The recent selloff in stocks has allowed for extremely attractive buying opportunities for financially strong companies, with compelling dividend and earnings growth potential. In addition to owning the stocks, albeit at times at quite a bit higher prices due to the significant market selloff we have experienced over the past two months, we have been taking advantage of heightened volatility via selling covered calls on our long positions.
Volatility and time are two of most important pricing components with options. When volatility climbs, it increases the attractiveness of selling options. The combination of deep value investing and the incorporation of using options as a tool to generate income, reduce risk, and to instill disciplined buying prices is a core tenant of T&T Capital Management.
Below is a brief example of how it works. Recently Bank of America (BAC) common stock has been trading around $12 per share. This is about 77% of tangible book value per share and is only 53% of book value. Keep in mind tangible book value per share grew to $15.62 from $14.43 at the same time last year, while book value per share grew to $22.54 from $21.32. Bank of America earned just under $16 billion last year, or $1.31 per share, and could very well increase earnings this year. The company is aggressively cutting costs from its legacy mortgage exposures and has more efficiency gains available to it than some of its better performing peers such as J.P. Morgan and Wells Fargo.
In 2015, the company paid out $.20 per share in dividends, making the current yield roughly 1.6%. With Bank of America’s earnings almost tripling from 2014, Bank of America is likely to significantly increase its dividend payout and/or stock buyback program. A conservative 40% payout ratio as a dividend based on 2015 earnings would equate to a dividend of $.524 per share, or roughly 4.3% based on the recent stock price. We clearly believe this stock is one of the best values we’ve seen since 2009 when you factor in the incredibly strong balance sheet, the very valuable Merrill Lynch and U.S. Trust franchises that would be worth large premiums to book value, and the ability to dramatically grow earnings from depressed levels.
In addition to owning the stock, we’ve been selling calls at around $17 per share that expire in January 2017. This gives us the dividend, and all upside to $17, and for being willing to sell at that price we have collected premiums of roughly $.53 per contract in many circumstances. $.53 equates to a 4.4% yield based on a $12 share price so basically we have manufactured an enhanced dividend while still retaining a great deal of upside. Using last year’s dividend of $.20 and adding the $.53, we have a cash flow yield of 6.1%. Like I said, I believe that dividend will be higher in 2016 once the results of the CCAR process come out in March. In addition, we have upside all the way to $17, which represents an additional 42%. Bank of America traded well over $17 per share as recently as late 2015 and the company hasn’t reported a loss of a penny since then to justify the current prices. I’m extremely confident it will get back there sooner than later, as market participants realize that this is not 2008 all over again. While, I do believe the stock is worth more than $17 and for that reason we have kept some shares uncovered, we believe that the reward/risk of these attractive premiums make it a very healthy endeavor.
2016’s volatility has been truly dramatic and really this has been going on since the summer of 2015 to a large extent. The amount of stocks down 30-50% is absolutely staggering during that time period. With that said, I’m confident that none of our large financial positions have taken any hit to intrinsic value over this period and that we bought them at large discounts to intrinsic value in the first place. This sets the stage for explosive long-term returns. There are several catalysts to achieving this. First of all we have the CCAR process where the banks will be approved for stock buybacks and dividend increases. Stock buybacks at big discounts to book value are enormously accretive and grow intrinsic value per share quite quickly. Increased dividends will attract income-oriented investors. Secondly when first quarter earnings come out in April, I expect the banks to remain profitable and to have grown their respective book values. It makes no sense for these huge discounts to liquidation value unless these companies start losing tens of billions of dollars, which is not in the cards. Lastly, the passage of time and financial world now blowing up like 2008 will be a great catalyst. These prices are irrational and are impossible to justify. Each economic report that doesn’t augur impending doom should add to the case for materially higher share prices.
You’ll notice covered calls on many stocks, while still allowing plenty of upside potential. Many of these are longer-term in nature and at the same time are taking advantage of the heightened volatility. I’m excited to see how things play out once the short-term panic dissipates. We’ve seen some slight progress over the last few days, but there is a long path to go to get to anything close to intrinsic value. The downside seems very limited, so the big money will be in the waiting at this point. As always, if you have any questions, please don’t hesitate to contact me!