July 12, 2018 Freebies 0 Comments

LEAPS: The Joel Greenblatt Way to Bet on Entercom (ETM) and GameStop (GME)

Member Write-up by VETLE FORSLAND

Investing in companies with big upsides (and big downsides) with LEAPS, instead of common stock, to up your return (and minimize risk)

 

If you believe that a stock is excessively mispriced, and you want to buy that stock, there is a way for you to translate a say, 30% gain into a triple digit gain. It’s called LEAPS, or “Long-Term Equity Anticipation Securities”, and if used wisely, it is one the best ways to leverage your investment returns as a retail investor. Joel Greenblatt wrote about it in “You Can Be A Stock Market Genius”, where he described it as a tool that “has many of the risk/reward characteristics of an investment in the leveraged equity of a recapitalised company”. I recommend reading his bit on LEAPS, starting on page 213, as Greenblatt himself can show its pros and cons much better than I ever could. But, the strategy is basically buying stock options that expire 2 years down the road. Stock options are usually not attractive for long-term investors as they don’t allow sufficient time for a larger repricing, and are dependant on a short-term catalyst. However, as you can own LEAPS up till two years, chances are a stock that is severely and obviously mispriced will reach (or get close to) its fair value during your holding period.

 

Since, LEAPS are basically long-term options, how do options work? You can buy put options and call options, but in this case we will just look at calls, which is basically the right, but not the obligation, to buy a stock at a specified price within a specified time. For instance, let’s say you purchase a call option on shares of GameStop (GME) with a strike price of $16 and an expiration date of August 10th 2018. This option contract would give you the right to purchase 100 shares of GameStop at a price of $16 on August 10th, but as this right is only valuable if GameStop is trading above $16 on the expiration date, you risk expiring the option valueless. Right now, you can buy one call option on GameStop for August 10th for $0.50, which represents 100 underlying shares of stock, so the cost of a trade of 100 call options will be $5,000 (($0.50 x 100) x 100 shares. If by August 10th, GameStop trades at $17, the buyer could use the option to purchase those shares at $16, then immediately sell them for $17. Therefore, the option will sell for $1 on August 10th, and as each option represents 100 underlying shares, and our hypothetical trader bought 100 options, this will all total a sell price of $10,000. Because the trader bought this option for $5,000, the net profit equals $5,000 – comparably, a common stock buyer would have had to invested $160,000 to make the same profit from the same trade.

 

If, however, GameStop stock trades for $16.50 at the expiration date, we can use the same analysis as above, and find that the trader breaks even. If the option trades at $16.25, our trader will lose $2,500 on the trade, and so on. If GameStop trades at less than $16 at the expiration date, there will be no use of the option to buy GameStop at $16 when you can buy it for less in the stock market, so the option is deemed worthless. In this scenario, the trader would have lost his initial investment – $5,000.

 

Essentially what you do here, is leverage up your investment without paying an interest, and without risking a margin call, and without the chance of losing more than your initial investment. (The only extra cost here is the cost of the option). And, as you could see in the example above, there is big money at stake.

 

Now, as a value investor, trading like shown above wouldn’t make much sense. After all, most value investors have decided that trying to time the market is a waste of money. But, with LEAPS, the expiration date might be sufficiently far away for a serious repricing to happen to a seriously mispriced stock.

 

There are two stocks that I wrote about on Focused Compounding that might be underpriced enough for LEAPS to make sense as a strategy. Those are GameStop and Entercom. I put a $33 price tag on GameStop, (when including all the cash they will generate) and around $20 per share for Entercom. As these valuations are much higher than the current stock prices of $15 per share and $8 per share, respectively, considering LEAPS makes sense with both of these stocks – and not just because of the upside.

 

GameStop and Entercom are both dirt cheap because the market is questioning the sustainability of their business models, and it’s uncertain what will happen to the companies in the near-future. Right now, the market isn’t quite sure if GameStop will at some point enter bankruptcy, if it will be bought out by a Private Equity firm, and how much of all physical video game sales will be replaced by digital. By the time the LEAPS expire in January 2020, GameStop’s future will be much more clear, allowing the market to price GameStop with more certainty. This means that if things are looking good in early 2020, a stock price of $20-$25 isn’t unthinkable. However, if the market doesn’t see a turnaround or a buyout as a likelihood, the stock price could be well below $15 – and even plummet towards zero, if we’re being extreme.

 

Right now, you can buy GameStop 2020 LEAPS for $2.30, with an exercise price of $15. Essentially, this means if you buy these LEAPS, and GameStop trades below $15 at the expiration date, you will lose your initial investment of $2.30 (really $230, as each option contract price really represents 100 contracts, but I’ll stick with just the single option price for simplicity). So, $2.30 is your downside here (obviously, if you buy GameStop stock, your downside is $15). If GameStop trades at $17.30 by the expiration date, you break even – as you have the right to buy GameStop stock at $15 per share, + the cost of the LEAPS. From here, it only gets better: at $20, you make $2.50 on a $2.30 investment; at $25, you make $7.30 on the same initial investment, and if you hit a home run; at $30, you make $12.30 on your original $2.30, representing a gain 5.3 times the size of your initial investment. In the latter scenario, if you bought GameStop stock at $15 and sold at $30, you would have made “only” 1 times what you invested.

 

In other words, you can see how using long-term options can offer a greater risk/reward if you have a case where the upside is big, and so is the downside. Another stock that has these qualities, and I would even say to an even greater extent, is the radio broadcasting company Entercom. I don’t personally think GameStop shareholders are risking a bankruptcy in the next couple of years. However, if Entercom fails to turn the CBS-ship around, create synergies, and the U.S. enters a larger recession, Entercom shareholders might get wiped out completely. But, as argued in my initial write-up of the stock, the large upside might compensate for this risk, making it a good candidate for LEAPS options.

 

Entercom is on sale on fears that radio is dying, and that they have acquired so much debt that they might have to enter bankruptcy sooner or later. This debt comes from a huge acquisition of a radio peer as mentioned, CBS Radio, and the market is skeptical if the expected synergies will materialize as planned. To top it off, investors are anxious to see whether or not CBS Radio will be fully integrated in the business, and if the acquisition will pay off in the end or not. Two years down the road, we will probably know how the deal played out for both parties. So, the situation will be clearer, meaning that the stock could go to the mid-teens and upwards, if my long thesis plays out as expected, or the leverage will be too much and the acquisition deemed unsuccessful – the latter is especially true if it’s matched with a larger domestic recession. In the first scenario, we are talking a stock price of (for the sake of our risk/reward calculation) $16. In the latter, if we are being extreme, the stock could go zero. So, if we would buy Entercom stock, our odds are 1 up to 1 down – we might earn $8 or lose $8.

 

What about with LEAPS?

 

Entercom January 2020 LEAPS with an exercise price of $8 last traded for $1.30 each, allowing us to buy Entercom stock for $8 at any time before the expiration date. If Entercom was trading around $16 per share by then, we would be able to buy Entercom stock for $8 and then sell it right after for $16 – in other words, an investment of $1.30 could result in a profit of $6.70, or a fivefold increase from our original investment to our total gain ($16 – $1.30 – $8 = $6.70). However, if the stock was trading for less than $8 in January 2020, the calls would expire worthless, and we would lose $1.30.

If we decide to buy 10 Entercom LEAPS contracts, we will put $1,300 at risk, if they expire worthless. But, if Entercom stock jumps up to $16 per share within our time frame, we will get $8,000 back – equaling a profit of $6,700. If we wanted the same return on the same initial investment, but with common stock, the share price must have surged from $8 per share to around $50 per share. Outlandish, in other words. Only if a common stock investor was willing to put $8,000 at risk, he would have garnished the same return as a LEAPS investor if the stock had doubled – $8,000.

 

So, by using LEAPS, we could improve our risk/reward ratio from 1/1 to a 5/1 – not bad.

It remains to be seen if these two stocks will be great investments or not. However, if you are seriously considering buying either of these stocks, but are particularly scared of a bankruptcy, LEAPS could boost your reward while limiting your downside. I will mention again that the spin-off champ himself, Joel Greenblatt, dedicated 15 pages to LEAPS in “You Can Be A Stock Market Genius”, and carefully walks through a Wells

Fargo case study from the early 2000s. In that scenario, he decided that the LEAPS were a better investment then the underlying security itself, with a similar risk/reward ratio as our own in GameStop and Entercom.

 

Share: