By Alex Gavrish, Etalon Investment Research; author of “Wall Street Back To Basics”
Conservative strategy for uncertain market conditions
During periods of uncertainty in markets many investors find it hard to initiate new long positions. Some experts perceive the market currently as overvalued and preach caution and restraint. Focusing on fundamentals and timeless value-investing principles will serve investors well during such periods. Combining value and a fundamental valuation approach with a conservative options strategy can provide additional downside protection while generating attractive income.
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The approach involves selling insurance policies (put options) against the decline of individual equities. By selling such an insurance policy you agree to buy the stock of a specific company at a certain price during some period of time, which can be anywhere between a month to one year or even longer. In return for agreeing to do so, you receive a premium, just like an insurance company. In case the stock price declines below the price at which you have agreed to purchase it, you will have to purchase and own the stock.
Both academic and business literature have proven that the approach of selling put options achieves better results than market averages over long periods of time with a volatility that is significantly lower than that of the market. The Chicago Board of Options Exchange (CBOE) has developed a Put Write S&P 500 Index, which measures the performance of a strategy wherein one sells an at-the-money put option with a maturity of one month on the S&P 500 Index (SPY), and continues to do this consistently each month. This strategy has outperformed both S&P 500 (INDEXSP:.INX) Index as well as Buy Write S&P 500 Index (a strategy of selling covered call options).
Let’s take a look at a possible put-write position in Tibco Software Inc. (NASDAQ:TIBX), a leading independent provider of infrastructure and business intelligence software:
Tibco’s convertible debt
Tibco Software Inc. (NASDAQ:TIBX) has convertible debt outstanding with $600 million principal amount. This debt is convertible at a price of $50.57 per share. As the conversion price is significantly above the current market price, the issue of dilution is of no immediate concern to investors.
Cash and potential for increased buybacks or a special dividend
Tibco Software Inc. (NASDAQ:TIBX) had $760 million in cash and equivalents, based on its most recent quarterly report. This amount represented 24% of company’s recent market capitalization. Company repurchased $36 million worth of shares during first quarter of FY 2014 and had spend $182 million dollars annually on average during a three year period between 2011 and 2013. Annualizing the first quarter share repurchase amount would provide a share buyback yield of approximately 4.5%. It is reasonable to assume that with a significant cash holding Tibco will continue to repurchase shares at the same rate, increase share repurchases or even return capital to shareholders in a more accelerated fashion such as tender offer or a special dividend.
Valuation and put-write position example
Tibco Software Inc. (NASDAQ:TIBX)’s market capitalization was $3.2 billion as of April 8th, 2014. The company is valued at an EV/EBITDA multiple of x13.91 (FY 2013). Based on April 8th 2014 closing prices, one could sell an out-of-the-money put option with a maturity of about nine months (January 17, 2015) and exercise price of $18 for a premium of $1.45. By doing this, investor agrees to purchase Tibco shares for $18 share in case the stock price declines below $18. Actual cost and breakeven price of shares for investor would be $16.55 as the investor receives $1.45 per share in premium upfront. At this purchase price Tibco would be valued at an EV/EBITDA multiple of x11.4. In percentage terms, a decline of 17% from current stock price is required to get to this price – a nice downside cushion during uncertain times. If, on the other hand, Tibco shares will trade sideways or rise, the investor will earn an annualized premium income of about 11.3% for taking the risk.