By: Steve Smith
Put this bank on your calendar for steady returns.
Banks have historically been known, and invested in, for their consistent and conservative returns. But through the years of deregulation and globalization the business models morphed into more complex and increasingly speculative activities. Banks soon became synonymous with “Wall Street.” This all culminated in the financial crisis which created the current environment of heavy regulation, restricted activity and to the consternation of investors, steep cuts in valuations.
But one big bank has remained far removed, both geographically and philosophically, from Wall Street, and is set to continue delivering steady profits. By employing an options calendar spread strategy we can turn this bank into our own cash machine.
Well Fargo (WFC) is located in San Francisco and provides retail, commercial, and corporate banking services to individuals, businesses, and institutions. Meaning it makes its money on the traditional bank model holding money in the form of savings and wealth management accounts and then lending that money out for purchases of cars, homes or business investments.
Its reward for sticking to its knitting is a premium valuation compared to the other big banks. Well Fargo currently trades at 1.67x book value. That stands head and shoulders of JP Morgan (JPM) and Bank America (BAC) which trade at 0.97x and 0.74x book value respectively. For a sense of perspective 25 year historical average for the nation’s 10 largest banks has been 2.3x book. At the nadir of the financial crisis many sank below book follow with Wells Fargo bottoming at 0.23x book value. Wells Fargo also delivers a profit margin of 27% and return on equity of 13.5%, both healthy premiums to its east coast brethren.
Two important drivers will be the eventual rise in interest rates which will boost net interest margin. This is basically the differential between what a bank pays to savings and the interest in charges for loans. For a bank that sticks the traditional model net interest margin is key to profitability.
Secondly, one of the important areas in which I think lending demand will increase is in housing. Yes, the housing theme again. Wells is the leading home loan lender, writing some 35% of all mortgages in the U.S. And unlike many other institutions that repackage and resell those loans to third parties such as Fannie Mae, Wells keeps them in house which boosts their profitability through service fees and tighter credit controls.
I think WFC’s valuation and its share price expand as revenues and margins steadily increase. It has gained some 20% over the past 52-weeks and I think it should continue on that pace.
I’m going to use a diagonal calendar spread to establish a bullish position that will benefit from both time decay and a steady rise in the share.
I’m buying the October $55 calls and selling the April $57.50 calls for a $2.60 net debit.
The specifics are:
-Buy October $55 call at $3.00 a contract
-Sell April $57.50 call at $0.40 a contract
Assuming the shares simply remain at $55 during the until the April 17th expiration we collect that $40 per contract which translates into a 15% return on risk for just the one month.
We can than roll out the sale of another call to May, or even using weekly options and adjust strikes up or down as needed, and continue to reap approximately 15% per month. By the time September rolls around we’ll have collected over $2.40 or a 90% on the initial risk. If shares shoot up above the strike sold short we can close the position healthy profit in excess of 20% in a short time frame.