CSP Example: WFC

Note: I wrote this memo for private consumption about a month ago. With the decline in WFC, I have re-established a short-put position.


I just got off a 118 day cash-secured put campaign on Wells Fargo. I pegged WFC’s worth at about $60 or more, and it has been trading in the $51-56 range since April.

It isn’t rich enough for me to write covered calls on, or cheap enough for me to add to the position directly (I require a margin of safety of 20%).

wfc_csp

On April 10, I wrote 1 $54 put 25 days out (5/5 expiry), when the stock was trading at $54.42. After earnings, which came out right away, the stock dropped to $51.53, when I wrote another put $52 put, expiring 5/12. I booked premiums of $128 and $158, after commissions.

On 5/5, the stock traded above $54, and the first put expired worthless. On 5/12, the second put also expired OTM, with the stock trading around $53.

I immediately wrote 2 more $53 puts ($128), and rolled them over twice. Once on 5/25 ($174) and 6/8 ($126). On July 14, the stock ended above $53, and I let the position expire.

Overall, I collected $714 in premiums after commissions (on $10,600 cash outlay) over 118 days, for an annualized return of 33.5%.

This campaign reduced by effective buy price to $49.50, even though I ended up not buying any shares.

If WFC falls to $53 or below, I will probably embark on a new CSP campaign.

 

The Moat around Magic Kingdom

This summer we took a family vacation to Magic Kingdom in Orlando. My experience, (especially the $150 entry pass) re-emphasized the enormous pricing power of Disney.

While there were many other excellent theme parks in the vicinity, suggestions of substitutes went unproposed to my 4- and 8-year old daughters, due to perceived cruelty.

Next summer, we are also going on a Disney cruise with a bunch of extended family. The cruise costs nearly 2.5x as much as its competition.

I always knew that Disney had a strong moat. However, the observation of how powerless someone as cheap and brand-agnostic as me is, in avoiding paying up premium dollars, forced me to look at Disney the business after we got back from the trip. The recent swoon (after earnings) forced me to pen down my thoughts.

Background

Disney has four business segments. In the order of revenue generated in FY 2016,

  • Media Networks (ABC, ESPN, cable channels) – 43%
  • Parks and Resorts – 30%
  • Studio Entertainment (film, TV, home video) – 17%
  • Consumer Products (books, video games, licensing) – 10%

We can think of Disney as two units, Media Networks + Studio Entertainment, which contributes 60% revenues and 65% EBIT, and Parks + Products, which constitutes 40% revenues and 35% EBIT.

DIS is insanely profitable.

It boasts of consistent gross and net margins of approximately 45% and 15%, respectively. The return on equity has been around 15% since forever, and has occasionally breached 20%. The company is generally well managed; its long term debt/capital is about 25-30%. Over the past 10 years, the number of shares outstanding has been shaved by 20%.

Risk Factors and Opportunities

Subscriber Loss at ESPN and pay TV channels

ESPN earns ~$8/month per subscriber in bundled cable plans. People are moving away from bundled cable packages. This will hurt ESPN (and other channels) in the short and medium term.

  • Longer term (10 yrs), new sports contracts will reflect this deterioration, and will probably be priced accordingly.
  • Management will figure out a way to best monetize these assets. The situation may be more serious for other pay TV providers, which lack a franchise or differentiation.
  • The recent “DTC” move while painful in the short run, was inevitable. In the long run, it will probably look smart.

Heightened CapEx at Parks will Subside

Currently, CapEx/Sales at Parks and Resorts is high (25%). If and when it normalizes to the 15% level,  cash will start gushing out of the pike. Credit Suisse estimates that cash-flow will grow from $800m in 2016 to about $2.7B, when that happens.

Valuation

ROE

The long-term ROE is in the vicinity of 15%. If you hold DIS for long enough, your returns should be pulled or pushed towards this number, unless the story changes dramatically.

Multiple

For FY 2017, EPS is estimated to come in at about $6. At $103, DIS is trading at a PE of about 17. Given the quality of the company, it probably deserves to trade at a premium to the market. If we say it deserves a multiple of 20 (arbitrarily for now, will contextualize later), then it is probably worth around $120.

Terminal Model

Let’s use a simplified “terminal” model. Revenues have been growing at 5% or more since a long time. Operating and net income have been growing at 10% CAGR in the past, but let us suppose that this will taper down to 5% (same as revenue growth).

The return on capital has been around 12%, historically, while the cost of capital has been 8-9%. Given Disney’s moat, let us assume that is one of those rare moaty companies which can earn above its cost of capital, and continue to grow, thereby creating value. Note that this implies a reinvestment rate of 5%/12% = 40%.

It is estimated that DIS will earn an EBIT of about ($15.7B) $9.80/share in 2018 (fiscal years end in October).  Thus, the value of its operating business is,

Operating Value = NOPAT(t+1) (1 - growth/ROC)/(COC - growth)

= $9.80 * (1-0.35) *  (1 – 0.05/.12)/(.08 – 0.05) = $124/share. If we subtract the present value of the long term debt (~$13/share) from this, we get an estimate around $110/share for the equity.

Past Relative Valuation

Over the past 5 years, the PE ratio has varied between 15 and 25. Based on current earnings this implies a $90-$150 band. The EV/EBITDA has varied between 8.6 and 14 implying a slightly narrower $88-$140 valuation band. It must be remembered that over the past 5 years the stock has basically doubled.

Portfolio Activity

This year – so far – has been unusual.

Long Positions

I haven’t bought many new positions, except for the following.

  • increased my Oaktree Financial position by 33% at the beginning of the year for $40 (put got assigned)
  • doubled my position in Fairfax Financial around $435/share
  • started building a position in ALJ Regional holdings. Currently I am 1/2 or 2/3 full, at an average price just below $3.20.
  • bought a slug of IBM after the latest disappointment.

Consequently I am about 35% in cash.

My largest positions are “financials” BRK (15%), LUK (10%), FRFHF (8%), OAK (7.5%), and WFC (6.5%), and account for nearly 50% of my invested portfolio.

Options

I have been been trying to educate myself about using options more opportunistically. It has become a new weapon in my arsenal. It fits perfectly as an overlay to a long-term value investing strategy.

At some point in the year I’ve embarked on months-long cash secured put campaigns  on:

I’ve had shorter lived positions in HBI, FSLR, and NOV, in which the position moved away from me rather quickly.

I currently have open CSP positions on UA, GME, DIS, FAST, MSM, and STX.

Between 2010 and 2016 my total “income” from dividends and options increased from $3,000 to $9,000 (yield between 2-3%). So far this year (2017), I’ve generated about $18k of income from options and dividends, and feel reasonably confident about hitting $25k by the end of the year (yield >5%).

Investing Buckets

I like categorize stocks into three buckets.

Compounders

The first bucket is compounders.

This bucket includes stocks like BRK, MKL, WFC etc. that have solid revenue growth (secular or structural advantages), high returns on capital (good business/industry), and plenty of reinvestment opportunities.

These are the best companies to own. Their intrinsic value rises steadily with time. If you stick with them long enough, your returns will mimic the return on equity (~low to mid teens). If you can add to your position when the price dips significantly below the prevailing intrinsic value, your returns will be juicer.

Ideas - 39

With compounders, you let time do all the work. These stocks let you sleep soundly at night, and require hardly any upkeep.

The relentless increase in intrinsic value is forgiving of valuation mistakes. The risk of overpaying can be mitigated by long holding periods.

So what’s the catch? Why can’t we just invest in compounders?

Turns out, you and I are not the only people in town who have this “deep insight”. Since everyone sees how desirable such companies are, the market rewards them with high valuations. Opportunities to buy these companies at substantial discounts to intrinsic value are rare.

From my experience, they encounter blips about once in year or two, when some short-term setback gets temporarily mispriced. Here I am talking about decent prices, not “back-up-the truck” type prices. Those, unfortunately, are really rare.

Our edge here patience, decisiveness, and a long horizon. There is no informational or analytical advantage.

If you are like me (someone who has fresh periodic infusions of cash to deploy), the waiting can be frustrating, if that’s your only trick. You may think that having a list of 5-10 compounders on a watchlist might help. It does. But only partially. Often when opportunities arise in such stocks, they arise all at once (like the 2008-2009 crash).

Small Caps

The second bucket is small caps and foreign stocks.

Examples of these in my current portfolio include stocks like MNDO, CODAF, and RSKIA, which are all sub $500m companies.

These are profitable companies with strong balance sheets and decent returns on equity. In the past, I have invested in companies with poor or negative earnings, so long as the company’s assets provided a sufficient margin of safety. I have now mostly abandoned this cigarbutt strategy. Time is the enemy in such asset-based investments, as intrinsic value gets eroded by mounting losses.

If you can psychologically handle such investments, then you should absolutely invest in such companies. For a small investor, the universe of such companies is far larger than the universe of small profitable companies with light debt burdens.

I have tried to fish in that pond. But I have realized that I don’t enjoy fishing there as much. Being around morbid companies makes me feel pessimistic.

So these days, I focus only on profitable small caps with decent balance sheets. Our edge here is the relative lack of competition, and tolerance for illiquidity.

Some of these stocks will go months without trading. This is both a pro and a con. The small size and illiquidity keeps the big fish and traders away. The downside is that building reasonable positions in some of these stocks takes patience.

Liquid Mid and Large Caps

Finally, the third bucket of stocks is liquid mid and large caps.

Stocks that I currently own that fall under this bucket include AAPL, LUK, IBM, and NOV. Even though they are followed and owned quite widely their stock prices can fluctuate over a large range.

Consider AAPL for instance, the largest company in the world. Over the last year and change, its stock price has fluctuated between ~$90 to ~$155. During the dip last summer, I bought my last slug of AAPL shares at $96. I sold out of most of my position between $125-$135. I hold my last 1/3 position, which I plan to dispose of shortly. AAPL may not be overvalued, but I am not as comfortable holding it at $150 as I was when it was sub-$100.

In any case, this volatility creates an opening for overlaying some options strategies. The options on these securities have a vibrant market, due to their size and liquidity. Strategies like cash-secured puts and covered calls can be used to enter and exit positions, or generate income on the side.

A current example is NOV. The stock has been trading between $30 and $40 for nearly a year. At $30, I think NOV is cheap. At $40, I think it is reasonably priced. So every time it drops to the low $30s, I begin selling puts methodically. Every time it springs back to $40, I begin ratcheting some covered calls.

Revisiting GME

I looked at GME late last year, just as the share price moved away from me. I was not able to establish a position, but have been keeping an eye on it ever since.

Recently, the stock price fell back to the $20.xx range, and I started writing cash-secured puts, with the intent of establishing a 3-4% position.

Here is a slide-deck, which summarizes my current thoughts (Revisiting GME).

Basically, in the base case, I think the stock is worth somewhere between $25-30. In the worst case, it is worth somewhere around $15, while in the best case, it could be worth nearly twice its current worth. At current prices, it seems like an interesting risk-reward bet.

The stock has declined substantially, has high short interest, is extremely volatile, and pays a fat dividend. The sentiment against retailers is brutal. In short, if we have adequate faith in the valuation, it is an ideal candidate for selling options on.

Ask Chuck about Schwab

Charles Schwab (SCHW) offers brokerage, banking, wealth management and financial advising services. It is one of the largest brokerage and banking firms in the US, founded in 1971, with over 330 branches, almost all of which are in the US.

Resources

Some useful reports on SCHW on the web are listed here:

  • Boyar Research put out a case study in Sep 2013 (pdf) with an estimated value of ~$32/share. At the time SCHW was trading at $14.
  • The Brooklyn Investor looked at SCHW in Aug 2015, after Lou Simpson had established in a position. At the time SCHW was trading at $30, and BI thought that it was relatively cheap (14x PE) if interest rates normalized.
  • In Feb 2017, Argus Research put out a note arguing SCHW was worth $46, when SCHW was trading in the low 40s.

Background

Like Vanguard, SCHW provides real value to its customers.

It lead the drive to lower commissions, ramped up its ETF business with Vanguard like expense ratios, proactively waived client money management fees due to low interest rates, and starting to snowball its RIA services. It is a top notch company, leverages its scale in the brokerage and banking businesses, and has a potentially long runway in front of it.

A company creates value when it grows revenues, and commands high returns on capital. SCHW checks both these boxes.

Over the past 5 years, SCHW has grown revenues at 10%, EBIT and net income by over 15%/year. Operating and net margins have been relatively stable around 35% and 20%, respectively.  Book value has also grown at 15+% rate, while the return on equity has been in the 11-14% range.

SCHW has been able to crank out this amazing performance, despite multiple headwinds. The most significant challenge is the low interest rate environment. It is possible that some of these headwinds will slowly turn into tailwinds.

One can make a reasonable case that the current EPS ($1.30+) greatly understates the true earnings power of the business.

The company lays out the key drivers of near-term value in their April 2017 “Spring Business Update” presentation.

Screenshot from 2017-04-29 23-01-08

Essentially, the company is doing what it can to grow profitably. It cannot control a few factors, like taxes and interest rates. The current climate seems to suggest that both these factors might swing in favor of SCHW. As an example, each 25bp rise in interest rates increases cash flow by about $250m.

Valuation

There are several ways of valuing a high quality company like SCHW.

IRR =ROE

The ROE for SCHW is 10-15%. If interest rates rise then hitting or even exceeding the upper end of that range is likely. If one holds SCHW for a long time, then one should expect return to match ROE.

While this exercise doesn’t give us an intrinsic value, it tells us that if the valuation doesn’t change while one holds the stock, the gravitational pull (or push) is towards this 10-15% return.

10x PTI

Now let us consider Buffet’s 10x PTI rule for high quality businesses. Last year PTI was about $2.25/share, which would put the value around $22.50/share. This is nearly half of the current market price (~$40). As stated previously, SCHW is currently a coiled spring. If interest rates go up by 2%, PTI will go up by nearly $1.60/share, resulting in a 10x PTI of $38/share.

Financial Services Company

We can value SCHW using the equity method.

BV = book value of equity = $16,421M
ROE = return on equity = 15%
COE = cost of equity = 10%
nNI = normalized net income for next year = ROE * BV = $2,463M
g = stable earnings growth into perpetuity = 5%
p = dividend payout ratio = 1 - g/ROE = 67%
Equity Value = nNI * p/(COE - g) = $32,842M
Shares Out = 1,324 M
IV/share = Equity Value/Shares Out = $25.

This gives us a value of $25 without any sudden improvement in interest rates or the tax environment. To justify the current price of $40, we need to either get to high ROEs (20%, at 5.5% growth), or sustain much higher growth rates (8% at 15% ROE).

Summary

In the long-term, there are many ways to win with SCHW, because the intrinsic value is constantly increasing. There are not too many ways to lose, although depressed interest rates can impair its underlying earnings power.

Estimates of value are all over the place. The floor seems to be somewhere around $25 (a price it was trading at not too long ago) – and can be justified essentially if nothing clicks as hoped. On the other hand, the current price of $40 seems fully priced, and assumes about a 1-2% increase in interest rates in the next year or so.

Yes, SCHW is an above average business, and probably deserves a premium. It is stock that one could hold on to for a long time, without any headaches. Perhaps, a good strategy might be to scale into a position in the $25-35 range.

If the market undergoes a correction (as it certainly will sometime in the future), I might have to keep an eye out for SCHW. But right now, it is a pass.

The Allure of Cash Secured Puts

Recently, I wrote an example of a CSP campaign on VFC.

The ideal layup for CSPs is the following:

  • you are interested in a liquid large cap stock,
  • options on the stock are available and liquid,
  • you have done a valuation and price is below the intrinsic value,
  • however, (intrinsic value – price) > margin of safety,
  • the stock has fallen in the recent past (greater implied volatility),
  • you have tons more cash than ideas.

Let’s consider my campaign on VFC, and how it ticks many of the conditions above.

Liquidity

VFC is a large liquid large cap stock. Its market cap is ~$21B, and nearly 3M shares trade every day. Monthly options are available on VFC, and the ATM calls have a daily volume of a few thousand. Bid-ask spreads on such options are usually between 5-20c. While this is not as liquid as a megacap like Wells Fargo or Apple, it is sufficient.

Valuation

I did a valuation of VFC, and determined that it was worth somewhere between $55-$70. Lets pick $65 as a point estimate of the intrinsic value. I like to buy stocks with at least a 20% margin of safety.

Thus, I would be interested in VFC at 80% * $65 ~ $52. Since VFC is a reasonably safe, unexciting, range-bound stock, which pays a 3% dividend – I really don’t mind buying it around that price – although I would really like to buy it under $50.

Environment

Two years ago, VFC used to trade over $70. In the past year, its range has been $48-$65. Thus, it has had a somewhat rough time.

At the same time, the overall market is going gangbusters. I haven’t found too many new opportunities. My cash balance is over 35% of my portfolio. The only stocks I have bought in the past six months are OAK, FFH.TO, and ALJJ. I have liquidated a lot more. I don’t mind diverting a small part (say 25%) of my cash balance towards CSPs.

Advantages

CSPs open up the universe of investable ideas. For ideas where there is insufficient margin of safety, it provides a method to work out a reasonable cushion by embarking on a campaign that can last several months. It lets you lower the effective buy price below what the market offers over that time period.

It also helps psychologically.

I know we are all supposed to be patient and wait for the really fat pitches. But the wait can be really hard and exasperating. It gets harder as you continue selling positions that have risen above your estimate of fair value, and the cash keeps building up. Furthermore, if you are adding external cash to your portfolio like me, it just compounds the aggravation. All that cash has nowhere to go.

CSPs help alleviate frustration, by keeping you productive and busy. They increase the size of the available opportunity set. They prod you to keep looking. If done carefully, they either lower your effective buy price, or help you collect some income on the side, while you wait for the market to swoon and offer better opportunities.

Either way they prevent you from splurging on something overpriced, or going crazy.