Winning in a Down Industry

Some investors have been scorched by ad-industry stocks’ flameout during the past year, but others—especially investors savvy about options—may get a shot at a phoenix-like recovery over the next year or two.

Omnicom’s stock, which is less than $60, is off by more than 40 percent from its 52-week high of $97.35. IPG, at about $12, has fallen more than 65 percent from its high of $34.98. To a large degree, this price pressure reflects the fact that the ad business has been soft for three years, and many analysts think it will remain so.

This is bad news for company execs holding options. Many of these are exercisable at prices higher than current levels, giving them scant current value. But it could be good news for risk-tolerant investors who buy long-term options on each of these stocks. Options bought now, if it turns out that these stocks are near their price bottoms, would prove worthwhile, granted certain conditions.

Let’s say the media’s negative speculation about these companies becomes old news and, in the absence of new developments, ends. Let’s say further that the advertising business takes off, perhaps feebly at first, but reaches cruising altitude in 24 months. Given these two assumptions, the share prices of Omnicom and IPG will be higher in two years than they are today.

Here’s some math: Right now, Omnicom is selling for about $57. One can buy an option that gives its holder the right, but not the obligation, to buy the stock at $60 at any time between now and January ’05. This option costs about $13. Now why would anyone pay $13, or even 13 cents, for the right to buy a stock for $60 when you can call your broker today and buy the stock itself for $57?

Omnicom’s previous high price is close enough to $100 to call it $100. Let’s say the share price gets back there by January ’05. In a conventional stock trade, that would produce a $43 profit. (Buy it at $57, sell in two years for $100.) That’s a 75 percent return.

But given the same stock-price action, someone buying the option would do much better. At a stock price of $100, the option to buy at $60 would be worth at least $40 and would sell for at least that. These options can be freely bought and sold. If January ’05 were still some months away when the stock hit $100, the option would be worth even more than $40. So if someone buys the option today at $13 and it increases to $40, the investor would score a 200-plus percent return upon its sale.

Of course, if the stock languishes, the profits on this option might be elusive, and, after the option’s expiration date, its worth would sink to zero. In that case, an investor who bought the stock rather than the option would still own the stock, and could sell it and recoup something, while the option investor would just have an unpleasant memory.

The opportunity regarding IPG, which is much further from its former high price, might be even better, but the longest-term option presently available on that equity expires in January ’04, vs. Omnicom’s longest option, which will live for a year longer.

These long-term options, known as Leaps (for long-term equity anticipation securities), can be created by any of the five national exchanges that trade Leaps, and they trade on all five. The companies themselves are not party to these transactions. The next opportunity for the creation of long-term options in IPG’s stock will be in May, when it may initiate options to expire in January ’06.