So many options
If you open a finance textbook and search for options, you’ll probably find chapters dedicated to the intricate world of derivatives. It’s a bit like music. There are only 12 notes in any octave but they can be combined in so many different ways that they form an important part of the fabric of humanity.
We won’t give options that much social credit, but you get the idea. With put and call options and the ability to determine different strike prices, structures can be built with exotic names such as “protective collar” and “long straddle something that might be tricky to explain to your parents.
Options trading has filled many new sites in the financial graveyard, particularly when punters don’t understand the volatility and risks properly.
Far away from the world of financial derivatives, however, we find another type of option that is a useful tool for investors, dealmakers and corporate managers: real options.
There are no bull put spreads or long straddles here. Instead, there are economic opportunities that introduce choice into a business. The rule is straightforward: whenever possible, it is always better to have an option available to you.
Nobody wants to be forced to do anything, and by having a right rather than an obligation to do something, you are able to change your mind.
For investors, having exposure to a management team that has real options at hand is powerful. If you read up about real options, you’ll find definitions that talk to the ability to make or abandon some kind of choice in a business.
Examples are the options to invest further in a subsidiary, pull the plug on a project or move into a new product line. Whenever a company has more options available to it, there is more flexibility and arguably more value.
You’ll find the word “optionality” used in other contexts as well. For example, when investing in a company that is trading at a valuation that reflects only the core business, any other assets in the group represent optionality. By effectively getting those assets for free, there is only upside potential for them.
This isn’t quite true, of course, but the key point to remember is that flexibility is your friend. When looking at the fundamental characteristics of a business, it’s valuable to consider potential routes the management team could take.
High school lessons
A business that is hyper-focused on a particular industry or market can dominate that space but the valuation will always be held back by the lack of either perceived or real optionality. To break that spell, the management team often tries to demonstrate that the company can move beyond its core. This frequently has devastating results for shareholders, as most companies can’t move beyond the core with any ease. An even more dangerous situation occurs when a company has little or no optionality, yet the market values it like a growth stock that still has an impressive runway. This becomes a game of hot potato, when an investment in a bluechip stock can turn out to be a huge disappointment for those who buy near the top of the growth curve at a multiple that is too high.
As a business matures, you would expect to see the valuation multiple “unwind a term used to describe a company growing into its multiple.
School uniforms provide a powerful analogy. When a child is still growing, parents happily buy clothes that are too big, safe in the knowledge that the kid is likely to grow into them. But in high school, that’s risky. Most of us know puberty can be unkind, with some kids never growing into the bigger clothes.
The investment equivalent is buying a company such as Capitec or Clicks on a high multiple. Both have achieved exceptional growth, capitalising on the weaknesses of competitors and winning a healthy slice of market share. Investors were rewarded handsomely and the valuation multiples have been high. But eventually companies reach high school. The runway starts to look a lot shorter and perhaps those clothes are simply too big. The only way to justify the multiple is through real options, such as opportunities for management to take the company to new markets. If those options are lacking, the valuation is probably too expensive.