The Mad Men era of smoking in the office may be gone. So too is the time of Joe Camel and the Marlboro Man. But Big Tobacco is still around.
Sure, it is a dying industry, literally. But 1.1 billion people still smoke around the world. Many others have begun electronically vaping. And still more use chewing tobacco, cigars and pipes.
So, when governments discuss curbing the use of tobacco, it usually only brings out reactionary speculators to tobacco stocks. And over the past month, that’s exactly what’s happened.
FDA Commissioner Scott Gottlieb announced an aggressive new attack on menthol and flavored tobacco, including flavored vape juices. We’re still weeks if not months away from any real action. But tobacco investors took this news to heart.
Altria (MO) is the largest U.S. tobacco company, with a market cap of $123 billion. Well, at least it was that large two weeks ago. Since then, it has shed more than $20 billion worth of its market capitalization. Meaning, because of this FDA speculation, investors feel it is now only four-fifths of the company it was.
As Market Watch points out, Monday’s share price decline marks the longest losing streak in Altria’s stock in 48 years… 11 days of straight losses.
Now, you might believe this fall is justified. And to some degree that is just what the Efficient Market Hypothesis would have you believe. EMH is the notion that a stock’s valuation is the product of all available information about the company. If the news says that the FDA is going to strike Altria in some of its product offerings, then its stock should therefore fall by the appropriate amount to incorporate this new information.
But there is plenty of evidence that in the short term, EMH doesn’t work perfectly. We’ve all seen it. A company gets a bad headline and investors flee. After these investors have had time to digest this news, they feel comfortable to return to buying that stock. That’s the nature of volatility… and a core reason option investing works.
That looks like it is happening at Altria. The company’s shares look like they will break their streak of losing days with a 1% gain in early trading today.
But such a free fall as this in such a large and well-known company is not usually solved by a 1% bounce. There’s room for further gains in coming weeks.
Altria’s Role in Portfolios
No one buys Altria because they like the idea of cigarettes. In fact, most smokers are the first to say they need to quit and it’s bad for them. Investors are no different. But tobacco stocks have long offered just too good of a reward for these investors.
Despite how this particular fall for Altria looks, tobacco companies are often very stable businesses. Their customers are literally hooked on their products. And it’s very easy for management to project just what their future sales and earnings will be.
Now, obviously, this has changed a bit. There have already been several laws passed in many nations curbing the use of tobacco. But these companies still have a great idea of just how many products they’ll sell throughout a year’s time. And they know just how big of a tax burden they’ll face. So, the numbers don’t change too much.
This lets them offer larger than average dividend payments, a perk for many looking for retirement distributions or general investment income. That’s why these kinds of companies often find their way into retirement funds and pension plans. Altria is one of the most held stocks for just this reason.
The current fall in share price have raised the company’s dividend yield to 6%. That’s one of the top ten largest dividend payers in the S&P 500.
On top of this appeal to income seekers, this fall has also put Altria in undervalued territory. Right now, the company’s 2019 earnings is forecast to come in at about $4.33. That gives MO a price to earnings ratio of 12.4. That compares to the current S&P 500 average P/E of 21.8. That’s a huge discount.
These investors who have fled on the recent speculation about the FDA’s plans, will likely return. We might already be seeing the start of it with today’s early movement.
This presents us with a reason to be short-term bulls on Altria. Fortunately, there’s a way to play just such a scenario.
A Strategy For Short Term Bulls
You could simply buy shares of Altria, hoping to frontrun some of this return to regular valuation. But that’s a long-term prospect. Then, you’d be sitting on shares in a stock that has indeed been under attack by the FDA and many other countries’ governments for the past two decades.
Alternatively, you could buy a call option on MO. This would let you profit from short-term gains without the risk of owning the stock. However, this would put you at risk of losing 100% of your investments if shares don’t move.
There is, however, a strategy the lets you use call options to bank short-term gains on an upward moving stock while limiting the amount of money you have at risk. This is called a bear call spread.
The way this works is by buying a call on a stock one believes will rise in the short term and then selling a call option with a higher strike price on the same stock with the same expiration. The proceeds from the sold call offset some of the money the trader needs to put down for the bought call.
Here’s how this strategy looks in graph form:
Source: The Options Industry Council
As you can see, the amount of money at risk with this strategy is limited. So too are the potential profits. But this is one of the easiest and most efficient ways to take advantage of short-term gains in an underlying stock without all the risk of owning it or betting on a long call option by itself.
The risk in this strategy is limited to the difference in premiums for the call options. Simply take the amount paid for the long call option and subtract the premium received from the short call option. That’s the total amount at risk here.
To find the profit potential, simply take the difference between the strike prices and subtract out the cost to enter the trade.
A Specific Trade for MO
To enter this kind of trade on MO, one could buy December 21 $54 calls for $1.27 per share and sell December 21 $55 calls for $0.91 per share. That would result in a debit of 36 cents per share. Since each contract is worth 100 shares, that’s a total net debit of $36 to the trader’s account.
That $36 is the total money at risk (plus commissions). The trader in this scenario wouldn’t lose more than this amount no matter what happens to MO shares over the next month.
The maximum profit potential here would be $64. To find this, take the difference in strike prices ($55 – $54 = $1). Then subtract the amount paid to enter the trade ($1 – $0.36 = $0.64). Finally multiply by the 100 shares per contract ($0.64 x 100 = $64).
That works out to a potential 178% gain on the total amount risked. Very few MO investors can say the same.
To get this full profit, shares of Altria would have to hit that $55 upper strike price. They are currently trading at $53.93. In a month’s time, $1 in price gains for this major company is quite possible.
— The Option Specialist