Divided About Allied Capital Dividends

The love hate relationship investors have felt with the financial sector has resulted in stock prices that change directions quicker than a cat on Velcro. Those that fear (a further) loss of their investment are quick to push the sell button at the first sign of red. On the other end of the spectrum, those who dread the thought of missing a run frantically chase these stocks like they were catching a bus.

So, would this roller coaster price fluctuation indicate we are in a bear market or the early stages of a bull? While there are bold analysts that remain steadfast to their long horned convictions, anyone who’s taken a look at their portfolio would probably argue otherwise. At a minimum, if in fact we are in a bull market, it’s definitely got its head stuck in a jar of honey.

A commonly utilized strategy in a bear or sideways trading market is to purchase stocks that have a high dividend yield (i.e. pays high dividends relative to price). The logic behind it is simple and intuitive: get paid while you wait. Empirical studies on the performance of dividend versus non dividend paying stocks in down markets have supported this concept.

Yesterday, Allied Capital Corporation (ALD) saw its stock price close at 1.56, after trading between a 52 week high of 21.99 and a low of 58 cents. Put differently, what was once enough to purchase two twelve packs of your favorite brew, is now worth two twelve packs of empty cans. A disturbing fact if you’re thirsty on a Friday night. Even more alarming is Allied Capital’s disproportionate dividend which pays 2.60 a share. With a yield over an astonishing 165%, can Allied Capital be the answer to our bear market woes? Well, not exactly.

If my mother taught me nothing else, she told me never to assume. It’d be naive to assume Allied Capital will maintain its dividends at these egregious levels. Across the markets, firms have been cutting dividends like school bullies in a lunch line. For the first quarter of 2009, Standard & Poor’s reported the number of companies that slashed dividends outnumbered those that raised them. To put this into perspective, the markets had never experienced a quarter where the cuts outnumbered the increases since S & P began collecting this data in 1955. In addition, they recently recorded losses of 1 billion as a result of defaulting on a revolving line of credit. However, on our voyage back to positive levels, even the strongest willed investor may find it difficult to resist the siren song of 165% dividend yield.

While there is little one can do to guarantee receipt of dividends, investors can do more than exercise the buy pray strategy. Suppose an investor is only concerned with Allied Capital’s dividend payment, not the stock itself. An interesting strategy for an investor to speculate on dividend receipt while minimizing price risk can be constructed using the November and January options.

For those unfamiliar with the impact of dividends on stock and option prices, here’s a very quick rundown. When dividends are paid, a stock’s price (theoretically) drops by the full amount of the dividend. In actuality, the price decline is less than the full amount distributed. Concurrently, a call option should decrease proportionately to the dividend payment (which reduces the stock’s price) and a put option should increase by the proportionate amount.

Getting back to Allied Capital, the stock ended the trading session at a price of 1.56. The November 2.50 call options traded with a bid price of .40 and ask of .65, the January 2.50 puts had a spread of 1.35 by 1.50. An investor seeking to capitalize on the receipt of dividends can:

• Long shares of Allied Capital Stock (ALD) at 1.56
• Long a proportionate amount of the January 2.50 put options at 1.50
• Short a proportionate number of November 2.50 call options at .40

Here’s the rhyme behind the reason. An investor that purchases both the 2.50 put options and ALD stock has an unlimited upside potential and his downside capped at 2.50 a share by expiration. However, the total amount paid for this insurance is 3.06 [=1.56 (stock) + 1.50 (put)] meaning there is a potential loss of .56 (=3.06-2.5).

Since the investor is attempting to capitalize on the potential receipt of dividends, we can short the November 2.50 calls at .40. Now, the total amount invested is 2 .66 (= 3.06 - .40), but the investor has locked in the amount due by the November expiration of the calls at 2.50. Therefore, regardless of where the stock is by November, the investor can expect a return of 2.50 and any premium left in the January put options. In the worst case scenario, assuming the January put options are worthless by November, the max loss is 16 cents (= 2.66 - 2.50).

However, besides whatever premiums may be left in the put options, I deliberately chose the November calls, since it provides us with an opportunity to roll the options over to January. Hopefully, the investor is able to short the calls at .16 or more, so that the max loss is potentially reduced to 0, or better yet nothing but gains.

Again, the goal of this trade isn’t to gain from the potential roll of the call options or the residual premiums of the January puts: it’s a means to speculate on dividends receipt at lower levels of risk. If Allied Capital were to maintain their dividend payments, (which again, is a pretty big if) the investor of this strategy would receive 2.60 on a 2.66 investment by January. If the company slashes dividends to zero, the investor’s loss is capped at .16, but even this level has the potential to be dynamically reduced. While there’s nothing wrong with speculating on a stock or potential dividend, it never hurts to look for creative ways reduce your risk while doing it.

Disclosure: no positions

Comments

[NNP:]

Allied Capital is not paying dividends in 2009!

Apr 21 09:05 AM

[DanTheMan:]

ALD suspended their dividend months ago. Further, their revised credit agreement from December prohibits them from paying out more than 20 cents per quarter. And more changes are likely coming to that (and their private debt) since they have breached their covenants. And just as importantly, the Investment Company Act of 1940 prohibits them from paying any dividends until their debt:equity ratio is back to 1:1 as they took more writedowns in the 1Q and are in (substantial) violation of that requirement.

Apr 21 09:06 AM

[kimball:]

This is rather ridiculous as ALD has not paid a dividend this year and most likely will continue to not pay until things turn around.

Apr 21 09:07 AM

[Wise Golden:]

Unbelievable. Was this written by a child? Did Kim do any research at all? ALD has placed dividends on hold.

Apr 21 04:30 PM

[Tae Kim:]

Hi all,

Thanks for reading my a (obviously controversial) article.. I do agree that the likelihood of dividend reciept is slim to none... But I also feel (unless you know otherwise) that it's NOT an impossibility.. I'm sure you'll agree, crazier things have happend in these markets..

While the firm doesn't "expect to declare dividends in 2009", the payments are mostly hinged on the overall success of the company. Similar to other corporate structures (like LP's, Trusts etc..) ALD is an RIC which REQUIRES them to payout a significant % of EPS.. Meaning IF (again a big if) the company is able to recapitalize and improve solvency/leverage ratios and EPS, the anticipation of dividends should increase proportionately.. The company can't simply hoard the earnings for future growth needs..

Many are SPECULATING that the dividends have shot at being paid, contingent on the overall earnings success and improvement of of the firm's fundamentals... If i'm not mistaken, the company has paid dividends annually since the 60's without missing a beat.. While I do agree with everyone here that the likelihood is VERY small, I am not a good enough analyst to say this is impossible. For anyone who is speculating on these dividends, I just wanted to offer a different way to place their bets..

Apr 21 04:57 PM

[NNP:]

The company did miss a beat--they did not pay the March 27th dividend. I sure miss it...


On Apr 21 04:57 PM Tae Kim wrote:

> Hi all,
>
> Thanks for reading my a (obviously controversial) article.. I do
> agree that the likelihood of dividend reciept is slim to none...
> But I also feel (unless you know otherwise) that it's NOT an impossibility..
> I'm sure you'll agree, crazier things have happend in these markets..
>
>
> While the firm doesn't "expect to declare dividends in 2009", the
> payments are mostly hinged on the overall success of the company.
> Similar to other corporate structures (like LP's, Trusts etc..) ALD
> is an RIC which REQUIRES them to payout a significant % of EPS..
> Meaning IF (again a big if) the company is able to recapitalize and
> improve solvency/leverage ratios and EPS, the anticipation of dividends
> should increase proportionately.. The company can't simply hoard
> the earnings for future growth needs..
>
> Many are SPECULATING that the dividends have shot at being paid,
> contingent on the overall earnings success and improvement of of
> the firm's fundamentals... If i'm not mistaken, the company has paid
> dividends annually since the 60's without missing a beat.. While
> I do agree with everyone here that the likelihood is VERY small,
> I am not a good enough analyst to say this is impossible. For anyone
> who is speculating on these dividends, I just wanted to offer a different
> way to place their bets..

Apr 22 04:21 AM

[User 400019:]

Do your research Tae Kim! Where's your credibility? Your lack of understanding regarding ALD is deplorable. Verifying facts glaringly supplied on the ALD website would have quickly put an end to your theorizing. Whatever further comments you have to make on any particular subject will be met with a healthy dose of skepticism!

Apr 22 12:58 PM

[Wise Golden:]

Kim -- I'm long on ALD, but I know there are no dividends being payed in 2009. 2010 is an entirely different story as the company has cash flow, and by then (2010,) they will no longer be in technical default because their debt will be lower (and they are unable to borrow more.) At that point, dividends will return, and the yeild will be very high reletive to todays stock prices. My belief is that the yeild in 2010 may exceed 150% of todays stock price. The history of ALD shows us that the stock "likes" to be valued at about 7-10% yeild. That gives us a share price of $24 to $34, but the pain of this recent downturn still fresh in everyones minds will likely hold the stock well below the $24 mark for years to come. Today it closed at $1.60. It would be cheap at ten times that value.

Apr 22 04:51 PM

[maryanne:]

This is second most incredible article read today! (the first was a blog on MSN Money suggesting to reduce car insurance costs by reducing liability limits to the minimum and dropping uninsured converage. penny wise, pound foolish) ALD is in default of everything, even Morningstar thinks they will end up in severe distress (Read: bankruptcy) I was long at $16, took tax loss at $1.99 Read David Einhorn's book on how ALD is a total fraud.

Apr 23 04:48 PM

[masterofnom...:]

TASER KIMMONS!!!
Like the general concept. Would be helpful to do an analysis of the decay vs. expected dividend as, in most cases where the company actually could pay the div, I suspect it would be a smaller div and your decay would eat your lunch for you. Perhaps GE?

Jul 29 01:01 PM