Investing for Income in 2011 with Stocks and Options – Part 2

While some tech companies have been on fire this year, sporting valuations and price action reminiscent of the tech bubble, the older tech giants have grown into their valuations and many look like good investments at current prices. Here is a look at forward P/E ratios and dividend yields for a group I call Value Tech:

Considering historical growth of revenues and earnings, as well as estimates for the coming years, all of those companies appear reasonably valued. Hewlett-Packard (HPQ) has a strikingly low forward P/E ratio and Apple (AAPL) has a lower one than might be expected for a company experiencing breakneck growth and with a massive amount of cash. Of the companies on this list, only Intel (INTC) and Microsoft (MSFT) provide meaningful dividend income.

The idea is to profit handsomely on modest or even no share price appreciation, while being willing to take the risk of the shares moving down strongly. This involves buying shares and selling strangles as described in Part 1.

Judging by options prices all the stocks are perceived to have roughly equal risk, with implied volatilities for at-the-money options expiring in January 2012 in the mid to high 20s. Apple is the exception, with implied volatilities in the low 30s. Here I will use Microsoft as an example.

Microsoft Corporation (MSFT)

The company so many people love to hate, Microsoft nevertheless grows revenues and earnings year after year. Over the last five years, annual revenue growth has been 9.4% while earnings have grown 13.4% per year. In the current fiscal year (ending June 2011) analysts expect revenues to grow 9.8% and EPS to grow 16.7%, on average.

The big risk Microsoft faces is that cloud computing will cut into the profits of its two big cash cows, Windows and Office. While this is certainly a valid concern, it will take many years to play out and it should not be forgotten that Microsoft is and is likely to remain one of the key players in cloud computing.

Suggested Options Trade

The example assumes that 100 shares are purchased and a put and a call option are sold. For the put option I use the $27.5 strike price and for the call the $32.5 strike.

The static return – which assumes no change in the share price – on this trade is $474, which is a 19.8% return on the initial cash outlay, or 8.5% taking into account cash to secure the put options sold.

If the share price is above 32.5 on expiration the shares will be called away, leaving the investor with no position. A 15.8% increase in the share price would give the investor a 38.3% return on the initial cash outlay or a 16.5% return assuming the puts are cash secured.

For this trade to produce a loss, the share price would have the be under 25.42 at expiration, a 9.5% decrease from current prices.

Dislcosure: Author is long AAPL, CSCO, and INTC

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