After Reading This Article We Will Explain How it Can be Combined With a Number of Call Option Strategies
by Alexander Green, Investment U Chief Investment Strategist
Tuesday, June 26, 2012: Issue #1802
There are a number of signals that bode well for price appreciation with individual stocks: growing market share, rising sales, strong earnings growth and improving margins…
But you shouldn’t overlook another excellent indicator: share buybacks.
According to Standard & Poor’s, U.S. public companies spent at least $437 billion last year buying their own shares back. That was 46% more than in 2010.
Is this a good thing? Absolutely…
Regardless of whether you’re an individual or a corporation, sitting on cash isn’t terribly rewarding these days with the average money market fund paying five one-hundredths of 1%. And if the outlook is uncertain, a business owner doesn’t want to commit to building new facilities or taking on employees that aren’t needed. Nor is it necessarily in the best interest of shareholders to distribute this cash in the form of taxable dividends.
So buying back shares often makes good sense. Why? Because when you divide net income into a smaller number of shares outstanding, you get greater growth in earnings per share. And, ultimately, that’s what drives share prices higher.
Of course, stock buybacks boost earnings per share only if they’re larger than stock issuance. Historically, that hasn’t always been the case. (Much executive compensation today comes in the form of stock options that have a dilutive effect on existing shareholders.)
But in recent quarters, the supply of shares outstanding has been shrinking. And, according to analyst Howard Silverblatt at Standard & Poor’s, during the current earnings season, 97 of the S&P 500 enjoyed a boost to earnings per share of at least 4% from repurchases alone.
More Buybacks Ahead
Expect to see more of these buyback announcements in the weeks ahead. Why? Because U.S. corporations are sitting on more than $2 trillion in cash. That’s enough to buy all of ExxonMobil (NYSE: XOM), Microsoft (Nasdaq: MSFT) and IBM (NYSE: IBM).
There are some caveats, however. Some companies announce their intention to buy back shares and then don’t follow through. If business conditions change, interest rates rise, or cash flow decreases, a repurchase program may never get completed.
The other thing to watch is the exercise of stock options, as mentioned above. If a company is only buying back enough shares to offset the dilution that occurs when executives exercise stock options, you won’t see the buyback boost earnings per share.
But, generally speaking, share repurchase programs are a decided positive. And right now, with money cheap and corporate earnings strong, buybacks are occurring at record levels. Cash-rich companies in the midst of major share buybacks right now include Smithfield Foods (NYSE: SFD) and Juniper Networks (NYSE: JNPR).
Having Your Cake and Eating it, Too…
Of course, some analysts would rather see corporate executives buying shares with their own money rather than the company’s money. And I don’t disagree…
But sometimes you can have your cake and eat it, too. In a recent study, stocks that were subject to repurchases but not insider buying beat other stocks by nearly nine percentage points over four years. But stocks that were the subject of both repurchases and insider buying beat others by a whopping 29 points over four years.
Which companies have enjoyed share buybacks and insider buying recently? Two of them are CACI International (NYSE: CACI) and Crawford and Company (NYSE: CRD-A).
These are the kind of companies that should handily outperform the market in the months ahead.
Here’s You Can Use This Idea for Call Option Trading
For stocks that look to be appreciating in value in the short term there are some excellent option trading strategies that are worthwhile considering. These are in addition to simply buying call options and each has a different risk profile.
Covered Calls – one of the favourites because it’s considered to be one of the safest strategies. You buy the shares then sell call options on them – they call this a “buy-write”. Benefits include the gain on the appreciation of the share price, plus the option premium received. Your stock only needs to remain at, or above, your original purchase price in order to profit. Even if it doesn’t, covered calls give you enough flexibility to adjust your position and retain profits or alleviate losses.
Debit Spreads – buy a call and sell another call at a higher strike price. Because it is a spread, it will lower your entry price, but great profits can be realized from this strategy. Spreads also include some flexibility should the price action go against you.
Credit Spreads – in this case, when the stock is expected to appreciate, you sell put options at a strike price below the current stock trading price and then buy an equal number of puts at another strike price lower again. For this you receive a credit. As long as the stock price action remains above the sold put strike price until expiration date (or close to it) you keep the credit and realize an income. Credit spreads can also be adjusted should the price of the stock your positions.
There are more exotic option strategies such as long condors and such, but the above may be the easiest to understand and implement while maintaining that “sleep at night” factor.
Call options leverage your profits and are a much better strategy than merely buying the shares themselves.