With stock swings reaching historic levels this week, many investors are simply throwing up their hands and saying “screw this, we’ll wait.”
That’s not necessarily a terrible plan. However, by the time that crowd comes back into the fold, the valuations on many companies could be drastically altered.
Speaking of valuations, the recent market turmoil has already done some serious damage to many companies’ share prices. Just consider that the average price to earnings ratio of S&P 500 stocks fell from around 25 this time last year to around 17 today. As the Washington Post pointed out, that’s not a bad place to be:
This fall back into normal range for overall valuations could be one of the many reasons the market has rebounded post the Christmas Eve Massacre. But for some stocks, the drops from their late summer highs have left them miserably undervalued still… far below their “normal” level.
Take Carnival Corporation (NYSE:CCL) for instance. This is an industry leader in a very niche and hard-to-break-into area. Earnings have been good, beating estimates. Revenues remain strong, despite overall consumer confidence waning in the second half of 2018. And it is the least leveraged company in an industry that relies heavily on debt.
But investors haven’t seemed to notice:
This latest fall, just last week, came following its fourth quarter earnings report. You might suspect that Carnival missed analyst estimates, or its top line fell. In fact, neither was the case. The company grew its top line and beat both revenue and EPS estimates during the period.
The reason the company’s stock tumbled the way it did was because of outlook. Oh, the outlook is fine for almost every indicator. But the company did disappoint by telling analysts that its revenue yield growth would come down to 1% from an estimated 2%.
This is certainly an important figure to watch for a cruise ship operator. It basically measures how efficient it is in booking to capacity… getting each dollar out of each open bed. But we’re talking about sustained growth here for a company that historically undersells its guidance figures and frequently gets away with it because analysts seemingly undervalue the company.
All of this said, the real reason anyone looking to get into Carnival now, a company that profits off high disposable income in a time when headlines and markets are in a whirlwind… comes back to value.
As noted, the S&P 500’s average P/E ratio is near normal at around 17. Carnival has always somewhat traded on the cheaper side with an average P/E of 15.5. Right now, the company is trading at less than 11. Based on even the low end of next year’s estimates, it is trading at a forward P/E of less than 10.
To put this in perspective, Carnival hasn’t been valued so low since the depths of the Great Recession in mid-2009.
It has return investors more than 200% since then… including ones still holding now after the latest decline. A similar rebound is not off the table.
We opened with saying that many investors are leaving this week’s trading to the wolves. Whatever may come, let it be. Volume from these traders will pick up next week. Congress will be back in session and efforts to reopen the government will begin again. The serious investors will come back to the market and once more look for oversold investments to get into for the new year. Carnival should be one of them.
So, how do you play such an expected bounce?
A Strategy For a Short Bounce Back
Buying stocks outright, as we’ve pointed out before, takes a lot of time and patience… and capital. The returns on straight equity investments usually take time to make, unless you are willing to invest several thousands or tens of thousands of dollars on an individual bet.
On the other hand, simply buying a put or a call option is a casino-style gamble. If the stock moves in the right direction, you stand to make good money. But if not, you lose it all.
Alternatively, we’ve often implored the use of spread trades, which limit the amount of capital that’s at risk in return for a sizable potential gain. That’s the exact right strategy here.
You see, Carnival should be trading at a much higher price. Investors returning next week should make that happen. But we all know investors are fickle.
So, instead of buying up shares of CCL ahead of time and hoping for the best… or playing a game of roulette with straight options… one strategy that keeps both the risks low and benefits high is a bull call spread.
Source: The Options Industry Council
A bull call spread is a type of trade that benefits the trader whenever the underlying security goes up in value. However, the amount of capital at risk is hedged by giving up some profit in the case of a real short-term breakout.
The way it works is for a trader to buy a call option with a strike price near the current trading price of the stock and selling a second call option with a higher strike price. The income from the second call offsets some of the cost of the first one.
Let’s look at a specific example to see how this would play out for CCL.
A Specific Trade For CCL Bulls
Shares of Carnival are trading at about $49 as we write. So, a trader could buy a January 18 $50 call for $1.10 per share and sell a January 18 $52.50 call for $0.20 per share for a net debit of $0.90 per share. Since each contract covers 100 shares, that’s an outlay of $90 per contract.
That $90 is all the trader would have at stake in this trade. He couldn’t lose a dime more than that. The potential profit, however, is much larger.
To find it, take the difference in strike prices of the two calls ($52.50 – $50 = $2.50) and subtract the initial cost to enter the trade ($2.50 – $0.90 = $1.60). For 100 shares, that gives the trader a potential upside of $160 on a $90 investment.
That works out to a 178% potential return on the amount the trader has at risk. These kinds of numbers are rare and show just how few are looking at this kind of bounce. With markets so wildly inconsistent, that’s exactly where a smart trader should go with his money.
True, the trader would have to see CCL’s price rise 7.1% to reach this maximum profit level. But that’s a drop in the bucket compared to how much the stock has moved in just the last week. When the regular value investors come back to invest in their 2019 portfolio, that would be an easy move for them to make.
— The Option Specialist