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Camille Shirley
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I grew up in rural Alabama with my family teaching that our main investment should be land. Over time I have expanded my horizons and have started following dividends and long-term investments.
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  • Supercharge Blue Chip Investing With LEAPS

    Recently while reading an analysis of Exxon Mobile, (NYSE:XOM) a commenter mentioned the use of deep in the money LEAPS and that he was investing in Exxon through these financial instruments. It gave me the idea of creating a blue chip portfolio of LEAPS that offers an investor a speculative but highly profitable way to invest in blue chip, dividend growing companies.

    The Plan:

    • Find high quality blue chip companies that are undervalue relative to their Morningstar Fair Values.
    • Screen out those companies who have 2015 price targets below the Fair Value price, (thus leaving just stocks projected to climb even higher than Fair Value).
    • Buy deep in the money LEAPS expiring Jan 15, 2016.
    • Wait patiently until Jan 2016 and sell LEAPS, hopefully at a large profit.

    The Logic:

    First of all, to those investors new to options investing, I'll quickly explain what a LEAP is and why I believe this idea will work.

    LEAPS stand for Long-Term Equity Anticipation Security. Its a long-term call option.

    Call options are a contract that gives the owner the right to, (but not obligation) to purchase a stock for a particular "strike price" by a certain date. Each contract is for 100 shares.

    The benefit of options is that they are a form of leveraged investment. Each contract controls 100 shares of an underlying equity for a fraction of the cost of 100 shares. The amount of leverage is dependent on how much time is left on the option and how deep in or out of the money the option is.

    In or out of the money simply refers to the price of the stock relative to the strike price of the option. The strike price is the price of stock mentioned in the option.

    For example, a Cisco (NASDAQ:CSCO) $20 call option is $5 in the money, if Cisco is trading at $25. Any call options that are for strike prices higher than the stock price are out of the money and consisting entirely of "time value". This is the value the market places on the option because the stock has time to increase above the strike price.

    If a call option is in the money than it has "intrinsic value" which is the stock price-strike price. The remaining value of the option is the time value, which decays over time until it hits 0 at the expiration date.

    For example, if a Microsoft $30 2016 LEAP is trading at $15 and the stock is at $40, then the intrinsic value is $40-$30=$10 and the remaining $5 is time value. If the price were to remain the same over 2 years the time value will decay to $0.

    So now I turn to this idea of a blue chip deep in the money LEAPS and the risks and rewards.

    First the risks:

    • Call options are speculative because you don't own anything nor collect dividends.
    • The capital gains that can be derived are based on both the price of the stock and timing.

    For example, if you buy a $20 call on a $40 stock and that stock goes to $60 within 2 years then you make a bundle. However, if the market corrects for whatever reason, right before the option expires then you stand to lose a great portion of your gains or even incur a loss if the price drop is severe enough.

    • Call options utilize leverage which is always a two edged sword. Greater gains on the upside, greater losses on the downside.

    Benefits:

    • The leverage used through options is cheaper than borrowing on margin and paying the broker interest.
    • The leverage used can be much higher than any broker would allow. For example, the average leverage for the experimental portfolio is 3.58x. This is far higher than could safely be attempted by purchasing stock on margin at a broker.
    • Because I'm looking at deep in the money call options there is very little time value, or "premium". This greatly minimizes the risk of losing money in the future, compared to at the money or out of the money options. Those options will lose value over time if the stock stands still. Deep in the money options have very little time value and so will retain their value.
    • Rising interest rates, which will increase the cost of buying on margin, don't effect this system.

    Ok, so new investors may still be a bit confused as to what exactly I am talking about so I will use a specific example from my experimental portfolio.

    Exxon Mobile: 2016 $60 LEAPS, cost to purchase $34.31.

    At the time of purchase Exxon was trading at $94.31.

    To calculate the time value add the strike price of $60 and the option cost, $34.31. This sums to $94.31, indicating there is no time value on this option. We are paying purely for the intrinsic value.

    The leverage on this option can be calculated by taking the % increase of both the share price and the option.

    For example, because the option is so deep in the money, a $1 increase in Exxon's price will result in an increase in the intrinsic value of the option.

    If Exxon goes up $1, that's a 1.06% increase.

    The option goes up by $1, which is a 2.91% increase.

    2.91%/1.06%=2.75. This tells us that this option represents a 2.75x leverage on Exxon shares.

    Now, how is this system supposed to work? Well according to Morningstar.com, Exxon has a fair value of $109. If we assume that this is the price the stock trades at by the end of 2015, then our profit would be (Price-Strike price)/cost of option.

    ($109-$60)/($34.31)=42.82% profit. This annualizes to 23.79% CAGR.

    This is the profit to be expected if Exxon achieves its fair value, (today) over the next 2 years. However, because the company is actively trying to increase its Fair Value we hope that the stock not only catches up to its Fair Value in 2014 but reaches its Fair Value in 2015.

    From this fast graph we see that analysts are projecting Exxon reaching $116.12 by the end of 2015. If this target price is reached then our profit becomes ($116.12-$60)/$34.31=63.57%. This is equal to 34.27% CAGR.

    So that is the basics of this portfolio. I have found 6 undervalued blue chips that are predicted by analysts to increase greatly over the next 2 years. I have purchased a portfolio of 6 deep in the money LEAPS and will track how this portfolio does relative to the S&P 500.

    A note of caution: options are speculative and this method should not make up more than 10-15% of one's total portfolio. I am running this experiment to see how it will work over the next 20 months. However, the market is now in its 6th year of a bull run and a correction may result in losses to this portfolio.

    After a market correction, especially after a recession, this system could certainly result in exceptional profits and minimize the risks that are currently associated with it. These risk minimizing features are:

    • undervalued blue chips
    • deep in the money LEAPS, with essentially no time value to decay
    • After a recession, blue chips can be expected to grow by 30-50% over a 2 year period. This would optimize profits and minimize risk to the down side.

    Ok, so what does my portfolio look like?

    CompanyDateS&P 500 startShare Price (start)LEAPLEAP priceTime Value (%)leverageMorningstar Fair valueAnticipated profit (%)Anticipated CAGR%Fast Graphs 2015 Price TargetAnticipated Profit (%)Anticipated CAGR (%)
    XOM3/23/20131866.5294.312016 $6034.3102.7510942.8223.79116.1263.5734.27
    F3/23/20131866.5215.472016 $105.550.522.7925170.2781.3728.71237.11107.03
    GM3/23/20131866.5235.012016 $2015.310.862.295743.6324.2194.53386.81157.98
    CSCO3/23/20131866.5221.642016 $156.951.433.112658.2731.6431.32134.8266.72
    CVX3/23/20131866.52115.632016 $9026.851.064.3113256.4230.72169.82197.2892.01
    COP3/23/20131866.5267.482016 $57.510.851.296.227561.2933.1491.5213.3698.17
    AVG    99.820.863.58 72.1237.48 205.4992.7

    • Exxon Mobile (XOM) Jan 2016 $60 call
    • Ford (NYSE:F) Jan 2016 $10 call
    • GM (NYSE:GM) Jan 2016 $20 call
    • Cisco (CSCO) Jan 2016 $15 call
    • Chevron (NYSE:CVX) Jan 2016 $90 call
    • ConocoPhillips (NYSE:COP) Jan 2016 $57.5 call

    For the purposes of the experiment I am assuming a purchase of a single option as listed above. It would require $9,982 to do this plus commission, ($5 for up to 5 contracts at Optionhouse). With commission the total cost of this portfolio is $10,012.

    Note that because the high cost of the XOM, CVX and COP options, 70% of the portfolio is in these 3 companies. Ideally the portfolio would be better balanced. However, with my advised 10% maximum allocation to this system of investing, the above portfolio is designed to represent the smallest amount advisable to invest in a portfolio of total size $66,677-$100,000 and thus the most realistic to interested investors.

    I will be updating this portfolio on a monthly basis and potentially adding more companies should I come across undervalued blue chips that fit the investing criteria outlined above.

    I invite interested investors to follow this experiment along with me and to offer their own potential ideas. Whether it be to improve the system or with potential portfolio candidates.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Mar 24 5:53 PM | Link | 3 Comments
  • Lorillard: Why This Tobacco Stock Owns The Future Of Its Industry

    Traditionally when one thinks of tobacco stocks one thinks of high yield and slow growth. The decline of smoking in the US seems to limit the future growth of the industry. Yet, I have discovered in Lorillard, a company with a bright future and one of the shareholder friendliest managements I have ever seen.

    Background

    Lorillard (LO) was founded in 1760 and is the third largest tobacco company behind Altria (MO) and Reynolds American (RAI). Its most popular brands are Newport, Kent, True, Maverick and Old Gold. It recently broke into the electronic cigarette space with its $135 million 2012 acquisition of blu. In October of 2013 it acquired SKYCIG an UK electronic cigarette company.

    Thanks to Newport, Lorillard has recorded 11 straight years of market share gain. It now owns 14.9% of the cigarette market in the US. On the electronic cigarette front it holds 47% of market share.

    Recent Results

    • 2013 sales increased 5%.
    • 2013 earnings were up 11%, the best in the industry.
    • Tobacco market share rose 50 basis points to 14.9%.
    • Electronic cigarette market share is an industry leading 47%.
    • 4th quarter cigarette volumes declined by 1%.
    • This compares favorably to industry wide 6.2%.
    • Management is guiding for annual 3-4% declines in cigarette volumes.
    • Electronic cigarette sales account for about 1% of this decline.
    • Electronic cigarette division net sales up 300% to $230 million.
    • Management has decided to merge SKYCIG into blu and expand blu into European markets that SKYCIG services.
    • Management's eventual goal is to turn blu into a dominant global brand.

    Risks

    Continued decline in US smoking rates:

    Screen Shot 2014-03-18 at 6.53.58 PM.png

    Regulatory risk against Menthol: On November 22, 2013 the FDA closed a public inquiry on a proposition for it to regulate or even ban menthol cigarettes. 90% of Lorillard's sales are from menthol cigarettes and though it is attempting to diversify its product line, any regulations targeting menthol cigarettes could have a devastating affect on sales.

    Regulatory risk against electronic cigarettes: The FDA is deciding whether or not to regulate or even ban electronic cigarettes. Like the issue with Menthol, the FDA is concerned about any manner of nicotine delivery that is more appealing than regular flavored tobacco. The concern is that electronic cigarettes, with their lack of carcinogenic chemicals, bad smell and lower cost, may act as a gateway drug to individuals who wouldn't consider using regular tobacco. Once a non smoker tries and likes electronic cigarettes they might be willing to switch to regular tobacco, with all of the negative health implications.

    Potential For Future Growth

    Larger market share of a larger (but shrinking) pie: The US smoking rate has recently hit a new low of 18.1%. By 2050 the US Census Bureau estimates the US population will increase by 100 million. If the US smoking rate stabilizes at some point, say 15%, that would represent a 17% decline. However, a 30% increase in population would actually increase the number of smokers in America. In addition, if Lorillard is able to continue to increase its market share than its sales of traditional tobacco would increase moderately over the coming decades. The growth wouldn't be fast, but it would continue providing the company with the consistent cash flow with which it has could finance stock buybacks and dividends. The company has an excellent track record of returning cash to shareholders. Over the last 5 years Lorillard has returned $8.224 billion to investors through these two methods.

    Electronic Cigarettes: Regular tobacco is a $500 billion global business. Currently electronic cigarettes represent only $1.5 billion in sales but by 2023 Bloomberg Finance projects electronic cigarettes may overtake regular tobacco sales. That would mean electronic cigarettes could grow into a $250+ billion industry within a decade. Given that Lorillard owns 47% of this promising market the potential for profit growth is staggering.

    Share Buybacks:

    Screen Shot 2014-03-18 at 7.33.16 PM.png

    Over the last 5 years Lorillard has bought back $4.6 billion in stock. Over the last 6 years its decreased its share count by an astounding 29.8%. This represents a 5.73% CAGR decrease in the share count. Such aggressive share repurchases are helping drive Lorillard's impressive EPS growth rates.

    If the regulatory risks prove overblown than Lorillard may end up being one of the greatest investments of the next 10-20 years. This is because the potential for electronic cigarette growth, combined with the company's passion for buying back shares, could result in EPS growth of 20+%.

    Consider this: Lorillard's 2013 sales were $7 billion. If Bloomberg is even 10% accurate the electronic cigarette market would grow to $25 billion within a decade. Lorillard has 47% market share, which would represent revenue growth of $12.5 billion, tripling current sales. The growth in revenue would allow an acceleration of the stock buyback and the dividend growth rate, both of which have been superb. Though this potential hyper growth is a more speculative best case scenario, it shows that boring old Lorillard may have an amazing future ahead of it.

    Future Projections and Current Valuation

    Screen Shot 2014-03-18 at 7.45.29 PM.png

    As seen in this fast graph, the average PE for Lorillard over the last 8 years is 12.5. Thus the current PE of 15.3 seems to indicate that the price is overvalued. This may be true based on a trailing earnings basis, but on a 10 year projected growth basis the opposite is true.

    Screen Shot 2014-03-18 at 7.48.04 PM.png

    As seen here, the 10 year projected return of Lorillard is 10.9% CAGR. This does not include dividend reinvestment. If we compare this rate to the stock market's 1871-2013 9% CAGR total return, we see that Lorillard is likely to outperform the general market by about 21% over the next decade. Thus I determine that Lorillard is 21% undervalued at its current price. Investors can probably expect to beat the stock market over the next decade but is it enough to be compensated for the risk of owning the stock?

    Risk Adjusted Cost Of Equity Calculation

    This calculation tells us how much a stock must return for investors to be compensated for investing in the stock vs a risk free return, aka ten year treasury bonds. The formula for this calculation is:

    risk free return+beta(market return-risk free return)

    • 10 Year Treasury Bond: 2.76%
    • Lorillard Beta: .33 (this means that Lorillard is only ⅓ as volatile as the stock market over the long-term)
    • Market return: 9%

    The cost of equity is just 4.82%. This low hurdle rate is due to Lorillard's incredibly low beta. Historically, lower beta investments have outpeformed the market. This calculation helps us to see why.

    4.82% is the rate of return Lorillard would have to deliver to be worth the risk of investing. As we can see from the fast graph 10 year projections, the expected rate of return is projected to be over twice this. Thus Lorillard is a terrific investment at today's prices on a risk adjusted 10 year basis.

    Dividend Analysis

    Screen Shot 2014-03-18 at 8.35.10 PM.png

    Recently the dividend was raised 12% to $2.46/year. Note that the 2008 dividend is only for 2 quarters so it must be annualized to $1.22 to get a true comparison. We can see that in the last 7 years the dividend has grown 10.54% CAGR.

    Looking ahead 10 years, using the earlier fast graph, we see a projected dividend of $5.61 in 2023. This represents an expected dividend growth rate of 9.59% CAGR.

    DGI Score

    A good rule of thumb is that total return equal: Yield+dividend growth rate. Keeping this number at 12+ is a great way to maximize the chances of outperforming the market in the long term.

    If we look at Lorillard we see 5.1% yield+9.59% expected CAGR dividend growth for a total DGI (dividend growth investor) score of 14.69. This indicates that Lorillard is an excellent dividend growth stock.

    Bottom Line

    When it comes to great dividend growth stocks Lorillard is a prime example. It possesses a stable, repeat business and has a dominant position in the fast growing electronic cigarette industry. Its shareholder friendly buybacks and fast dividend growth make this stock a likely long-term market beater. At the current valuation the stock is massively undervalued in terms of its likely 10 year future performance.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

    Tags: MO, RAI, LO, dividend-ideas
    Mar 24 1:42 PM | Link | Comment!
  • Ford: Detroit Giant Poised For Massive Growth

    As a dividend growth investor my typical stomping ground is the realm of dividend achievers, aristocrats and kings (10, 25 and 50 consecutive years of dividend growth respectively). Lately, I've come to believe waiting for a company to grow its dividends 10+ years in a row means leaving a lot of potential profit on the table. For example, during the financial crisis a lot of great companies cut or eliminated dividends. This means that a dividend aristocrat could lose its status after just one bad year. So I began looking at companies that struggled and cut dividends during the financial crisis. My goal was to find a company that had reinstated its dividend and was growing it quickly. Moreover, I wanted to find a company with characteristics that would likely result in continued fast dividend growth going forward. In Ford Motor Company (NYSE:F) I believe I have found such a company.

    Historical Context:

    Ford was forced to eliminate its dividend in 2006 after difficulties with profits caused by an over reliance on gas guzzling trucks in an age of increasing gas prices. In addition, high legacy costs from generous union pension and healthcare benefits hurt profitability. The financial panic of 2008 and great recession that followed resulted in a near 40% decline in auto sales from 2005 through 2009.

    Screen Shot 2014-03-21 at 6.25.09 PM.png

    Source: Car & Driver

    However, the dark times seem to have ended for the automotive industry. 2013 global vehicle sales reached a record of 82.84 million which is a 4.4% increase over 2012. Analysts are projecting that by 2018 global auto sales will surpass 100 million. In the US 2013 auto sales increased 7.6% to 15.6 million. By 2017, US sales are projected to reach 17 million.

    Short Term Headwinds:

    Screen Shot 2014-03-21 at 8.14.54 PM.png

    Source: IBTimes

    Ford recently reported a sharp drop in January and February sales of 7% and 6% (respectively) due to the extreme winter. This is a temporary event that will hurt first quarter results and possibly result in a buying opportunity.

    A longer-term headwind would be the need to reduce inventory ahead of 23 new model launches over the next 2 years. Ford and GM (NYSE:GM) have been in a recent discount war; with Ford discounting by an average of $3305/vehicle this past month which is $100 more than GM. Its largest discounts were on its best selling F-150 (up to $8,000/vehicle). These kinds of heavy discounting will lead to lower earnings growth in 2014 but that should result in a great buying opportunity for long-term investors.

    Long-Term Potential:

    Ford has a lot of long-term catalysts that will drive its shares higher in the coming decade.

    Europe, which has long been a losing region for Ford, is starting to turn around led by a thriving UK auto industry. Across Europe, Ford reported an increase of 9.2% in January sales. Thanks to a planned $450-$500 million in plant closures and cost cutting measures Ford expects its Europe division to break even in 2015.

    Screen Shot 2014-03-21 at 8.31.26 PM.png

    Source: Reuters

    Sales in China are booming with Ford posting an impressive 67% growth in February. Commercial vehicle sales were up 22%, passenger cars 81%. The Chinese auto market is expected to grow by 11% in 2014 which gives Ford ample opportunity for continued growth.

    This is especially true given Ford's strong investment plans in China. As part of a $5 billion investment program designed to double production and market share (to 5% in 2014 from 2.5% in 2011) Ford is investing an additional $100 million into its Nanjing R&D facility. This is on top of an initial $200 million investment. By the end of the decade China is expected to account for 30% of Ford's sales. To put into context how important China is to Ford's future growth plans the company is introducing 15 of its 23 new models in China over the next 2 years. In contrast Europe is getting only 2 models and the Americas 6.

    In fact, international sales will be the key to Ford's mighty future. By 2015 the company predicts that 50% of sales will come from overseas. Over the next decade management predicts that 70% of its growth will come from the Asia-Pacific region. To give a more specific example, Ford is expecting to sell 1 million cars in China in 2014.

    Along with strong investment in global manufacturing capacity, Ford is planning on simplifying its operations. By 2017 the company plans on 80 total factories producing cars from 9 platforms vs 15 platforms today. This should allow for lower production costs and increased margins.

    Undervaluation and Future Over Performance:

    Right now Ford is trading at a forward earnings of 8.1. Does that mean its undervalued? Well Morningstar seems to think so claiming the company is a ⅘ star valuation rating. Morningstar's analysts say Ford has a fair value of $25/share. This would represent a 38.1% margin of safety. Screen Shot 2014-03-21 at 9.01.26 PM.png

    If we look at Fast Graphs we can see that Ford is expected to grow its earnings at 10.1% over the next 10 years.

    One can also use a discounted cash flow model to estimate Ford's fair value:

    • 10 years at 10.1% growth (from fast graphs)
    • 15 years of terminal growth at 5% (growth rate half of next decade)
    • Discount rate, 9%, stock market's long-term historical return.

    Under these assumptions I get a fair value of $39.66/share. This represents a 61% margin of safety.

    Finally, one other method of valuing a company I like to do is to discount the projected 10 year price by the stock market's historical return of 9%. Looking at the above fast graph 10 year projected price of $53.5, one would discount this by 136.7% return the stock market is expected to return every 10 years. This would give a fair value of $22.60/share and represent a 31.5% margin of safety.

    So in conclusion, after valuing Ford 3 different ways we get a range of fair values between $22.6-$39.66. This represents a margin of safety (aka discount to fair value) of between 31.5%-61%. If we take the average of these we get a fair value for Ford of $31.16 which represents a margin of safety of 46.25%.

    Dividend Growth:

    Screen Shot 2014-03-21 at 9.30.16 PM.png

    Of particular interest to dividend growth investors is Ford's high dividend of 3.22%. This is nearly twice the industry average of 1.7%. In addition, from the Fast Graphs one can see Ford's 3 year dividend growth rate is 100% and its 1 year dividend growth rate is also 100%. Most important to long-term investors is the 11.5% CAGR expect dividend growth rate.

    This high growth rate, combined with the high yield is the majority of the reason that analysts are expecting a 15.1% CAGR total return from Ford over the next 10 years (according to Fast Graphs).

    Bottom Line:

    Ford Motor Company has faced much hardship in the last 10 years and it was forced to eliminate its dividend for a 5 year period. However, now the company is back on secure footing. It is investing heavily in new models that consumers actually want and focusing on overseas markets where there is potential for double digit growth for decades to come. Given the company's massive undervaluation and projected fast growing dividend long-term investors are likely to experience market beating returns and a large and steadily growing stream of income.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

    Tags: GM, F, dividend-ideas
    Mar 22 1:20 AM | Link | Comment!
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