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A Simple Trading Strategy Using Fundamental Value Analysis

October 03, 2007 | About:

Kevin Pilon

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Like many successful investors, I am a buy and hold, fundamental value guy who looks for good or great businesses selling at a steep discount to intrinsic value that are run by competent, shareholder oriented managers. I am patient and comfortable with returns that occur in big jumps after several years of a stock declining or going nowhere. And I am very aware of the compounding benefits that can accrue by holding great companies “forever” (as Buffett suggests) instead of selling and incurring capital gains taxes. I also see the value of keeping some cash handy so I can capitalize on market turmoil by buying when stocks go on sale.

But there are times (market and economic situations) and places (deferred tax accounts or the accounts of individuals with a low tax rate) where low risk trading with the potential for market beating returns can make sense as a supplement to a buy and hold approach. I think now may be one of those times.

We have had an excellent bull run since March 2003, with four and a half years of sustained gains and a market that has more than doubled. Although the Fed funds rate cut of fifty basis points and signs of stabilization in the frozen credit markets have cheered investors lately, we shouldn’t lose sight of the fact that the Fed cut came in response to signs of significant economic weakening. The probability of a recession is still significant. The popping of the regional housing bubble and its affect on debt markets, individual spending and employment will continue to ripple through the economy and the stock market for the next 12–18 months—with the most dramatic effects likely to occur in the next few quarters.

One way of playing this likely downturn and associated volatility is to buy stocks that are cheap on a fundamental value basis and sell (or write) a covered call on all or a portion of your position. This strategy can also be useful when the stock of an attractive company trades at a slightly lower discount from fair value than you normally require and the sale of the call reduces the net price below your buy threshold. Although the market has been trending up, attractively priced individual stocks still pop up frequently and I believe this trend will continue.

To illustrate the pluses and minuses of this approach, let’s look at an example. Stocks that derive a significant share of their earnings from the housing market have sold off sharply lately. A great example is USG, the recapitalized maker of Sheetrock ™ wallboard and acoustic ceiling tile, which is held by a Who’s Who list of Guru investors, including Wally Weitz, Bruce Berkowitz, Marty Whitman, Brian Rogers, John Rogers and the investing demigod Warren Buffett (Berkshire Hathaway owns 17% of the company). These gurus were buying the stock in the mid to high $40s, implying a fair value of at least $65. The stock has recently sold under $36. In addition, insiders have been buying in the open market at current prices.

Is this a great buy and hold investment at current prices? Absolutely, I recommend it. But the new home market is definitely going to be to be soft for some time and it could languish for several years--with a negative affect on USG’s earnings. So the stock may be an ever better play at the moment as a buy accompanied by a corresponding sell of an out of the money call. (Quick overview of selling call options: A call gives the buyer the right to buy the shares you own at the exercise or strike price you sold the call for. Calls are in the money when the current stock price is above the exercise price. They are out of the money when the current stock price is below the exercise price.)

Since we have a fundamental value approach and are comfortable holding for long periods of time, we look to sell an out of the money call. Which call we choose depends upon whether we want to increase the likelihood of the call being exercised and earning a short term return or want to generate income and lower our basis while holding the call longer term.

Buying the stock at the current price ($39.85) and selling the February 16, 2008 $42.50 call currently yields about a 14.4% return (38.6% annualized), before trading costs—if the price exceeds $42.50 on that date and the call is exercised. Or if you want to use the call to generate income while holding the stock longer term, you would sell a higher priced call. The February $45 call yields about 18.2% (49.0% annualized) before costs—if the call is exercised. (Note in the above example that although the $45 call has a higher yield in the scenario described, exercise of the call is less likely to occur).

What can wrong with this strategy? Well, the stock could have risen higher than the strike price and you would have left some money on the table. But you would have made an acceptable annual return on a stock in about four months and you would also have the cash available for another trade. To mitigate this disadvantage, you can combine this approach with a buy and hold position in the same security so this outcome becomes a win/win, or sell a higher priced out of the money call.

The worst case scenario is that the stock falls dramatically, but buying a stock that’s cheap on a fundamental value basis somewhat reduces the likelihood of this outcome. And, as buy and hold investor, you are likely to be comfortable holding an out of favor equity. If the price of USG is below the exercise price of $42.50 on February 16, 2008, you pocket $2.70 per share you sold the call for (effectively lowering your basis to $37.15). You then have the option of either selling the stock, holding it with a lower basis than if you had originally simply bought the stock outright, or sell another call (thereby lowering your basis further). This strategy is made for a market with a downward bias, as it can provide income and lower your cost basis during a downturn.

Some caveats: this approach works best when volatility is relatively high (you will get paid more for the call), and when market and economic prospects are riskier than usual.

Although market volatility has declined slightly recently, it remains high enough that a call seller is being reasonably compensated. I believe the market and economic risks are still there, but Mr. Market doesn’t seem too concerned about them.

This strategy is more efficient for individuals who trade in a tax deferred account or have a low marginal tax rate in their taxable account. It takes more effort than buy and hold so it is best suited to those who enjoy the challenge and competition of trying to outperform the market. At the moment, there are numerous candidate stocks that are reasonably cheap on an intrinsic value basis and that have above average volatility. As a result, fundamental value investors have another potentially lucrative approach to use for lower risk, above average returns.

Note: the author owns shares of USG.

_____________________
Kevin Pilon is Principal of Probity Financial Advisors LLC (probity2@comcast.net) and a successful value investor. He also works as a management consultant in business strategy. He owns the investor distinction of having bought Berkshire Hathaway B shares at $1351 in March 2000, a ten-year plus low.

About the author:

Kevin Pilon
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.6/5 (22 votes)

Comments

musto
Musto - 7 years ago
Excellent idea that spells easy money in my opinion.

buffetteer17
Buffetteer17 premium member - 7 years ago
I'm dubious. Writing calls trades some immediate cash against the chance to profit from an upside surprise. I've seen enough upside surprises in supposedly "dead money" value stocks that I don't want to give up that possibility.

For example, I have some MTH shares at a basis of around $18.15. After languishing around $15-16 for a while, the price shot up briefly to $20.25 on Bernake Bounce day (9/18). The short ratio is very high. Any glimmer of good news could cause a short squeeze and a price spike.
suchcrust
Suchcrust - 7 years ago
It's not recommended as your only, or even your primary approach. It makes a great secondary strategy with a high probability of market plus returns and lower risk than buy and hold. Ironically, I own MTH too and I used the Bernanke bounce to sell an out of the money call on it. You might make more $ on MTH or any other given stock, but I'm likely to make more on a basket of 10 stocks in a sideways or down market.
hameed
Hameed - 7 years ago
Gurufocus, what are the other "there are numerous candidate stocks that are reasonably cheap on an intrinsic value basis and that have above average volatility"?

What do you think is the general timeline horizon for USG to reach it's fair value? 2 years? 3 years?
suchcrust
Suchcrust - 7 years ago
Since I sell financial advice for a living, I'm not going to answer the first question for free. There's plenty of info on the site suggesting what's cheap vs. fair value (FV).

I have no idea when USG will reach FV--though your guess sounds about right. The beauty of the strategy outlined here is you can make good $ even if it doesn't.
kfh227
Kfh227 premium member - 7 years ago
I am torn on this strategy. I think covered calls are great, but I reserve them for when stocks are atleast 25% over IV.

I do naked puts which is a similar strategy, but the only risk is assignment of an undervalued stock. The best part is that no capital is put up, up front on my part. I simply take cash from others, a strategy I adore. naked puts ... this is another thread though. Do a search of the forums though, I've mentioned it in the past in more detail.

buffetteer17
Buffetteer17 premium member - 7 years ago
25% over IV? I'd just sell the stock. Unless there was a special consideration, such as long vs. short term cap gains.
bednaw
Bednaw - 7 years ago
Interesting! If this compliments the buy, hold, value strategy, what is the investing style of the call buyer?
rpatel
Rpatel - 7 years ago
kfh227 Wrote:

-------------------------------------------------------

> I do naked puts which is a similar strategy,

Naked puts aren't only similar, but exactly the same (with less capital up front as you mentioned)

From wikipedia -- Covered calls are synthetically the same as selling a naked put in the money.

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