This was originally published on RealMoney. It is being republished as a bonus for TheStreet.com readers.
You don't often hear the terms "value investing," "fundamental analysis" and "equity options" used in the same sentence. That's because stock options are speculative in nature; they have definite life in which your bet has to play out. In addition, time is
on your side when you buy options, whereas, with stocks, time is an investor's best friend.
Nonetheless, with so many great businesses getting clobbered because of the sloppiness of some of the financial institutions, an investment via long-term options, or LEAPS, can offer a compelling bet: little upfront capital with the possibility of huge gains. But since you are getting involved with a decaying financial instrument, LEAPs should be used on only the most compelling investment ideas.
LEAPS, or long-term equity anticipation securities, are long-term options on a common stock. Generally, LEAPS have a duration of two years, but sophisticated investment firms can create longer-dated LEAPS.
The appealing quality of LEAPS is obviously the length of time imbedded in the option. The common mistake that investors make with options is not a matter of making the wrong call but rather not having enough time in the option to allow a strategy to play out.
LEAPS provide the investor with sufficient time, so that usually is not the issue. Two years should be sufficient time for any business to regroup from most operating environments. The issue to consider when buying a LEAP sits squarely on the underlying business.
Invest, Don't Speculate
The use of LEAPS is most prudent and successful when it is most businesslike. The primary advantage of buying LEAPS vs. the outright stock is of course the capital that is required. Buying LEAPS requires a fraction of the capital needed to buy an equivalent amount of stock. Yet the disadvantage of owning LEAPS vs. the stock is that if your analysis is wrong, then you could lose 100% of your capital. So use LEAPS only when the odds of success are skewed heavily in your favor.
A few days ago, I
wrote about why I believed
was a solid bet over the next couple of years. Mohawk commands a third of the flooring market, with
( BRKA) 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) 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
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.
Another solid bet is
, the retailer controlled by investor Eddie Lampert. If you look at Sears as a retailer, then you might not see a bright future. But if you look at Sears as a company run by one of the best long-term money managers around who happens to own over 50% of stock for himself, Sears could be worth a lot more.
Don't forget that Berkshire Hathaway was once a textile mill. Sears is off more than 50% from its all-time high and is currently at $88 a share. If you believe Lampert can deliver the goods, then the LEAPS are worth some examination.
With bright prospects for equities in 2008 all but gone, participation in LEAPS today can yield terrific results for investors who have the patience. The current sharp decline in equity prices further brightens the picture.
(Note: Current financial Web sites are displaying January 2010 options as being the longest-dated. However, your broker can inform you of the longer dates.)
This was originally published on
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At the time of publication, Gad was long Berkshire Hathaway, although positions may change at any time.
Sham Gad is the managing partner of the
, a value-centric investment partnership modeled after the original 1950s' Buffett Partnerships. Previously, Gad was a writer for The Motley Fool and a securities analyst for UAS Asset Management, a small, value-focused fund in New York City.
Gad also runs a
inspired by the teachings of Benjamin Graham and Warren Buffett. Gad is working on a value investing book (title forthcoming) to be published by John Wiley and Sons in the summer of 2009. Reach Gad at