A note from the senior managing editor…
Below, you will find your January 2016 Sovereign Edge pick from Chad Shoop, the editor of Pure Income.
Sr. Managing Editor, The Sovereign Society
This Stock Is About to Bottom
Everyone likes a bargain. It’s why Black Friday has become such a hit in the States. But whenever you’re buying something that’s been marked down drastically, it’s easy to question the quality of the product — and it’s the same with investing.
Today, we are going into a new trade on a stock that is trading at a steep discount from where shares were just over a year ago. But I think its quality is worth more than the bargain-level price investors are paying for it.
The discounted stock I’m talking about is Waddell & Reed Financial (NYSE: WDR), an asset management company for mostly mutual fund and institutional accounts.
Shares have been under pressure since mid-2014, plunging nearly 70% for a few reasons I’ll explain in a moment.
But the selling is overdone at this point. Shares are trading at just seven times earnings while the stock is paying out a 7% yield. That’s what I call a bargain.
In order to collect even more income from this opportunity, we are going to sell a put option.
Action to take: Set a Good ‘Til Canceled limit order to sell to open the WDR March 2016 $22.50 put option (WDR160318P00022500) at $1.50. At last glance, it was trading at $1.55. If your order is not filled by Friday’s close, cancel your order and I will update you next week.
How the Trade Works
Since each contract covers 100 shares, you will collect $155 per contract sold.
In a cash-secured put transaction, you will need to deposit $2,250 with your broker. This will give you a yield of 7% ($155 divided by $2,250) in about two months.
If you use margin, you will just need to deposit about $450, a fifth of the full amount, with your broker. This will give you an impressive yield of 34% ($155 divided by $450) in about two months.
Make sure you are comfortable with the cash-secured account requirement. That is the amount that you will need in your account if we are put the stock.
By selling puts, we risk holding shares of the stock. However, I never sell puts on a company that I don’t want to own. So if shares of Waddell & Reed are below our $22.50 strike price by March 18, we’ll have to buy 100 shares for each contract we sold at $22.50, regardless of market price. And that’s perfectly fine with me.
I think the stock is nearing a bottom and set to outperform in upcoming quarterly reports.
So why are shares trading at these bargain levels?
One issue facing the company is that analysts believe it’s exposed to regulatory headwinds. There is a new regulatory proposal that has the potential to limit asset managers, such as Waddell & Reed, from directing investor funds mainly into its own proprietary funds. The proposal could also mean higher compliance and other operational expenses. But all of this is already priced into the stock.
Another issue is its exposure to the high-yield debt market. Roughly 8% to 9% of the firm’s managed assets fall into the high-yield bracket, which has been extremely volatile recently as investors rushed to take money out. This left money managers, such as Waddell & Reed, with significant withdrawals. But this too is already priced into the stock.
Ultimately, since these key headwinds are already built into expectations, I think it’s likely the stock will surpass those expectations and rally the same way it did after the 2008 financial crisis.
See, worries about the stock’s future have caused shares to trade at their lowest valuation since the 2008 crash, which hit banks and asset management companies extremely hard.
Shares have plunged nearly 70% in less than two years. To compare it to the financial crisis of 2008, shares plummeted 75% in a matter of months. Clearly that was a much swifter drop, but the company survived. It even ended up rallying more than 300% from the bottom.
Plus, the company has a strong history of paying its dividends. It hasn’t decreased its dividend at all since it started paying one in 1998. Take a look:
This is the exact kind of company I want to own. While I don’t expect a dividend increase this year, it already yields 7%.
In short, I think the challenges facing Waddell & Reed are something the company can overcome. In the end, it will be a stronger and financially stable company that you want in your portfolio.
Editor, Pure Income