Option Investor

Covered-Calls 101

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Buying "Valuable" Stocks

The selection process for covered-call candidates in the CCS Portfolio focuses primarily on technical analysis. Nevertheless, many investors prefer to use the covered-call strategy with fundamentally sound stocks and considering the market's current lofty levels, a value-based approach may be appropriate.

There has been lots of discussion recently about stock valuation and the need for fundamental analysis in investing. Warren Buffett of Berkshire Hathaway describes the concept best; he says that evaluating securities and businesses for investment purposes has always involved a mixture of qualitative and quantitative factors. At one extreme, the analyst exclusively oriented to qualitative factors would say, "Buy the right company (with the right prospects, inherent industry conditions, management, etc.) and the price will take care of itself". On the other hand, the quantitative spokesman would say, "Buy at the right price, and the company (and stock) will take care of itself". In the world of the stock market, money can be made with either approach and a combination of both may offer the best balance in a long-term portfolio.

The first step in examining the fundamental factors in a company (net asset value, working capital, price-to-earnings ration, debt to equity ratio, etc.) involves identifying the minimum criteria that determines a favorable characteristic in each specific category. A well-known expert on fundamental analysis, Benjamin Graham, provided the following list of attributes of an undervalued stock. In his list, criteria 1 through 5 measure risk; while 6 and 7 establish financial soundness; and 8 through 10 show a history of stable earnings. Any company that meets 7 out of the 10 criteria is considered undervalued with regard to its fundamental condition. Keep in mind, some of the valuation criteria in Benjamin Graham's list are more important to certain types of investors than others. Depending on a person's risk/reward outlook and investing goals; income, safety, or growth, he or she can focus on those elements that best achieve future objectives and give heavier weighting to the valuation attributes that fit their personal investing style.

1. An earnings-to-price yield (reverse of P/E ratio) double the current AAA bond yield. If the AAA bond yield is 6%, the earnings yield should be 12%.

2. A price-to-earnings ratio that is 40% of the highest average P/E ratio achieved by the shares in the most recent 5 years.

3. A dividend yield of 2/3 the current AAA bond yield. Stocks that lack either a dividend or current profits are eliminated here.

4. A stock price that is 2/3 the tangible book value per share.

5. A stock price that is 2/3 the net current asset value or the net quick liquidation value.

6. Total debt that is lower than the tangible book value.

7. A current ratio of 2 or more. This is a measure of liquidity, or a company's ability to pay its debts from income.

8. Total debt of no more than the net quick liquidation value.

9. Earnings that have doubled in the most recent 10 years.

10. Earnings that have declined no more than 5% in 2 of the past 10 years.

For definitions of any terms above, refer to this glossary.

Every investor knows that fundamental factors play a major role in determining a company's share value. However, if you form your price expectations based on those factors, it is important to also study the issue's price history or you may end up owning an undervalued stock that remains undervalued for a long time.

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