Long-Term Options Plays: Mohawk, Whole Foods

A few days ago, I wrote about why I believed Mohawk Industries (MHK Quote) was a solid bet over the next couple of years. Mohawk commands a third of the flooring market, with Berkshire Hathaway's (BRKA Quote) Shaw unit commanding another third. Mohawk is operated by first-rate management, and the company produces gobs of free cash flow. (Don't miss "Free Cash Flow Rules: AmEx, Mohawk")

At the current stock price of $66, the business trades for less than one time book value. On the basis of a conservative free cash flow valuation, I determined that Mohawk shares could easily fetch $125 in the next two to three years. (The current Value Line estimate is $150 a share by 2012.)

So you have a company with solid assets trading at below book, a history of prodigious cash flow generation and a high probability of strong upside in a few years. With the current share price at $66, January 2010 calls with a $90 strike price currently cost $6.10 per contract. If you were planning to allocate $100,000 to buy the stock, why not allocate $40,000 to the long-term options? (The allocation decision will be unique for each individual investor; I'm simply using numbers for examples.)

If, by January 2010, Mohawk shares are fetching $110, your LEAPS are worth $20, a 214% return. Owning the equity at $66 and selling at $110 would yield a 67% return. Of course, if the shares are at $85, your options are worthless, whereas you would have made about 25% on equity trade.

So the most important consideration with any LEAPS investment is simple: You need a business with a very high probability of upside return with very low chance of downside. This being a down market, the hunting ground is much more fertile for such opportunities.

More Possible Plays

Whole Foods Market(WFMI Quote) offers another interesting play. With the stock at a multiyear low of $18, the business is trading at valuation metrics that we have not seen for years. This business is worth much more than where it is currently priced, for a number of compelling reasons [RealMoney access required]. And the Jan 2010, $30 LEAPS are currently $1.50 per contract. If Whole Foods is trading at $40 in 2010, your LEAPS are worth $10, or a 566% return. When times were good, Whole Foods fetched over $70 a share.