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Today, I want to explain the reasons for taking a long position on The Western Union Company (WU) as part of the Rock Solid Yield Portfolio. But first, let me first explain a little about the Rock Solid Yield Portfolio (RSY). RSY was built using Sabrient Systems' quantitative analysis to generate higher returns than the market (alpha), with overweighting on such factors as balance sheets, dividend yields, fundamentals, and earnings quality. Basically, picking high dividend payers with strong value attributes.

The last post, with a long recommendation of Armour Residential REIT (ARR), included the positions currently in the RSY portfolio as an online broker might display with cash balances and option positions. Unfortunately, ARR has dropped around 5% since the buy recommendation, which was partially explained by its public offering of 65,000,000 shares of common stock. All things being equal, this would have been a non-event. While there are bound to be transaction costs and friction of adding to the capital base, if we assume that management has done a good job with current capital, then adding more should not be a major concern for long-term dividend investors. Since the recommendation, RSY has received two dividends of 8 cents per share, for a total of $128 on the 800 shares purchased versus less than $300 in paper losses. So give it a few more months, and RSY will be back to par. Below are the trades recorded by RSY since January 2012:

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Often to protect the downside risks and to generate greater returns, RSY recommends selling the covered calls. But with small-cap stocks or lightly traded stocks, options may not be available or so low in value that even normal transaction costs prohibit much return. ARR is an example of such low values that it is not worth it. Even out to October 2013, calls at the strike price of $7.50 are 5 cents, and selling a put at $7.50 also only nets (hopefully) $0.50 over current prices.

RSY Recommends A Buy Of Western Union Company

After looking through thousands of stocks for equities with outstanding traits that can be quantified into rankings, WU rose to the top for being in the top 1% for its value score and having outstanding accounting practices. Thomson Reuters rated WU a 10 for "Relative Valuation" based on forward PEG, trailing PE and forward PE. That sounds great, but let us delve into the specifics. StockScouter rates WU as a 7, down from a recently rated 8. Part of the change may be attributed to its statement about insider buying: "Insider trading information is unavailable or inconsistent." This merits it a C for Ownership. Insider buying activity is the secondary reason for RSY recommending a long position, aside from its value score. The insider buying since November 2012 is below, with up to a 10% increase in holdings for each person.

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The graph below shows the quantitative changes over time of the insider trading score (complements of Thomson Reuters). The jump in insider buying scores reflects the 3 month data shown above. It is worth noting that, on average, insiders are neutral to slightly negative, but one year ago, sentiment was lowest at 1 out of 10. It seems obvious that insiders considered the drop of around one-third of WU's price in the last week of September 2012 as overdone. While the mood was bad, according to Jim Cramer, the sentiment has changed drastically since September.

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The reason for the drop in price last September was related to lowered guidance for the 2012 fiscal year and forward concerns about margins. Basically, it was a 7% reduction in EPS for 2012, even though EPS beat last year's third quarter results by at least 11%, and even analysts' expectations by 1 cent at 45 cents per share. WU may be the biggest, but without some monopoly market power, any business faces continual competition from up-starters. The one moat it has (as anyone that gets market share now) is the regulator hurdle, and recent events have strengthened that moat for businesses that adapt to the new regulations.

WU has started a campaign to reduce operating costs while reducing fees through a price cut strategy. Not necessarily the best strategy given the situation, but so far, margins have not been affected, as shown below. Even though WU has raised its dividends by 25%, its payout ratio (with reduced EPS last year) is under one-third.

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The last chart is a 1 1/2 year price history for WU, along with the calls (ratings) from SmartConsensus. Their short-term buy signals have not been very good, but did manage to get to Hold before the price collapse. The RSY portfolio did not decide based on this graph, but it is an important tool for deciding if a strategy (i.e., analyst) is good on specific stocks.

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Based on a portfolio of $100,000, RSY recommends a buy of 400 shares of WU at a limit price of $14.06 (GTC). And to be a little more creative, sell 3 contracts of the August 2013 open put at a strike price of $14.00 at a limit order of $1.10, and after acquiring the long position, selling the covered call for August contracts at a strike price of $15.00 at a limit price of $0.75. One reason to explore selling some option positions is that WU's momentum scores are low, even with its trend being slightly positive since last November. Just like ARR above, there is always a chance of a further pullback. Thomson Reuters rates WU's Price Momentum at 2, and Market Edge gave it a score of -1 based on purely technical indicators.

Source: Western Union Company: A Beat Up Stock That Insiders Love

Additional disclosure: I have no position in WU, but plan to initiate a long position in the next 72 hours.