Rainy days, Mondays, and uncertainty always get investors down.
OK, while I can't prove the first two, it would be hard to argue that shareholders aren't concerned with title insurer Fidelity National Financial's (NYSE: FNF) prospects as it works its way through mortgage moratoriums, executive changes, and dividend cuts. Off 15%-plus from its September highs, I believe the recent storm clouds hovering over the stock will clear up in relatively short order, making an opportunistic option play an attractive strategy for my real-money portfolio.
Fidelity's ups and downs
Fidelity National is in the relatively boring business of insuring property owners' titles. By guaranteeing that buyers truly own the piece of property that they've purchased, companies like Fidelity help curb unscrupulous operators who might otherwise try to sell you the Brooklyn Bridge. Historically, this has been a wonderful business as only a small amount of premium revenue ever gets returned through claims. The industry's historical claims ratio (midsingle digits) is the envy of underwriters everywhere.
For years, Fidelity battled with its largest competitor, First American (NYSE: FAF), for the top spot in the industry. But in late 2008, Fidelity was able to pole-vault into industry dominance when it slyly acquired the choicest assets of the third-largest industry player after its bankruptcy. The acquisition -- which most likely would not have been approved by regulators in calmer times -- gave Fidelity close to 50% market share. Within months, Fidelity's stock price skyrocketed.
However, as the market realized that a housing recovery was years in the making, the stock returned to earth and remained relatively range bound. Fidelity, for its part, reined in costs, reduced debt, returned cash to shareholders, and opportunistically liquidated portions of its unique investment portfolio. The market, rightfully so, embraced the developments, and shares made repeated runs upward.
Now, a plethora of seemingly bad news has the stock singing the blues. Adding to the uncertainty raised by foreclosure-gate, Fidelity subsequently announced a CEO change and also decided to institute a more conservative dividend policy. While mortgage moratoriums and legal wrangling could possibly affect Fidelity, the executive and dividend changes do nothing to change the fundamental value of the company. I believe these are short-term disruptions that have created a window of opportunity to profit from.
Why I'm buying (and how much)
First of all, I believe that Fidelity National's stock is currently undervalued and I would be happy to buy shares at current levels. I believe, nevertheless, that favorable options pricing makes a purchase of June 2011-$10 calls an attractive way to participate in a Fidelity National price recovery.
As to valuation, I believe the shares of this industry leader are quite cheap. With about 40% share of title insurance issuance, and massive national scale, Fidelity sports some of the best margins in the business. In a generally stable housing market, I estimate that FNF can produce between $400 million and $600M in EBITDA. Shares currently trade for 89% of stated book value -- $15.40 -- and, by my calculations, trade for around six times normalized EV/EBITDA. Given Fidelity's earning power and a sum-of-the-parts analysis of its eclectic investment portfolio, I believe the stock is worth over $20 a share.
As to catalysts, the biggest recent knock on the stock has come from foreclosure-gate headlines. While the situation is an utter mess -- potentially more so for former subsidiaries Fidelity National Information (NYSE: FIS) and Lender Processing Services (NYSE: LPS) -- it's still a manmade problem that banks can't afford to have linger. For the most part, it will be resolved sooner rather than later and will not have a material impact on FNF's title franchise.
Secondly, the CEO shift is simply par for the course as the company likes to mix it up internally every so often. Lastly, the change in dividend policy is actually a good thing. While the company was paying out a higher dividend versus its peers, it wasn't being afforded a commensurate premium in the stock price. Instead, management will use this cash to opportunistically buy back shares, pay off debt, and reinvest. With more than 70% of the shareholder base being institutions, all signs point to the fact that fixed-income institutions fled when news broke that management had decided to turn down the yield spigot.
With that in mind, I believe now is the time to act. That is why I will be buying ("buy to open") June 2011-$10 calls. I anticipate allocating between 2%-3% of the total portfolio for this position and between 8% and 10% of the portfolio to a potential position in Fidelity National. I anticipate investing about $400 in the call, buying one contract. The recent price on FNF's stock is about $13.46 and the spread between the bid and ask ranges between 3.70 (bid) – 4.00 (ask).
I will be using a limit order as liquidity and volatility on these calls can be an issue.
The strategy
The essence of an in-the-money call is that you get to buy the right, but not the obligation, to purchase shares at a fixed price. While I could simply buy the shares outright, this strategy allows me to put out less upfront capital. The downside to this is that I won't be entitled to the dividends and I'll pay a small (time) premium versus if I simply bought the shares today. I believe these downsides are offset by the upside leverage embedded in the call.
For example, say I bought the stock outright for 14.00 and the shares move up $1.00. My gain would be around 7% on my $14 investment. However, say instead I purchased an in-the-money call for 4.00 (strike price of 10.00). If the stock moved up $1.00, my call would be worth at least $5.00, which translates to a 25% return on my investment of $4.00.
Keep in mind, my example ignores time premiums and the loss of the dividends over this period of time, but hopefully you get the fundamental point. If not, I suggest you read Jeff Fischer's Options 101 or visit The Options Industry Council website, as these are great tools to bring you up to speed on options.
While buying in-the-money calls leaves me exposed to a sharp drop in the share price, and potentially a 100% loss if shares stay below the strike price through expiration, I'm comfortable with that possibility. I think FNF trading below $10 a share means that either my thesis on the stock is broken or a huge macro event has ensued. In either case, my equity position would likely be down more than the amount paid for the call. If the stock trades somewhere above $10 and below $14 at expiration, I'll happily buy the shares then either hold, trim, or sell covered calls against the position.
The Foolish bottom line
I believe the market is being unduly harsh on shares of Fidelity National Financial and that the negative vibes around the stock will dissipate in the near future. While I would be content buying and holding the stock outright, I believe a well-timed option buy could provide my Rising Stars Portfolio a nice early jolt. While I would prefer to own LEAPS -- longer-term options -- on Fidelity, I expect prudent asset allocation (through buybacks, portfolio sales, and strategic investments) and simply increased certainty will help shares rebound.
