Dykstra: Pick Profitability at a Bargain

Monday's market plunge -- sending the Dow Jones Industrial Average below 7000 -- has made it ever harder to find profitability the conventional way. My deep-in-the-money call options trading system, which has a win record of 95-1, sidesteps the conventional buy-and-hold strategy. I look for returns through options plays on undervalued stocks that I expect to pay off more quickly.

I get this payoff by setting limit orders $1 above my average call-option contract price. When the contract gets that $1 boost, I cash out. My secret sauce is in the stock picking. Through my Nails on the Numbers newsletter, I issue specific stock picks, strike price and contract prices.

Nails on the Numbers

Market volatility has pushed up contract prices on stock options, making some of them too expensive for my taste. But Monday's down market let us get an options position on Cameron International ( CAM). In a rocky market, positions like this one pay off quickly.

I'm also waiting to close out open positions in Dow Chemical ( DOW), Cisco ( CSCO) and Terex ( TEX), among others. But all of my open positions have at least until January 2010 to meet their targets.

When I pick stocks for options trades, I look for continued profitability at a bargain price. One of the simplest measures of a stock's profitability is its return on equity. This metric can vary widely from company to company. It is expressed as a percentage and boils down to net income divided by total shareholder equity -- or the company's book value.

It's fairly easy to calculate, although you need the shareholder equity figures for both the most recent year and the year prior in order to derive total shareholder equity for a fiscal year.

For example, in the case of Home Depot ( HD), the company's shareholder equity remained nearly constant at $17.78 billion to its last fiscal year. Averaging the total shareholder equity for both years, we get $17.746 billion. Dividing the company's net profit of $2.26 billion for the past four quarters by that average book value gives us a return on equity of 12.7%, down from 21.4% a year ago.

That drop is probably fairly common in this market because of declining profits at most companies. Yet, some companies have reported an increase in return on equity. Looking behind the bare ROE rates at the actual profit and book values is important, because a jump in the rate of return can be misleading.

This is true for IBM ( IBM), which showed a big jump in ROE to 58.8% in 2008, from 36.6% for the prior year. Net income did rise 18.6% year over year to $12.34 billion, but that does not account for such a big change to ROE.

Rather, Big Blue's book value shrank an astonishing 52% year over year due to a "remeasurement" of its pension obligations. IBM's shareholder equity dropped to $13.5 billion at the end of 2008, from $28.5 billion a year earlier. That's a big bite out of IBM's retained earnings.

And at Caterpillar ( CAT), ROE climbed a few percentage points in 2008, to 47.5%, as shareholder equity value fell 31.5% year over year to $6.1 billion. Net income growth for the period was flat at 0.5%, or $3.56 billion.

So, when looking at profitability, look at the numbers behind the ratios to be sure you're seeing the whole picture.

Lenny Dykstra manages Nails on the Numbers, a subscription service sold by TheStreet.com. Mr. Dykstra is 92-0 in his options picks this year. Click here for a free trial to Nails on the Numbers. Mr. Dykstra writes regularly about options trades for TheStreet.com.

At the time of publication, Dykstra had no positions in stocks mentioned.

Nicknamed 'Nails' for his tough style of play, Lenny is a former Major League Baseball player for the 1986 World Champions, New York Mets and the 1993 National League Champions, Philadelphia Phillies. A three time All-Star as a ballplayer, Lenny now serves as president for several privately held businesses in Southern California. He is the founder of The Players Club; it has been his desire to give back to the sport that gave him early successes in life by teaching athletes how to invest and protect their incomes. He currently manages his own portfolio and writes an investment strategy column for TheStreet.com, and is featured regularly on CNBC and other cable news shows. Lenny was selected as OverTime Magazine's 2006-2007 "Entrepreneur of the Year."

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