Volatility has begun to pick up in equity markets as bond yields have continued to creep higher, based on fears of higher for longer inflationary pressures. I’ve warned before about being too aggressive in this environment. Too many people expect equity markets to perform like they did in exceptionally low interest rate periods and that is simply not realistic. Remember that the higher bond yields are the largest competition equities face. This tends to compress multiples on equities and lower the risk premium investors will pay. Our approach at TTCM has been to take advantage of those higher yields by buying some bonds, while focusing our equity investments on deeply undervalued securities often with double-digit earnings yields. As a reminder, earnings yields are the inverse of P/E ratios, so it reflects the yield that a stock could pay out if it paid out 100% of its earnings as cash flow. If a stock has an earnings yield of 15%, with the ability to grow earnings per share from there, that is obviously still immensely attractive relative to Treasury bond yields near 4%. Conversely, a 2% earnings yield on a glamour stock can look abysmal in this environment.
Another way that we take advantage of this environment is by utilizing volatility to obtain higher option premiums. Lending Club (LC) trades at $9.72, which is about 1.05x its tangible book value per share. Normalized earnings are about $1.60 per share, offering an earnings yield of 16.5%. This is a company that is growing rapidly since its acquisition of a bank, which dramatically lowered its cost of funds. The company can earn a return on tangible equity of 20-30%, which is very high for a bank. One conservative way to play this is selling an $8 January 2024 put for $1.20.
Sell 1 January 2024 put for $1.20
Maximum Risk= $680
Target Profit= $120
Target Profit%= 17.64% or 19.6% annualized.
The stock could drop by 30% before it reaches our breakeven level, where we’d happily end up owning the stock, or if the stock stays above $8, we make nearly 20%. This is a highly attractive and in my opinion, quite conservative investment, which typifies how we build portfolios for our clients. I’ll provide some more fun examples these next few weeks.