Today we are going to open another diagonal call. This is a strategy that lets us earn a good return in the short term while having leveraged exposure to long term capital gains. We want to use this strategy on big slow moving mega-caps with dominant market positioning and that gush free cash flow. Pepsico (PEP) fits the bills.
PEP has grown revenue over seven percent annually over the past five years. Distribution growth over the past five years is an impressive 6.9%. Pepsico is also rewarding shareholders via share buybacks. Return on Assets of 9.3 exceeds the industry average of 8.4 by almost 11 percent. Most importantly price to free cash flow is nearly half the industry average, 38.50 versus 71.00 (assumes last years free cash flow of 7.647 billion as per the cash flow statement.) Today’s trade lets us earn better than 5% annualized while we wait on share appreciation that should total an additional few percent a year. And we are going to use a purchased call to leverage that extra few percent a little over five to one. We expect approximately 15% annualized over a two year period. Not bad on a big slow moving slug of a mega-cap.
Action one is to buy PEP170120C00082500 for today’s price of 17.47. Action two is sell PEP150320C00105000 for 0.12. For each contract, this puts $1,747 of capital at risk and earns immediately 12 dollars in premium income. Over the twenty nine days until expiry we will earn an annualized 8.65% return (I promised you at least 5%.) We will continue writing slightly out of the money calls on PEP with each expiry until the December 2016 expiry. At that time we will sell our in the money purchased call. Any capital appreciation will be leverage by a little over five to one. If we can get 2% appreciation a year, that will be about 4 percent time leverage of 5X or a bonus 20% in return (note that PEP bought back over 2% of its shares in 2014, we should manage our target without even getting any sales growth.)
A note about margin: greedy raptors may be thinking if 5 times leverage is good, borrow money from my broker to get 10 times or more leverage would be even better. Don’t do it raptors, that is a dumbo T. Rex move. While it is unlikely, we could technically lose all of our 1,747 at risk. If you borrow money, you can lose more than you have to put at risk. You don’t want to be flat broke, unable to trade another day, and owe a debt to your broker too.
Devour your prey, raptors!