Own the Call Options Instead of the Stock

 | Nov 21, 2012 | 3:00 PM EST
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I have been advocating for the long-term purchase of various large-cap stocks that have continued to trend lower. These businesses have remained solid but the market has lost patience -- a scenario that is always exists in the stock market. Investors will indiscriminately dump shares that are performing below expectations, regardless of what long-term opportunities may manifest. To be sure, often the market is right but that is not always the case. Opportunistic investors thrive by exploiting those exceptions.

Dell (DELL) is an excellent candidate for the purchase of long-term call options. Recently trading around $9, the company's share price has slowly been nicked at as Mr. Market has no patience for Dell's transformation from a PC seller to an enterprise solution systems provider. An interesting point of reference: IBM's (IBM) metamorphosis from a seller of PCs to what it is today was nearly a decade in the making. Big Blue's transformation attracted none other than Warren Buffett as a major investor in the company. Coupled with a stock price that suggests Dell has no future, you have a founder/CEO who has furiously bought shares for himself. The company has also been buying back shares and now also yields nearly 4%.

Dell's January 15, $7 calls can be purchase for approximately $2.50 today (we exclude commissions for this article). If Dell is successful in its plan -- which I think it will – the shares are easily worth $16-$20 a share if not more. Keep in mind that the significant reduction in shares outstanding will only serve to accelerate earnings-per-share (EPS) growth in the future. A $16 share price by January 2015 results in a $9 option price, a 260% return in just over two years. A $20 share price represents a return of 460%.

Chesapeake Energy (CHK) is another misunderstood name that is a quality call option candidate. For years, CHK has leveraged its balance sheet to acquire natural gas assets that are irreplaceable today. Thanks to a push from Carl Icahn and Southeastern Asset Management, CHK now has an impressive Board of Directors who are significant shareholders. In addition, CHK is now monetizing assets and has been doing so at impressive prices. Both Icahn and Southeastern own shares at prices much higher than today's $17.60 share price. Another tailwind is the likelihood that, after falling to historical lows over the past few years, natural gas prices are headed higher.

The January 2015, $15 calls can be purchased for approximately $5.75 for a company that many value investors peg fair value in the low $30's. And if natural gas goes on a tear, the shares could be worth over $40. A $25 share price by 2015 -- a highly probable and conservative scenario -- will result in a $10 option price, a return of 75%. A $30 share price will create a 250% return from holding the call option.

The next year will likely be fraught with many uncertainties, both economic and political. Owning some long-dated calls on quality undervalued businesses creates a way to look beyond the immediate future and focus on the longer-term picture, which, hopefully, we will have addressed and fixed some our current issues today. More so, the capital outlay is reduced, allowing investors to preserve some cash.

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