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.
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.