This is the third and final article in a series exploring the use of options to minimize risk but potentially still earn a reasonable rate of return under circumstances in which someone wants to save for a large purchase in 3-5 years but is not satisfied with the 1% risk free returned offered by CDs, at least as it relates to all of the money saved.  In the first article, we set up the scenario and discussed the various saving options.  In the second article, we discussed how buying a put option tied to the stock being purchased would work from a practical standpoint, as well as what would happen if we also sold a call option to reduce the cost of buying the put option, using JNJ as an example.  In short, we learned that the put option limits your downside exposure significantly, but the potential loss, due to the cost of the put option, is still likely 5-10%.  Your upside opportunity on the stock is unlimited.  As a result, the strategy itself is viable, but certainly not risk free, and it should be used in very limited circumstances.

In this article, we are going to create a list of criteria to find good candidates for implementing this strategy and look at the cost of their put options.  The goal is to find companies that are low risk relative to the overall market, so a beta (which measures volatility compared to benchmark, usually the S&P 500) less than 1.0.  I also looked for stocks that appear to be a good value relative to their expected future growth, so a PEG (price to earnings to growth rate ratio) less than 1.25.  The remaining criteria are stocks with a market capitalization greater than $5 billion, an expected earnings growth rate of at least 5% a year for the next five years, a return on equity greater than 10% and a dividend yield of at least 2%.  Of the 15 results, I removed stocks that had not been increasing their dividends each year, I removed a MLP (master limited partnership), stocks that did not offer longer term options (January 2014 to be exact) and stocks that met the above criteria but for other reasons did not appear to make sense in terms of our goal of finding conservative, strong companies.

The six remaining stocks were Cardinal Health (CAH), Darden Restaurants (DRI), Home Depot (HD), Intel (INTC), Raytheon Company (RTN) and United Parcel Service (UPS).  Here is the chart using Yahoo and Morningstar as of 5/13/2012:

Here are the costs of their respective January 2014 put options closest to their current stock price:

INTC $27 put option = $4.25, or 15.4% of the purchase price of a share of INTC stock

CAH $40 put option = $5.15, or 12.1%

DRI $50 put option = $8.10, or 16%

HD $50 put option = $7.15, or 14.2%

RTN $50 put option = $5.30, or  10.2%

UPS $75 put option = $8.10, or 10.8%

Let’s run through the analysis for Darden Restaurants (DRI), as it has the lowest beta, the second highest yield, the highest dividend growth rate, a good PEG and ROE.  Our goal was to save $200,000 towards a large purchase in 3-5 years, and we are two years in with $100,000 saved.  Our client is ready to put approximately $25,000 towards this strategy, with the other $75,000 and all future savings going into CDs, money market account and short term individual bonds.  Again, all of this money is separate from 401k contributions, IRAs, whole life insurance and other savings as part of the regular investment plan.  So we purchase 500 shares of DRI at $50.63/share, for a $25,315 purchase price.  We also purchase a put option for January 2014 @ $50/share, for $8.10 x 500 shares, so our purchase price is $4,050.  Our total investment is $29,365, not including transaction costs of hopefully under $50.  Depending on when we want this money, we could possibly sell our January 2014 puts late in 2012 or early in 2013 and purchase January 2015 puts, but for simplicity sake, lets assume that we intend to access this money in late December 2013.  Also for simplicity sake, lets assume that the dividend of $0.43 a share each quarter does not rise prior to January 2014, so we have quarterly dividends of $215, or $1,290 in dividends received over the six quarters between now and late December 2013.

If in late December 2013, DRI is trading for $40, then our 500 shares are worth $20,000, our put is worth at least $5,000, and we have received $1,290 in dividends, against which we must offset our purchase price of $25,000 for the stock and $4,050 for the put, for a total loss of $2,760, which is slightly under 10% of our initial investment.  Note that if DRI is trading at $20 in late December 2013, then our loss is still that same maximum of approximately $2,760.  If in late December 2013, DRI is trading for $60, which is certainly what we are hoping for, then our 500 shares are worth $30,000, our put is worthless and we have received $1,290 in dividends, against which we offset our purchase price of $25,000 and $4,050 for the put, for a gain of $2,240, or approximately 8% over the past year in a half.  Compare this to the gain on that same $29,050 if invested in a CD at 1%, which in 18 months would be approximately $29,487, for a gain of $437 with compounding interest.

As I’ve mentioned in the other articles, this is not a risk-free alternative, but it is an alternative that may be worth considering under limited circumstances.  As always, do your own due diligence or seek the advice of a professional before investing.

-Richard

Prosper Financial Management, LLC and Richard Pearce do not own any of the securities mentioned in this article and will not initiate any positions in any of the securities mentioned for at least 72 hours.

To follow up my prior post regarding some of the large U.S. and foreign banks, below is a similar chart regarding some of the medium and smaller U.S. banks.

This information is from Morningstar and Smartmoney on February 22, 2012, and yes, that 3370 number is correct.  Anyway, as with the big banks, there appear to be some banks that have been fairly stable throughout the banking crises, have rebounded nicely, and are still paying a decent dividend.  There are others that have taken more of a beating, as reflected in their P/B ratio and their PEG ratio.

The banks that stand out to me are Bancorp South, Inc. (BXS), Suntrust Banks, Inc. (STI) and Zions Bancorproation (ZION).  All three are trading under their book value and with PEG ratios under 1.0, which indicate that they may be good values for the long run.  In particular, Bancorp South, Inc. appears to be in good financial shape and is still trading pretty close to its 5 year low.  All three have plenty of room to run as they shore up their balance sheets and the market gives banks a more reasonable valuation.  Consider purchasing BXS and/or STI as a long-term value play as investor perception of banks eventually rebounds and banks shore up their balance sheets.

On the more conservative side, BOK Financial Corporation (BOKF) appears to be in much better shape, as it managed to increase its dividend throughout the banking crises, has a solid balance sheet and is yielding approximately 2.5%.  Its P/B and PEG ratios are both 1.3, which is higher than the other banks listed above, but that results from its stability and conservative nature.

Another bank worth keeping an eye on is Republic Bancorp, Inc. (RBCAA).  This bank primarily operates in Indiana and Kentucky and it is where I bank.  Its P/E ratio at 6 is quite low compared to its 5 year average and range, and its has been able to raise its dividend the past few years.  Having been to 4-5 of its branches, I have received excellent service and had a good experience every time that I have been there.  On the other hand, although I do most of my banking online, I have rarely, if ever, been to a branch when it was crowded.  More often than not, it is either empty or there are one or two other people inside.  I realize that is anecdotal, so take it for what it is worth.

As always, do your own due diligence or seek the advice of a professional before investing.

-Richard

Prosper Financial Management, LLC does not own any of the securities mentioned in this article.  Richard Pearce owns shares of Suntrust Banks, Inc. (STI) but none of other securities and will not initiate any positions in any of the securities mentioned for at least 72 hours.

Below is a comparison of many of the large U.S. and international banks.  The information was taken from Morningstar and Smartmoney on February 21, 2012.

If I am going to recommend an individual stock, however, it needs to be a special opportunity.  Depending on the individual investor’s goals and risk tolerance, there are two risky long-term plays and two safer plays.

Citigroup (C) is somewhat unique compared to the other U.S. banks in that it has significant foreign and emerging market exposure.  In addition, although it has a significant amount of bad debt still on its books, it appears to be well positioned to continue its turn around.  Citigroup’s upside is significant, as it has a P/B ratio of 0.6 (no doubt reflective in part of an expected continued deterioration of its balance sheet) and a PEG of 0.7.  Its price and PE ratio are near its 5 year low. Again, this is a risky stock, but I believe that most of the downside is priced in and I am going to add it to my “Top 25″ at the price mentioned above as of today’s date.

Bank of America (BAC) appears to be in similarly poor shape to Citigroup.  BAC’s P/B ratio of 0.4 is the lowest of the U.S. banks listed above and its PEG of 0.7 is quite low.  I review BAC as a riskier version of Citigroup with similar upside.

On the more conservative side, I like Barclays PLC (BCS) and Credit Suisse Group (CS).  Barclays managed to avoid the bailouts provided to RBS and Lloyds during the banking crises, but it significantly diluted its shareholders and continues to have some financing issues.  That said, its debt level appears to be manageable, its P/B ratio is 0.6, which appears to be too low relative to its competition, its PEG is 0.9 and it pays a 5% yield.

Credit Suisse Group had a very rough fourth quarter of 2011, although it managed to handle the banking crises fairly well and without diluting its shareholders like Barclays.  Credit Suisse Group, like  Barclays, has a P/E ratio slightly above its 5 year average, though it has a P/B ratio slightly under 1.0 and a PEG of 1.0.  It is yielding 5.4%.  Barclays and Credit Suisse Group appear to be more conservative ways to play the eventual banking rebound while collecting a significant dividend in the meantime.

In my next article, I will review some of the smaller U.S. banks to see if there are any stocks worth purchasing.  As always, do your own due diligence before purchasing any security mentioned here or in any article.

-Richard

Prosper Financial Management, LLC does not have any interest in any of the stocks mentioned above nor will it initiate any such position in the next 72 hours.  Richard Pearce holds options on BAC only, and will not initiate a position on any of the other securities in the next 72 hours.

With natural gas trading at multi-year lows (which always gets my attention), the contrarian in me wanted to see whether there is way to play what should, eventually, be a bull market in gas.

First, the negatives.  There has been an increase in production of natural gas without a matching rise in demand, newly discovered reserves, the development and use of methods to increase the production of current wells, and other factors that have kept the price of natural gas down. Of course, economically speaking, when natural gas becomes cheap enough, some suppliers exit the market, companies find additional uses for natural gas, and eventually, not only will supply (at least from the production standpoint) fall to some degree, but demand will also rise and prices will increase.

Unfortunately, there is not an efficient, direct way to invest in natural gas. UNG and GAZ are ETFs (exchange traded funds) that use the next month’s natural gas futures contract as a method to track the price of natural gas.  This results in multiple problems, including inaccurate tracking of the commodity and the potential for a state of “contango”, where the price of the next month’s futures contract exceeds the current month’s futures contract and therefore the fund loses money each month, perhaps even if the actual price of natural gas rises.

Chesapeake Energy Corp (CHK) is the second largest producer of natural gas in the United States, has significant reserves and is vertically integrated in the production of natural gas.  CHK has a PE ratio of 12.4, which is well above its 5 year low of 6 and even above its 5 year average of 10.  Its PEG ratio of 1.0 indicates that the company may be undervalued relative to its expected future growth rate.  CHK’s dividend has either increased, or been steady, over the past ten years, and it currently yields 1.42%.  CHK has overcome some significant financing issues, particularly in 2008, and has a significant amount of debt.  I do not like that its current liabilities exceed its current assets, that it has a significant negative free cash flow, and that it has net losses in some recent quarters.  In an industry that is itself fraught with risk because of its relationship to the price of natural gas, I cannot recommend purchasing CHK unless its price further decreases or its major risks become satisfactorily mitigated. It is, however, one of the most direct plays on natural gas and should be carefully watched going forward.

Apache Corporation (APA) is a very diversified company, being involved in the production of both oil and natural gas, with projects across the world.  APA’s PE ratio of 10.6 is quite a bit higher than its 5 year low of 6.4.  It’s PEG of 0.8 indicates that it is perhaps undervalued relative to its projected growth.  APA’s yield, at 0.62%, is quite low, and the payout has been flat for a number of years.  This stock appears to have much less risk than CHK, although it is not as pure of a natural gas play.

Devon Energy (DVN) is an oil and natural gas producer that is primarily focused in the U.S. and Canada.  Its PE ratio of 15.1 and PEG ratio of 1.5 are both high compared to its competition and perhaps reflect its very stable financial position. DVN’s yield of 0.91% is not compelling and dividends have not increased significantly in the past five years.  This company appears to be a classic example of a good company that is not a good buy right now.

EOG Resources (EOG) is primarily a natural gas producer, although it is increasing its production of oil and natural gas liquids.  Its PE ratio of 29 is significantly above its 5 year low of 5.6 though well below its 5 year average of 48.  Its PEG ratio of 0.6 is very attractive, both in general and compared to its competition.  The yield, at 0.56%, is not impressive, but it has increased significantly over recent years.  EOG appears to be worth further consideration due to its healthy financial position, rapidly increasing dividend, and significant potential for future growth.

Comstock Resources, Inc. (CRK) predominately produces natural gas, and is a much smaller producer than the above companies.  CRK is trading near a multi-year low and is trading under its book value, at 0.7.  It also has a PEG of 0.6.  From a value standpoint, it looks great, but it had a net loss the past two years and does not pay a dividend.  The company appears to have difficulty meeting its current liabilities without additional borrowing, and it is attempting to shift away from natural gas to produce more oil.  At first glance, it is difficult to tell whether this company is going to be a profitable turn around story or a company that is going to continue to struggle.

Contango Oil & Gas Company (MCF) produces mostly natural gas liquids and natural gas, with minimal oil production.  It is primarily focused on the Gulf of Mexico.  It’s PE ratio of 14.5 is in the middle of its 5 year range and it does not pay a dividend.

Spectra Energy Corp. (SE) is formerly part of Duke Energy, and handles natural gas gathering, transmission, processing, storage and distribution.  It is different than the above companies, in that it is not involved in exploration or production, but rather almost every other aspect of getting natural gas to market, so while it is still a natural gas play, it is not quite as tied to the price of natural gas.  I like the revenue mix of Spectra, in that some aspects of its business have a high moat, such as the pipeline business, and others have the opportunity for significant expansion and growth.  Spectra’s PE ratio of 16.8 is higher than its 5 year average, and its PEG of 1.8 indicates that its PE is high relative to its expected future growth.  Spectra’s yield of 3.62% is significant and it’s dividend has either been flat or increased in every year of its existence.  Spectra does not appear to be a good company to purchase now because of its high valuation, but it is worth keeping an eye on as a long term purchase if the price declines.

In short, none of these companies appear to be great purchases right now.  Either they have a significant amount of risk as a result of heavy debt loads, or else they are fairly priced or overpriced as a result of being in good financial condition.  That said, if you are looking to make a long-term natural gas play, do your own due diligence and consider purchasing one of the safer natural gas plays, such as SE or EOG, along with one of the riskier ones.

In a separate article, I will examine master limited partnerships (MLPs), including natural gas-focused ones, to see if any are strong buys now.

-Richard

Neither Prosper Financial Management, LLC nor Richard Pearce own any of the stocks or ETFs described above nor intend to make any purchases in the next 72 hours.