Practical analysis for investment professionals
27 January 2020

Value Investing’s Neglected Tool?

Value investing comes in many flavors.

The Graham and Dodd approach out of Columbia Business School focuses on earnings power value. The more traditional variety — the staple of business school finance courses — discounts cash flows. “Back-of-the-envelope” strategies rely on multiples comparisons based on price-to-book, price-to-earnings, dividend yield, and enterprise-value-to-EBITDA, among so many other metrics.

While value is geared more toward out-of-favor investments, it is flexible enough to incorporate equities in the growth-style box, as growth at a reasonable price (GARP) approaches demonstrate.

All of these methods seek to identify the intrinsic or fair value of what a security’s price should be versus how it is priced in a market of varying volatility and liquidity.

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Optionality above Intrinsic Value

One often overlooked tool in the value investor’s toolkit is the optionality above the intrinsic value. Why do value investors so rarely write calls on their long positions?

If a value investor sells an equity when it reaches or exceeds its intrinsic value, why wouldn’t they exercise a call option to sell off that upside now? After all, the long position will be sold anyway.

Our value portfolio contains a basket of 20 to 30 securities rebalanced semi-annually or annually. We write calls with strikes as close as possible to our estimate of intrinsic value per share, rounding higher when needed. Expirations range from six months to one year. These calls tend to be out of the money with strike prices within 15% to 30% of the current market price.

We typically are out of the money in the calls we write by roughly what value investors would consider the margin of safety.

After running this type of simple overlay for three years, we find that about two out of every 10 of our calls are exercised. Moreover, the premium from these calls adds about 100 basis points (bps) or more to our annual returns.

If we value a stock at $55 a share when it is priced at $49 (Wells Fargo on 16 January 2019), there is a margin of safety of about 11%, so we could write a call at $55/share strike for one of the longest call options available. The January 2021 call options at $55 could be written at about $1.30 per contract. Here the premium potential would be nearly 2.8%, or $1.30/$49.

While the maximum return potential, excluding dividends, within the year would be 13.8% — and 17.7% with a trailing dividend yield of 3.9% — it would have only been 11% if there was a rule to sell the stock at $55.

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What’s a Value Investor to Do?

Many value investors believe they need to let their winners ride, even when they exceed their estimated value. Indeed, perhaps some of the observed value premium of the past relies on the full spectrum of returns, including those that beat investors’ collective estimates. Writing calls on stocks with high margins of safety is one way to retain much of the upside such that there are handsome holding period returns before a written call is ever exercised.

Call writing on stocks may seem like a value-added proposition in today’s presumed low-rate, low-return environment. The “giveaway” of the call may not feel as material if the stock doesn’t look likely to reach its out-of-the-money strike price.

But we’ve found it can add a small amount of incremental return to stock positions that we would otherwise sell.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/Patchakorn Phom-in


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About the Author(s)
Benjamin Doty, CFA

Benjamin Doty, CFA, is senior investment director at Koss Olinger & Company, based in Gainesville, Florida. Prior to Koss Olinger, he worked at Galliard Capital. Doty began his investment career as a credit analyst for a municipal bond fund. He received a bachelor’s degree in economics and an MBA from the University of Georgia.

4 thoughts on “Value Investing’s Neglected Tool?”

  1. duong trong thang says:

    the risks in “markowit” line are not defined. the text explaining the Markowit line do not define Risk in the curve line. if you read again the text regarding markowit line (sorry for mispeel Markowit”, you will see that no definition of the risk is given. so, how can you find some stocks with specific risk to make the Markowit line “more beautiful”.

    I think that if I suppose that competitive positioning of each stock dose not change. this means no companies go bankrupt or loose competitive positioning and that ‘risks” in the Markowit line are ‘short term “risks such as small fire, the decline of profit in one quarter, a bad news such as thief of the manager. all of risks which dose not destroy competitive advantage/positionning of a company, are the risk in the markowit line. if i suppose these things, we have markowit line.

    of course, even if we do not know what are risks in the Makowit line, we can still get benifit of the diversification. this is why no one care what is risks in the Markowit line.

    most stock investors and I focus on possibility of bigger profit of a stock. this is strategy analysis. so, I think MBA program is ideal for stock investment.

    the analysis of a stock should be begun with competition analysis and then we look at financial reports to prove the result from the competition analysis. of course, both processes can be incorrect and we get a stock whose price is lower and lower. the critical part is the competition analysis. is this product still better than other products and, so, this stock has price higher than price of other stock. dose the Phillip led light bulb is still better than a chinese light bulb. if two bulb are the same , and only the brandname Phillip is better than brand name Chinese , then possiblly Chinese bulb stock will go up. the finnancial reports may, but not must, help you to realize what happens. this is core of business and the core of stock investment.

    what I want to say is that DCF model with supposition that a company grow for 15 % for nest 5 year is only for you to understand the concept of stock value. stock value can not be known exactly. stock value is investor’s conception of business risk, risk of loosing or chance of getting some competitive advantages. this risk is conceived by the investors, and this way a stock price appear on the screen. the art of stock investment is art of anticipating the business risk. we anticipate business risk and we accept a stock price for this risk. the person with good knowledge of business , the persons with MBA degree, for example, can anticipate business risk better.

    because each investor has his own financial position, they accept business risk differently. this make a case in which both buyer and seller get benefit when they trade. the seller want 20% per year and, so sell stock which yield 5% a year . the rich buyer want only 5% a year, and , so will buy.

    suppose, I open a vietnamese restaurant in us. I can not know wheather my busines will growth 15% for the next 5 years. it is funny to think about 5 years. but if a stock investor realize that I have good knowledge of vietnamese food and I have good management skill which are competitive advantage, the investor will buy the stock of my business.

    if we choos a wrong stock, which is loosing competitive advantages, we loose money and all of skills of diversification, swap, future, are meaningless.

    I read some books in CFA program but I still want to read more book on competitive advantage. I want to know more about how a company break the competitive advantages of other company or how to realize competitive advantages in each industries. a book which explains the competitive advantages in airline industry, retailing industry, online selling industry or manufacturing industry would be great. I want to know how competitive advantages explained in Porter books can be applied in each industry or in two competing companies.

    sorry for my not good English. I write this quickly

    1. Markus K. says:

      I’m currently thinking about the same stuff like you and started reading “Competition Demystified”. So far, I rly like it so maybe you should have a look too!
      Best, Markus

  2. H P Boyle says:

    You could be making even more incremental return if you sold positions with low risk-adjusted return and redeployed the capital into positions with higher expected risk-adjusted returns in a more dynamic fashion.

    I guess this strategy of forced time rebalance and call option sales makes sense if you have low idea velocity (i.e., there is no better alternative for the capital).

  3. Kirk Cornwell says:

    This long-time covered call seller shot himself in the foot recently (missing a lot of “multiple expansion” in what had been a “low beta” stock), and while I don’t disagree with most of these suggestions, I think “low interest rates forever“ has changed the playing field. “Value” does not obscure the market dynamics which exaggerate both short term news and black swan events. It’s dangerous to generalize. A stock whose history is a PE close to 10 for years can be adopted by the street and command 20-plus indefinitely. (Vice-versa of course).

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