Frankly Speaking, This Looks Like a Great Trade

Solid Finances, Low Valuation and an Extra Margin of Safety

Let’s be Frank…

Sometimes, obvious is best. Money management firm Franklin Resources (BEN) has been a huge money maker over the long term. It has a cash-rich balance sheet and a wonderful business model.

Despite the impact from the Crash of 2008, BEN’s earnings per share surged by 410% in the decade from 2003 tp 2013 as they leapt from $ 0.66 to $ 3.37 (fiscal years end Sept. 30). Today’s fiscal second quarter earnings report was just a penny shy of estimates ($ 0.89 versus the $ 0.90 consensus view) but the stock sold off by more than 2% intra-day.

On Monday afternoon BEN was trading more than $ 7 below its 2014 high of $ 58.87. The market seems to have overreacted. For the record, first half EPS totaled $ 1.85 versus $ 1.71 a year ago. Trailing 12-month profits have never been higher.

The well-covered dividend was increased twice in the past 12 months. The quarterly rate has climbed by 25% since the middle of 2012.

Franklin Resources’ relative P/E hasn’t registered this low in decades. BEN’s nominal P/E averaged 15.2x in the full seven-year period from 2007 through 2013, which spanned both bull and bear market conditions. The stock sells for around 13.7x current fiscal year estimates and just 12.5x next year’s projections of about $ 4.10 to $ 4.13.

The company’s record fundamentals are not being reflected in the current share price.During times when the market mood was more upbeat BEN often sold for 17x to 20x multiples (see chart).

I am not alone in seeing the stock’s potential. Standard & Poors carries a BUY rating and calls “fair value” as $ 64. S&P’s, perhaps conservative, one-year goal price stands at $ 60. S&P noted Franklin Resources’ high quality in their analysis (see investability quotient).

Independent research firm Morningstar also rates Franklin Resources as a 4-star BUY and came up with an almost identical fair value projection of $ 63.

I already own a decent chunk of BEN at lower price points. I’ve profited handsomely on previous put sales as well as covered calls written against my core position. Monday’s dip allowed me to short-sell some BEN January 2016, $ 50 puts in my margin-type account portfolio at the excellent price of $ 6 per share.

There is a margin requirement, but no cash outlay involved in this transaction.

I am able to sell the puts against buying power generated by the paid-up value of my current holdings. If the options end up expiring worthless, something that is good for me as a seller, the incremental return on invested capital is an incalculable number. It is impossible to measure any percentage profit earned from a negative outlay.

If I end up getting exercised — actually being forced to buy more shares — all normal profit and loss calculations on the newly acquired stock will come back into play.

The worst case scenario would force me to buy 100 BEN shares, per contract sold, at a net cost of just $ 44 per share ($ 50 strike price — $ 6 put premium). That is equivalent to getting in at BEN’s exact, and very fleeting, absolute nadir dating back all the way to January of 2013.

If Franklin Resources merely stays above $ 50 through the options’ expiration date I’ll keep the $ 600 per contract received without having to add any more shares. In the meantime, the premium money will be held in my account in the same way that Berkshire Hathaway (BRK.a, BRK.b) gets to play with the float on insurance premiums it holds, which are reserved for possible future claims.

Warren Buffett (Trades, Portfolio) has employed this put selling technique many times in the past as a way to either simply make money, or alternatively, acquire stock at a below current market, as of trade inception date, price.

Buying Franklin Resources outright at $ 51.69 looks like a winning move. Option savvy traders might find that the extra margin of safety and the income generation from selling puts proves a nice addition to their basic buy and hold strategy.

Disclosure: Long BEN shares, Short BEN covered calls, Short BEN naked puts

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