Note: A previous version of this article incorrectly explained the process of creating a synthetic long. We regret the error.
One of the most difficult dilemmas a value investor faces is whether or not to buy the once-loved stock that has caught the seemingly incurable disease known as headline risk.
How many times have we considered taking the plunge on a beaten-down stock only to wait too long and see it rebound some 50% or more?
We wait because the buy feels risky, what with all of those screaming headlines. But is it really?
Headline risk reduces economic risk
Yes, you read that right.
The stock market was extremely risky late in '08 and early '09, right? But somehow investors made a fortune. How about investing in '07? Everyone was doing it, but investors managed to lose their pants.
What happened? Investors forgot about price and focused way too much on the headlines, which in 2007 were rosy and ever-optimistic.
Today, alongside the generally pessimistic headlines, we've got the catastrophe in the Gulf. And I'd argue that every day BP's (NYSE: BP ) and Transocean's (NYSE: RIG ) share prices drop, a little bit of risk disappears.
Are you kidding me?
Conventional wisdom says stay away from companies exposed to headline risk. But true value investors actually begin feeling a bit giddy when solid companies begin to slump due to negative press.
BP may be a bit too risky or may just make your skin crawl, but the Gulf debacle has also opened up opportunities for oil and gas plays a bit further away from the carnage.
For example, National Oilwell Varco (NYSE: NOV ) is better known as "No Other Vendor" by workers in the industry. Unlike BP or Transocean it doesn't drill or operate drilling rigs, but it is the largest equipment maker in the oil & gas industry.
The company has been around for over a century and has spent that time consolidating the industry. National Oilwell has its sights set on upcoming orders from Brazil and also stands to benefit from equipment orders for new rigs and safer equipment standards.
Not just for oil and gas
Another area that's seen a lot of headline risk lately is the private health insurance industry. The health-care debate demonized the industry, and stocks such as WellPoint (NYSE: WLP ) and UnitedHealth (NYSE: UNH ) are trading at all-time lows relative to book value. From a cash flow perspective the market says these firms will ultimately vanish in a decade.
Despite the apocalyptic health care debate, our massive government debt, on-balance sheet and off, makes it tough politically or economically for the government to take over the insurance industry. In other words, the market is underselling them.
Or consider credit rating agency Moody's (NYSE: MCO ) , which has seen the market knock off nearly half of its value as financial reform heats up. While the credit raters may deserve to have their heads cut off, the likelihood of that outcome is slim -- and the cheaper Moody's gets the more attractive the risk/reward scenario becomes.
Because credit agencies require little capital, they generally see fat margins and gobs of free cash flow. Even if reform attempts to increase competition and hinders profit margins, the downside is already likely priced in.
I'd like even less risk, please
Even though headline risk substantially reduces the stock risk by driving down the price, we're still faced with not knowing when or how the company or industry will recover. Since companies with near-term catalysts often present better choices for our cash, we need a different way to get in.
Enter the synthetic long, which lets you open a bullish position in a beaten-down company without the need for upfront capital.
Here's how it works. You write puts on the stock with the latest expiration date available. To determine the right strike price you can use the break-even price between the puts and the corresponding calls -- the closer to the stock's current price the more conservative the bet. With the cash that you receive from writing puts, you buy calls with a matching expiration date and strike price as the puts.
If the stock goes up, your returns mirror that of a normal equity position without the upfront capital. If the stock remains depressed but doesn't go down much, then you can simply purchase the stock at the strike price when the options expire. But if the stock continues downward and remains there until expiration then you stand to lose as much cash as an equity holder at the strike price.
That's why this strategy is ideal for companies that have been hammered beyond what makes sense -- the odds are in your favor that the headline risk will fade and the stock will trade for what it's really worth.
Embracing headline risk
Investors who have learned to withstand headline fear-mongering will likely earn outsized returns in some of the most unlikely places. Motley Fool Pro took advantage of the fear surrounding health care reform by purchasing Kinetic Concepts (NYSE: KCI ) -- and it's beating the S&P by over 20%. In addition, they're using options to hedge against the volatility.
If you'd like to learn more about how our Motley Fool Pro team is managing their $1 million real money portfolio using stocks, ETFs, options, and shorting to take advantage of opportunities in the market, just drop your email in the box below.