The financial sector offers some of the best potential returns over the next few years, with big banking institutions such as Citigroup (C), Bank of America (BAC), and Morgan Stanley (MS) trading at substantial discounts to book value, which historically has not been the case. These companies have been making money hand over fist due to factors such as the almost nonexistent cost of borrowing money to lend out, and loosening credit in the lending marketplace in recent years.
Many investors are just as bullish on the banks as I am, but what are those people for whom income is a priority? These bank stocks barely pay any dividends at all (4 cents per year in Citigroup's case), so most income investors don't even include them on their radar. However, I believe that the relatively high volatility associated with these stocks creates a scenario where they can be owned and used to create a relatively safe and stable income stream that rivals the yields of any other blue-chip dividend stocks.
I have written extensively about these companies, and my most recent piece can be seen here for those who want a more in-depth look at the fundamental reasons I like the banks. Before we get to our income strategy, let's take a quick look at just how much of a discount these companies are currently trading for, where they have been in the past, and where we can reasonably expect them to go in the near future.
How they have been valued historically
All three of these banks are trading at tremendous discounts to their historical levels. Now, while I have no delusions that any of these companies will be valued at 4 times book value, as they were just before the crisis, I think the true "fair" price is somewhere in the middle. Let's take a look at the price/book for these three companies over the past decade:
Not surprisingly, the valuation of all of these banks peaked in 2007, just before the financial crisis and then took a nosedive. What is surprising is that since the crisis, although the fundamentals of each bank have improved tremendously, the valuations continue to fall. Each of these companies' valuation is less than it was in 2009, the bottom of the recession.
Again, I'm not saying that the pre-crisis valuations were justified at all - they weren't. What I am saying is that a discount to book value at this stage in the recovery process is simply unwarranted. What the "fair" valuation is remains to be seen, but I don't think that a value between 1.0-1.5 times book value is unreasonable by any means.
For income seekers
Since the expected volatility of these stocks is relatively high, let's take a look at what that means for income seekers like us. In short, it means that we can sell covered call options that are pretty far out of the money, but still provide us with a decent annual yield on our holdings. We want to own these stocks for the long term (at least a few years), so a priority should be making sure there is a relatively low chance that we will get "called out" of our position, and if it does happen, it will mean that we have gained so much that it'll be worth it.
For example, if you were to buy 100 shares of Morgan Stanley and sell a January 2015 $35 call against your position for $1.00, you would increase your income to $1.25 before the options expired ($1.00 options premium plus 5 quarterly $0.05 payments), for a total yield of 4.6% in a little over a year. This is a yield that would rival any large-cap dividend stock in the market, and it is extremely safe. In order to get your shares called away, it would mean Morgan Stanley closed at more than $35 at expiration, giving you a 30% gain on your shares. I wouldn't mind getting called out for a 30% gain, plus income…
Similar strategies could be employed with Citigroup and Bank of America, and can be adjusted to provide varying levels of income and safety. A "safer" strategy would involve selling further out-of-the-money calls, which would lower your income, but make the chances of getting called out very slim. An "aggressive" approach could produce an annual yield of 10% or more, but greatly increases the chances of your shares getting called away.
Whatever you decide to do, a strategy like this is definitely worth considering for income investors, as it really opens up your potential investments to more than just the traditional dividend stocks.