Some of you, on reading the title must be wondering – Rohit is again on his options trip ! this dude is going to get kicked big time, one of these days 🙂

Well, in the spirit of learning and experimenting lets look at an options strategy, that I think marries the value investing approach with options quite well.

What are covered calls?
You can read about call options here. Selling covered calls mean selling a call option in the market while holding the underlying stock. Selling a call option without holding the underlying stock is naked selling (no its not selling without wearing your clothes :), but you could lose them if the naked selling bet goes wrong).

How does it work with value investing ?
The logic is as follows – Suppose you hold a stock which is a mid to long term holding. Lets say you bought the stock for 60 Rs and think the fair value is 100. Now let’s assume that the stock is selling for 95 and you plan to start exiting at 100-105 as you really do not want to hold above fair value. In such as case, one can sell a call on the stock for a strike price above the current quote, say around 110-115.

If the stock continues to climb, the call will get exercised and you will get the 110 exercise price + the premium amount. If the stock drops back and if you had planned to hold on to the stock for the long term as long as the price was below fair value and the fundamentals are good, then you pocket the premium and continue holding the stock.

An example
Lets take the example of a favorite of mine – Infosys technologies. My own estimates of fair value for the stock are around 2700-3000. The stock is currently selling for around 2700 which is close to fair value.

The first option for me is to sell the stock once the price crosses 2700 and be done with it. The other option is to start selling covered calls with a strike price of 3000 or higher. If the stock keeps rising and the call gets exercised, then I will end up exiting at 3000 + premium as planned. On the contrary if the stock drops from here, I can pocket the premium for free. The flip slide is that I will lose money on the stock as it drops.

The risks
If someone ever tells you that there is no risk in an investing strategy, ask him what he is smoking or drinking.

There are several risks in the above plan and it works only for a very specific situation. I would sell a covered call on a stock which I think is selling close to fair value and I would not mind holding it if it dropped below this price – the second part of the statement being the key. As a corollary, the reason I would not mind holding if the price dropped is because I think the company will continue to do well and will increase its intrinsic value at a good rate.

A valid question would be – why not sell and move on? . One reason for trying this approach is plain experimentation – with limited amounts of the stock. The second reason is that I would continue to hold on to the stock for the long term as the company is still doing fine and selling covered calls increases my returns. At the same time if the stock gets too overvalued, I would exit it by selling via the covered call.

If you do not want to hold the stock for the long term and would regret holding it if the price drops, then one should just sell the stock and move on. In summary this is a strategy of trying to be a bit too clever and squeezing out a few percentage points of returns.

As an aside which options should one sell in this case ? – I would prefer to sell the ones with the longest duration (May 2010 exercise) as I would also benefit from the time decay and the premium is also worth the effort.

You have a lot of cash burning in the pocket and are looking for an opportunity to invest. An old time favorite is now selling for cheap. All and sundry feel that the company is undervalued especially if a series of ifs and buts get resolved. You look at the annual report of the company and it appears cheap by historical standards. Feeling confident, you go ahead and put in a decent amount of money.

Smart decision? maybe, but then maybe not.

Looking forward
Although no one can predict the future, it is an unfortunate reality of the stock market that stocks are priced based on the expected future of the company. I am using the word ‘expected’ as no one knows for sure. If someone claims that they are a 100% confident, then either the person is a complete moron or trying to sell you something.

If you are in the business of stock recommendations and tips, appearing anything but 100% confident is professional suicide. So I would blame the investor more for the garbage sold in the market than the seller. Do you really think all this junk would sell if there was no demand? anyway I digress.

So if one cannot predict the future, how does one invest? There is no surefire approach, though one can improve the chances of success by picking a company in stable industry. If the industry is fairly stable and not undergoing too much change, it possible to guess (all investing is finally a guess ..sometimes a good one or sometimes bad) with reasonable accuracy on how the company will do in the next 3-5 years.

An example
Let’s consider two companies. I am comparing these companies not from a valuation or investing standpoint, but purely trying to contrast their business performance. Stock performance in the short term is a different issue.

Let’s take the example of Gujarat Ambuja and Bharti airtel.
Gujarat ambuja is in the business of manufacturing and selling cement. It has grown at an average CAGR of 13-15%, maintained a net margin of 15% and an ROE in excess of 25%. It is not possible to know the exact profit or sales (many try that though) for the next 2-3 years, but looking at the business and the economics one can make a fair guess that business could clock 5%+ growth and 15% ROE for the next few years. Anything can happen, but the probability of the business achieving these numbers is high.

Bharti telecom is a telecom service provider, which has done extremely well over the last few years. The company has grown the topline at 30%+ and profit at 45% per annum for the last 5 years. The company has maintained an ROE in excess of 25%. These kind of numbers would warrant a PE in excess of 20. However the market is currently assigning a PE of 11 which values it as a commodity business. So is the market wrong? Some would say so looking at the past performance.

However there are certain structural changes and realities in the telecom industry

1. The industry has been witnessing severe price competition for sometime now. All the other companies other than bharti do not have great fundamentals (please look at the complete financial statement for all these companies and not the P&L account alone to understand what I am saying)

2. The industry has faced a lot of change in the past and will do so in the future. Do you really think anyone can be sure how the industry will look like in the next 5 years? What will be the technological changes, new entrants, government regulations etc?

3. Bharti is now expanding internationally via the Zain acquisition. They are looking at additional acquisitions too. All this activity at the very least introduces more uncertainty into the equation.

The reason I have taken the example of bharti and ambuja cement is because I have analyzed both the companies in the past and gave a pass to both for different reasons. Ambuja cement was not cheap enough for me.

In case of bharti, if i was looking at the just the past data, it would be an incredible buy. However as I said earlier, investing and valuation requires looking ahead and in case of bharti my crystal ball is completely cloudy. It may be my own limitations, but that is precisely the point. If one does not have the confidence of being able to assess the long term economics of a company and its industry, then one should give the stock a pass. The last thing one should do is depend on someone else’s analysis to make a decision.

There is no penalty for missing on a stock idea – there are 5000 public companies and a decent portfolio requires 15-20 stocks at the most. I see no point in buying something where there are too many unknowns and I am not confident on how it will all work out.