Defending Your Virtual Portfolio With Dividends – Q4 (Members Only)
In uncertain markets, dividends can give you a critical investing edge.
As you can see from the chart on the left, just mindlessly investing in dividend-paying stocks can give you more than a 2:1 annual advantage in your investments.
Of course, here at PSW, we teach the art of selling options premiums – something that turns virtually any stock into a "dividend" payer. For example, MSFT is only a small, 2% dividend-payer but a fairly solid cash-machine of a stock that we don't feel is likely to go bankrupt overnight so it makes for a nice safe staple in a long-term virtual portfolio. But MSFT is also a very poorly-run company that hasn't grown in 20 years but we can make it a much more interesting stock by simply selling covered calls.
For example, in our August edition of Dividend Payers, we looked at MSFT for $24.23 and we sell the Sept $24 calls for .77. This lowered our effective basis to $23.46 and selling the call putus in no special danger – we simply agreed to sell MSFT for $24 on expiration day in September (the 17th).
The stock was called away from us, and we made a .54 profit or 2.3% of our net $23.46 cash investment in less than 30 days. That works out to a 26% annualized ROI and we had an opportunity (as we had expected) to buy the stock again and again at $24 on Oct 4th and 5th and sell the November $24 calls for .90 for a net $23.10 re-entry and ANOTHER 3.8% GAIN if we are called away at $24 or greater on Nov 19th. Doesn't that beat waiting a whole quarter for your 1% dividend checks?
Of course, you can optimize all this with timing and we favor stocks that are on sale – this is just a very simple example of how our most basic options strategy can drastically boost your annual returns on any stock in your virtual portfolio.
Let's say you don't want to mess around with MSFT every month. You could have simply sold the 2012 $22.50s for $4.40 (also suggested in the August post), that dropped your net entry from $24.23 to $19.83 and getting called away at $22.50 would be a profit of 13.5% over 17 months PLUS you would be getting your .52 annual dividend so let's call it .75 more for a total profit (if MSFT holds $22.50) of $3.42 or 17.25%. 1% a month certainly beats what the banks are offering these days as well as the dividends paid by most stocks! Not as sexy as the 26% ROI you make by working the trade every month but you do get a built-in cushion that drops your break-even price to $19.83, which is a full 18% below the current price. So MSFT would have to fall 18% (not including the .75 dividend) before you are even behind on this trade.
Would making 1% a month on your entire virtual portfolio have enhanced your lifetime earnings? If so, you should probably be using this strategy whenever possible, right? Here's a nice chart showing average annual S&P results for each decade:
|
Price Change |
Dividend Dist. Rate |
Total Return |
Inflation |
Real Price Change |
Real Total Return |
|
|---|---|---|---|---|---|---|
| 1950's | 13.2% | 5.4% | 19.3% | 2.2% | 10.7% | 16.7% |
| 1960's | 4.4% | 3.3% | 7.8% | 2.5% | 1.8% | 5.2% |
| 1970's | 1.6% | 4.3% | 5.8% | 7.4% | -5.4% | -1.4% |
| 1980's | 12.6% | 4.6% | 17.3% | 5.1% | 7.1% | 11.6% |
| 1990's | 15.3% | 2.7% | 18.1% | 2.9% | 12.0% | 14.7% |
| 2000's | -2.7% | 1.8% | -1.0% | 2.5% | -5.1% | -3.4% |
| 1950-2009 | 7.2% | 3.6% | 11.0% | 3.8% | 3.3% | 7.0% |
Notice the inflation the Government keeps denying is a actually 3.8% for the past 60 years and is still 2.5% despite all the talk of deflation. That means, if your money isn't doing SOMETHING to make at least 2.5%, you are falling behind every day. Of course, putting your money in the market for the past 10 years hasn't helped, without dividends that would have cost you an additional 2.7% of your cash! Notice that in EVERY decade, our very simple combination of dividends plus call selling would have kept you above both inflation and market dips – IN THE LONG RUN.
I emphasize IN THE LONG RUN both because it's a great Eagles song and also because most investors are way too short-term focused and forget to look at investments as…. well, investments. Using a simple Compound Interest Calculator, you can take $10,000, add just $5,000 a year for 30 years at the average real total return (ABOVE inflation) of 7% and that nets you $581,487.76 inflation-adjusted dollars to retire on. This should be the base goal of any investor – simply make sure you have a conservative base to build on.
Keep in mind that selling covered calls adds no risk other than you may, potentially miss a big move up in the stock as you have already promised to sell it for "just" (in the MSFT example) a 26% annualzied ROI but are there ANY decades where the market gained 26%? No, of course not. Just change that 7% figure in the calculator to 17% and watch what happens when you hit the "calculate" button - $4,898,165.34!!! Don't you think this is a strategy that deserves some of your attention?
Is this realistic? Of course it is! If people would get their head out of the short-term trading BS and concentrate more on their INVESTING, the World would be a far better place. Few people plan for the far future but look at this chart of what 8% in a Roth IRA can do for your children's children. Do you need a new Mercedes or do you need to leave a family legacy?
Hopefully, I've done enough to get your attention so that now we can look at some boring, slow-moving, dividend-paying stocks in a better light. It's all well and good to have fun playing the short-term market moves but, without a solid base in your virtual portfolio that is delivering consistent annual returns, the risks can be unacceptable. Short-term trading can be wonderful as we can hedge our longer-term positions against market downturns or we can take advantage of aggressive up moves in the market that will be calling away our longer positions but, in both cases, the short-term trading is the fine-tuning that is meant to lock in those 8% annual returns (hopefully better!) that will make you a family legend for generations to come.
Our last set of picks is, of course, 100% successful as we stuck to "safe" Dow plays when the Dow was 10% lower, my comment at the time was:
"In the grand tradition if KISS (Keep It Simple, Stupid), let's start by looking at the Dow's top dividend players. We like the Dow because it's easy to hedge with our Mattress Plays (see "The Stock Market Parachute" as well as commentary in our Strategy Section). T, VZ, BA, HD, KFT, MRK and PFE are generally the best payers and, in establishing a long-term virtual portfolio with a dividend strategy, it's good to keep an eye on your diversification. Since we are selling covered calls as well, we also take into account which option sales give us the most bang for the buck and, of course, which stocks represent a good value at the current prices. That knocks MCD, XOM and CVX off our list as they represent more of a gamble and, if we are going to gamble – we can do A LOT better than 3%.
I'm not going to review the whole thing but I led off saying BA was the best at $63.16 (now $71.26). It was 10 for 10 on the rest with VLO, XOM and EXC added in the comments that same day (8/29). I hate it when I have to do a follow-up to a perfect post as the pressure is on to do it again so I wlll caution now against runaway expectations because this is not the same market we had in late August, when we were very confident we had formed a playable bottom. As we did last time, we are using buy/writes for the spreads. You can opt NOT to sell the puts, of course – it will simply lower the returns but if you can get 17% in 17 months – that's PLENTY and that's all we look for in our Dividend payers (now looking for 15% in 15 months with 2012 hedges).
Sadly, the Dow is no longer cheap, and, while I do favor cash in this market, if we continue to have a runaway Federal Reserve that is hell-bent on devaluing our cash assets – what choice do we have but to BUYBUYBUY – at least enough to guard against the inflation that is robbing us of our savings? Last time I got away with very little company description for our trade ideas as they were all Dow components but this time we're bargain hunting so forgive a little color commentary with the picks but I'm not here to sell you the stocks, so just quick notes:
CTB makes replacement tires and, with auto sales way down, at some point all these older cars are going to need new tires. Revenues have been growing at a 25% clip despite the recession and the company is expanding internationally. This company dropped like a rock in the crash so not for the feint of heart but you can buy the stock for $20.46 and sell the May $17.50 puts and calls for $6 and that nets $14.46/15.98, which is a 22% discount to the current price and that makes the little .42 annual dividend a whopping 3%, which isn't sexy but you do net an additional 21% profit in 7 months if you are called away at $17.50, which is 14% LOWER than we are now.
NGG was on my Watch List in August but they had just popped from $37 to $42.50 so I figured we should wait for them to come down, now they are $46.35 and I STILL like them! NGG is an electric and gas infrastructure (transmission) play in the US and UK. Nice, steady business, good profits and a 7.7% dividend paid twice a year (June and December). After paying a $1.77 dividend in June the stock fell $4 so be ready for that! Since we expect a dip in Dec, selling the Dec $45s for $2 makes sense and those can be paired with the sale of the June $40 puts for $1.50, which nets a reentry back at net $38.50, which is where we wish we had gotten in in the first place! So net $42.85 on the buy/write and collecting about $1 (2.3%) in December makes for a pleasant couple of months, with another $2.15 profit (5%) if called away at $45 – that's how we turn a 7.5% Annual dividend payer into a 7.5% Quarterly dividend payer! After the dividend dip, you can take out the Dec caller and sell some June calls for more premium.
PVR is an old favorite of ours as they have some very fun dips they tend to recover from. The last fun dip was during the "flash crash" when the went from $23.50 to $9.82 and then back to base at $18 in May before climbing back to $25.60. So I'm not as gung-ho as I was before but they control (leases) of 829M tons of coal (collecting royalties) as well as a nice nat gas pipeline business. Not the best call options to sell but the May $25 calls can be sold for $1.45 and the $22.50 puts can be sold for $1.40 for a net $22.75/22.63 entry – just a 10% discount but the 7.5% dividend will soften the blow and that 10% is for 7 months anyway….
BMY is a long-time favorite of ours and is no longer cheap but, even at $26.96, the $1.28 dividend adds up to 4.7% a year, which is nothing to sneeze at (get it, drug co – sneeze!!). Earnings are on the 26th and you can hope a miss of some sort gives you a cheap entry but I say blow off the dividend and let's look at buying 2012 $20 calls at $7.30 (which is just .34 of premium) and selling the 2012 $22.50 puts for $1.80 and the Jan 2011 $27 calls for $1.10 which is a net of $4.40 on the $7 spread so a nice 60% profit if you get called away is better than the dividend and don't forget you own the calls so you can demand ownership of the stock at any time for $20 more, which would put you in a traditional buy/write and let you begin collecting dividends. The benefit of starting with the spread is you get a bit more protection if they do miss and, if they hold $22.50 through Jan 2012, your net entry if you pull the stock into a 2013 buy/write is $24.40 on round one (10% below current price), less whatever additional calls you sell in 2012.
Good time to remind you: We do not necessarily get called away at $62.50 - we can execute our Rawhide Strategy of "Rollin' rollin' rollin'"… Had we sold, for example, the August $60 calls and decided we did not want to get called away, we could still roll the net $4.60 caller out to 2012 and collect net $8.70. Presumably, we would have a far lower basis and you will find this happens over the years as you build your virtual portfolio as it would only take 8 rounds of collecting net $8.70 against your BA shares to lower your net basis to zero – at which point collecting $1.68 in dividends starts seeming like a great deal! And what do you do with the cash? Buy more dividend-payers of course!
This is how we "compound" our virtual portfolios over the years, we sell options and collect dividends and use them to buy more stocks that we can sell options and collect dividends against. That brings up another thing we are not discussing here – the naked put sale! This is the key to our Buy/Write Strategy (see "How to Buy a Stock for a 15-20% Discount") and I am 100% in favor of it but this is a post for the IRA crowd, who do not get the full benefits of selling the naked put side (and are often not allowed to) so we're concentrating on the basic strategy – feel free to ask if you are interested in the more advanced versions.
PFE makes for an interesting conservative buy/write as they are still pretty cheap at $17.50 but still pretty volatile. Selling the 2012 $15 puts and calls for $4.65 drops your net entry to $12.85/13.93, which is 20% off even if put to you. If PFE manages to hold $15 (not lose 20%) by Jan 2012 expirations, then you get your .72 dividend plus $2.15 in profit on your $12.85 investment for a very nice 22% return. This is what I'm talking about – you MAKE 22% EVEN IF the stock drops 20% – THAT'S the way to construct a conservative virtual portfolio!
JAG doesn't pay a dividend but, as I demonstrated with MSFT, you can pay yourself a dividend by selling calls. JAG came off my watch list because they ended up with the Gurupi Project in Brazil, which has 1.4M ounces of proven reserves, which is 3x more than Jags market cap. They sort of lucked into owning this as, over the years, the $550 per ounce extraction cost had caused various operators to walk away so this is a bet on gold staying near or above $1,000 long-term. Very simple buy/write with the stock at $6.46, selling June $7.50 calls for .85 and the $5 puts for .50 is net $5.11/5.06 with a nifty 47% profit if called away in 7 months and, if not – do it again and you've got a long-term gold hedge with a good chance of collecting 50% annual dividends.
HRB cannot be less loved at this point. This is very much about the demise of "rapid refund" which was a big source of revenue as well as fears they have sour mortgage loans due to Foreclosuregate but, strip that away and you still have a nice little company that pays a nice 5.6% dividend. We did this one during the week and the stock is now $10.78 and you can sell the 2012 $10 calls for $3 and the the $7.50 puts for $1.80 for a net $5.98/6.74. It is VERY possible that they drop enough to concern you so make sure you REALLY want to own 2x at $6.74 (37% off). $6.74 makes that .60 dividend close to 10% a year on the best known tax preparation service in America that has learned their lesson and will be more likely to stick to the knitting from now on.
FHN used to pay a dividend but hasn't since March, 2008. They did a 66:16 reverse split in September and announced a dividend of 1.8% payable in new shares to holders of record on Dec 10th. It will be messy if you don't own 1,000 share blocks though. So this Tennessee-based bank is a LONG-TERM recovery play but I think if they put those dividends through for a couple of quarters, interest will perk up. They repaid $8.5Bn in debt in '08 and '09 and took a big adjustment in June but they are sitting on $5Bn in cash with $21Bn in investments with just $23Bn in liabilities yet their cap it just $2.3Bn – priced for liquidation. At $9.93, 1,000 shares will set you back $9,930 but you can get $1,500 back for selling 10 May $9 calls fro $1.50 and another $900 for selling the puts for .90 so that's net $7,530 for 1,000 shares and you'll get bonus shares in Dec and a 19.% profit if called away at $9 (10% below current price) or an average entry of $8.27 on 2,000 shares if they fail to hold $9 at May expiration, which would price them 15% below book value.
HCBK does pay a 5.2% dividend and they are location, location, location for me as a NY/NJ bank servicing the top 10% suburbanites in the North. I've always liked these guys and I love them when they are being sold off on fear and lumped in with all the dumber banks. At $11.53 a share, you can play this safe and sell the 2012 $10 puts and calls for $3 to make a $8.53/9.27 buy/write which pays 17% plus the dividend if called away at $10. I like them more than that and prefer the riskier sale of the $12.50 puts for $2.10 along with the $2 sales of the $10 calls which give you net $7.43/9.97 so not too much more upside but a great 34% if called away at $12.50 in exchange for a much greater risk of assignment at .70 per share more. Keep in mind that, since you are doubling your return on the riskier strategy, you can bet 1/2 as much in the first round and diversity is key with the financials because you just do not know what dirty little secrets they may be hiding…
MTB caught my attention because they dropped over 20% since September because all banks are evil or whatever. They just put out nice numbers and no one cares. Deposits increased, impairments are down, loan-loss provisions have decreased and write-offs dropped by 1/3 and no one cares. Well I care! Investors have turned prejudiced against banks and it's a heck of a good opportunity to buy some and Buffett owns MTB so I like the partners. At $74.44 you bite off a lot to get involved so it's more of a set and forget play, selling the 2013 $70 calls for $14 and the $60 puts for $10 which is net $50.44/55.22, a 25% discount if put to you and $50.44 makes the $2.80 annual dividend 5.5% while you wait so that makes for a 36% downside cushion before you even buy a hedge.
OK, that's 10, which is good for now. We'll look at more during the week and please, Please, PLEASE keep in mind that I'm not all gung-ho to buy anything right now but, if we are going to hold those 10% lines and move higher, then we'll need something to guard against inflation and these are a good place to start.
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