3M Diagonal Call Spread: After 3 Years At 55.8%, What Next?

| About: 3M Company (MMM)

Sometimes a bowler, after throwing a strike, will pause and reflectively repeat the delivery motion, as if trying to memorize how he did it, for future reference. As an investor, I typically review my trades after closing them, sometimes finding errors that can be discussed in a "lessons learned" type article. Every once in a while, I get the equivalent of a strike, and say to myself, "more like this."

Back in August, James Kostoherz did a fine job on the lessons learned genre, forthrightly going over a broken thesis and his discipline in closing the trade and moving on. I've done a few of them myself - most recently on Radian (NYSE:RDN), previously on (NYSE:LDK). Today I'm going to talk about getting it right.

The Wrap-Up

On 8/6/2012 I closed a diagonal spread on 3M (NYSE:MMM), which had been running since 9/9/2009, with an internal rate of return of 55.84%. That's an annualized return, figured with compound interest.

  • Macro thesis - in September 2009, with the S&P 500 at 1,030, I was investing on the basis it would hit 1,200 by year end 2010.
  • Sector selection - "Going forward, with interest rates low and business conditions uncertain, large, well-capitalized and relatively steady performers will command a premium." Agnostic on sectors at the time, it was more about quality.
  • Stock selection - with MMM at $76 - "there is no reason why the company should not revert to its historical valuation, suggesting a target price of $99."
  • Strategy - "Reduced volatility makes it attractive to buy options, primarily deep in the money LEAPS expiring in January of 2011. These provide leverage at an affordable premium. Writing short term calls, close to the money over these positions, attractive returns are possible, like covered calls on steroids."
  • Tactics - the LEAPS were rolled out, up and down, while selling covered calls repetitiously. Considerable thought was given to the selection of strike and expiration for the calls sold.

It's fun when you get it right. Comparing this to similar efforts that didn't work as well, the others missed on one or more of the criteria evaluated. Some thoughts on the items considered:

  • Macro - as an investment discipline, it's worthwhile to have a carefully considered opinion on market level. There's no reason to be aggressive initiating new positions if the market is at or above its midpoint.
  • Sector selection - rotation in and out of defensive vs. cyclicals, financials, and technology has been ongoing. I got it wrong in 2011, stayed with too much life insurance and high beta, very painful.
  • Stock selection - MMM was kind of a no brainer mean reversion idea. Just finding a well-regarded company that was undervalued by conventional metrics was enough in this case. For Hewlett-Packard (NYSE:HPQ) just having undervaluation by the usual metrics worked poorly. There is much more to stock selection.
  • Strategy - if options are to be used, a review of volatility, bid/ask spreads, and open interest has to be done. Document the thinking involved in strategy selection.
  • Tactics - sometimes it's best to avoid excessive trading, or guesses on short-term market direction. Tactics that rely on selling options when volatility is high, and buying when it is low, make sense. My brokerage, having received 9.94% of my profits on MMM, loves me when I trade frequently. Go Tommy Go!

Back to the Grind

In due course, a long-term unsuccessful trade on Hewlett-Packard needs to be reviewed, with a lessons learned section. I expect to write up the results for readers, in the hope that my learning experience may help others. While I plan to stay with that situation, when the final wrap-up comes, it will be a mediocre result, for the simple fact of starting too high.

While I can appreciate the line of thinking of those who advocate ditching losing trades promptly and without regret, I've had a number of cases where my experience is, once I have seen a stock tank, in the meantime I get to know the company pretty well.

Rather than going with a thesis and exit when it's broken, I start with a hypothesis, unproven, and subject to revision, confirmation or rejection as additional information comes in. The exit point comes when the current hypothesis, even if confirmed, does not provide an adequate return for the risk assumed. In the best case, with the hypothesis confirmed, the stock hits its target and the position is closed on that basis.

My winners seem to take care of themselves. Similarly, the clear-cut errors can be discarded without regret, once they are identified. In the gray areas in between, patience, well thought out procedures, and careful selection of strategies can make incremental improvements in performance.

What Next on 3M?

Using 4 years actual plus an estimate for 2012, 5 year average EPS will be $5.49 as of the end of the year. Applying a historical average multiple of 17.6, I arrive at a target price of $97. With shares trading in the area of $92, based on valuation there is still some upside here.

However, the debt crisis and recession in Europe, and slowdown in China, have put pressure on industrial share prices lately. 3M is a global company, and will encounter headwinds as a result of the worldwide slowdown.

With that in mind, I plan to keep some dry powder and attempt to re-enter the trade in the $85 area. Sometimes getting it right involves quitting while you're ahead, while staying ready to pick back up if a favorable opportunity presents itself.

Disclosure: I am long HPQ. 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.