How To Earn A Potential 10.3% ‘Rental Income’ In 38 Days

One of my favorite screens for stock ideas is to look at the most heavily shorted companies in the market. For one reason or another, the market has gotten severely pessimistic on these stocks and traders are borrowing millions of shares to sell short. 

Most of the time, the short attack on the company is for good reason. Maybe management has squandered an advantage or the company just operates in a deteriorating industry. But every once in a while, I come across a company that does not deserve the negative sentiment and is actually a strong buy rather than a sell target. 

#-ad_banner-#That is exactly what I found when I looked at my screen of heavily shorted companies this week. Not only is today’s pick a leader in two of the three markets it covers, but it just announced plans to triple the size of one of those markets.

A Market Leader Opening New Markets

ADT Corporation (NYSE: ADT) is a leader in security and automation. Its 25% share of the $11 billion residential security market gives it more than six times the share of its next largest competitor in a market with just 19% penetration. 

The company also holds 13% of the $2.4 billion small business market, also the highest among its peers. Finally, its 2% share of the $1.2 billion market for personal emergency response systems (PERS) makes it seventh in the industry.

The market has overlooked this strength for much of the past year as higher expenses and promotional spending dragged on the company’s earnings. The trend of higher expenses and promotional spending is likely to continue, but for a very good reason. The company is about to open up a new market and could be setting up for some extremely strong sales growth. 

At the end of September, ADT announced the expiration of a non-compete clause with Tyco (NYSE: TYC). The clause was a holdover from the company’s spinoff in 2007, and prohibited it from offering services to companies with more than 7,500 square feet of space. 

ADT said it will now begin marketing to mid-size companies, which it estimates will triple its potential market in the commercial security space to $6.5 billion by 2016. While moving into a new market is sure to increase expenses, revenue could rocket higher.

The table below shows my estimate for 2016 sales based on current market share and the company’s estimates. The estimate for 2013 sales is based on recurring revenue from the three segments. (It is slightly lower than the $3.3 billion reported in annual filings on rounding differences in market size and share, and $268 million in other revenue from sales of equipment.)

Simply by maintaining its current market share, the company could be set to increase sales by more than 25% over the next two years. That is a compound rate of more than 12% a year and could be a conservative estimate if ADT can use its leadership position and new scale to capture a higher market share. 

Overly Bearish Sentiment Against Strong Long-Term Potential

On the chart, we see ADT plummeted 24% in two days in late January after the company reported lower-than-expected fiscal first-quarter 2014 earnings. The average cost to acquire a new customer jumped on higher promotional activity and spending on the company’s new Pulse bundling program. Even though total sales increased 3.7% year over year, the company’s earnings fell 26% from the same quarter in 2013.

ADT Stock Chart

Shares have not fully recovered since the earnings slaughter, but they did rebound nearly 35% from their March lows to the mid-September highs. Since that peak, they have succumbed to broader market weakness and recently fell into oversold territory, with a slow stochastic oscillator below 20. This may offer a good entry point ahead of its next earnings announcement in November.

With 22.8% of the float held short, ADT is the third most shorted company in the S&P 500 after GameStop (NYSE: GME) and Cablevision Systems (NYSE: CVC). The overly bearish sentiment is in stark contrast to strong long-term sales potential and its commitment to returning cash to shareholders. ADT has repurchased $1.5 billion in shares over the past four quarters and offers a 2.5% forward annual dividend yield.

A Quick Profit Around Earnings or a Great Long-Term Holding

While the potential of the new commercial market will unfold over the next two years, investors can take advantage of recent weakness to reap a quick profit on the shares using a covered call strategy.

With ADT trading at $32.21 per share at the time of this writing, we can buy the stock in 100-share lots and simultaneously sell one ADT Nov 35 Call for every 100 shares purchased. The options are currently trading around $0.47 ($47 per contract), which lowers our net cost to $31.74 per share. The company is scheduled to report earnings on Nov. 12, so the options benefit from increased volatility around the release.

If ADT is above the $35 strike price at expiration on Nov. 22, our shares will be sold for that price. In this case, we will make $2.79 in capital gains plus the $0.47 in options premium for a total profit of $3.26 per share in 38 days. This is a 10.3% return over our cost basis. If we were able to make a similar trade every 38 days, we could earn a 99% rate of return in a year.

I set the strike price higher than usual on this one because I believe shares could jump on the upcoming earnings announcement. While sales are not estimated to be significantly higher, I expect management to give strong guidance thanks to the new mid-size commercial market. 

I like the trade as long as we can get in for a net cost of $32 or less, which still leaves us with a gain of 9% if the shares are called away. If ADT fails to rally to $35 by expiration, we keep the option premium and can sell more calls with later expirations. The long-term potential for the company is strong, and I wouldn’t mind owning the shares for a while.

Note: Selling covered calls is like collecting “rental income” on the stocks you own. If you’re not renting out the stocks in your portfolio, you may be missing out on the easiest income around. See how you can collect $1,200 or more each month by clicking here.

This article originally appeared on The Shorts are Wrong! ‘Hated’ Stock Could Make Traders 99% a Year