We use Morningstar's proprietary industry-level data to find sectors and industries attractive for option-based investment strategies. The charts below show how much the average implied volatility for each sector differs from its trailing three-month and one-year average for U.S.-listed equity options (vertical bars, indexed on the right-hand scale), the change in implied volatility from week to week (dark blue line, indexed on the left-hand scale), the implied correlations of small- and large-cap stocks, and the relationship of implied volatility across size and value stocks.
Implied volatility has fallen solidly below the trailing year and quarter for all sectors but health care.
Implied volatility broadly fell over the week for all sectors but utilities and health care, and most dramatically in real estate. Our sector standout chart below shows how much the average implied volatility for each sector differs from its average during the last year and last quarter. Vertical bars (indexed on the right-hand scale) show present sector volatilities with respect to historical averages. The dark blue line (indexed on the left-hand scale) shows change relative to the previous week.
Implied correlations continued easing this week, consistent with calming tensions over macro factors.
The option market continues to calm, helped along by falling realized market volatility, despite material risks in Europe and a still-fragile economic recovery in the U.S. We think the market is underpricing the potential for the asset prices to move broadly and in unison on negative news. Any material negative news could drive up implied correlations along with market implied volatility.
Also, as corporate earnings report season progresses, the potential for near-term stock-specific news falls, which should increase implied correlation, yet we see implied correlation continue to fall. We compare the implied volatility of the options on the average small- and large-cap stocks to the options on the index to estimate implied correlations, or expectations that all stocks will rise and fall in unison. During times of panic, this measure spikes and approached 100% during the crash in March 2009.
The uncertainty of large-cap stocks relative to small cap has fallen further.
Value and growth stocks are now seen as equally uncertain, and large companies are viewed as being 50% as uncertain as small companies. This is consistent with falling concerns about broad macro factors that would affect all businesses of large diversified companies.
Health care remains the one area of elevated implied volatility relative to the trailing quarter and year. We've selected the four least expensive of our best ideas in health care and highlighted them below as potential candidates for selling options to express a bullish opinion.
Covidien(COV)
Covidien, formerly the health-care unit of Tyco International, develops, manufactures, and distributes medical and imaging devices, pharmaceuticals, and other health-care products to medical professionals worldwide. The company, through its predecessors, has 140 years of operating history and boasts a direct sales presence in more than 50 countries. Covidien's overall growth prospects are compelling, despite struggles in its pharmaceutical business. The company's latest product launches have been well-received by the marketplace, and it successfully integrated a number of sizable acquisitions. Although a weak macro environment continues to hamper elective procedure volume, the company's revenue growth in the device segment remains robust due to market share gains. With emerging markets also fueling growth, we expect strong revenue momentum despite expected ongoing struggles in pharmaceuticals. We remain convinced this unit will be sold, but the presence of several underperforming assets could prolong the process. Even if it remains part of the company, a shift in product mix toward devices and the firm's focus on efficiency support our margin expansion and double-digit earnings growth forecast; we continue to recommend Covidien's shares.
Click here for option prices on Covidien.
VCA Antech(WOOF)
Founded in 1986, VCA Antech is the largest operator of freestanding, full-service animal hospitals and veterinary diagnostic labs in the U.S. With about 528 pet hospitals and 2,100 vets, the firm handled 6.8 million patient visits in 2010. It traded publicly from 1991 to 2000. After the company ran up a huge debt load to fund a buying binge in the late 1990s, a private-investment group purchased and recapitalized the firm. VCA Antech went public again in 2001. Although the pullback in pet health-care spending has bottomed out, we have not seen a resumption of robust growth. Our thesis on VCA Antech primarily rests on our belief that consumers will eventually feel confident enough to spend on nonacute, preventive care again, allowing the firm to slightly outpace the 8% historical pet market growth rate. We expect a gradual recovery for VCA during the next few years, contingent upon incremental improvement in unemployment. Despite potential near-term bumpiness, we appreciate that VCA is poised to benefit from longstanding trends in greater pet ownership and consumer attachment to pets that can translate into a willingness to spend on pet health care. Furthermore, the growing application to the pet market of technology initially developed for humans will increase the sophistication and cost of pet health services.
Click here for option prices on VCA Antech.
WellPoint(WLP)
WellPoint is the largest U.S. health insurer by medical membership, serving 34 million people. It holds the exclusive license to the Blue Cross and/or Blue Shield names in 14 states, including California, Georgia, New York, and Ohio. WellPoint's business mix is weighted toward the commercial market, with a particular focus on small-group coverage. Approximately 40% of members are in traditional risk-based products, with the remaining 60% in fee-based products. WellPoint's 14 Blue Cross and Blue Shield plans provide the company with a unique combination of regional and national scale. The former is the key to negotiating favorable provider rates, while the latter is essential for leveraging administrative costs. Investors remain fearful about the regulatory and economic headwinds facing WellPoint, causing the stock to trade at less than 9 times earnings and with a 35% discount to our fair value estimate. However, we think these concerns are overblown, as the recent health reform law should have only a modest impact on WellPoint's future profits. Although we expect ongoing medical cost pressure, this should be partly offset by revenue growth opportunities and potential SG&A leverage. In the meantime, WellPoint generates copious free cash flow, which it is using to repurchase shares at a breakneck pace.
Click here for option prices on WellPoint.
Abbott Laboratories(ABT)
Abbott manufactures and markets pharmaceuticals, medical devices, blood glucose monitoring kits, and nutritional health-care products. Products include prescription drugs, coronary and carotid stents, and nutritional liquids for infants and adults. Following the Advanced Medical Optics acquisition, Abbott also markets eye-care products. Abbott generates slightly less than 60% of revenue from pharmaceuticals. In an effort to unlock value, management has decided to split Abbott into two--a branded drug company and a diversified health-care company. Although we don't expect the breakup to significantly change our fair value estimate, we still believe the company is undervalued, and the breakup could draw more attention to Abbott's attractive valuation. In the pharmaceutical industry, Abbott faces relatively minor patent losses during the next five years and is well positioned to ride a strong tailwind of demand for its products. Most important, we expect continued strong demand for the company's top drug, Humira, based on low drug penetration in immunology diseases. Abbott's strong competitive position in nutritionals and diagnostics creates additional avenues of growth. Further, the recent acquisitions of Piramal and Solvay give the company a good position in the fast-growing emerging markets.
Click here for option prices on Abbott.
Philip Guziec is co-editor and portfolio manager of the Morningstar OptionInvestor online newsletter and research service, and is co-author of the Morningstar Investor Training course on Option Investing. For more about Morningstar's fundamental approach to investing in options, please use the link below to download our free guide to option investing:
http://option.morningstar.com/OptionReg/OptionFreeDL1.aspx
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