In 1949, Benjamin Graham wrote The Intelligent Investor. This book would go on to become one of the most essential books on value investing ever written. This book and Graham himself inspired and taught legendary investor Warren Buffett everything he knows about investing. And it’s pretty clear he learned a lot.
There’s one problem, however. When that book was written, the investment landscape was vastly different. Back then, only a handful of people actually traded stocks. Those that did would place orders with their brokers and could wait days before they were filled.
The financial print media was also much smaller than today. In fact, this created several blind spots in the market. It would not be unheard of to see a stock fall into one of these blind spots and remain completely inappropriately priced for weeks or even years. The ones that were inappropriately priced, based on their fundamentals (earnings, sales, equity, etc.), Graham noted, were the best ones to target.
This is what Graham and Buffett did. They found companies that were trading ridiculously cheap compared to their peers and the rest of the market. In general, it wasn’t too difficult to find a company trading at 8 or 10 times their earnings… or 50%-60% of their book value. Today, that just doesn’t happen. At least, it is extremely rare.
So, if we were to say that one of the most recognizable names in the world is trading at 9 times earnings (5 times its expected 2019 earnings), 90% of its book value and just 20% of its sales, you’d likely not believe it. But that’s precisely where Ford Motor Company (F) sits.
Now, plenty of people know this already. After all, this isn’t the 1950s. Ford didn’t somehow fall into a market blind spot or is experiencing a lack of financial analysis. There are some reasons investors see the name Ford and head the other way. But at these prices, that’s bordering on an absurd reaction.
The idea for those looking the other way is that Ford and its automaker brethren like General Motors are too capital intensive of industries to really make profits. They have too many union problems to deal with. Pensions are always hovering over their balance sheets. And to even think about buying a car maker during a trade war is crazy.
All of that is somewhat true. Ford isn’t a perfect company. It does have heavy competition, and many claims on the money it makes. But it also very, very cheap.
Now, one argument for why it is so cheap is that it trades more like a bank… a scary one. You see, a giant portion of its business is less about making cars and more about financing them through Ford Credit. Bank stocks often carry low multiples like Ford’s current ones. And for Ford, it could be even worse than other banks right now. There is a very real threat concerning subprime car loans. If that word scares you, it should.
But those problems have been in Ford’s DNA for years now. Yet, only now is the company trading so cheaply. A simple look through its recent financials show that there’s a lot to like.
Revenue is growing. Earnings are stable. Debt is low. Cash on hand is high. And just this week, the company announced a massive $1 billion investment in its Chicago assembly facilities. Clearly, Ford is confident in its own growth.
So, while we might not be looking at a 1950s type price misalignment, we could be seeing a modern-day equivalent. Does that mean Ford is definitely going to double or begin trading at much higher multiples overnight? No. It will likely remain undervalued for a time. But in the coming months, some life should come back into its stock.
Fortunately, there’s a way to play this slow rise in price without risking much money at all nor needing to wait years for it to play out. Let’s get into it.
A Strategy For the Slow Grow
A bull call spread is one of the simplest of multiple-leg option trades you can do. The strategy is used when one believes the underlying stock is set to go up by at least a certain amount in a certain amount of time.
And even though it uses options to play that type of movement, it is actually quite a conservative style of investment.
The way it works is by buying a call option on a stock you think will go up. Then, selling a second call option on that same stock with the same expiration date, but a higher strike price.
What this does is give the trader the chance to profit on any rise in share price without needing to spend a fortune to get into the trade. The premium received from selling that second call reduces the total entry amount, and therefore total risk, of the trade.
In exchange for that, the trader gives up any profit potential in the event that shares rise rapidly, past the strike price of the second call option.
Here’s how that looks in graph form:
Source: The Options Industry Council
For the situation we see in Ford, a company that is likely to rise in price, but slowly, this is an ideal strategy. You see, Ford is trading at $8.25 as we write. It is unlikely to start trading in the teens any time soon. But a rise to, say, $9 is not out of the question over a relatively small amount of time.
So, that would be a good starting place to use this bull call spread strategy. Let’s get into the specifics of a trade that might work well here…
A Specific Trade For Ford’s Creeping Rally
A trader looking to use this strategy on shares of Ford could buy an April 18 $8 call for $0.59 per share and sell an April 18 $9 call for $0.16 per share for a net debit of $0.43 per share. Since each contract is worth 100 shares, that’s a total entry price of $43 for this trade.
That’s the total the trader would have at risk for the entire duration of this trade, until April 18th. To find the profit potential, take the difference in strike prices ($9 – $8 = $1) and subtract that entry cost ($1 – $0.43 = $0.57). That means the most a trader could make on this trade is 57 cents per share or $57 total.
That would represent a 133% return on the amount of risk if this trade goes perfectly. Now, how much would F really need to move for that to happen. The answer is not much.
The maximum profit in a bull call spread trade is hit when the underlying shares rise above the strike price of the short call option. In this case, $9 per share. That means, shares of Ford would have to rise just 75 cents over the next 10 weeks. That’s a relatively long time. Ford could easily recover 75 cents, or 9% from where it is right now.
Think of it this way. We noted above that Ford is trading at just 9 times its earnings. At $9 per share instead of $8.25, it would be trading at just 9.8 times its earnings. That really is a tiny move… and one that could return this hypothetical trader more than double his money at risk.
Who knows what the future will bring for carmakers like Ford? Automation might roll over certain companies. Ride sharing could drastically decrease the number of cars in each driveway. A no-deal with China could puncture the American auto industry hard. So, rather than taking the long bet on shares of Ford, a trader could use this bull call spread strategy to profit and get out, without risking very much at all to do so.
— The Option Specialist