Today I’m recommending something that is more capital appreciation oriented, with a options income kicker as gravy. International Business Machines Corporation (IBM) has taken something of a beating recently. That leaves us a situation where a truly valuable global business is trading at a discount to intrinsic value. Big Blue has reinvented itself multiple times in the past and I expect another turnaround over the next 8 quarters. How good is the opportunity? I’m going to say at a minimum, IBM should trade at a Price to Operating Cash Flow multiple similar to its industry. (Ordinarily we’d use Free Cash Flow but IBM’s FCF is skewed by aggressive capital spending while it retrenches.) The industry is trading at a multiple of 11.00 while IBM is trading at a multiple of only 9.30. That gives us about 18.3% upside before accounting for any growth, dividends, or per share appreciation from IBM’s aggressive share buyback program (about 6% of outstanding shares per year!)
Today’s closing price was 164.83 and we’ll use that as our reference price. If we adjust this to the industry multiple of 11, we get a share price of 194.96. We are going to take this as “fair value” and write covered calls at the next strike, 195.
Action to take: Buy IBM at 164.83 and write IBM160115C00195000 for about $2.20. That is the 15JAN2016 expiry 195 strike call for raptors that don’t speak the lingo. Over 327 days until expiry, 2.20 in premium versus 164.83 in cost basis gives us an annualized yield of 1.5%. This doesn’t seem like much, but it is 55% more than simple buy and hold is earning from the 2.7% dividend yield. Our total gains could be about 30 dollars in capital appreciation, 4.40 in dividends, and 2.20 in options premiums for a maximum annualized return of 24.9%. More likely, is the call expires worthless, we keep the option premium, the dividends, some share appreciation, and get a roughly 6% bonus in the form of continued share buybacks. We can then write more covered calls. I get approximately 19% annualized for front month near the money covered calls on IBM, so we might do quite well over the next couple years. If growth returns to the company, the gains could be explosive.
Devour your prey, raptors!