Generate Up To 6.9% In 58 Days From Buffett's Favorite Bank

Chris Carson's picture

Wednesday, February 18, 2015 - 12:00pm

by Chris Carson

It's not always easy to go against the crowd, especially when it comes to investing.

 

But some of the best investments ever have been made when markets are paralyzed by fear.

 

Warren Buffett is the poster child for this style of contrarian investing. Just look back to 2011 when Buffett's Berkshire Hathaway  invested $5 billion in then-struggling Bank of America (NYSE: BAC). While most investors were fleeing, questioning the bank's solvency, Buffett saw an opportunity. Today the market value of his investment has more than doubled in just over three years.

 

And when it comes to another one of Buffett's well-known investments, we have a similar opportunity to profit tremendously today.

In the 1960s, American Express made a series of bad loans in a scandal dubbed "The Salad Oil Scandal." Essentially, American Express was the victim of fraud by a company that obtained loans based on its far-overstated inventory of salad oil. When all was said and done American Express shares dropped more than 50%.

 

Seeing a tremendous value, Buffet stepped in and bought a 5% stake in American Express Co. (NYSE: AXP) for about $20 million. As the years went on, Buffett has seen a tremendous return on his investment, increasing his ownership in American Express to roughly 14% of all shares outstanding currently.

 

The point of this look back in history is that tremendous gains can be made when great companies are going through temporary turmoil. And interestingly enough such an opportunity has popped up with American Express once again.

 

Now shares haven't dropped 50% this time around, but the company did just end a longstanding agreement with Costco, resulting in the mass retailing club no longer accepting or issuing any co-branded American Express cards.

 

Immediately following the announcement shares of American Express dropped 6.4%, and have slid even further now down by about 8%.

 

The company has been very clear about the impacts of the partnership terminating. On an analyst call hosted by American Express' management team, they projected that 2015 earnings will be flat-to-modestly-down year-over-year and should begin to grow in 2016. Furthermore management expects to begin posting 12%-to-15% earnings growth in 2017.

 

American Express will feel some temporary pain, but there was one interesting fact that not many analysts are talking about. More than 70% of American Express Costco cardholder transactions occur outside of Costco. That presents a promising opportunity for American Express to keep those cardholders. Though the market's knee-jerk reaction was to dump shares of American Express, I believe it's overdone.

 

For reference, look at where shares of American Express are trading relative to its competitors.

  American Express  Discover Financial 
MasterCard 
Visa 
P/E  14.4  11.4 28.2  30.1
P/S 2.5 3.3 10.8  13.1
P/CF 9.3  7.4 29.9  22.7

Other than Discover Financial, American Express is trading at a significant discount to its competitors. While many may just look at a stock's price-to-earnings or price-to-sales ratios, I prefer analyzing price-to-cash flow figures. In contrast to earnings and sales, cash flow provides a much more concrete picture of how much cash a firm brings in. And considering that its five-year average price-to-cash flow ratio has been about 11.7, at a current P/CF of 9.3, shares are trading at a significant discount.

 

Now, I'm not suggesting investors go out and buy shares on the open market today. There's a much better way that could generate 5.5%-to-6.9% in instant income. And what's more, we could have the chance to buy shares of American Express at 8.3% discount to today's already-discounted prices.

 

I aim to do this by selling puts.

 

As you may know, one "put" option gives buyers the right -- but not the obligation -- to sell 100 shares of stock at a specified price before a specified date (expiration date).

 

When we sell a put contract, we receive a cash premium, or what I call instant income, upfront.

 

Selling a put means we're expecting the stock not to fall to a certain price (the strike price). If it does, for every contract we sell, then we have to buy 100 shares at that price (more on why that's not a bad thing in a minute).

 

If the stock goes up, or doesn't sink to the strike price we chose, then we'll pocket that upfront money as pure profit.

 

As part of the process, your broker will likely require a deposit -- called a margin requirement. It usually runs about 20% of the amount it would cost you to buy the shares.

 

So let me show you how it works with American Express.

 

Shares of American Express closed yesterday at $78.09. I recommend selling April puts on AXP with a $72.50 strike price for a premium between $0.80 and $1.00. As long as the puts are trading between $0.80 and $1.00 I still recommend executing the trade.

 

Here's how the trade looks if we sold one AXP put.

 

Your broker would likely require a margin deposit of $1,450 per contract (20% of $7,250 -- the total cost per contract if you were to buy shares of AXP at the strike price).

 

Now I'm looking for one of two desirable outcomes with this trade.

 

1) Generate instant income: Selling these puts would generate between $80 and $100 (remember each contract controls 100 shares) of instant income. If shares of AXP trade above the strike price of $72.50 on April 17th (expiration date) then we keep the instant income for a return of 5.5%-to-6.9% in only 58 days. This comes out to an annualized return of between 34.6% and 43.4%.

 

OR

 

2) Buy shares of AXP at an average 8.3% discount: If shares of AXP trade below the $72.50 strike price on April 17th, then we are obligated to buy AXP at $72.50 per share. But adding in the $0.80-to-$1.00 instant income we received for each share, we'll end up buying shares of AXP for between $71.50 and $71.70. This averages out to an average 8.3% discount to the prior day's $78.09 closing price.

 

This strategy allows you to either rake in a spectacular 5.5%-to-6.9% return on investment in a short amount of time, or buy shares of a time-tested, American company at an amazing 8.3% discount to its already-cheap price. Both sound like great outcomes. Remember, just one week ago shares were trading above $86, and at the end of 2014, AXP was trading above $94 per share.

 

If you were obligated to buy shares of AXP, then you'd be buying them at an exceptionally cheap 8.4 price-to-cash flow multiple, one that hasn't been attainable in years.

 

Risks To Consider: With any investment there are risks involved. Should American Express shares decline below the $72.50 strike price and you are assigned shares, you could be sitting on a loss. If you're holding for a longer-term time horizon, that should not be a problem as you'd still be buying shares at a discount to where they're currently trading at.

 

 

Action To Take --> It's no secret that American Express will take a financial hit, but I believe the selloff is overdone, and this trade presents a great opportunity to exploit it. As mentioned above, I recommend selling AXP Apr $72.50 puts for $0.80-to-$1.00. This will allow you to either buy shares of American Express  at an 8.3% discount, or generate an instant return of 5.5%-to-6.9%.

Now this trade really gets me excited, but I do have to give credit to my colleague Amber Hestla of Income Trader for teaching me the ins and outs of selling put options. In her premium service, she consistently identifies high-potential options trades like the one I'm telling you about today. In fact since she began in February of 2013, Amber has closed an incredible 85 winning trades in a row -- a perfect track record.

 

Properly using options can be a powerful way to generate income, and Amber has put together an eight-minute tutorial explaining step-by-step what you can do to start collecting income immediately. If you're interested in using put options to generate instant income, then I encourage you to watch her presentation.

Chris Carson 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.