Whenever the market takes a tumble, as it has this week, investors seek to find a handful of companies to blame. This time around, two seem to be popping up constantly.
Walgreens Boots Alliance and CVS Health Corporation operate in somewhat of a duopoly. These two are the largest drug store companies in the world, with operations across the globe. But for some reason, investors have no faith in them anymore.
Both are trading at sub-10 earnings multiples. Both are down double digits so far in 2019. And each have had their fair share of analyst downgrades. But why?
For Walgreens, the answer seems to be a crackdown on its tobacco sales. The FDA announced a new effort to go after large retailers caught selling cigarettes and other tobacco products to minors. It found that Walgreens was the worst offender, with proof that 22% of its stores are guilty of this major crime.
Now, we’re not sure that’s a good enough cause to send its stock tumbling so far. But Walgreens isn’t alone in its bad year.
CVS is down nearly 20% in 2019 so far. The reason for its decline is very different. Last year, the company closed a merger with Aetna, the health insurance giant. According to investors, that deal isn’t faring well.
The combined company is expecting a weak year as it restructures its operations post-merger. CVS CEO Larry Merlo told investors:
“2019 will be a year of transition as we integrate Aetna and focus on key pillars of our growth strategy. We are fully aware of the need to address the impact of certain headwinds that are having a disproportionate impact in 2019 compared to prior years, and importantly, we are taking comprehensive actions to move past them.”
These headwinds and these words have been enough to send investors streaming out of CVS shares. And analysts have been downgrading them like wildfire. Citi’s analysts just cut its price target for the company from $94 all the way to $68 this week.
The question smart traders need to ask themselves after all of this is: has the market been too harsh on these companies… CVS in particular?
We’d argue that it has. The company is still set to have 2019 earnings per share of between $6.68 and $6.88. Yes, that’s down from $7.08 last year. But it still makes CVS one of the cheapest stocks in the entire market.
Even if its next few earnings come in on the low side of this guidance range, that still means CVS is trading at just 7.9 times its earnings. That’s nearly one-third the valuation the rest of the market carries today.
The Aetna deal, at the heart of the company’s share price weakness, is still too new to fully know how it will all play out. But already, in just the one-month period during the fourth quarter that the combined company reported together, that deal added more than $5.5 billion to the top line.
As time passes, investors will likely become more comfortable with this new entity. But for now, their abandonment of CVS shares is giving us a unique trading opportunity.
Investor overreaction is one of the best ways to profit in the short term. It doesn’t take long for a stock to bounce after a selloff like CVS has seen. Will it jump back to $80, where it was before the Aetna deal closed? Probably not, at least in the short term. But a surge back to $60 is certainly likely.
Even if investors simply valued the company comparable to Walgreens – itself an oversold one – shares of CVS would be trading at $73. But right now, they linger at $52.75.
This gives us a chance to profit off the almost guaranteed short-term bounce back from this bottom. And there’s one strategy that takes full advantage.
A Strategy For Short Term Bulls
A bull call spread is a type of trade that lets one profit off short-term rallies. Often, after a selloff of this size, it is relatively cheap to enter it.
To get in on this type of trade, you’d need to buy a near-the-money call option and sell an out-of-the-money one with a higher strike price.
This results in a net debit to your account. But that cost is the full amount at risk for the whole duration of this trade.
The upside for this strategy is found by taking the difference in strike prices of the two call options and subtracting the entry cost.
You can see how that works here:
Source: The Options Industry Council
Let’s look at a specific example of this kind of trade on CVS…
A Specific Trade For CVS’ Inevitable Bounce
Because of CVS’ recent share collapse, traders can get into a bull call spread trade for cheap. For instance, they could buy an April 18 $52.50 call for $2.58 per share and sell an April 18 $60 call for $0.44 per share. That’s would result in a net debit of $2.14 per share or $214 total (each call covers 100 shares of CVS).
That’s the total cost of this trade. It’s also the total amount the trader would have at risk for the full duration of it.
The upside is above average, thanks to the cheap option premiums. To find out how much the trader could profit, take the difference in strike prices ($60 – $52.50 = $7.50) and subtract the cost ($7.50 – $2.14 = $5.36). On 100 shares, that’s a maximum profit potential of $536.
In other words, this trade could bring a 250% return on the amount at risk. As noted above, shares could easily jump back to above $70 in no time. To lock in this 250% return, they’d only need to return to $60.
The risk-reward balance on this trade is unbelievable. Rarely do traders have the chance to take advantage this much from an oversold stock of such quality.
— The Option Specialist