With option expirations last Friday, many of the options I had written have expired. Generally speaking that was a good thing for me, as it meant I was able to keep the option premium. It also meant that I had to reload many of the positions, which I did yesterday.

There were a couple of situations in which I would have done better by simply buying or selling the stock outright rather than selling the options. In other cases, I would have fared worse. Over the long term, I think the option writing strategy will be more rewarding and less risky than a stock-only strategy.

The new option positions I have written (all expiring in June) are:

• Coach (COH) $35 puts
• Hansen Natural (HANS) $30 calls
• Radioshack (RSH) $15 puts
• Ansys (ANSS) $45 call options
• Starbucks (SBUX) $17 call options
• Adobe (ADBE) $45 call options
• Ceradyne (CRDN) $40 put options
• Nutrisystem (NTRI) $20 put options

I also sold outright a position in Itron (ITRI), which was too few shares to cover with a call option. I had a nice profit on the shares, but they have been acting punk lately and I’m a little worried about the potential for new smart meter competition. I might be interested in getting back at a cheaper price.

Disclosure: Obviously, at the time of publication William Trent has a financial position in all of the companies mentioned in this article with the exception of Itron.

Disclosure: Author is long Starbucks (SBUX) at time of publication.

When I first became an analyst, my boss was fond of saying he’d rather have luck than brains. There are so many times, as an investor, when I have considered the understated wisdom of those words. The whole field of behavioral finance is devoted to the tricks our brains like to play on us, and there are certainly plenty of examples of cases where investors simply became too smart for their own good.

I had a little case of luck last week, when I was going to write puts on either Ceradyne (CRDN) or Verizon (VZ - Annual Report), having the capital available for only one of the trades. I chose Verizon primarily out of luck, and it has rallied nicely from the intra-day lows near which I wrote my puts, making it quite unlikely that they will be exercised against me. Meanwhile, Ceradyne lowered guidance Tuesday and lost more than 25% of its market value.

Although I have often expressed the benefits of a put-write strategy (lowering the effective price of stocks you were willing to buy anyway, or collecting a more generous yield if the stock doesn’t fall below the strike price) I thought an analysis of the Ceradyne case would offer a good illustration of the risks – and why I like the strategy even when those risks are considered.

First of all, the 25% decline in Ceradyne was going to knock put sellers or long investors regardless of any stop-loss or other strategies commonly described as “risk reduction” tools. In fact, it nicely illustrates the criticisms of the Black-Scholes option pricing model so recently discussed in Conde Nast Portfolio. Namely, the big event risks are underestimated. Only having bought puts at a lower exercise price (and thus eroding the potential returns) would have offered some protection against the sudden price drop. 

That said, does the exposure to sudden price drops invalidate the strategy? I don’t think it does, provided investors focus on the stocks that they understand and are willing to be long anyway. In fact, when I looked at the put-write on Ceradyne in December I pretty much nailed the potential risks.

“Let’s say you write a January $45 put and get your $1.60 premium. In January, the stock trades at $44 and you end up with it, at a net cost of $43.40. You immediately sell a February $45 call option for something like $1.25, bringing your net investment down to $42.15.

“Then the company announces that earnings will only be $3 a share in 2008, and the stock drops to $30. You’re down $12.15, or 27% of the money you put at risk. So much for low risk.

“On the other hand, if you compare the same transactions to buying the stocks today for $48.30 you would be $6.15 ahead of the game if you used the option strategy. So, while the risks are real, I still consider the strategy to have less risk than either owning or shorting Ceradyne outright.”

Whether simply buying a stock, or using a put-write strategy, knowing the risks is imperative. I always try to look at a disaster scenario (like the one I illustrated for Ceradyne) that is outside the limits of what most investors consider. Usually these disasters don’t occur, but they happen more often than investors like to admit. Planning for them – and mitigating them when possible – should pay off over time.

Disclosures: William Trent has written put options against the shares of Verizon (VZ - Annual Report).

This article is a reprint of my February 13, 2008 RealMoney column.

Late last year I used the government’s PPI data by industry to scout out 26 investment ideas, among which were industrial valve manufacturers Flowserve (FLS), Crane (CR) and Curtiss-Wright (CW - Annual Report). In October, I said Flowserve may be the best way to play the PPI report.

Since that column in October, Flowserve has gained more than 22.5%, while the S&P lost nearly 12%. Now the question is whether to let this winner ride or to take the money and run. For now, I think the answer is to keep on going with the Flowserve.

For one thing, they call them “industrial” valves for a reason – and that means there is likely limited exposure to a consumer slowdown. According to the most recent 10K, the company’s customer mix by end market is approximately 43% oil and gas, 23% general industrial, 15% chemical, 13% power generation and 6% water treatment. These are industries with long-term planning needs, many of which are finding themselves behind the curve. I don’t see them slowing their spending any time soon.

This is supported by the pricing power the industry continues to enjoy. Although off the 2007 peak in the double digits, the year/year change in January was still far above the industry’s long-term average and still indicating an overall rising trend.

12-month Percent Change in Industrial Valve Manufacturing Prices

Source: Bureau of Labor Statistics

The pricing power is also flowing through to earnings. Flowserve is set to announce earnings on February 27, but they preannounced in a big positive way at the end of January, which explains most of the stock’s run. Curtiss Wright shares, meanwhile, gained 7% on Tuesday when their earnings beat estimates by $0.09 per share “led by our Flow Control and Metal Treatment segments, which experienced strong organic growth of 23% and 15%, respectively, over the prior year periods.” Crane also walloped estimates when it reported last month.

All these positive estimate revisions caused Flowserve’s Zacks rank to jump up to 1, putting the company among the top 5% of all companies measured in terms of earnings momentum. According to Dan Fitzpatrick, as of last Friday the technicals supported a buy (with appropriate risk controls.)

As with most stock ideas, Flowserve has some downside risk – particularly with regard to valuation levels. In particular, its 1.8% free cash flow yield is below the yield on Treasuries – meaning that a good deal of the return must come from growth. There are several names that offer similar growth and higher free cash flow yields, particularly among the software companies I look at. Still, I think there could be benefit to owning Flowserve for diversification purposes.

Its 19x forward P/E ratio isn’t among the cheapest available, and is toward the high end of the 8x – 24x range at which Flowserve has traded over the last five years. Its price/book ratio is also significantly higher than those of its peers. I would not be at all surprised to see the valuation contract in the short term, and I am virtually certain it will contract in the longer term.

But taking the valuation ratios down to the five year average over the next five years would knock about 4-5% per year off the return, by my estimates. Given the 20% annual expected growth rate over that period, that still leaves room for annual returns of 15% or so, which I think will far outpace the S&P 500 over that time.

Disclosures: None

Zacks Investment Research has provided Stock Market Beat with a complimentary trial subscription to Research Wizard.

The following is a reprint of my December 11, 2007 RealMoney column.

Ceradyne (CRDN) develops, manufactures and markets products based on highly technical ceramic materials. It is best known for selling ballistic plates used for body armor and light-weight vehicle armor by the U.S. military. Such sales accounted for more than 75% of total revenue during the last several years.

Much of that time, shares of Ceradyne have appeared very cheap on a price/earnings basis. Persistent fears that the body armor market would peak have kept a lid on the price. As an example, in October provided guidance for next year’s earnings per share of $5.60 - $6.65. Such a wide range would normally not be much help, but in Ceradyne’s case it means the stock is trading somewhere between 7x and 8x next year’s earnings.

Although I like a cheap stock as much as anyone, I too have been concerned that the military orders would peak. Although the company is expanding into other areas, it will be several years before any of them is likely to offset a potential decline in military sales. As a result, I have taken a very cautious approach to Ceradyne over the last couple of years.

Because of my caution, I missed the run from $50 - $80 per share over the last 12 months. But I also missed the run from $80 back down below $50. In the meantime, I still managed to earn $16 per share on CRDN - after transaction costs - mostly by doing my best not to have a position in the stock.

The really good news is that I think investors can once again profit from a relatively low-risk approach to Ceradyne. Here’s how it would work today.

Selling Options

If you don’t own Ceradyne today, you would sell a put option forcing you to buy the shares at a specific price on a specific date if the shares are trading below that level. Essentially, you are selling downside insurance to someone who owns the shares, and they are willing to pay you a premium for that privilege.

Today, that premium depends on exactly what risk you will allow them to insure. You could get about $0.55 to insure a drop below $45 before December 22, or about $1.60 to insure the same price until January 19, 2008. In either case, you get a return of close to 2% per month for the $45 you put at risk.

Alternatively, you could sell put options at $50, especially if you are confident of the current valuation being cheap. Since these options are in the money, a January $50 would bring in about $4.00 - $1.60 because it is already in the hole, and the other $2.40 being a higher premium than the $1.60 you get (see previous paragraph) for insuring a less likely drop below $45.

So what happens if the stock does drop and your counterparty makes you buy it? Then I would sell a call option. To illustrate, let’s assume you write the put option for $50 and the price doesn’t change between now and January.

You write the put option for $4.00 and on January 19 Ceradyne is priced at $48. Your put option is exercised against you and you pay $50 per share to buy it. Your net purchase price is $50 less the $4.00 premium or $46, and you are $2.00 ahead of the game.

You immediately sell a $50 call option expiring in February. Judging from today’s option prices, you might get $1.50 for this option, bringing your total outlay to under $45 per share. If the stock rises to, say, $51 you get called and sell your shares for $50, for a net profit of more than $5 per share even though you bought and sold at the same price. You may even want to write a new $50 put option at that time and start the process over again.

If the stock isn’t above $50 when the option expires in February, sell another one expiring in March and collect another premium. Incidentally, this is also the way investors who currently own Ceradyne can play this game - instead of starting with a put option, you start with the call.

Risks are Real

I described this strategy as low risk, and I believe it is. But anyone interested in giving it a try should be aware that there are indeed risks, and potentially substantial ones.

Let’s say you write a January $45 put and get your $1.60 premium. In January, the stock trades at $44 and you end up with it, at a net cost of $43.60. You immediately sell a February $45 call option for something like $1.25, bringing your net investment down to $42.35.

Then the company announces that for some reason earnings will only be $3.00 per share in 2008 and the stock drops to $30. You’re down $12.35, or 27% of the money you put at risk. So much for low risk.

On the other hand, if you compare the same transactions to buying the stocks today for $48.30 you would be $6 ahead of the game if you used the option strategy. So, while the risks are real, I still consider the strategy to have less risk than either owning or shorting Ceradyne outright.

Pick Your Value

I did a sensitivity analysis on Ceradyne earnings more than a year ago, and would highly suggest doing a similar one today. Given the range of estimates the company provided (and the possibility that future earnings could be lower) it is a good idea to get a feel for the worst-case scenario.

Once you get comfortable with the worst outcome, you can decide at what price you would be willing to have exposure, and can use options to limit your risk around that level. Small price swings can have a large impact on option prices, so you need to be aware of the market and I often use limit orders for this type of strategy.

Note: If you love stock and market analysis look into online college degrees in finance!

Last month I showed how investors can generate investment ideas by using the Producer Price Index (PPI) report prepared monthly by the Bureau of Labor Statistics. The idea is that industries where prices are rising may contain companies where revenue will grow faster and/or margins will improve.

Of course, like any initial screen the PPI report is only a starting place. It is useful to generate ideas, but further research is needed to determine whether they are good ideas. This month, I do some of that further research.

One industry where the price increases have been flowing is industrial valves. Although the increases have been flattening out somewhat, the 8.3% year/year gain in September is still pretty sweet.

As I mentioned last month, some of the industrial valve makers include Flowserve (FLS), Crane (CR) and Curtiss Wright (CW - Annual Report). Let’s see how they are doing.

According to Flowserve, the PPI indicator is right on the money. Flowserve noted in its latest earnings report that its Flow Control Division’s “gross margin of 35.6% for the second quarter of 2007 was substantially higher than the second quarter of 2006, up 140 basis points. This increase was principally due to improved absorption on higher sales, the implementation of various Continuous Improvement Programs and cost reduction initiatives and improved pricing.” With sales up 13%, bookings up 15%, and pricing remaining strong it looks like the trends could continue for some time.

Crane is also doing well. Crane’s Fluid Handling segment saw a 13% gain in sales and a 30% increase in backlog in the latest quarter. However, “Margins remained at 12% reflecting more price competitive project work and investments in new products and systems to support future growth.” That “price competition” isn’t doing any damage yet, but it could. It may be especially important to watch the PPI reports on a continuing basis to find the right time to get out of a position before the eventual loss of pricing power is picked up in an earnings report three months later.

For Curtiss Wright’s Flow Control division, “Sales for the second quarter of 2007 were $163.2 million, up 26% over the comparable period last year due to solid organic growth and the contribution from the 2006 and 2007 acquisitions. Sales from the base businesses increased 14% in the second quarter of 2007 as compared to the prior year period.” Profitability declined primarily due to cost overruns on a Navy project, but the company noted that margins were also impacted by “labor inefficiencies, business consolidation costs, and higher material costs experienced within our oil and gas market.” The stock has rallied on strong results and increased guidance from its other divisions, however.

After taking a closer look at the three valve makers, I think Flowserve may be the best way to play the PPI report. For one thing, valves and related products make up a larger part of its revenue. As a purer play, the pricing information conveyed from valve PPI is more relevant. It’s true that the better performance has not gone unnoticed by the stock market, which has boosted FLS shares more than those of CW or CR in the last couple of years. However, based on the continued strong pricing environment it looks like that strong performance could be sustained.

This article was originally published at RealMoney on September 26, 2007.

My article last week about mining the PPI report for stock ideas was so well received I thought I’d share another of my favorite taxpayer-provided idea generators, the durable goods report. Published by the U.S. Census Bureau, the report has a similar breakdown by industry of durable goods orders, shipments, inventories and backlog.  I came away with 28 potential ideas for further research.

In line with much of the recent economic data, the headline durable goods number was weaker than expected. To quote from the report, “New orders for manufactured durable goods in August decreased $11.3 billion or 4.9 percent to $219.5 billion, the U.S. Census Bureau announced today…. Shipments of manufactured durable goods in August, down two of the last three months, decreased $3.4 billion or 1.6 percent to $216.7 billion.”

But in this case, I think focusing on the forest means you could miss out on some of the more attractive trees. I gathered the data from the Census Bureau and created charts showing the year/year change in durable goods statistics for a variety of industries hoping to find some areas worth further consideration. Keep in mind, this is an initial screen for idea generation, not a full-fledged analysis of any of the names. You wouldn’t want to buy the stocks listed here without further research. That caveat aside, let’s look at some of the better performing industries.

First up is technology – computers and electronic products. Although 3.3% order growth year/year and essentially flat shipments may not be the type of growth investors typically look for from tech, it is a clear improvement from recent months. Inventories are starting to be drawn down and backlog remains strong.

But there are areas of strength and weakness within tech. Specifically, computers (and related products) themselves are starting to look strong, with backlog headed through the roof and inventories in check.

The fairly obvious stock ideas from this industry include Apple (AAPL), IBM (IBM - Annual Report) and Hewlett Packard (HPQ - Annual Report). If things keep getting better (and the company figures out how to file its required regulatory reports) Dell (DELL) might even look interesting again. Stretching a bit further, Sun Microsystems (a href="http://stockmarketbeat.com/blog1/category/tech/sunw/">SUNW - Annual Report) and Lexmark (LXK) come to mind. And don’t forget the storage plays, which also showed up on the PPI hotlist. The names I mentioned then were Brocade (BRCD), EMC (EMC - Annual Report), Iomega (IOM), Hutchinson (HTCH), Quantum (QTM), SanDisk (SNDK - Annual Report), Seagate (STX - Annual Report) and Western Digital (WDC).

Communications equipment is also showing some signs of strength. Though the latest month was down, the trend seems to be up.

I have actually analyzed Motorola (MOT - Annual Report), so that would be a play to include here. Cisco (CSCO), Research in Motion (RIMM), 3Com (COMS), Nokia (NOK) and Corning (GLW - Annual Report) also come to mind.

And finally, turning away from technology, I hope you didn’t think the aircraft boom was over. If anything, it looks to be picking up steam.

Ways to play this include Boeing (BA - Annual Report), Embraer (ERJ), General Dynamics (GD - Annual Report), United Industrial (UIC) and Cessna parent Textron (TXT). Parts suppliers include Rockwell Collins (COL), Curtiss Wright (CW - Annual Report), and LMI Aerospace (LMIA).

So there you have it: 28 potential stock ideas from what looked at first glance to be a negative report on durable goods.

Disclosure: Long RIMM put options at time of publication.

Originally published at RealMoney on September 19, 2007.

Tony Crescenzi says the latest PPI report should be tossed because the benign headline reading will almost certainly be reversed in the months ahead owing to the surge in energy costs that has occurred of late. I say not so fast! If prices are rising, that means some companies out there are likely to see better profits. Before tossing out the report, I’m betting we can figure out who a few of them will be.

The Bureau of Labor Statistics, which prepares the PPI report, provides detailed information on an industry basis. The problem is figuring out how to find it on their web site. Starting at the PPI home page, I scroll down to the headline that says “Get Detailed PPI Statistics” then click on Industry Data. You can then pick out which industries you want to see (I pick ‘em all) and click “Retrieve Data.” Then I select “More Formatting Options” and click on the boxes for 12-month percent change, all years, and include graphs. Once I hit “retrieve data” again I have what I’m looking for - graphs that make it easy to tell which industries are gaining or losing their pricing power.

First up is the fruit and vegetable canning industry. At 5.3% year/year inflation, pricing is clearly better than normal. It is down from a recent peak but still looks to be generally in a rising trend.

Possible plays on this industry include can makers such as Ball Corp. (BLL), Crown Holdings CCK - Annual Report), or Silgan (SLGN - Annual Report). Or you can go to the food processors such as Campbell Soup (CPB), Del Monte (DLM - Annual Report), Hain Celestial (HAIN), or HJ Heinz (HNZ).

Looking better still are industrial valves, up 9.3% year/year against tough comparisons.

Some of the industrial valve makers include Flowserve (FLS), Crane (CR) and Curtiss Wright (CW - Annual Report).

But enough with boring “old” industries. How about tech? It is seldom that tech prices actually increase, but sometimes they decline at a slower than usual pace, which can provide a similar opportunity. That may be the case right now with computer storage devices.

Last month’s 2.9% decline from last year was the smallest price drop on record for this industry, and the ongoing consolidation may help the trend continue. Plenty of ways to play this one, including Brocade (BRCD), EMC (EMC - Annual Report), Iomega (IOM), Hutchinson (HTCH), Quantum (QTM), Sandisk (SNDK - Annual Report), Seagate (STX - Annual Report), and Western Digital (WDC).

By contrast, semiconductors are experiencing the worst pricing on record.

That could be the signal for a contrarian play (I happen to think the worst will soon be over for semiconductors) or possibly just an excuse to avoid the group for a while.

The PPI clued me in to the opportunity in railroads a year before Buffett bought in. I hestitate to bet against him, but it looks like the industry’s price increases have ground to a halt.

If you have the guts, I’d count this as bad news for Burlington Northern (BNI), CSX Corp. (CSX), Norfolk Southern (NSC), and Union Pacific (UNP).

Finally, Wired Telecommunications saw pricing decline for years after the 1996 Telecom Act, but recent consolidation is allowing them to raise prices again.

Winners here would be CenturyTel (CTL), AT&T (T - Annual Report), Verizon (VZ - Annual Report) and Embarq (EQ).

By my count, that is 26 potential stock tips, all courtesy of the U.S. government. I’ll take that over tossing the report any day.

Disclosure: Long Semiconductor HOLDRs (SMH).

 This morning’s PPI report showd that the frantic price increases for industrial valves have cooled a bit. Still, price gains are well above the long-term average and the general trend still seems to be rising.

According to Alexander’s Gas & Oil Connections:

The market leader positions in the industry changed considerably with the acquisition of Invensys Flow Control by Flowserve (FLS). The combination is now the second largest supplier with a 4 % market share. This compares to a 6 % share for the leader Tyco (TYC). Emerson (EMR) with 3 % is in the third position.The industry is very splintered with more than 1,000 companies carving out niches.

Moog (MOG.A) and Curtiss Wright are others that come to mind as possible beneficiaries.

Mid Cap Watch List (Track at Marketocracy) member United Industrial Corporation (NYSE: UIC) announced today that holders of the 3.75% Convertible Senior Notes due 2024 (”Senior Notes”) can convert their Senior Notes into shares of UIC common stock during the calendar quarter from July 1, 2007 through September 30, 2007.

A holder electing to convert Senior Notes will receive either cash or 25.4863 shares of UIC common stock (or a combination of cash and common stock) per $1,000 principal amount of Senior Notes. Conversion is at the option of the holder. Payment in cash and/or UIC common stock is at the option of UIC. This event is triggered by UIC’s stock price remaining above $47.09 (120 percent of the initial conversion price) for at least 20 consecutive trading days during the last 30 trading days of the quarter ended June 30, 2007.

If the Senior Notes are converted into common stock, holders will forfeit their right to receive 3.75% annual interest on the Senior Notes and will instead be entitled to receive future dividends (if any) on UIC common stock. Such dividends are currently $0.40 per share per year, equivalent to an annual dividend yield of 0.67% based on the closing stock price on June 29, 2007.

With UIC shares currently trading at $62.24, conversion would yield $1,586 worth of value for each $1,000 bond. The $0.40 annual dividend would result in a cash flow of $10.19 per year, compared with the current $37.50 from the bond interest. Investors in a high tax bracket would also benefit from the lower tax on dividends than on interest income, which would narrow the differential.

On the other hand, investors who choose not to convert will continue to have the higher annual payments for another 17 years, and will have an effective limit to any stock market losses should the share price decline.  If I were a bondholder, the only reason I’d be likely to convert would be if I thought the shares were as high as they could go. Otherwise, I’d just hang on to the higher annual payments and the valuable long-term call option.

I have discussed Ceradyne’s operating leverage in the past, and noted that what is more important than the quarterly results is whether they will prove sustainable.  To that end, the company’s latest press release is interesting:

Ceradyne, Inc. (CRDN) announced today the opening ceremonies for its new 98,000 square foot factory in Tianjin, China. This newly constructed factory will produce high purity ceramic crucibles for the forming of large polysilicon ingots for use in the manufacturing of photovoltaic silicon solar cells.

Wow! China and solar energy. Can’t get much growthier than that. Of course, they are making the crucibles that will make the ingots that will make the solar cells… kind of like saying a cement company makes the product used to build buildings in which cutting-edge pharmaceuticals are developed.

Breathless headlines aside, however, the plant marks a step in the right direction. Namely, diversification away from the body armor products that are approaching their natural demand limits.