October 13, 2005

Covered Call Analysis - A Delphic Lesson
by John Brasher, CallWriter Publisher

A few weeks ago auto parts giant Delphi Corp. (DPH) was at the top of our Real Time Lists™ of the  top covered calls, with a very nice return. The company's fall in fortunes over the last few weeks illustrates the importance of examining the news before writing covered calls on a stock. This issue provides an object lesson in how to spot the problem trades when you see them.

The Setup

Our Real Time Lists™ present the highest-returning covered call trade setups, arranged according to potential return. Delphi was approximately $6.30 at the time it first hit our lists in late August, offering a return well over 5% for less than a 30-day trade. For that matter, it hit the lists of every other online service that offers covered call lists. The stock soon began to decline after first hitting the lists. On Saturday, October 8th, Delphi filed for Chapter 11 protection; the previous day the stock had dropped from $2.20 to $1.12, and this week traded down to $0.23, although it has since bounced back slightly. That's a loss of roughly 95% of its value from its appearance on the lists. It has dropped from the New York Stock Exchange to the over-the-counter Pink Sheets and now trades as DPHIQ. Delphi inherited a lot of problems when spun off from parent General Motors (GM), and I believe it will come back (a large hedge fund bought 9% of Delphi this week, so others believe as I do). But right now it's in the gutter and a speculative play.

It was a magnificent downside play, perfect for shorts and not bad for put buyers, but not a good stock for covered calls. The question is, how does a covered call writer avoid such a stock? Were there warning signs that would have steered a prudent trader away from Delphi?

The Analysis

It is important to know where the highest returns are, but that is just the starting point. Each trade has to be evaluated. I have always stressed the need for analyzing potential covered call writes before hitting the trade button, and the educational materials on CallWriter go into this subject in great detail. Actually, there were numerous warning signs for Delphi. Even though it is no fun talking about plays from our list that later sold off, it is instructive to look closely at them, because there are vital covered call lessons to be learned. Over the years I've learned far more from the stocks that withered than from the shining successes. Though I was not in Delphi, I nonetheless have learned much from it. That is the purpose of this newsletter issue - I want you to learn from it, also. So let's tear into Delphi as it presented when first hitting our lists.

Profitability: Delphi, which does $28 billion annually, lost $338 million for Q2 2005 (including a $49 million charge for restructuring), compared to a $143 million profit for the same quarter 2004. The future outlook under its current labor agreements with the UAW is not good.

Chart: in late August, Delphi hit its highest point since early March 2005; it looked to be in a nice uptrend on a daily chart until it started falling on the news. Delphi really underlines the importance of looking at longer-term charts, also, because It was in a long-term downtrend on a weekly chart - and it was clear on the weekly chart that the August advance was really a failure to get back to the long-term trendline. The chart below illustrates the length and depth of Delphi's decline.

Financial Health: Delphi has $17.1 billion in assets but $22.2 billion in debit. Spun off from General Motors in 1999, Delphi inherited from GM an abysmal union labor cost structure of high salaries and high benefit levels, plus high pension payments to retired workers and an unfunded pension liability. I'm not pro- or anti-union, but only a company in the prime of health can afford top-tier compensation and benefit packages, which for Delphi amount currently to about $65 hourly per worker. Getting a D- in profitability and an F in financial health, this company was not a good choice for covered call writing. In fact, this company dramatizes the importance of looking at financial health even of giant companies, which are not exempt from laws of financial gravity.

Business Profile: While Delphi is a robust company, General Motors accounts for 50% of its business. Any decline in GM's fortunes (which are not so good, either) would carry Delphi down with it, and any cutback in orders or worse, cancellation of the business relationship; this reliance factor worries me about any company. Almost any discussion of Delphi dwelled upon its excessive reliance on GM.

Relative Strength:  Delphi has for years under-performed the DJIA and S&P 500 indices, and its own industry, and has grossly under-performed them in 2004. When looking for covered call candidates you are looking for strength or for the company to at least hold its own, certainly not a company weaker than the overall market or its industry. A good place to check this instantly is to use the CallWriter Research Page, click on the stock symbol and view the comparative performance chart in the Snapshot window that opens.

News: Delphi has been in trouble for some time. At the time it first appeared on our lists, news commentators were already talking about Delphi's need to restructure its labor package in order to survive, let alone prosper. And Delphi management was publicly mulling over the Chapter 11 bankruptcy reorganization option as a way to bring the unions to the bargaining table. In fact, it was clear at the time that Delphi would make a Chapter 11 filing if it failed to get the concessions.

Although a Chapter 11 filing may in the long run clear Delphi's decks and make a return to profitability possible (lifting the stock price considerably), in the short run it is poison for the stock price. Investors remember how, not that long ago, K-Mart went into Chapter 11 and its existing shareholders got wiped out. This draconian possibility exists, which is why in my mind Delphi is not a buy at its current price. It is a buy only for speculators. Buyers run from a stock with a realistic prospect of filing Chapter 11. This prospect alone made Delphi a no-go for covered calls or any strategy involving long stock! Once the Chapter 11 possibility emerged, nothing else mattered for a covered call writer, even if Delphi had otherwise presented as a good covered write candidate.

Trade Discipline vs. Reading the Tea Leaves

Be very clear on this: despite the fact that a company's call premiums may offer good returns, when it is the subject of news stories that could foreshadow a catastrophic drop (especially when the company is the source of the the news), you stay away from it - no ifs, ands or buts. News of this kind is the rattler's rattle. No covered call management strategy can cope with a selloff of this magnitude. Those stuck in Delphi as it sold off can only take the loss or hold on in hopes of a recovery, which could take a long time and is not assured - if the common stock is not canceled.

Let's recap at this point: a company with failing financial grades, losing big money, its stock in a long-term decline as shown on a weekly chart, significantly under-performing its industry and the major stock indices. Add to that management's public threats to file a Chapter 11in an attempt to bring the unions to heel.

The question is not so much what should have warned us away from it, but what factors other than the high return ever would have enticed a trader to put the Delphi covered call trade on. One did not need a Delphic Oracle to steer clear of it. Thus Delphi is not an object lesson in the dangers of covered call writing. It is instead a lesson in the need to take a careful look at each company before squeezing the trade trigger.

Avoiding this kind of situation is not a matter of arcane skills in reading the tea leaves on a stock. Simple trade discipline would have sufficed to keep you out of Delphi. It is when traders lose that discipline, don't look at fundamentals, perhaps don't bother to scan the news, perhaps just glance over a daily chart and ignore the larger trend, that real losses occur. It is not difficult to avoid companies whose rattles are buzzing like Delphi's were.

Question:  Johnny, I know that P/E is a highly popular method of valuing stocks. Do you believe it is useful for measuring a company's value or that it is a basis for selecting good covered call stocks?

Answer:  No. The price-to-earnings (P/E) ratio is the most widely used stock valuation metrics among professional analysts and individual investors alike. It is calculated as the company's stock price divided by its earnings per share. A stock’s P/E is easy to understand and is published daily in newspaper stock tables. Its apparent simplicity and ready availability play a major role in its popularity. But investors are interested in whether a company's stock is undervalued (and thus perhaps a good investment), fairly valued or overvalued (a poor investment). Unfortunately, P/E offers no way to divine this.

Current earnings or lack of earnings can be due to accounting tricks or to extraordinary (one-time) events. Who knows, earnings might even fairly present the company's results! But companies use a lot of different accounting "techniques" to manage earnings. But even if accurate, current earnings are no guide at all to the company's prospects and to whether it will produce added value in the future. Here's an example: suppose we look at three hypthetical companies in the same industry, each growing revenues and making money according to their SEC filings, each with a P/E multiple of 10. The P/E multiple provides absolutely no hint that the first company’s growth adds no value, that the next adds substantial growth-related value, and that the third's growth will over time destroy value. In other words, the first company is fairly valued, the second is undervalued and the third overvalued. The P/E multiple offers no means to discriminate among the three companies.

For covered call writing, I tend to avoid companies with really high P/E ratios, which will be the subject of a forthcoming newsletter. This is why I put the P/E on our lists - not to use in selecting trades but as a guide to whether it is overheated or not. A low P/E does not necessarily signal a good covered call candidate. But I would never look at P/E by itself to try to determine a stock's worth for investment or any other purpose, because it doesn't provide that information.

Good luck and good trading!