When creating a dividend portfolio, I like to have exposure to all of the major sectors. Unfortunately, the financial sector creates some difficulty in this area. The banks that I feel have the most growth potential pay little or no dividends due to the lingering fallout from the financial crisis. Examples of this include Citigroup (C) and Bank of America (BAC), which have tremendous upside potential but pay meager annual yields of 0.08% and 0.28%, respectively. Other bank stocks, such as SunTrust (STI) and Regions (RF) aren't much better. On the investment banking side, JPMorgan (JPM) pays a respectable 2.95% yield, but I feel they are a bit overvalued right now and that is another topic for another article.
However, there is one very bright spot in the banking sector in the form of Wells Fargo (WFC), which meets all of my criteria when choosing long-term dividend holdings. They pay a 2.84% annual yield, one of the best in the sector. They have outstanding long-term growth potential, and actually improved their well-being during the financial crisis. Finally, they are stable, and have relatively low volatility, making it a good candidate for a slow, steady growth play. Let's take a closer look at Wells Fargo, then see if we can take advantage of its stable nature to extract even more yield out of our shares.
Wells Fargo in a nutshell
The fourth largest bank holding company in the U.S., Wells Fargo has assets of about $1.44 trillion and provides banking, insurance, investment, and mortgage services. The company's assets have grown tremendously as a result of several acquisitions over the past few decades. Most notably, Wells Fargo acquired Wachovia for pennies on the dollar in what I consider to be one of the saaviest acquisitions of the financial crisis. Wells Fargo paid just $23 billion for the failing company, including debts, and in doing so more than doubled their size.
This merger was an especially good fit because of the geographical footprints of each company before the crisis. Wells Fargo was largely focused on the Western U.S., while Wachovia was very dominant on the East Coast. This allowed the companies to merge with very little redundancy in their business. What I mean by that is if Citigroup had acquired Wachovia, as was the original plan, it would have created inefficiencies such as branches too close together.
Yield and financial health
Wells Fargo was and remains one of the healthiest of the "big banks". The company repaid all of the funds provided by the Treasury by the end of 2009, and has done very well on every "stress test" it has been subject to since. In fact, it is an excellent sign of strength that Wells Fargo has been able to rapidly increase its dividend to nearly pre-crisis levels. It took the company a couple of years to improve their financial condition to a point where it satisfied the U.S. Government, who has the final say in Wells Fargo's dividend, and was the reason for the initial dividend cut during the crisis. While the first attempt to raise the dividend was denied, the company has taken prudent steps to create financial well-being, and has somewhat made up for lost time since then. Since 2011, the company's quarterly dividend has increased from $0.05 per share to $0.30 per share in four incremental raises, following the Federal Reserve's Comprehensive Capital Analysis and Review (CCAR).
Even after the increases, Wells Fargo's dividend looks remarkably sustainable. The consensus calls for earnings of $3.84 per share for this year, so the current dividend represents a very low payout ratio of just 31%, very low on a historical basis. During more stable times for U.S. banks (pre-2007), Wells Fargo's payout ratio was consistently between 40-45%, which leads me to believe that further dividend increases are on the horizon, especially with earnings expected to rise in the coming years.
How I'd play it
Wells Fargo by itself is a fine investment, but regular readers of mine know that I like to employ some conservative and safe strategies in order to maximize my yield and to provide some downside protection for my holdings. In this case, I'd like to sell some long-term call options against my position, which works well here due to the low volatility and steady upward movement of the shares over the past several years. My preference would be to sell the January 2015 $47 calls for $1.57, but for those who want to be even more conservative, the $50 strike price calls work well too.
I like this for a few reasons. First, it provides me with significant downside protection by reducing my breakeven point for the stock. Let's say that I buy 100 shares at $41.73, the current share price, for a total initial cost of $41.73. If I sell a $47 call against it, I receive $157 in call premium, plus the $150 in dividends I receive from now until expiration (5 quarterly payments). This means that as long as my shares are over $38.66 at expiration, or 7.3% below the current price, my trade makes money.
Also, in the highly likely case of an expiration price between the current price and the strike price, the $307 in income produces a 7.35% yield on my original investment, and my shares have appreciated. I am then free to write another option at a higher strike price, continuing the process.
Finally, in the also-likely case that Wells Fargo is trading for more than $47 per share at expiration, let's see how we would do. Our shares would be called away, meaning that you'd be forced to sell for $47, or $4,700 for your 100 shares. You also get to keep the dividends and call premium you got along the way, for a grand total of $5,007, or a gain of 20% in about 16 months. I don't know about you, but I wouldn't mind getting called out of the trade for a 20% profit. In my opinion, this upside potential greatly outweighs any downside risk associated with the stock in that timeframe. Of course, as I mentioned earlier, if you don't want to limit your upside quite so much, you could sell a call with a higher strike price which would sacrifice just a little bit of your call income.