Masters Series: How We Made 177% in 11 Months on a Tobacco Giant

How We Made 177% in 11 Months on a Tobacco Giant
By the Stansberry Alpha team

As we explained yesterday, tobacco giant Lorillard had many of the characteristics we look for in a good investment: capital efficiency... cheap valuations... a history of rewarding shareholders... and massive growth potential in the electronic-cigarettes market. But we didn't want to simply buy shares...

Our strategy at Stansberry Alpha is to find "anomalies" in the markets.

We first look for value in the underlying stock... That's what we talked about in yesterday's Masters Series essay.

Then, we find anomalies in the market with one single, simple options-trading strategy.

This strategy increases the returns on margin we're able to earn on our highest-conviction ideas. And at the same time, it lowers the risk we take to open a position.

The way to leverage our ideas is by buying call options. Call options give investors huge upside potential, while limiting risk to the premium paid for the option. (Remember, if the price of the underlying shares rises... we can buy the stock in the future for less than the market is asking.)

We pair our purchase of calls on these recommendations with the sale of a put. Doing so will not only allow us to finance the purchase of our call option... It will provide us some upfront income. That mitigates our risk.

By buying an options pair, we get paid generous upfront net credits to open the position. Then we also have the potential for high-double-digit (or triple-digit) returns as the trade plays out.

The options pair we liked best for this Alpha trade, which we recommended in February 2014, expired in January 2016. While we didn't expect we'd need to wait that long, it gave us plenty of time for our trade to play out.

Here's the trade we liked best...

Buy, to open, the Lorillard January 2016 $55 call for about $2.50, and
Sell, to open, the Lorillard January 2016 $47.50 put for about $8.30.

This trade generated a net credit of $5.80 per share.

As always... selling the put meant you accepted the potential obligation to buy shares of Lorillard at $47.50 each if they traded for less than that by January 15, 2016 (the day the options expired). That was a potential $4,750 obligation per contract. Buying the call gave you the right (but not the obligation) to buy shares at $55 until that same deadline.

The net credit received for opening a position gave us an entry price of about $41.70 ($8.30 for the put minus $2.50 for the call gave us a $5.80 net credit, which we subtracted from the $47.50 strike price to get our entry price).

So if we had to buy shares, we would do so at a discount to where they were trading when we put on our trade... In this case, it was about 13% lower than the previous day's closing price.

If put the stock at those prices, for example, you could have immediately turned around and sold the stock for a small profit.

Then, we looked at how this trade could have played out. It could have worked out one of three ways by January 2016...

1. Lorillard traded for less than $47.50. Our calls would have expired worthless. The puts would have been exercised, and we would've been required to buy Lorillard shares at $47.50 each. When you account for the $5.80-a-share net credit, we would've owned the stock for a net cost of $41.70 a share. We thought the shares were cheap already at around $48. So getting them 13% lower would have been a bargain.

At a net cost of $41.70 a share, we would have taken less risk than if we had bought shares outright at the time...

2. Lorillard traded between $47.50 and $55 per share. In this case, both options would have expired worthless. We would have kept the $5.80 per share ($580 per contract sold). That would have given us a 61% return on the margin requirement (which was $950). This outcome would have been better than buying the stock outright. Even if we had held on until January 2016, it still would have been better than what most alternative investments offered.

3. Lorillard traded for more than $55 per share. This would've been when the upside potential of our Alpha trade would have started to pay high rewards for opening a trade.

Let's say that the market would have priced the shares at $60... which was a conservative valuation in our view.

Including the upfront net credit, that would have given us about $10.80 per option contract – 113% on our margin requirement of $9.50 per share (22% compared with capital at risk).

This trade had exactly the same risk parameters as buying the stock at $41.70... and of course, you couldn't have bought shares at that price then. But if you could have – and assuming the stock did go to $60, as in our example above – you would have made roughly 44% in capital gains on your investment. That's a great return. But it's less than half of what we would have made for the same outcome with our Alpha trade. Plus, we were putting up much less capital.

Just 11 months later, in January 2015, we closed out of the trade.

A few months after our original recommendation, competitor Reynolds American entered into an agreement to buy Lorillard for around $27 billion – a little less than $69 per share. Lorillard shareholders gave the green light with more than 98% of the voting shares approving the deal.

However, there were significant regulatory hurdles to the deal. To head off some potential monopoly issues, Reynolds agreed to a brand-swapping arrangement with British firm Imperial Tobacco to help appease regulators. The deal then was in regulators' hands and reports indicated they would decide by mid-2015.

We couldn't know what the regulators would decide. What we did know was that with shares trading at around $66 per share, we were sitting on 177% gains on margin (35% on capital at risk) at the time. There was about $3 more upside if the deal went through at the offer price. But if the deal fell through, the stock could have dropped to pre-offer levels in the $50s. That would have meant giving up a large part of the huge triple-digit gains we had on the trade.

With the downside far outweighing the upside that remained in the trade, we suggested taking our profits off the table. We had surpassed our initial target of 113% returns on margin, and we could then deploy our winnings into future Alpha trades.

We recommended the following actions...

Sell, to close, the Lorillard January 2016 $55 call for about $11.60, and
Buy, to close, the Lorillard January 2016 $47.50 put for about $0.60.

The prices we used gave us a net credit of $11 to close the position. Added to our opening credit of $5.80, our total return was $16.80. That represented a 177% return on margin (35% on capital at risk) in approximately 11 months.

Regards,

The Stansberry Alpha team