This article is not appropriate for licensing: 
News Analysis date published New: 
Monday, February 25, 2013 - 11:30
New Date created: 
Monday, February 25, 2013 - 11:30
New Date last updated: 
Monday, February 25, 2013 - 11:30

The Best Way to Beat an Overvalued Market

Monday, February 25, 2013 - 11:30am

He's not as well-known as Warren Buffett, but he's of the same ilk: A successful mega-investor who's looking for value -- and finding it more often than not. And as with Buffett, when he talks, people pay attention.

Jeremy Grantham co-founded Boston-based asset manager Grantham Mayo Van Otterloo (GMO) in 1977. Today, GMO has a whopping $106 billion in client funds under management. Grantham's chief claims to fame are his calls on various market bubbles, including a bearish prediction for U.S. stocks in 2000.

So it came as no surprise when the financial media gave widespread coverage to the release a couple weeks ago of Grantham's most recent quarterly letter to clients. (Spoiler alert: Except for "quality" stocks with stable earnings and low debt, Grantham believes global assets are once again becoming overpriced, many of them "brutally" so, according to Bloomberg's account.)

I suspect many of you saw the headlines from the GMO report. But did you read the fine print?

Toward the bottom of the letter, the co-head of GMO's asset allocation team wondered aloud about the possibilities going forward. "What is there to get excited about?" he asked, given that "historically strong-returning diversifying assets deserve a certain amount of wariness with regard to their future correlations and returns."

Here's how he answered his own question:

"We believe there is (something to get excited about). One clear example, which had made its way into our multi-asset portfolios, is equity put selling."

Equity put selling. That's the same "instant income" strategy I told you about in The StreetAuthority Insider six weeks ago, and again here. The same strategy Warren Buffett famously used to earn $7.5 million in income instead of having to buy shares of his beloved Coca-Cola Co. (NYSE: KO) outright, at an elevated price. The same strategy espoused by my colleague Amber Hestla-Barnhart, an options strategist at ProfitableTrading.com, a StreetAuthority sister site.

"Instead of telling their clients to simply expect lower returns, GMO says they will be selling put options to help them beat the market," says Amber. "What's more, they're actually 'excited' about it -- just like I am."

Let's go through this one more time: "Put" options give investors the right -- but not the obligation -- to sell a stock at a specified price before a specified date.

When you sell a put, you are obligated to purchase that stock from the put buyer if it falls below a specified price (the option's "strike price"). When you accept that obligation, you receive "instant income" (known as a "premium") up front. You can be asked to buy the stock at any time between the moment you collect the premium and the expiration of the option contract.

In Amber's case, the former military analyst only sells puts on stocks she would want to own in any event. By so doing, "if the stock falls below the strike price, obligating me to buy the stock, I'm buying shares of a stock I wanted to own anyway -- and I'm getting it for a better price than it once was."

(Note: As I've said before, you don't have to be a billionaire guru to benefit from options -- you just have to act like one. And it's easier than you might think. To learn more about the key to earning instant income in the options market, follow this link. You'll hear a presentation from Amber, and you'll see the details of some of her recent winning trades.)

Here's more from Amber on how you can generate steady income and ensure you never overpay for stocks...


Bob: Why would an old-school value manager get "excited" about selling puts?

Amber: Because selling puts offers opportunity in what Jeremy Grantham believes is a low-opportunity environment right now.

Grantham founded his firm in 1977, a year when the S&P 500 index was trading between 90 and 107. It's now trading at about 1,500. Grantham has enjoyed bull markets and survived the October 1987 crash, two market declines of more than 50% and several smaller bear markets. He has successfully navigated all manner of market conditions, and believes that now is the best time he's seen to sell options.

Why now? Stock prices have little upside after their recent run-up, in Grantham's opinion, because the economy will be growing slowly. Bonds may not crash, but because of some simple and irrefutable mathematical laws, bonds can't deliver big gains in the future. There just isn't room for interest rates to fall low enough to drive big gains in bond prices.

In this environment, Grantham and his colleagues at GMO are rethinking their approach. They see put selling as a way to increase returns at a time when stocks are risky and deliver high income when bonds fail to do so.

Bob: What kind of recommendations are you making in your new advisory, Income Trader?

Amber: All my recommendations have been to sell puts on high-quality, undervalued stocks. All of them pay dividends, but they don't have to in order for me to earn income on them. These kinds of stocks make great long-term investments and are perfect for my options strategy.

More important, they tend to be safer. My primary objective is to protect capital, and my secondary objective is to generate income from that capital by selling options. All of my recommendations follow those principles.

After finding undervalued stocks, I sell puts to collect income. If I have to buy shares, then it's always at a price that I calculate to be a bargain. In most cases, I won't have to buy shares, and I book the premium as pure profit. If I am obligated to buy the shares, then I'll own a great company at a dirt-cheap price.

If I'm ever asked to buy shares, I will implement a covered call strategy to generate additional income. With my covered call strategy, we basically get paid to sell shares we already own at a higher price. Similar to selling a put, we decide the price and the timeframe.

In my opinion, these two strategies, when combined, are the best way to generate income and boost total returns in any market.

Bob: You've mentioned you sell options on "high-quality, undervalued stocks." Can you give me an example?

Amber: Sure, I recently told Income Trader subscribers about one of the most undervalued stocks in the market...

Joy Global (NYSE: JOY) makes mining equipment that is used for mining coal, copper, iron ore, oil sands, gold and other mineral resources. This equipment includes electric shovels that can scoop as much as 135 tons of dirt at one time and machines that can carve out underground tunnels in coal and gold mines. It's a "picks and shovels" way to invest in worldwide commodity demand.

I'm not the only one who thinks this is a good stock. Goldman Sachs identified Joy Global as one of the top 10 stocks with the greatest upside potential in 2013. Goldman thinks the price of Joy Global should rise to $83 a share, about 32% higher than it is today, noting that "tightening commodity supply-demand balances over the course of 2013" will drive a recovery in the share price of Joy Global.

I think shares are a steal right now. But instead of buying shares outright, we can use my "Instant Income" strategy to take advantage.

Shares are currently trading at about $63, and we could sell Joy Global April 55 Puts for 85 cents. To initiate this trade, your broker might require a small "down payment" of about $1,100.

Selling these puts will generate immediate income of $85 (each contract controls 100 shares) per contract. This put will obligate you to buy Joy Global at $55 a share if the stock trades for less than that by April 19 (the last day these options can be traded). That is a key support level and a price I believe represents a bargain for these shares.

Assuming Joy Global trades for $55 or more on April 19, then we keep the "Instant Income" and make a profit of $85 on $1,100, or 7.7%, in 56 days. If we can repeat a similar trade every 56 days, we'd earn a 50% return on our capital in 12 months.

Action to Takle --> If Joy Global trades for less than $55 on April 19, then we'll keep the $85 per contract and buy Joy Global at $55 per share. In this case, you'll own Joy Global at a cost basis of $54.15 (the $55 strike minus the 85 cents premium, which you keep), a -14% discount to current prices. At $54.15, we'd own shares of a company crucial to the mining industry at nine times this year's estimated earnings, a great price for a stock expected to grow earnings at about 11% a year.

We're essentially getting paid up front for the chance to buy a great company at a lower price.

Note: Amber's new weekly advisory, Income Trader, has been on the street for less than a month, but the subscriber feedback is already positive. Linwood S. said he collected $1,000 from selling puts on Phillips 66 (NYSE: PSX), $700 from selling puts on PetSmart (Nasdaq: PETM) and $1,800 on the aforementioned Joy Global (NYSE: JOY). Linwood said he's found Amber to be "detailed and conservative," not to mention successful. You have until Wednesday, Feb. 27 to take advantage of a special charter subscription rate for Income Trader. For the details, click here.

Further Reading:
To learn more about Amber and her trading strategy, follow this link.
To read GMO's most recent quarterly letter, click here.

Bob Bogda does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.