“In the stock market, the most important organ is the stomach. It's not the brain.” -Peter Lynch
People usually equate taking risk in the stock market with high multiple, high flying stocks that have the market's attention. Often the people associated with taking the most risk are discussing whether or not a high multiple stock can continue growing earnings decades into the future. But there is high risk in stocks circling the drain of bankruptcy, as well, and thus there is a potential for very high reward. Properly playing bankruptcy dodge ball is highly lucrative.
Often, there are opportunities for bargains in options markets with stocks enjoy less of the limelight than the market's darlings. Everyone knows there can be opportunity in beaten down stocks, but when you add in cheaply priced derivatives, you can really boost returns.
Walgreens is not a stock that inspires confidence or enthusiasm, but I believe there is a major opportunity to profit from this stock avoiding bankruptcy. The position I'm recommending will also leave you time to get to the exit if bankruptcy does occur.
Of course, there is the old value investing paradigm of finding beaten down and undervalued stocks. But one of the main things you have to do when employing this strategy is avoiding the infamous value trap. That is when a stock looks increasingly appealing by valuation measures on its way to bankruptcy and siphons hopeful value investors in as it languishes and ultimately perishes or is restructured.
Walgreen Boots Alliance is a beaten down pharmacy/retail giant that has had a precipitous stock decline, dividend cuts, and a new shareholder lawsuit. But in this epic fall, and the doubt surrounding the future of the stock, lies a pretty substantial opportunity.
The stock was once a vaunted dividend aristocrat, but it has fallen on hard times after several failed attempts to pivot. And here's the thing, I'm not going to try to convince you that this is a great stock with bright future prospects relative to market winners at this time. It is not. It is facing a number of problems and the pressure on profitability could result in another dividend cut. But the stock is definitely undervalued and it is enjoying revenue growth that should provide a stay of execution.
So, when a stock has doubts about its future financial viability, this can actually be a major opportunity for options traders. The possibility of bankruptcy also increases as share price declines. So, if you have the benefit of options on your side, then the dogs of the market can become man's best friend. Let me explain why.
Owning the shares of Walgreens in large numbers could definitely be a hazardous prospect given the flock of serious risks and deteriorating financial condition. But I think if you're willing to forego owning the stock and collecting the dividend, which is one of its primary draws, you can get a lot of alpha by just exposing yourself to upside price action. If you're convinced the company won't go bankrupt, they still might need to cut the dividend to achieve that outcome, or even suspend it.
The stock is hovering near 52-week lows, and I don't see the price going much lower unless the prospect of bankruptcy dramatically rises. And while Walgreens faces some serious challenges, the firm's prospect of bankruptcy isn't so much higher than some peers and as the recent price drop would suggest.
Remember, that for a dividend aristocrat, a lot of the buying is driven by dividends and the stock losing its dividend aristocrat status was inevitably going to result in some serious punishment. But my bet is that it's overstated and partially a result of the composition of investors that owned Walgreens. However, given the beginning of the Fed cutting cycle and a recent report where the company lowered guidance, I think the the risk/reward is beginning to change favorably.
This trade is bullish on Walgreens, but we wouldn't be taking a bet on the stock without advantageous options pricing that I believe gives us a high probability of making hay with this one. A lot of institutional derivatives traders focus on Theta decay strategies, where they benefit from time value decreasing faster than intrinsic or extrinsic value can catch up with. But Walgreens gives us the opposite opportunity.
It gives us an opportunity to get extremely cheap time value to basically see what happens with Walgreens. We can use LEAPS to give the stock some time to recover from its dismal range near lows right now, and we have high leverage since these options will essentially move 1 to 1 with the stock price. The downside is controlled because such a high proportion of the option's value is from intrinsic value rather than extrinsic value.
The contract we are recommending is deeply in the money which means its value won't rapidly decline as time passes. It's value will only rapidly decline if Walgreens experiences material price declines from here, a prospect which I currently view as unlikely given the depths of their recent fall. Given the average sell side price target, if the stock avoid financial calamity, it should result in a very nice appreciation for cheaply acquired LEAPS.
As you can see above the extrinsic value of the option, or the portion of the value that comes from not being ITM is only $0.31 or about 5% of the value of the options contract. The sell-side price targets on the stock provide further support to this trade. This is a deeply contrarian call, but I think it will be highly profitable.
Here is the trade:
Buy January 17th, 2025 $WBA call options at $2.50. The current price is around $6.35. You want to hold them long enough for the extreme malaise of the stock to wear off.
If you are bullish on Walgreens, I would also compliment this position with a $15 call of the same expiry, January 26th, 2025. This will juke returns if the stock does experience a recovery, but will also increase risk. These last traded at $0.81.
Remember the $15 calls have a far higher chance of expiring at zero since they have no intrinsic value.
Walgreens has many risks, and the bears could ultimately be right. However, I think the prospect for bankruptcy is fairly low over the next year and a half, and I think we are at or near a low point of confidence in the stock. The last earnings report was potentially a kitchen sink report that will create the conditions for the company to start outperforming expectations and righting the ship. Furthermore, I have confidence in the economic backdrop and Walgreens has some counter-cyclical healthcare attributes even if economic prospects materially decline in the short-term.
