Saturday, July 16, 2016

Best Deal I'm Seeing Now Is a Macro Trade: SPY Put Combos

Update 8/4/2016

Looking at this post from a couple weeks ago, I seemed to be making the assumption that low VIX = low option prices. That is a naive view. I have learned a little more since this post and I will try to share here.

1) VIX only covers front month contracts, so options 6 months out are not necessarily cheap just because VIX is low. To get a sense of how expensive options are further out, you can look at VIX futures curve. In this case the VIX futures curve is actually quite steep, showing that options 6 month - 1yr out is reasonable but not super cheap.

2) Ok, so volatility is cheap, but is it calls or puts?  For that you can look at "skew". Barrons is a good source here. For a longer term view, you can look at the CBOE SKEW index. This shows that while demand for puts have came down from earlier in the year, it is about normal relative to recent history.

3) low VIX also benefits from low implied correlation. If the individual stocks in S&P500 are going to go opposite directions in prices, that would balance out index prices and dampen the overall index volatility. We're in the middle of the earning season so the low expected correlation makes sense.

So my post below is incomplete. However, the risk/rewards of the below trades are still what they are. Numbers don't change just because my understanding is flawed. They may not be as cheap as the low VIX would suggest, but I still find them attractive.  

Original Post:

Once in a while a good deal comes your way. That can happen in the single stock universe or in the macro world. At the moment I see one in the latter.

Right now, SP500 put combos offer a high probability trade with 4.5-to-1 upside/downside ratio.

Option prices are based on volatility and that is clearly at the lower end of historical range. Below is the historical chart of the VIX index from 1990. The red line is the latest VIX reading of 12.8 and green line is the 10th percentile level of 12.2.

While the VIX can go lower, any drops below 12-13 level tend to be followed by sharp bounces upwards within a few months. A 6 month option should be long enough.

With the VIX below 13 and SP500 at all time high, this is a good time to buy some SPY puts. Here’s a combo I was able to buy last week (all puts expire Jan 20, 2017).

The payoff diagram at expiration is as follows:

This combo goes in-the-money with SPY at $214 - the chances of SPY falling more than 1% from its current $216 level seems pretty high to me! It's not like the world has no problems! Peaks profitability comes if SPY falls to $203 by Jan 2017. Maximum upside is 4.5x the downside.

More importantly, you spend $2.54 to control a $216 position. That leverage allows you to hedge your entire portfolio with an 1.2% option position.

I started accumulating this last week. If the stock market continues to go up, I plan to take profit and plow it back into more of these trades as they become available. The plan is to be very aggressive if VIX falls to low 12’s or even lower.

Monday, July 11, 2016

Good News for Omega Protein

A quick update to my Omega Protein ("OME") write up from a few months ago.

1. On 6/28/2016, shareholders elected Wynnefield Capital's nominees for the board. The activist investor now has 2 out of 8 board seats.

2. The latest NOAA Menhaden fishing season status came out 7/5/2016 and it looks like OME is off to a strong fishing season.

These good news should lead to an upbeat 2Q'16 earning call and drive stock price upward.

Saturday, July 2, 2016

Sterling Construction Will Enjoy Higher Margins For Years to Come

Sterling Construction Company (STRL) works on transportation and water infrastructure projects (more of the former, particularly highways). It’s a microcap that few analysts cover. The stock trades at $5/share and I think it could be worth $8.

The company has all sorts of not-so-obvious positives: turnaround play with operating momentum, low margin legacy contracts fading away, big net operating losses (NOLs) to monetize, understated book value due to off-balance sheet asset. On top of all that, management incentives are aligned with shareholders.

The political/economic climate also favors Sterling. Monetary policy is running out of bullets and politicians have to start pulling fiscal levers. Highway construction is one area that enjoys bipartisan support – even Republican candidate Trump talks about using constructions to provide jobs.

The next few paragraphs will give a brief industry background before getting into company specifics.

Cyclical business, But Right Part of the Cycle

Coming out of the Great Recession, federal and state governments tightened their construction budgets. For the past few years, companies competed intensely for limited work and margins fell as a result.

That picture is reversing. At the federal level, Obama signed a $300+bn Fixing America’s Surface Transportation Act (“FAST Act”) in December 2015, which provides certainty over the next 5 years. At the state and local government level, politicians have also been working to boost construction budgets.

Texas and California are Sterling’s two biggest markets. Texas is already seeing a spike in highway construction budget. Not only that, the recently passed Proposition 7 will provide billions more in funding starting late 2017. California is also in the works - although transportation needs were not addressed in the June budget, it remains high on the agenda. Multiple stakeholders are united in their push for increased funding. Here’s a taste of what's happening from Granite Construction’s latest transcript.
"We are helping lead the charge in California where construction industry and labor leaders are working shoulder to shoulder to build legislative support for a long-term incremental commitment for transportation investment of at least an additional $40 billion over the next 10 years."
In the coming years, I expect even better legislative support for infrastructure projects as politicians turn to fiscal stimulus. With a bigger and more visible budget, competition will be more rational and that should lead to better margins.

Gross Margin Turnaround and Other Good Stuff

In fact, Sterling Construction is already seeing improving margins. Gross margin is by far the largest driver of net income and cash flows, and here’s how that’s looking:

The momentum is clear. Gross margin troughed during 2013-2014 and has been going up since. Also note that margins have plenty of upside before returning to historical norm of 10%+.

Backlog margins are improving as well. Gross margins in the backlog for the past 4 quarters (starting 1Q’15) are 6.0%, 6.5%, 7.0%, 7.7%. Management expects 8.5%-9% by year end.

Part of the margin improvement will come from better mix. Sterling has been held back by legacy low margin projects from 2013, but it is quickly working them down. Here’s what CEO Paul Varello have to say:
“…we have to complete approximately $70 million worth of legacy jobs that will finish over the next couple of quarters and will generate small to zero margins. We believe that we will start to see the higher margin projects generate stronger earnings in Q3 and beyond…In addition, by year-end we anticipate that our overall backlog margin will be in the range of 8.5% to 9%.”
Those higher margins come at a great time as Sterling had accumulated a big NOL. With the cycle turning, it will basically pay no taxes the next few years.

There are more goodies and I will quickly outline them here:
  • Sterling bought $40mm of life insurance policies. The policies are to cover Sterling’s commitment to buy out minority interests upon death of key executives. That commitment is booked as a liability on balance sheet, but the insurance policies are off balance sheet. So book value is understated by a material amount. 
  • The company just did an equity raise to deleverage the balance sheet. 
  • CEO Varello took an $1 salary and restricted stock when he took over last year. 

Put it all together

Backlogs have been increasing and will likely increase over the next five years. Margins have gone up with lots of room to go. But at $5/share the stock is trading like a normal cyclical. It certainly does not reflect the extended growth runway I described above.

2017 P/E is a modest ~9x. The real question is how does 2018+ look? I think the answer is higher revenue, higher margin, and no taxes will translate to explosive free cash flows growth and multiples expansion.

Note: Competitor Primoris was also bullish about Texas in its 1Q’16 call.
“We continue to expect substantial growth in the Texas heavy civil market, especially once Prop 7 money starts to flow. Which should be sometime late next year.”