It’s been a little over a month since I put out my article arguing that options are a better way to “play” QuinStreet Inc. (QNST) in an article entitled, originally enough, “Options a Better Way to Play QuinStreet Stock. ” Since then, the company has reported earnings, so I think this requires some commentary. In addition, the market apparently did not like those earnings, as evidenced by the fact that the stock is down over 30% against a gain of about 1% for the S&P 500. I want to try to work out whether the market’s correct or not by looking at the stock as a thing distinct from the underlying business. Finally, since I recommended selling put options just before the stock crash (my timing’s always perfect), I need to comment on that, too.
In case you missed the bullet points above, and you opened this article before reading the title for some reason, I’ll give you the “gist” of my article in this, the “thesis statement” paragraph. As I’ve admitted often on this platform, my writing can be a bit “tough to take” for some, and for that reason I think it’s only fair to reveal the highlights in a single paragraph, in order that people will not have to wander into the deeper, more tiresome tangled jungle that passes for my thoughts. I think QuinStreet is much closer to a price at which I’d be willing to buy the stock, but it’s not there yet. I think comparisons to 2020 are skewed by a $ 16 million “other income” element in 2020, and I think the market is overreacting to the drop in earnings. We should try to capitalize on that overreaction by selling more, lower strike, puts in my estimation. Although the puts I wrote only a few months ago are up in price, the losses I’ve suffered are far, far less than the loss suffered by long stock investors. This demonstrates, yet again, the risk reducing power of short put options. In my view, this strategy worked before, and I’m recommending selling the November $ 7.50s today. That about does’ er for the old “thesis statement” paragraph. Wraps her all up. So, if you venture deeper into this article, I do not want to read any complaints later from you about cheezy puns or whatever.
I wrote about the longer term financial history very recently in my previous article on this name, so if you’re interested in reading financial history for some reason, I recommend you check out my earlier work on the name. In this missive I want to focus on the most recent half year, and juxtapose it to the same period in 2020 and 2019. In spite of a significant uptick in revenue relative to both 2020 and 2019, net income was down significantly over the first six months of 2021. Specifically, net income swung from a profit of ~ $ 2.7 million during the first six months of 2019 to a loss of about $ 2.5 million during the most recent half year. Comparisons to 2020 look even worse, given the absence of “other income” (see below).
Earnings between 2020 and 2021 were down largely as a result of a collapse of “other income.” from $ 16.73 million in 2020 to $ 600 thousand in 2021. I should point out that of the two, it seems that 2020 was the outlier, given that “other income” averaged only about $ 160 thousand for the years 2017-2019. Thus, we should not be too “freaked out” by this drop.
The one potential cause for concern is the fact that cost of revenue was up by ~ 5.9% in 2021 relative to 2020, and general and administrative expenses were up by ~ 21%. I’m going to keep an eye on these costs, and may very well change my stance if they continue to outgrow revenue growth.
All that said, the capital structure is even stronger now than it was when I last looked at the business. For example, the current cash hoard of $ 115 million represents just under 90% of total liabilities. Thus, I conclude that the business is not going anywhere anytime soon, so I’d be happy to buy at the right price.
You may not believe it if you’ve been indoctrinated by such platitudes as “we do not buy stocks, we buy businesses”, but the fact is, we retail investors do not actually access the cash generating capacity of a public company directly . We access its future cash flows via stocks that climb and fall in a manner that is, apparently, a proxy for what’s going on at the enterprise. Thus, we need to spend some time looking at the stock as a thing distinct from the underlying business. In my travels, I’ve observed that people who buy stocks more cheaply tend to do better over time. This is because a great business can be a terrible investment if you overpay for it, and a troubled business can be a potentially good investment if you can buy it for a sufficiently low price. Rather than blather on as is my wont, I’ll demonstrate this phenomenon by looking at QuinStreet itself to make the point. For instance, if you bought QuinStreet on February 24, you’re sitting on a 2.4% gain. If you bought four days later, you’re sitting on a 5.1% loss. This 7.5% swing in returns in under a week comes down entirely to the price paid. The variability of results over such a short period of time supports the idea that person A who “buys the company” on February 24 is in a much different position than person B who “buys the company” on February 28. Both have “bought the company ”, but have experienced vastly different results. We want to buy shares cheaply. These offer the greatest returns in my view, and are simultaneously less risky.
If you follow me regularly for some reason known only to you, you know that I measure the cheapness of a stock in a few ways, ranging from the simple to the more complex. On the simple side, I look at the relationship between price and some measure of economic value, like sales, free cash flow, and the like. Ideally, I want to see a stock trading at a discount to both the overall market and its own history. One of the reasons I recommended people avoid buying this stock the month before last was because price to sales was ~ 1.4 times, price to book was about 2.8 times, and the shares were trading at a price to earnings of about 67 times. The stock is now 28% cheaper, 31% cheaper, and about 33% more expensive per the following three charts:
I consider this to be generally favorable, and I’m not too worried about the spike in PE multiples, given the relative impact of the “other income” described above. Although price to sales and price to book remain slightly on the high side for this business, it’s far less egregious than it was only two months ago.
As you know if you’re one of my regulars, I also want to try to understand what the market is currently “assuming” about QuinStreet’s future. In order to do this, I turn to the work of Professor Stephen Penman and his tome “Accounting for Value.” In this book Penman walks investors through how they can apply the magic of high school algebra to a standard finance formula in order to work out what the market’s “assuming” about a given company’s future growth. This involves isolating the “g” (growth) variable in this formula. Applying this approach to QuinStreet at the moment suggests the market is forecasting a growth rate of about 7.5%, which, although quite optimistic, is far better than the 9.5% growth rate assumed when last I looked at this name. Given the above, I’d say that it’s not yet a buy, but it’s quite close.
To refresh your memories, once again, dear readers, in the previous missive on this name, I recommended people sell the September puts with a strike of $ 10 for $ 0.40 each. These last traded hands for $ 1.20, so I’m currently sitting on an unrealized loss of $ 0.80 per contract. That certainly isn’t ideal, but it is preferable to the $ 4.77 loss the stock owners have suffered since I initiated this trade. This is why I like selling put options more than I like buying stocks. When things do not go your way, as will inevitably happen, you’re not exposed to as much risk with deep out of the money short puts as you are with simple stock ownership.
Thus, I consider my trade, though it’s currently unprofitable, to be a relative success. I like to try to repeat success when I can, so that’s what I’m about to do. I recommend selling more puts on this name as deep out of the money puts pretty clearly reduce risk, and potentially enhance returns. In terms of specifics, I would recommend selling the November puts with a strike of $ 7.50. These are currently bid at $ 0.55 which is a reasonable enough premium at this strike price. If the shares remain above $ 7.50 over the next nine months, I’ll simply pocket the premium, and add it to the $ 400 I’ve earned from selling puts on this name already. If they fall another 27% from their current level, I’ll be obliged to buy, but will do so at an approximate price to book ratio of about 1.4. So either the shares remain above $ 7.50, in which case I add to the premium received so far, or I am “forced” to buy this stock at a very fair valuation. This is why I call deep out of the money puts on companies I like “win-win” trades.
It’s time to talk about the risk of short put options, dear readers. I know I characterize them as “win-win”, but you might be forgiven for suggesting that’s a bit of hyperbole. The fact is that short put options, like everything in life, come with risk. The short puts that I consider to be ‘win-win’ are a subset of all short puts. I consider a short put to be a “win-win” when it’s written on a company that I would be happy to own at a price at which I’d be happy to buy. So, not all puts are “win-win” trades. If the strike price is a terrible entry price, for instance, that’s a very bad trade in my view.
I should also state that I think the risks of put options are very similar to those associated with a long stock position. If the shares drop in price, the stockholder loses money, and the short put writer may be obliged to buy the stock. Thus, both long stock and short put investors typically want to see higher stock prices.
Some put writers do not want to actually buy the stock – they simply want to collect premiums. Such investors care more about maximizing their income and will be less discriminating about which stock they sell puts on. To be very clear, I am not such an investor. I like my sleep far too much to sell puts based only on the income I can generate. I’m so much of a coward that I’m only willing to sell puts on companies I’m willing to buy at prices I’m willing to pay. I was not always so disciplined, but after painful losses, I decided to only ever sell puts on quality companies at prices I was willing to pay.
I should also write that I think put writers take on risk, but they take on less risk (sometimes significantly less risk) than stock buyers in a critical way. Short put writers generate income simply for taking on the obligation to buy a business that they like at a price that they find attractive. This circumstance is objectively better than simply taking the prevailing market price. This is why I consider the risks of selling out of the money puts on a given day to be far lower than the risks associated with simply buying the stock on that day.
I’ll conclude this rather long, ponderous, and probably dull discussion of risks by looking again at the specifics of the trade I’m recommending. If QuinStreet shares remain above $ 7.50 over the next several months, I’ll simply pocket the premium and move on. If the shares fall in price, I’ll be obliged to buy, but will do so at a price that lines up with a reasonable valuation in my view. Since all outcomes are acceptable to me, I consider this trade to be the definition of “risk reducing.” Weird of me to end a discussion of risk by writing about how these things can reduce risk. Can you believe it ?! I can be weird. I hope you were sitting down when you read that.
I think the shares of QuinStreet Inc. are fast approaching the “right” price at which I’d be willing to buy ($ 10). The puts I sold earlier correspond with this strike price, so I’ll be happy to be exercised. Although the puts are trading for more than I sold them for, that economic loss is far lower than the economic loss suffered by stock owners. This is why I’m comfortable proclaiming short puts risk reducing instruments. In addition, this strategy of selling deep out of the money puts worked in the past, and I suspect it’ll work again, so I’m selling more. If you’re comfortable selling puts, I would recommend this or another trade. If you’re not, I would put in a buy at a limit price of $ 10 and wait.