The Case For A Buy-Write Strategy On Deere

Introduction

With momentum and valuation conditions, and love for hot tech IPOs, reminiscent of fifteen years ago, it's time to dust off the playback to see what worked with safety back then. If one is not riding a hot stock, it's a tough thing to get in now, so it makes sense to look for high quality laggards that have their own bullish longer-term arguments that allow a buy and hold strategy.

If you suspect, as I do, that the Fed's policies have now been overused to justify current market prices, then you fear a sharp market downturn that would hit the momentum stocks hardest. My pick for new money is Deere (DE), with out-of-the-money options sales a sensible strategy.

Analysis

Why DE? Firstly, it has a great long term chart:

Second, it performed well during the late '90s and early '00s, even as cyclically earnings vanished.

Third, its P/E is so low that a large earnings decline would likely be met by a resiliency to the trading price; Caterpillar (CAT) shares are experiencing this phenomenon now. Here is the earnings estimate trend showing DE beginning to share CAT's cyclical fate:

EPS Trends	Current Qtr. Jan 14	Next Qtr. Apr 14	Current Year Oct 14	Next Year Oct 15
Current Estimate	1.52	2.66	8.33	7.59
7 Days Ago	1.52	2.66	8.28	7.68
30 Days Ago	1.39	2.58	8.02	7.91
60 Days Ago	1.39	2.58	8.00	7.90
90 Days Ago	1.40	2.58	8.07	8.05

I anticipate that if DE's earnings estimates drop further, the forward P/E will simply expand, as CAT's is doing and as DE's did about 12 years ago. Of course, this is a guess, and excludes massive bear market conditions.

Fourth, DE has a reasonable valuation. It's low current P/E is a positive. Price:sales is neutral and price:book is a bit rich, even after allowing for share count reduction over the years.

Fifth, in line with the long term chart, Deere is a high quality company, one which I am happy to own for years to come.

On its own merits, DE stock strikes me as likely to trend to all-time highs at an unpredictable time point. However, with out-year estimates declining and with general market valuations now at least as stretched as those of bonds (my view), it may now be a good time to be a bit of a yield hog and sell some covered calls. If the stock is called away, so it goes. I am looking at the January 2014 calls, $85 strike price. The latest quote of $1.30 per call looks fair to me. In addition, the shares yield 2.4%.

As I am far from an options expert, the above example was picked for convenience and liquidity reasons and not because it is "optimal" according to detailed analysis; also, this is written when the market is closed.

My view is that from a macro standpoint, the most important thing for investors, rather than traders, to do is to be aware that simply because yields on cash and bonds are unattractive, it does not follow ipso facto that "anything goes" for equities. The current situation has many similarities in reverse to that of the 1978-82 period, where both stocks and bonds became dirt cheap, and cash was also attractive.

Risks

The most important part of a buy-write strategy is the buy part. DE faces tough competition and has cyclical risks; weather; foreign country; labor; and other risks. Support for CAT and DE could simply vanish at the proposed $80 (or so) support level, and if so, the small option premium could look laughable.

Conclusion

I favor a defensive but active strategy here. I chose DE because it has the example of CAT's stable stock price despite weak operating results to suggest it could have similar support at $80; it has a great long term track record; it has superb management continuity; and it operates in one of the most essential industries throughout the globe.

Despite low volatility premiums, options are actually not unattractive in that they are above actual realized volatility. Given DE's challenge of a falling FY 2015 earnings consensus and high overall stock market valuations, I think that investors with cash to invest may wish to consider a buy-write strategy with DE shares.

Note I am long DE without options, but may institute this at any time.

Source: The Case For A Buy-Write Strategy On Deere

Disclosure: I am long DE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

Additional disclosure: Not investment advice. I am not an investment adviser.

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