Tag: Wells Fargo

How Joel Greenblatt Uses Options

How Joel Greenblatt Uses Options

Joel Greenblatt was previously a fund manager at Gotham Capital and delivered an annualized return of 50% from 1985 to 1994, before returning all capital to its partners in 1995.

In his book You Can Be a Stock Market Genius, Greenblatt shares his secret to generating parabolic returns with a long-term options contract—Long-Term Equity Anticipation Security (LEAPS).

(On using LEAPS) “There is almost no other area of the stock market where research and careful analysis can be rewarded as quickly and as generously.” — Joel Greenblatt

Greenblatt would purchase a call option—which is the right to buy a stock at a predetermined price for a period of time. For example, we could buy a call option on Facebook that gave us the right to buy its stock at $300 per share by Jan 2023, approximately 2 years away.

How Does A Call Option Work?

Typically, when we buy a call, we are bullish that Facebook’s stock price will go beyond $300. To buy this call option, we need to pay a premium of $45.

If Facebook’s share price goes up to $390 in Jan 2023, we would make 100% on our investment within 2 years. With an initial capital outlay of $45, we would reap a profit of $90 by exercising our call option, buying Facebook at a strike price of $300 and selling at a market price of $390.

But of course, risking $1 for $2 in returns is never a good investment from a risk-reward perspective.

If Facebook’s stock price trades below $300 in Jan 2023, the call option will expire worthless. For example, if it trades at $250, you would rather purchase from the market as opposed to exercising your right to buy at $300. You would rather let the call option lapse and lose the $45.

For Greenblatt, buying LEAPS call options makes sense only when there is a good chance of an event that will propel the stock price upwards significantly.

You can subscribe to my learnings on options here.

Wells Fargo Thesis

In Dec 1992, California was caught in one of the worst real estate recessions and Wells Fargo had the largest concentration of real estate loans in California.

During that period, many doubted if Wells would survive the real estate downturn and as a result, its stock price fell to $77.

Greenblatt’s thesis was simple_—_adjusting for cash earnings and one-time expenses, Wells was earning $36 per share before taxes. If things weren’t as bad as they seemed and returned to normalized levels, Wells’ loan-loss provisions would probably be $6 per share annually. This would translate to a normalized pre-tax earnings of $30 per share, or $18 after tax (assuming a 40% tax rate).

Conservatively giving it a price to earnings (P/E) multiple of 9 to 10 times, Wells could be trading at $160 to $180 per share (versus its price of $77 at the time).

Understanding the Downside

“Non-Performing” Loans

Greenblatt determined that while Wells was embroiled in one of the worst real estate downturns, its financial position was actually quite strong. At first glance, Wells’ non-performing loans were huge, coming up to approximately 6% of Well’s total loan portfolio.

But lo and behold, these “non-performing” loans were actually bringing in a yield of 6.2%.

This was when the bank’s prime rate (the interest rate paid by the bank’s best customers) was 6% and the cost of Wells’ money (the interest paid to depositors) was 3%.

Non-performing loans are loans that are substandard. These include (1) loans that do not pay interest, (2) loans in which the full interest obligation is not paid and (3) loans for which it is anticipated that future interest charges and principal payments might not be paid on time.

Wells was being so conservative that 50% of its non-performing loans were still paying all the required interest and principal payments on time.

In other words, the most worrisome part of Wells’s loan portfolio was still earning a return of 6%. There was a good chance Wells would be able to recover a good portion of these non-performing loans’ value.

Well Capitalized

Even after provisioning for potentially large loan losses, Wells still had higher capital ratios (e.g. tangible equity to total assets) than its competitors.

140-Year Track Record

In its 140-year history, Wells never had a loss in any year. Despite going through the worst real estate environment for California since the great depression, they still eked out a profit in 1991.

Few industrial companies demonstrated the predictability of Wells’ earnings. It was reasonable to assume that Wells would trade at a P/E multiple of 9 to 10 times normalized earnings (most industrial companies were trading above this).

Why Use LEAPS?

Banks are a different animal from most companies. It’s difficult to assess what makes up its loan portfolio. The financial statements only provide a very general overview of the bank’s assets.

Although Wells had been conservative and their financial strength certainly looked strong enough to withstand this recession, there was still a small chance that the bank’s loan portfolio could make the investment go south.

Investing in LEAPS is a great idea when the risk/reward ratios are in your favor. LEAPS lowers the capital outlay and magnifies your returns.

For Wells, there were two likely outcomes:

(1) Things were not as bad as they seemed, and Wells would trade above $160, or

(2) The housing crisis would worsen and Wells would trade significantly lower than $77.

Based on Greenblatt’s assessment, (1) was significantly likelier than (2).

And two years was sufficient for Greenblatt’s assessment to prevail—if things weren’t as bad as they seemed, Wells was likely to trade above $160 within two years.

Table comparing between buying LEAPS and stock

Buying LEAPS

In Dec 1992, Greenblatt purchased Jan 1995 calls at a strike price of $80 and paid a premium of $14. This meant that Greenblatt would have the right to buy shares of Wells at $80 in Jan 1995.

In two years, if Wells survived the California real estate crisis, and traded at $160, the value of these LEAPS would skyrocket to $80. This is because Greenblatt could buy shares of Wells at $80 and sell them immediately at $160.

On an investment of $14, this would mean a profit of $66 or a gain representing almost 5 times the original investment.

On the other hand, if Wells didn’t survive the real estate crisis, the total loss would just be $14. Investing in LEAPS set up a risk/reward ratio of 1 down to almost 5 up.

How About Investing in the Stock Directly?

Instead of using LEAPS, we could invest in the stock directly. However, this would not offer as good a risk/reward ratio, since Wells was either going to skyrocket or crash.

If the stock skyrocketed to $160, stockholders would have made a profit of $83 by having purchased in Dec 1992 at $77 per share.

On the other hand, if Wells didn’t make it, the stockholder could lose the entire $77. This offers a risk/reward ratio of approximately 1 up to 1 down, which would be significantly inferior using LEAPS.

Conclusion

Things played out according to Greenblatt’s thesis. By Sep 1994, Wells had more than doubled to $160 per share. Applying LEAPS in this case provided a much better risk/reward ratio. Options, when combined with sound fundamental analysis, can significantly increase your upside while reducing your downside.

Thank you for taking the time to read my article.

Subscribe to get updates whenever I publish company breakdowns and write about timeless investing concepts at SteadyCompounding.com

If you enjoyed today’s article, I’m sure you would enjoy the following: