While there is some hope that our leaders in Washington can reach some type of compromise before sending us "over the cliff" it is the retiree and prudent dividend investor that looks to be the worst hit by the impending cliff which seems to be a 50/50 proposition at best right now.
The main reason I believe we are going "over the cliff" is because John Boehner and company refuse to raise taxes on the richest Americans (who they represent). In my twisted view of politics, the Republicans either want lower corporate taxes, or a continuation of Bush rates but they will not stand for anything that affects billionaire take home pay. In my view, these guys are representing the big corporations and unless the Democrats concede defeat by either slashing entitlements (which I actually think need to be addressed) or lowering corporate tax rates to make up for taxes going back up for the richest .01% of Americans. Call me a skeptic, but I also think both sides have a perverse incentive to actually want to go over the cliff -- Democrats want higher taxes and Republicans want lower spending. The fiscal cliff provides a pretty good scapegoat for achieving both of those long term objectives which is why I believe we are heading over the edge by design -- everyone can blame someone else but nobody wants to surrender in public. In this Mexican standoff, both sides have more to gain by standing pat than they do in compromising. Furthermore, Obama does not need to run for re-election and feels he has a mandate -- I take him at his word that no deal gets done without the richest .5% paying a little more.
All of this bantering and posturing is downright depressing for some investors. Dividend tax rate hikes could mean that many, if not most, investors will lose at least a third of their dividend income to the taxman starting next year, though when taxed at income this may not hurt lower income investors from a cash flow perspective thanks to graduated income tax brackets. In the latest gridlock hurdle for U.S. investors, wise stewards of capital must find ways to increase yield or protect current profits. Even the most pious Sober Sarah before the talk of the cliff began may secretly yearn for a Jack and Coke at this point!$
One strategy which makes perfect sense given this reduction in yield is to sell covered call options against your stocks in order to pick up that lost dividend yield with option premium income. Here are my thoughts on Coke shares, the company's valuation and prospects, and some suggestions on how best to protect your investment and income stream if we go off of the proverbial cliff. What we aren't going to do is suggest taking up drinking, so you can leave that bottle Jack alone for now.
Coca Cola (KO) -- Coke is a bedrock investment for any dividend investor, having outperformed almost everything over the past thirty years. Coke shares are not exactly cheap at 19.4X earnings and changes in attitudes towards health and food are headwinds for all "junk food" businesses going forward. As Americans increasingly move toward non-GMO and healthier snacking options, companies like Coke are forced to adapt. We think the Vitamin Water purchase moves the company closer towards the overall trend in healthful eating, and could envision Coke adapting toward changing consumer views on beverage and chemical consumption -- the company also needs to become the go to company for water production as that resource looks increasingly scarce.
So far we have listed two obstacles for Coke investors to overcome, but in the short run it's the 150% hike in dividend tax rates that concern most Coke shareholders and most have good reason for concern.
If we do head over the cliff, which I think is highly likely (better than 50/50), investors could sell front month at the money call options on KO -- I suggest selling the January 2013 $37.50 calls for $.60 per contract. More conservative investors who own KO in IRA accounts could also buy a longer dated, slightly in the money put option on Coke shares to create a "collar." Using a Collar that is longer dated allows this "trade" to earn low risk income while locking in gains. We don't think collars are the best option for most investors, but covered calls make sense in an environment of falling dividend yields and sequestration. Alas, I get genuinely thirsty just thinking about the word "sequestration" and "carbon," and most importantly carbonation.
In conclusion, the rise in organic consumption along with crashing dividend yields make Coke shares a bit risky at 19X trailing earnings and 16.8X forward earnings but the company is well worth the substantial price. Even though growth is still ticking along, and Coke's moat is as strong as ever, a large crash in dividend earnings means that investors could sell some upside in exchange for some income and capital protection. While we don't suggest selling your Coke shares, we do think that investors in dividend names need a solid game plan before going over the cliff. It may be time to lock in some profits here on your long term winners before next year when tax rates may spike for long term capital gains.