One of my favorite long-term investing strategies involves selling long-term out-of-the-money calls against the purchase of high-yielding stocks. For this strategy to be consistently successful and to minimize surprises, the companies you choose to employ this strategy with should be low volatility, well-established, and medium yielders (3.5-5% annual yield). A great example of this is AT&T (T), whose 15.7% implied volatility and 5.24% yield make it a great candidate to safely maximize our returns.
AT&T: recent performance and future catalysts
Over the past five months or so, AT&T has significantly underperformed the market, falling from a high of $39.00 in April to its current share price of $34.32, a 12% drop. As a result, not only does the future potential look skewed to the upside, but the annual yield has risen significantly from 4.6% to the current 5.24%, creating an excellent opportunity for income-seekers.
Going forward, the company's wireless revenues should fuel growth for the next several years. While the U.S. mobile market is pretty much saturated, the level of services purchased is on an uptrend. The number of customers purchasing data plans, for instance, is expected to rise as high-capability smartphones continue become more prevalent in the market. Currently, about 73% of AT&T's customers use smartphones, and I fully expect this to trend toward 100% over the next five years or so, as the devices become more affordable.
One area of wireless where AT&T has a tremendous amount of room to grow is in its prepaid business, which currently represents about 30% of the company's customers. To this end, AT&T recently announced its intention to buy Leap Wireless (LEAP), which currently serves 4.8 million subscribers (all prepaid).
U-verse, AT&T's video and broadband service network, is another area that could grow significantly. The service has only been rolled out in a portion of the company's operating territory, and is growing at a tremendous rate. In fact, U-verse generated $2.9 billion in revenues last quarter, a 30% year over year increase.
The dividend: past and future
When examining potential dividend stocks to invest in for the long-term, the important things to consider are the current yield, as well as the track record of dividend increases by the company. AT&T's current yield is pretty impressive, so let's see how it has evolved over the years.
Over the past decade, AT&T has increased its dividend almost linearly as earnings have increased, maintaining a payout ratio of between 70-75% most of the time. During that time, the payout rose from $1.25 per share in 2004 to $1.80 currently, an increase of about 4.1% annually, which should help investors keep pace with inflation and more. It is important to note that AT&T increased the dividend every year over that time period, including the 2008-10 period when dividend cuts were extremely frequent in the market.
A trade to maximize returns
In order to maximize our returns, my trade involves buying shares and selling the January 2015 $37.00 LEAPS for $1.25, giving us an instant 3.64% "refund" on the purchase. I like this trade for its downside protection, increased income, and relative stability. To highlight these points, let's look at the three ways this trade could play out.
- Worst-case scenario: AT&T closes below the current share price ($34.32) at expiration in 16 months. Let's say that it closes at $29.00, about the low of the past couple of years. If we had simply bought 100 shares, our original $3,432 investment would be worth $2,900 plus the $220 in dividends we've collected (5 quarterly payments before expiration), for a value of $3,120 (loss of 9.1%). Since we're selling the calls, we also get to keep the $125 in call premium, which limits our loss to 5.4%, a big difference.
- Most likely: AT&T closes between the current share price and $37.00, say $35.00. Not only did our investment appreciate in value a bit, but we earn $220 in dividends and $125 in call premium, for a total income of over 10% of our original investment in 16 months.
- The upper limit: shares close over $37 at expiration, which is also fairly likely. Since we sold our calls, we are forced to sell at $37, giving us $3,700 for our shares. Including dividends and call premiums, we have $4,045, or a 17.9% gain in 16 months. Not a bad return for such a safe stock.
The most frequent question I get when advocating a strategy like this is "why buy calls so far out and not sell new calls each month." While this is certainly a valid alternative, this allows for more of a hands-off approach and limits your chances of being "called out" at an unacceptable price level. For example, the $36 calls expiring next month will only get you about $10 in options premium. Commissions alone will kill your profits! Additionally, if a position is held for over a year (including a short options position), any gains are taxed as capital gains, as opposed to ordinary income, a big difference unless you are trading in an IRA or other tax-advantaged account.
While a strategy like this won't make you rich overnight, it is a great way to build income while protecting yourself to the downside at the same time. The potential for a return of almost 18% with much less downward risk should build your portfolio nicely over the years and decades to come.