Buying LEAPS To Generate Outsized Returns | The Acquirer's Multiple®

During his recent interview with Tobias, Matthew Peterson, Managing Partner at Peterson Capital Management discussed Buying LEAPS To Generate Outsized Returns. Here’s an excerpt from the interview:

Tobias: The Greenblatt Yellow Book, How to be a Stock Market Genius, he includes in there this discussion of buying leaps where he says if you’ve got a position where the downside could be unlimited, it might be a zero, but you like the risk-reward of the position that you could then go and buy a leap, which is a long term equity, anticipation, security, something like that.

Matthew: Yes, that’s right.

Tobias: Something odd. Basically, it’s just a–

Matthew: I think the definition of a leap is simply an option that’s out longer than a year, I believe.

Tobias: Yeah, that’s what I understand too. So, you can buy a call in something that expires in 2020. I think they’re currently traded now for a lot of stocks, 2022 January or 2023 January might even be available at the moment. Do you ever do any call buying of that kind of nature?

Matthew: So, it’s a really good question. And these are all great strategies. Given the exact scenario that you’re mentioning, it’s something we would consider. But at the fundamental level, what I’m really looking to do is– so how can I say this?

Tobias: You prefer to be a vol seller than a vol buyer?

Matthew: Yeah, I prefer cash coming in, rather than cash going out. So anytime you buy a call, you are at a risk of the timing being wrong. And so, that’s what’s most challenging for me, is that markets can be irrational and if you happen to be in a recession or a pandemic, or there’s something going on, and the prices aren’t where they really rationally should be, you just automatically lose 100%. So certainly, if you took a basket– I can see a scenario where you have a basket of securities that might play out, and you can maybe call that one position, and it actually is 10 underlying securities. And maybe there’s really a symmetric upside, but it could be a zero. It might be a winning strategy, it’s not something that we usually do. We’re really focusing on capturing the long-term securities through the sale of these puts, and we just use it as an entry price. But other than that, it’s pretty plain vanilla.

Tobias: So, you tend to be a vol seller rather than a vol buyer. So, let’s talk about selling a position and the reverse of selling a put is selling a call, which is then giving you the– if you hold the underlying security and it gets to your price, then you become– yet that’s a way of exiting and capturing some of the volatility on the upside. Is that a strategy that you employ?

Matthew: Right, that’s exactly what we do. So, if we had a hypothetical situation where there was a security that fell from $100 to $50, and we thought maybe the value was $200 and now it was so attractive, that we wanted to make it a position, instead of buying at $50, we might sell puts at $50, pick up $10 in premium and ultimately pay $40. As they start approaching $200, and this could be 8, 10 years later, they’re approaching $200, we’ve now made 400% almost, and we then go to sell a call, that call then would pay us premium. And by the way, as the shares have risen, the call price has become more expensive. So, we pick up quite a bit of premium on that side as well. I’m just hypothetically using 10% or so but if the shares are appreciating, and they’re out $190, we might sell a $200 call, strike, pick up $20 for that, and should they rise above $200 now, we’ve exited. Instead of going from $50 to $200, we’ve now gone from $40 to $220.

And so, it actually makes a meaningful difference to your IRR. Even over a 10-year time horizon, you end up adding multiple single-digit but solid single-digit percents to your holding throughout a long period of time.

Tobias: So, the positions that you are writing the options on, if you’re underwriting the downside in one of these, you have to be reasonably confident that this is a solid thing that you’d like to own, so what’s the process? Just ignoring the buy, the actual mechanics of buying and selling, let’s talk about the qualities of the businesses that you like to buy. Where are you focused and how do you think about them?

Matthew: Yeah, it’s a really important question. And it’s similar, again, to holding the underlying equity. So, I have a very straightforward framework that I just a little mental model in my own mind that I think– that I try to adhere to. And it’s basically I’m looking for the greatest business models and the greatest management, and then a fair price. And if you can sort of get into that intersection, I think you have a– you increase your odds of weathering any unforeseen storm, because you have a great business model and you have great managers, and you’ve paid a good price. So, that’s something that is always very helpful. But I’m fundamentally looking at all the same metrics that you’re looking at. I think I bend a little bit more to some qualitative aspects, but I want to make sure that the multiples are within proper ranges, and I’m not overpaying some EBIT, EBITDA, or whatever. I really care about cash flows.

I’m evolving, as I think everybody does, and I used to care or look carefully at book value and underlying assets. And now, I’m questioning some of these legacy philosophies that I had because cash flows can come with no book value. And so, cash flows are much more important to me. But what I’m really looking for is clear quality assets that sort of underwrite the firm in general, if that makes sense. And a lot of times, what I really appreciate finding, and oftentimes I think this is where deep value is, is I’m finding value that is somehow off the financial statements. So, that could be super high-quality management, or some moats or brand that’s not really apparent in the financials because I find if it’s really obvious in the financials, nobody’s missed anything. And the markets are usually pretty efficient. But I really try to find something that is creating a floor to this position that we’re looking at, for example.

Tobias: Right. That makes sense.

Matthew: Did that make sense? I’m not sure if that was– [crosstalk]

Tobias: Yes, as a volatility seller– and this is not something that’s unusual to value guys, but you think about the downside a lot, that’s the first step in the process.