited | Farm Products | 14.7% | 3.58 | 1.4% | |
Baker Hughes Inc. | Oil & Gas Equipment & Services | 16.4% | 3.29 | 2.1% | |
CVS Caremark | Drug Stores | 12.8% | 4.02 | 1.3% | |
Chevron Corporation | Major Integrated Oil & Gas | 20.2% | 4.54 | 1.1% | |
Dell Inc. | Personal Computers | 48.7% | 3.19 | 2.1% | |
FedEx Corporation | Air Delivery & Freight Services | 11.1% | 3.85 | 1.3% | |
Forest Laboratories | Drug Manufacturers - Other | 23.0% | 6.34 | 1.4% | |
Humana Inc. | Health Care Plans | 15.2% | 3.21 | 1.8% | |
Murphy Oil | Oil & Gas Refining & Marketing | 19.0% | 4.21 | 2.0% | |
National Oilwell Varco | Oil & Gas Equipment & Services | 12.7% | 4.52 | 1.9% | |
Nucor Corporation | Steel & Iron | 17.1% | 3.83 | 1.8% | |
Smithfield Foods Inc. | Meat Products | 7.5% | 3.33 | 2.3% | |
Safeway Inc. | Grocery Stores | 5.5% | 4.06 | 2.4% | |
TIE | Titanium Metals | Industrial Metals & Minerals | 5.2% | 5.52 | 2.4% |
Tesoro Corporation | Oil & Gas Refining & Marketing | 11.6% | 4.59 | 2.4% | |
Unitedhealth Group | Health Care Plans | 24.4% | 3.13 | 1.6% | |
Valero Energy | Oil & Gas Refining & Marketing | 12.5% | 4.25 | 2.5% | |
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.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
