Case Study: Using Call Options To Bolster Return. Learn How One Hedge Fund Manager Earned A 471% Return Using Call Options

In 1992, a hedge fund manager name Joel Greenblatt, spotted an opportunity in the form of a company called Wells Fargo. The company experience a beaten down share price as it was exposed to a downturn in the California real estate market. In this article/case study, the reader will :

  • Understand how to use long term call options called LEAPS to magnify the returns on your portfolio
  • Learn that a favorable risk/reward ratio is a factor of important consideration when buying options
  • Fundamental analysis can help an investor determine whether to buy an option
Wells Fargo & Co
Wells Fargo & Co
Wells Fargo & Co
Wells Fargo & Co

Fundamental Analysis of Wells Fargo

At a time when the short sellers were predicting doomsday scenarios and where experts had opinions that ranged the gamut, a few hedge fund managers took the opposite bet. They bet that Wells Fargo would be worth a lot more in time to come. Two of these notable hedge fund managers were Bruce Berkowitz and Joel Greenblatt.

Amidst the real estate crisis in California, stocks of financial institutions were beaten down tremendously. Many banks found their market capitalisations sliced into half because of the crisis.Wells Fargo was no exception. During the last quarter of the year 1990, its stock price had halved. The major cause of this is sentiment driven. At that time, the two banks  that were on the radars of many fund mangers were Bank of America and Wells Fargo.

In terms of the net interest margin, Bank of America had a 4.7% net interest margin. Wells Fargo, on the other hand had a superior net interest margin in the form of 5.7%, approximately 1% greater than that of Bank of America. In fact, the net interest margin of Wells Fargo had been above 5% for the past 4 years. And there was no indication that the net interest margin was going to decrease.

At that time, the bears were essentially saying that the recession in the Californian real estate market was going to affect Wells Fargo loans business. When mortgages were defaulted on, Wells Fargo loans portfolio would be gravely affected and hence, huge charge offs would have to be made against the net earnings of the company. While there was some merit in this argument, one really had to look closer at Wells Fargo whose business spans a 140 year period. It is notable that over the history of Wells Fargo till that point, Wells Fargo had never failed to earn a profit. That is, losses were never reported on its income statement.

Wells Fargo had a very adequate capitalisation ratio at that time.

Tier 2 capital

Company

Tier 2 Capital

Bank of America

10.9%

Wells Fargo

12.3%

As you can see, it’s capitalisation was superior to Bank of America although many people though otherwise.

Loan loss provisions

Company

Loan Loss Provisions

Bank of America

3.3%

Wells Fargo

5%

It also had a more conservative loan loss provisions. The loan loss provisions refer to the amount of funds set aside in the financial statements that reflect the possible losses that the company has to take.This is an allowance for bad loans, loans that may be defaulted on and where terms may be modified that may not favor the bank.  It is however different from charge offs as charge offs are reflected directly in the income statement as expenses.

Now, if one were to study the financial statements of Wells Fargo, one will realise that these loan loss provisions were massive. The management  was trying to convey to the public that they were being ultra conservative in having such massive loan loss provisions.A large loan loss provisions is definitely more conservative than a small loan loss provision in a real estate recession. Furthermore, the yields for Wells Fargo property loans was impressive in a real estate downturn.

Yields on commercial loans

Segment

Retail Office Space Apartments

Industrials

Yields

9.6% 10.7% 10.8%

11.1%

These were very impressive yields that were generated in its loan portfolio amidst a real estate downturn. At this time, history also suggests that its yields were in fact going up.

Non-performing loans

And with regards to its non performing loans, they were yielding 6.2%. This does not look like a company that was going to be made bankrupt. While there were arguments that made a point that the real estate market was going to cause Wells Fargo to make more risky loans going forward, they were in fact hiring sales staff to transition into a company where a greater portion of its revenues came from net fee income instead of interest margin income.

At this point, Joel Greenblatt, a hedge fund manager realised that Wells Fargo was in fact a gem. A simple argument made for Wells Fargo was this: Considering all the above factors, Wells Fargo was already earning $36 per share before taxes when loan loss provisions were excluded. When the real estate environment normalised, loan loss provisions will fall to approximately $6 per share. This would cause earnings to spike up to an after tax basis of $18 per share. If one were to apply a multiple of 10 times( PE ratio), the stock would be worth $180 a few years out from 1992.

Potential double with risk

In Greenblatt’s eyes, it was a potential double from a price of $77. For one, there could be prolonged downturn that really could have affected the other assets in Wells Fargo and cause Wells Fargo to decrease to less than $77.

Joel Greenblatt could have bought the stock or call options on the Wells Fargo. Wells Fargo did eventually earn $15 per share in earnings in 1994 and $20 per share in 1995. And by 1994 in September, the stock did manage to trade at $160.

If Joel Greenblatt bought stock at $77, his profit percentage would be:

($160 – $77)/ (77) x 100% = 107.%

However at a price of $160, his options traded at a price of $80. He garnered an approximate profit percentage of:

($80 – $14)/$14 x 100% = 474%

Favorable risk/reward ratio

But of course, he felt that the risk reward ratio would be better if he had bought call options instead. To him, buying call options was akin to borrowing the money to buy the stock but only having to pay interest without the principal. For every dollar which he risked, he could make a profit of approximately $5. The price of the January 1995 call LEAPS were $14. When the price of Wells Fargo traded at $160 on expiration date, the LEAPS would be worth $80 on if he had bought the calls at a strike price of $80.

Time to expiration – LEAPS

Joel Greenblatt had a long time horizon when he evaluated Wells Fargo. He was looking at a recovery of Wells Fargo share price by 1994 to 1995. That is the reason why he bought Jan 1995 calls expiring in 1995. It was 1992 at that time.

Near the money call options

While there is no confirmation as to whether Joel Greenblatt bought in the money or out of the money, it is reasonable to agree that he bought near the money call options, that is options with a strike price that is near the current trading price. Call options which are in the money have a higher positive delta that call options which are out of the money as the price of the underlying security moves upwards.

Money management considerations and opinion

While options can offer a tremendous upside to investors and traders, it is important to look at it from a money management perspective. While Joel Greenblatt made a bet, we believe that that bet was a risk he could take as his other positions in his portfolio may have increased in value. Also, the amount invested in LEAPS as a percentage of his portfolio did not make up a significant percentage of his portfolio. Please read [Intelligent money management strategies for option traders] for more on money management strategies for options.

Summary

While many traders rely on technical analysis to make decisions on when to buy or sell an option, fundamental analysis can be used as a basis to determine the type of option, the duration of the option and the strike price of the option to buy or sell. The option premium will not reflect changes to the businesses fundamentals and events such as corporate restructuring which affect shareholder value. Hence, many a time, when deciding to buy options, one should incorporate financial and fundamental analysis to allow for the element of surprise to the upside of downside.  These “surprises” are not priced in the option premium and hence, an investor or trader may get an option for cheap. 

Read:

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