Is This Large Cap Really Turning Around?
Traders often see small cap stocks make large moves in one day. After earnings are announced, the stock of a small company could jump, or fall, 10%, 20% or even more in one day. But, for large cap stocks the moves are often significantly smaller than that.
An example of how small price moves can be is the stock of PepsiCo (NYSE: PEP). With the stock up about 4% after an earnings report, The Wall Street Journal wrote,
“shares had their biggest percentage increase in nearly a decade…on hopes that the company is arresting the decline of its core, domestic beverages business. Investors are celebrating prematurely.
The company reported revenue that was in line with estimates and adjusted earnings per share that were ahead of expectations…Pepsi’s snack business continues to perform well, as American consumers these days are less worried about the health impact of salt consumption but are more worried than ever about sugar.
Comparable sales for the Frito-Lay North America segment rose 4% from a year earlier, while the North America Beverages segment saw a 1% decline.”
The report was generally bullish. The company beat analyst profit forecasts by nine cents a share, posting adjusted earnings of $1.61 a share on the back of cost cuts in its various divisions. At $16.1 billion, net revenue was slightly ahead of consensus estimates.
Organic revenue, which reflects the core operations of PepsiCo and excludes currency fluctuations, rose 2.6%. The company reiterated its full-year sales and earnings-per-share growth forecasts.
However, a chart summarized the story in beverage sales and told a less upbeat story.
Source: The Wall Street Journal
For investors, the question is whether the improvements in the down trend are enough to justify a position in the stock.
Digging Deeper Into the Data
Consumers have shown a shift away from sugary drinks, preferring bottled water and other drinks that are perceived to be healthier than soda.
Pepsi understands this and on a conference call, Chief Executive Indra Nooyi noted a new zero-sugar Gatorade line is designed “for the light exerciser who didn’t want the carbohydrates that real athletes needed.”
Analysts noted that the Gatorade drink is competing with Coca-Cola ’s Powerade and Vitaminwater which have both been available for several years.
After the report, Pepsi shares are currently trading at around 19 times forward earnings, compared with a five-year average of 20.4 times, according to FactSet.
Analysts noted that “until there is a more convincing turnaround in its single largest business, that discount looks justified. Shares may have popped, but don’t expect them keep sparkling.”
Well Fargo added, “We were pleased that PEP generally exceeded muted sales growth and EPS estimates heading into the print – and we expect the stock to respond favorably today in response.
That said, results were not entirely clean, and we note that a gain from refranchising the company’s beverage business in Thailand contributed 5 points to core OI growth (although this was partially offset by a -3 point impact from last year’s gain from the Britvic minority stake sale).
Furthermore, we are disappointed by mounting commodity pressures (negatively impacting results across all of PEP’s segments) and soft NAB results, which despite sequential improvements, remain challenged.”
Overall, it’s likely that the stock will remain in a relatively narrow trading range with limited upside potential.
A Trading Strategy to Benefit From Potential Weakness
The prospects of further short term gains in PEP seem to be remote. But, significant weakness is also unlikely. Traders should consider using an options strategy known as a bear put spread to benefit from the expected trading range in the stock.
This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.
Source: The Options Industry Council
A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.
The Trade Specifics for PEP
The bearish outlook for PEP, at least for the purposes of this trade, is a short term opinion. To benefit from this outlook, traders can buy put options.
A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expires. While buying a put is possible, it can also be expensive. The risk of loss when buying an option is equal to 100% of the amount paid for the option.
To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.
Specifically, the July 27 $108 put can be bought for about $0.30 and the July 27 $106 put can be sold for about $0.15. This trade will cost about $0.15 to enter, or $15 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $15. This loss would be experienced if PEP is above $108 when the options expire. In that case, both options would expire worthless.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in PEP, the maximum gain is $1.85 ($108 – $106 = $2.00; $2.00 – $0.15 = $1.85). This represents $185 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $15 to open this trade.
That is a potential gain of more than 1,100% of the amount risked in the trade. This trade delivers the maximum gain if PEP closes below $106 on July 27 when the options expire.
Put spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $15 for this trade in PEP.