Bank of America LEAPS are an excellent 'Buy Bullish' opportunity.
By Philip Guziec, CFA | 08-13-07 | 06:00 AM | Email Article

My colleague Ganesh Rathnam's analysis of  Bank of America  tells the story of a wide-moat business with great long-term earnings and cash-generation prospects, and the recent sell-off in the equity markets has pushed the discount on the shares into "screaming buy" territory.

Philip Guziec, CFA, is a strategist on the alternative funds research team for Morningstar.

As Ganesh discusses, rising charge-offs and a slowing investment banking business could impact earnings in the short run, and do pose some downside risk, but the long-run prospects are great, so an ideal investment would limit the short-term downside risk while exposing an investor to long-run upside, and LEAPS (Long-Term Equity Appreciation Securities) provide just that kind of payoff scenario. LEAPS are simply long-term options, both calls and puts, in this case going out over 900 days.

Referring to our Option Strategy Map, the undervalued B of A shares fall clearly at the bottom of the bottom row. Ganesh also thinks the shares are average risk, which should correspond to middle-of-the-road volatility; however, an examination of the options shows that the implied volatility on the LEAPS is in the low-20% range. I haven't yet developed a clear guideline comparing risk with implied volatility, but from anecdotal experience, low-20% implied volatility is at the bottom end of what I typically see. Low implied volatility relative to the risk of the B of A options would place them in the left-hand column of the Morningstar Option Strategy Map--undervalued implied volatility.

Undervalued stocks that have options with low implied volatility tell us to "buy bullish"--to be net buyers of the options, and to buy options that pay off to the upside.

Call Option Scenarios
In this case, let's talk about a simple call option purchase. The longest-term options available are 900 days out, and we'll look at those because they'll leave plenty of time for our story to play out--for Mr. Market to come to his senses and for the price of B of A shares to realize their fair value. This is a big assumption, but it has been my experience that a mispriced stock will typically converge to its fair value within three years, unless some other news changes our fair value estimate in the meantime.

As of late July, B of A is trading for about $47.50 per share. However, to figure out where we expect the stock to be, we'll look into the future in a couple of ways--one way that assumes the shares are fairly valued at current prices, and one way that assumes Ganesh is on the money, and the shares are very undervalued.

First, let's assume that B of A is currently fairly valued. The stock should pay about $5.50 per share of dividends over 900 days, and we'd expect the shares to fall that much in price if nothing else changes, so the future "at the money" price would be about $42 per share. Even if the shares are currently fairly valued, we still expect them to go up by the firm's 10.5% cost of equity over that time period, which translates to a 28% increase in the share price over 900 days. This results in a $53.75 expected future stock price ($42 x 1.28), again assuming that the stock is actually fairly valued at its current price.

But now let's assume, like Ganesh, that currently the stock is actually worth $70 per share. Subtracting the $5.50 in dividends brings us to $64.50, then multiplying by 1.28 gets us to $82.50, our expected future fair value 900 days from today.

The $50 call options cost $5.30 (the option premium). By our calculations, those call options should pay $3.75 if the shares are currently fairly valued; however, that assumption is really too precise for a two-and-a-half-year time horizon, so let's play it safe and say those options will actually expire worthless. However, if we're right about the shares being worth $70, the calls should pay $32.50 ($82.50 - $50). The beauty of the options is that, if we're really wrong, and the shares drop in value in the next 900 days, our only loss is our option premium.

Our Bet with Mr. Market
Let's look at our return in a couple of ways. First, comparing that option premium of $5.30 to buying the shares at $47.50 translates to an "interest" expense of about 4% for 900 days. Even if we account for our calls being $2.50 out of the money, $7.80 over 900 days would translate to about 6% interest. Both of these values compare pretty favorably with the 8% or more margin rates that brokerages charge to individual investors, plus we have the bonus that if we're wrong and the shares decline in value, our losses are limited to losing the "interest."

But let's say we're exactly right about B of A's value. In that case, our return on those options is 6.1 times our money ($32.50/$5.30), or a 510% return over 900 days. Annualized that's 109%.

Simplifying the statistical math, a return of 6.1 times translates to a 16.3% (1/6.1) chance of success. That means two things: If we think we have a greater than 16.3% chance of being right, it's a good bet. It also means that our bookie, Mr. Options Market, says there is only a 16.3% chance of us being right. So, just as in stock investing, we're making a bet with Mr. Market that we're right and he's wrong.

There's risk, though. We could be wrong. Those options could expire worthless. Even if we really have a 50% chance of being right, that's a 50% chance of losing the entire investment, so this is a strategy that's appropriate only for a small percentage of an investment portfolio. A small bet, but we think a bet worth making.

When should an investor exit this position? There are a few considerations. First, if the stock converges to fair value, the timing element for options may suggest selling. If the stock price appreciates past the 1-star price (meaning the stock becomes overvalued according to Morningstar's rating system) or if news comes out that changes the fair value estimate for the stock, making it overvalued, selling the options would certainly make sense. Also, purchased options receive the same tax treatment as stocks, so holding the LEAPS for 366 or more days will cut your tax rate from ordinary income tax rates to 15%. Finally, if the implied volatility of the options spikes and winds up overvalued, there is always the potential choice of taking the profit on the options and buying the undervalued stock instead.

Fear is currently dominating over greed in the banking sector, and Morningstar's financial-services research team is bullish on the long-term prospects of a myriad of other banks, including:  Western Alliance Bancorporation  Capital One Financial ,  Washington Mutual ,  J.P. Morgan Chase ,  Old National Bancorp ,  Citigroup  ,  US Bancorp , and  Associated Banc-Corp . Morningstar's free option chains will calculate implied volatilities for the options on these companies, and Morningstar Premium members can compare the company risk ratings to the implied volatilities to find other "buy bullish" options opportunities.

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Philip Guziec, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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