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Do you make as many photocopies now as you did a year ago? Thanks to the Internet, probably not. But I bet you're doing a lot more e-mailing and printing. Now take a look at Xerox Corp.'s stock (XRX). It traded as high as $60 a year ago. These days, it's down around $20.
That simple juxtaposition explains a good part of Xerox' decline. Throw in a management shakeup, a bungled sales-force reorganization, repeated earnings disappointments, and, most recently, a Securities & Exchange Commission investigation into accounting problems in Mexico -- and you've pretty much got the full story.
Most investors would want to just steer clear. But for George A. Fontanills, president of Pinnacle Investments of America, long-term options provide a low-risk way to bet that the stock won't stay this depressed forever. "We use it to play stocks that have been beaten down due to disappointing earnings, but ones that we also believe won't be going out of business," says Fontanills, who manages a hedge fund and is the author of Trade Options Online.
PREMIUM.
Here's how buying a call option on Xerox could work. You purchase an option with a $20 strike price that expires in January, 2003. (Because of that extended time horizon, these are known as LEAPS -- long-term equity anticipation securities.) That gives you the right, but not the obligation, to buy 100 shares of Xerox for $20 a share some time in the next 2 1/2 years. (Most people never exercise the option -- they trade it instead.) For that right, you would pay about $600 (a $6 premium per share). For you to break even, the stock would have to climb higher than $26 by January, 2003. If it falls below $20 a share, the option expires worthless, and you're out $600 bucks.
But let's say it goes back up to $50 (where it was trading only last September). The option would now be worth $3,000 ($30 gain x 100 shares), plus the extra amount that traders are willing to pay because there's still time remaining on the option. That equals a 400% net gain on your $600 initial investment. If you had bought the stock rather than the options, you would have paid $2,000 ($20 x 100 shares) to make $5,000, for a net gain of 150%.
Even if you wouldn't make a bet on Xerox now, the LEAPS strategy is still worth considering for other stocks. Scott Fullman, an options strategist at Swiss American Securities, happens to agree with Fontanills on Xerox. He also says that anytime Microsoft (now about $80) trades at around $70, it's a candidate for this strategy. He also would consider AT&T and Lucent Technologies as other candidates.
The idea is that Xerox, which trades at a price-earnings ratio of 14, is a cheap stock that's far from going bankrupt. In 1999, it earned $2 billion, or $1.96 per share, on $19.5 billion in revenues. It has a great brand name, strong technology, and a broad product line, believes Standard & Poor's equity analyst Jim Corridore, who has a "hold" rating on the stock and expects earnings per share to decline only slightly in 2000, to $1.90. Fontanills believes the stock has a base of support at $20 a share, which means it shouldn't fall further from here.
ON THE FENCE.
Still, while this company is far from going bust, don't look for a quick fix, either. Xerox has spent most of the past decade trying to transform itself for the digital revolution (see BW, May 8, "Xerox Is Still Looking for Wall Street's Respect"). Only a year ago many analysts thought it was well on its way. "It wasn't that long ago that analysts had the confidence that it was going to be able to cope with its changing marketplace," says Chuck Hill, director of research at First Call Corp. But starting with an earnings warning last October, analysts' faith has eroded to the point where 9 out of the 15 who cover it rate it a "hold." Hill believes Xerox won't go out of business, but "it's a tough call" whether to buy the stock.
The beauty of buying a call option is that you don't tie up much money while you wait for things to turn around, says Fontanills. "It's a low-risk way to buy the stock," he says. Most people who lose money on options make the mistake of buying ones that expire in a couple of months -- or, worse, weeks, he says. "Go longer term and give yourself a chance to be right."
He may not be right on Xerox. But during earnings season, buying long-term calls is an interesting, simple strategy to have in your repertoire. It's worth considering when you're confident a stock will turn around, but you don't want to tie up too much money waiting for it to do so.
Amey Stone covers investing for Business Week Online
Got a question or comment? Go to our Ask Amey Stone Forum now! EDITED BY THANE PETERSON
Copyright 2000 , by The McGraw-Hill Companies Inc. All rights reserved.
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