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Michael Fowlkes' Analyst Insights

InvestorsObserver
Options and ETF Analyst Writer
Michael Fowlkes
Author Bio


April 13, 2015 - Follow Buffett into Victory Lane with CarMax

Many investors are still a bit weary of the auto industry following the great recession. The recession took a heavy toll on the auto industry, but in the few short years since the recession, the industry has charged forward, and analysts expect that trend to continue.

One investor who is not scared of the sector is Warren Buffett. He has been active in the industry; recently acquiring the nation's fourth-largest chain of car dealers… and it appears as if he has an appetite for more. He recently stated that he expects to buy more dealerships, and believes that the experts who are predicting a slowdown in the U.S. economy are wrong.

Auto sales have definitely been strong, and analysts expect more of the same moving forward. Forecasts call for 17 million vehicles to be sold this year, and that figure could rise to around 20 million by 2018. However, after 2018, sales are expected to decline. Last year, the final numbers showed 16.5 million vehicle sales, so the increase that is coming is rather significant.

Seeing the expected increase, it is easy to understand why Buffett is gobbling up car dealerships. It seems a wise move, and one that would be nice to follow. So, if you have a few hundred million dollars lying around, you can start looking to buy up some dealership chains and mimic Buffett's move.

Don't have hundreds of millions of dollars? It's OK, I don't either… but that does not mean we still cannot follow Buffett's lead. Using a covered call strategy on CarMax (KMX), one of the nation's biggest auto retailers, we can easily afford to own a little piece of the dealership industry.

CarMax sells both new and used cars, and it is reasonable to believe that if the new car market remains strong, so will the used car market, and CarMax is in a great position to capitalize on both.

The company has been growing earnings nicely, with fourth-quarter numbers showing 28.8% earnings growth. Analysts expect the trend to continue, with 11% earnings growth forecast for next year.

Let's take a look at a July $72.50 covered call on the stock, which is currently trading at $73.76.


Chart courtesy of stockcharts.com

 

To set up this trade, you would buy shares of KMX at $73.76 (typically 100 shares, scale as appropriate), and sell the July 72.50 call for a credit of no less than $4.70 per share. The result of selling the call against your stock lowers the cost basis on your shares to $69.06, and this figure now becomes your break-even on the trade.

The best-case outcome of this trade is for KMX to be trading above $72.50 on July 17. If that is the case, the call will be assigned, and you will sell your shares for $72.50. Since your cost basis is just $69.06, you will profit $3.44 per share, for a gain of 5.0%.

There are always risks, and the big risk with this covered call is that KMX is below $72.50 on July 17, in which case your options expire worthless and you are left holding just the stock in your portfolio. Should that be the case, there are a couple of different outcomes.

As long as the stock is above your break-even of $69.06, you can simply sell your shares, and enjoy a little profit. The profit depends on how close the stock is trading to your break-even, but as long as it is above $69.06 you can turn a profit, or you may also chose to sell another call against you stock, which would lower your cost basis even further.

The worst-case scenario is if KMX falls below your break-even. In this situation, you can either sell your stock and take a loss (which would be substantially less than you would have taken if you had simply bought the stock at today's price), or you can once again sell another call and lower your cost basis. Or you could just hold on the stock and see what happens and wait for a rebound to sell.

As you can see, there really are not horrible outcomes. Even in the worst-case scenario you still wind up owning the stock with a cost basis that is 6.3% less than where it is trading today.

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