Buy and Write on Boring Wal-Mart for Un-Boring Total Returns
$400+ billion sales Wal-Mart needs no introduction. Value Line awards them an A++ financial strength, their highest safety rating and 100th percentile rankings [with 100th being best] in both ‘stock price stability’ and ‘earnings predictability’. Morningstar rates them 4-stars (out of 5) and sees ‘Fair Value’ as $60 /share. Standard and Poors gives them a ‘strong buy’ (5-star) rating and carries a 12-month target price of $62 /share. They agree with VL on the A+ financial strength (S&P’s highest score).
Why, then, are WMT shares near their 52-week lows? When the market tanked about one year ago investors flocked to Wal-Mart as a safe haven that figured to benefit from the ‘trade down’ in retail due to the punk economy. WMT hit $60.22 last October 6th on its way to posting FY 2008 earnings of $3.42 /share.
Now with EPS for FY 2009 (ends January 31, 2010) expected at $3.58 the shares are offered at $49.06 – just 6.1% above their 52-week low of $46.25. The huge run up in stocks since last March has bypassed Wal-Mart. Investors in safe, boring WMT have seen losses of 12.4% since the end of 2008. That makes money managers loathe to show its shares in their portfolios as they’d be sure to attract criticism.
Here are Wal-Mart’s per share numbers from (cont. ops) as reported byValue Line:
|
FY
|
Sales
|
C/F
|
EPS
|
Div.
|
B/V
|
Avg. P/E
|
|
2002
|
55.64
|
2.61
|
1.81
|
0.30
|
8.95
|
30.3x
|
|
2003
|
59.46
|
2.95
|
2.03
|
0.35
|
10.12
|
26.9x
|
|
2004
|
67.36
|
3.47
|
2.41
|
0.48
|
11.67
|
22.8x
|
|
2005
|
75.01
|
3.78
|
2.63
|
0.58
|
12.77
|
18.3x
|
|
2006
|
83.51
|
4.27
|
2.92
|
0.65
|
14.91
|
16.0x
|
|
2007
|
94.27
|
4.83
|
3.16
|
0.83
|
16.26
|
14.9x
|
|
2008
|
102.23
|
5.16
|
3.42
|
0.93
|
16.63
|
16.2x
|
Zacks sees FY 2009 and 2010 earnings of $3.58 and $3.89 making the multiples 13.7x and 12.6x respectively. That’s the lowest valuation ever for these high-quality shares and less than half the P/E level of 2002.
Wal-Mart raises the dividend each year. At today’s rate of $0.2725 quarterly, the current yield is 2.22%. That’s the highest payout ever for WMT and it compares quite favorably with rates on bank CDs, money markets and T-bills. It’s well covered at about 30% of this year’s earnings.
A return to even 15 times next year’s estimate would bring these shares back to $58.35, about 19% above today’s close. With the dividend added in you’d see approximately 22% total return by the end of 2010. (There will be 5 quarterly ex-dividend dates between now and then). Value Line sees a 3-5 year P/E of 16.5x while Morningstar assumes a long-term normalized P/E of 17x.
Risk? The absolute lows touched in calendar 2005-2006-2007-2008 and 2009 ranged from $42.10 to $46.30 - all when sales, cash flow, earnings and dividends were less than they are today.
If you’re not swinging for the fences WMT shares seem to provide a reasonable yield and a shot at sustainable double-digit capital gains.
Here’s a relatively low-risk way to make even better returns…
|
|
Cash Outlay
|
Cash Inflow
|
|
Buy 1000 WMT @ $49.06 /share
|
$49,060
|
|
|
Sell 10 Jan. 2011 $50 Calls @ $4.60 /sh.
|
|
$4,600
|
|
Sell 10 Jan. 2011 $50 Puts @ $6.20 /sh.
|
|
$6,200
|
|
Net Cash Out-of-Pocket
|
$38,260
|
|
If WMT shares creep up to at least $50 (+ 2%) by Jan. 21, 2011:
· The $50 calls will be exercised.
· You will sell your shares for $50,000.
· The $50 puts will expire worthless.
· You will likely have received at least $1,363 in dividends.
· You will have no further option obligations.
· You will end up with no shares and $51,363 in cash.
That’s a best-case scenario net profit of $13,103/$38,260 = 34.24%
achieved on shares that only needed to rise by 2% from trade inception over
the less than 15.5 months from start to expiration date. That’s better than 26% /year
on an annualized basis.
What’s the downside?
If WMT shares remain < $50 /share on January 21, 2011:
· The $50 calls will expire worthless.
· The $50 puts will be exercised.
· You will be forced to buy another 1000 WMT shares.
· You will need to lay out an additional $50,000 in cash.
· You will likely have received at least $1,363 in dividends.
· You will have no further option obligations.
· You will end up with 2000 WMT shares and $1,363 in cash.
What’s the break-even on the whole trade?
On the original 1000 shares it’s their $49.06 purchase price less
the $4.60 /share call premium = $44.46 /share.
On the ‘put’ shares it’s the $50 strike price less
the $6.20 put premium = $43.80 /share.
Your break-even would be the average of those two figures or $44.13 /share
(without dividends) or $43.45 /share (including the yield). Wal-Mart could fall by
up to (-11.4%) without causing a loss on this trade.
That $43.45 break-even price would be very close to the absolute low
prices since 1999 and at about 11.2x the projected EPS for the fiscal year
ending in January 2011.
Summary:
Wal-Mart is a low-risk, steady grower with a low valuation and a decent yield. A rebound to a still lower than normal P/E should bring these shares back to $58 or better over the next 12 – 18 months.
Selling both puts and calls at the $50 strike for January 2011creates a wide band of profitability that would allow for a 34% total return on any price increase of 2% or greater.
Even if I’m wrong you’d be protected against loss as long as WMT holds above $43.45 through expiration date in January 2011.
Disclosure: Author is long WMT shares and short WMT options.
Paul,
You are overstating the ROI %. You should not use options income to both reduce the numerator and increase the denominator (double dipping).
In addition, you are not indicating if your short put is cash-secured or margin secured and your investment needs to reflect the extent of your cash securitization as well.
My recommendation is to (1) treat all options income as returns on investment; and (2) assume 100% cash-securitization of short puts.
Thus, in your example:
Income = $4,600+$6,200+$1,363+($50.00-$49.06)*1000 = $13,103
Investment = ($49.06+$50.00 for cash-secured put)*1000 = $99,060
Maximum Potential Annualized ROI % (If Exercised)= 10.2%
= ($13,103/$99,060)*(365/473 days)
@Jeff
Sorry, but I should have said “increase the numerator and decrease the denominator”
My numbers reflect best-case scenario, cash-on-cash returns. It also assumes you are writing your puts against marginable equity already held in the account rather than agaist cash.
If WMT finishes above $50 you weill never have to lay out another penny from the original $38,260.
Even if you countedf cash requirements you would only tie up 20% of the $50 strike price on the puts (as a maintainence requirement or $10,000 - not the full $50,000 amount you are using.
Jeff,
To see how your numbers are flawed consider the return on just buying the shares at $49.06 and selling only the $50 calls at $4.60/share.
Your outlay would be………….. $49,060
less call premiums recevied ……. $4,600
Net original cash outlay ……… $44,460
Less Dividends Received ……….. $1,363
Net final cash outlay ………… $43,097
If WMT finishes above $50 …
You will be called and receive …. $50,000
Net total profit (without puts) …. $6,903
$6,903/$43,097 = 16.02% for stock with covered calls only.
By definition, if the shares are called (vecause they’re above $50 then the $50 puts (if written) would expire.
The $6,400 extra profit would be in addition to the 16% already earned on the stock and calls.
Paul,
1. Re your comment “assumes you are writing your puts against marginable equity already held in the account”, the marginable equity you are holding must be added into the denominator.
2. Re your comment re covered calls only position=16.02%, I agree. If you annualize that, the resulting 12.36% [16.02%*(365days/473days)] is fairly close to the 10.2% I show for the combined investment.
To think through this further, calculate your potential return % if you established a short put alone (without the covered calls).
Jeff
A short put on a $50 strike price requires just 20% in maintenance for margin purposes or $10,000 of actual cash tie up.
A $6,400 profit on that requirement would be a 64% return on capital.
Even if you use a 100% cash requirement you would only need $43,600 of your own money as $6,400 could come from the sale of the puts.
If the puts expire you would make $6,400/$43,600 = 14.68% even on a 100% cash-secured put.
Using marginable equity already in your account [to write against] does not reduce your cash-on-cash returns by one penny. You would make the exact cash-on-cash return described in my original write-up.
I have to go with Jeff on this. By basing returns on the use of margin, you’re not giving a fair assessment of the transaction. For example, no IRA account holder could do that transaction without the puts being cash-secured.
Plus, eliminating the use of margin cuts your percentage return calculation by over half, which means your position is getting most of its gains from the margin itself, NOT the puts and calls.
> If the puts expire you would make $6,400/$43,600 = 14.68% even on a
> 100% cash-secured put.
But then it also affects your calculation of the cost basis of your original stock purchase since you can’t use that $6400 to decrease your cost basis of the stock AND use it to offset the cash requirement of the put.
Without margin, I only see a best-case return of about 15%. A far cry from 34%.
Paul,
I would hope that you would agree that using only the minimum 20% margin securitization would not be a prudent, advisable approach for anyone. Since many investors who use covered calls do so in retirement accounts (such as IRAs), I’d recommend you consider using only 100% cash-secured positions in your examples, especially since most major brokerage firms (including Schwab which is my broker) require no less than 100% cash-secured puts within IRAs.
In addition, please reconsider the double-counting issue in your most recent comment. You cannot rightfully both subtract the options income from your investment and also count it again as a return on that same reduced investment. One or the other, but not both!
Jeff
Jeff,
Covered calls [even in IRA accounts] have no margin requirement other than holding the proper number of underlying shares.
I don’t do put writing in IRA accounts BECAUSE I’d have to be 100% cash secured and that takes away most of the benefit of put writing.
If you have plenty of paid-up equity in a margin-type account writing against 20% - 50% requirements is absolutely fine to do. You’ll have more than enough buying power for the occasional put exercise.
If you write covered calls you can absolutely deduct the call premium from your net investment amount.
Buy 100 shares at $10 for a $1000 original outlay.
Sell 1 $10 call for $1.25/share and receive $125.
Your net outlay is $875.
If the shares are later called you made $125/$875 = 14.28%.
The call premium helped pay for your stock and reduced your outlay.
You could withdraw the $125 or reinvest in in anything else you like. It is no longer at risk or part of your investment calculation.
Paul,
Respectfully, if your shares are called you will receive:
$10 (the strike) x 100 = $1000. That’s the same $1000 you used initially to buy your shares.
You will now have your orig investment plus the $125 premium.
So your return is 125/1000 = 12.5%
I agree with Jeff. The fact that you get your return delivered to your account at the beginning of the trade does not change the fact that you need $1000 in stock in order to write the call. You invest the $1000, you earn the $125.
In a Buy/Write order, your account may be debited only $875, but the short call is booked as a negative number too. The total is still $1000. You don’t really “get” the $125 until expiration.
Paul/Jeff,
Hope you don’t mind me chipping in.
I have a simple way to calculate returns which suits ME.
Calculate the income generated.
Calculate the amount at risk.
In the simple example posted by Paul directly above, then I agree with him:
Income is $125
At risk is (10-1.25)*100 = $875
So, as Paul says, the return is 14.28%
Jeff, there is no point in saying we have $1000 at risk. There is no way this position can lose $1000.
Moving to the original position (CC and sold put).
The income (unchanged stock price) is = $4,600+$6,200+$1,363 = $12,163
Amount at risk (assume worst case - stock goes to zero) = (49.06-4.6)*1000+(50-6.2)*1000 -1363 = $86,897 (this is the maximum we can possibly lose).
So return = 14% (about 10.8% annualised).
However, I find the idea that WMT goes to zero quite silly. Could thousands of stores, complete with their stock, and distribution centres and trucks etc. all become worthless? If we assume that WMT could fall by 50% over the next 15 months (it never has fallen that much), then a 28% return starts to look good.
Personally, WMT is too lacking in volatility for me - the premiums are too low. I prefer dabbling in option selling on more volatile stocks, or selling far OTM puts on SPX (using margin, of course).
Steve
@paul price
So why not just write the puts and forget the covered call? Then you have no cash outlay at all — with virtually the same return curve. And a much higher ROI the way you’re calculating it.