Is it possible to add reward to a dividend stock, without adding more risk? More specifically, will selling call options make a significant difference to the income from a conservative company and conservative dividend payer?
By most published accounts, Chubb (NYSE:CB) is a stellar company and stock, with a modest but steadily rising dividend. However, with that dividend below 2.5%, it's not attractive for income, at least not immediately.
Would that change significantly if we sold covered calls for income, while holding or waiting for capital gains? Would covered calls, combined with the dividend, provide the incentive to buy and at least temporarily hold this stock?
Perhaps, but with recent catastrophes like Superstorm Sandy still visible in our rear-view mirrors, we would first want reassurance from the fundamentals. One of the best pieces of advice I've seen in my time buying and selling options is that we should only buy a stock we're prepared to hold for a longer term. Buying for the covered call yield alone can give us a severe case of unintended consequences.
I first took a serious look at Chubb after discovering its high level of institutional ownership: 85.4% as of December 31st, 2014 (according to nasdaq.com). Looking at the 13-F reports of four very big pension funds, I discovered three of them still buying in the last half of 2013, as the following table shows:
CalPERS, the California Public Employees' Retirement System, increased its holdings by 12%, as did NYSCRF, the New York State Common Retirement Fund, while CalSTRS, the California State Teachers' Retirement System, upped its holdings by 4%. The State Board of Administration of Florida Retirement System reduced its holdings by 3%.
Given this high level of institutional ownership, and that big funds were continuing to buy recently, I'm relatively confident about price stability.
Chubb, the Company and its Business
Let's first get a grip on the names: The Chubb Corporation is the official name, but for marketing purposes, calls itself the Chubb Group of Insurance Companies. The Chubb Corporation, symbol CB, holds the NYSE listing.
Chubb describes itself (in its 10-K report for 2012) as a holding company for a number of property and casualty (P/C) insurance companies, firms that sell business insurance, personal insurance, and specialty lines of insurance. From the profits of these companies, Chubb derives its operating income. This may also be called underwriting income.
The P/C business is cyclical, with alternating "hard" and "soft" markets. Economic conditions, capital flowing in and out of the industry, natural disasters, and other factors affect the operating income of companies in the industry. Some companies do better than others, a reflection of their management strength.
Like other insurers, Chubb collects premiums in advance, and consequently, holds a large float that it invests. This provides the second stream of revenue, investment income, which can also vary from year to year. Profitability of this stream will vary, depending on factors such as interest rates, inflation, and asset allocation.
The company currently finds the generation of investment income a challenge. As Chairman, President, and CEO, John D. Finnegan says in the 2013 Annual Report,
"If... interest rates remain at depressed levels, a further decline in investment income will increase our reliance on underwriting results to achieve our performance targets."
In announcing its fourth-quarter and year-end results for 2013, Chubb reported investment income had fallen 5%, from $1.2 billion in 2012 to $1.1 billion in 2013. For 2014, it forecasts another decline of 5% to 6%, which would take this income down to just over $1.0 billion.
The following chart summarizes sources of income in 2013.
Insurance companies take on large risk exposures when they accept premiums from their customers (also called policyholders). In part, insurers manage this risk by diversifying, being selective about the risks they underwrite, and charging adequate underwriting premiums. Most importantly, though, they buy insurance themselves, from reinsurance companies.
Chubb has reinsurance, and as noted in its 10-K report for 2012,
"The P&C Group is selective in regard to its reinsurers, placing reinsurance with only those reinsurers that the P&C Group believes have strong balance sheets and superior underwriting ability. The P&C Group monitors the financial strength of its reinsurers and its concentration of risk with reinsurers on an ongoing basis."
For diversification, the company can point to its three separate lines: business, personal, and specialty. It enjoys geographical diversification with agents and brokers around the United States, as well as an international presence. International operations accounted for 26% of its revenues in 2012.
Chubb tells us in its annual reports that it does underwrite selectively and with adequate premiums. It focuses on customers willing to pay a premium on the premium, so to speak; customers willing to pay somewhat more to ensure good service in the event they need to file claims.
Returns to Shareholders
With annual increases in its dividend for 32 years, Chubb is known as an S&P Dividend Aristocrat and a Dividend Champion at the DRiP Investing Resource Center. In both cases, these are companies that have increased their dividends every year for at least 25 years.
At $0.50, the dividend represents a 2.3% yield on the recent price of $86.23. Ex-div dates routinely occur in March, June, September, and December (unless otherwise noted, data here and below come from Yahoo! Finance).
The payout ratio currently stands at 19%, a conservative level, indicating the company should have no difficulty in continuing to increase the dividend in the foreseeable future.
Share buybacks have played a large role in shareholder returns since December 2005, when the current round of repurchases started (Annual Review 2013). That practice continues. In a news release announcing its fourth-quarter and 2013 full-year results, the company said it had repurchased 14.9 million shares at a cost of $1.3 billion. In a separate news release on January 30, 2014, Chubb announced its intention to repurchase another $1.5 billion worth of shares, but provided no timeline.
2014 guidance puts the average number of diluted shares at 245 million, compared to 259.4 million in 2013 (Press Release, January 30, 2014). This suggests Chubb management expects to repurchase some 14.4 million shares this year. In 2013, it bought back 14.9 million shares at an average price of $87.33.
The practice of buying back shares has proven controversial in the investment community, with strong opinions on both sides. Where we do seem to see common ground is in the idea that buybacks make sense for undervalued stocks, and do not make sense for overvalued shares. In my own analysis below, Chubb comes out as fairly valued at its current price, $86.23 (March 21, 2014).
But we also need to ask about the alternatives to buybacks available to Chubb management. As a mature company in a mature industry, with high underwriting standards, it seems unlikely Chubb will make any significant acquisitions. Further, since it already has challenges with its investment portfolio, it seems short-sighted to add retained earnings to the investment portfolio.
It might also use special dividends to deliver cash to shareholders, but that would complicate its reputation as a Dividend Aristocrat/Champion. With each of these factors considered, I believe share buybacks make sense for Chubb.
Based on the average numbers of shares outstanding, from 2013 and expected for 2014, we would expect a 5.5% reduction in the float, and theoretically at least, a comparable increase in the earnings per share. Or more accurately, 5.5% more than it would have otherwise gained or lost.
As the following chart shows, earnings have generally trended upward over the past 10 years, although we obviously saw a prolonged dip that began in 2008.
The numbers for 2011 and 2012 reflect the extra costs of covering natural disasters, particularly Storm Sandy.
In its fourth-quarter earnings news release, Chubb offered earnings guidance of $7.10 to $7.40 in operating income for this year. Assuming 245 million shares, that works out to $1.74 billion on the low side and $1.81 billion on the high side. Analysts tracked by Yahoo! Finance put 2014 earnings at $7.40 (after closing, March 21, 2014).
The cost of dividends for 2014 will be about $0.49 billion (245,000,000 shares x $2.00 per share), and it expects to spend $1.5 billion on share buybacks, giving us a total outlay of $1.99 billion. Assuming $1.74 billion in operating income and $1.0 billion in investment income, Chubb should be able to comfortably cover the cost of both the dividend and the share repurchases.
Combined Ratio (Profit Margin)
The insurance industry uses a concept called Combined Ratio to describe its profit margins. Short for Combined Loss and Expense Ratio, the Combined Ratio tells us at a glance whether underwriting operations have made money. A ratio below 100% indicates profitability; a ratio above 100% indicates losses. And obviously, the lower the number, the better. The following chart shows Chubb's Combined Ratios for the past decade.
Again, we note the impact of natural and man-made disasters (also called "catastrophes" by the industry) in 2011 and 2012. In broader terms, we note that Chubb has posted a positive Combined Ratio every year of the past decade, despite the catastrophes. In its guidance for 2014, Chubb expects a Combined Ratio between 89% and 90%, taking into consideration bad weather claims expected from severe weather in January.
On Friday, March 21, 2014, Chubb shares closed at $86.23, with the 52-week range bounded by a low of $81.68 and a high of $97.79.
Analysts tracked by Yahoo! Finance (16 of them) target a range of $76.00 to $102.00, with a mean of $92.09 and a median of $93.25.
And as the following table indicates, Chubb's key ratios generally look better than those of its main competitors, but not dramatically.
(all data for the preceding section from Yahoo! Finance, March 18, 2014)
Return on Equity
As the following YChart shows, Chubb has delivered reasonable returns over the past 10 years.
With one exception, 9.88% in the fourth quarter of 2012 (Storm Sandy), ROE has ranged consistently between 10% and 15% (data from YCharts).
Overall, then, I see Chubb as fairly valued, an opinion that's shared by at least one other Seeking Alpha contributor.
Finding Extra Income
Based on what we've seen, about both the business and its fundamentals, Chubb is a solid company with an excellent history of taking care of shareholders, as well as a positive outlook.
Satisfied that this is a company worth owning, regardless of its option potential, we'll go to the next stage. More specifically, we'll look for covered call options.
Writing a covered call involves two elements: a long stock and selling a call on that stock. Covered calls offer one of two advantages, depending on your perspective. If you look at it as an income opportunity, you'll consider the premium an enhancement of your return.
If you look at it as a protective opportunity, you'll consider the premium an opportunity to reduce your cost basis in the stock. The disadvantage, the price or potential price, you pay for this enhancement or protection is that your stock may be called away.
In some cases, having your stock called away simply confirms that something good happened: the stock price went up further and/or faster than you expected. In other cases, though, you may find yourself called out of a stock you wanted to keep, for whatever reason. For a solid introduction to covered calls, please see this Seeking Alpha article by Richard Berger.
Because of its relative lack of volatility, Chubb does not attract a significant amount of options interest. In turn, this means relatively low premiums and the need to look forward at least three months to find enough premium to make the calls worthwhile. Of course, this also will depend on how many contracts (hundreds of shares) you wish to write. If you own a larger holding, you can cover off the transaction costs and still come out ahead with a smaller premium.
With that behind us, let's look at the Chubb option chain after the close on Friday, March 21, 2014, and with the stock closing at $86.23. A summary of the information in the chain follows in this table:
Quickly going through the information in the table above:
- Expiry month: the option expiry month (officially, on the third Saturday of the month; unofficially, at the close of trading on the third Friday)
- Strike is the price above which our stock would be called away
- Bid is the amount we receive for selling the covered call
- Ask is what the buyer would pay for the call we sell (a market maker gets the difference)
- Open Interest refers to the number of active options contracts - important because it lets us know if there is a market to buy or sell
- Probability refers to the likelihood the stock price will be above the strike price when the contract expires (more information below)
If we own 100 shares of CB and write a covered call, then we would sell 1 option contract against it (options always trade in lots of 100, and stocks must match up; no odd numbers).
In the case of the October $95 strike, we would immediately receive a premium of $0.89 per share, or $89 for one contract. That’s ours to keep, regardless of what happens. Please note that neither this calculation, nor any of the calculations below, take into account trading costs or potential tax implications.
If the price is below $95.00 when the contract expires, our return would equal the premium received; in this case, $0.89 per share, or $89 per contract/100 shares. That works out to just 1.032% over the term of the contract (211 days), or 2.3% annualized ((365/211) x 0.01032). Adding the annualized premium (2.3%) plus the dividend yield (2.3%), we get an annual yield of 4.6% (before considering the effect of share repurchases).
Of course, we keep the shares, and could write another covered call contract on the following Monday. Obviously, this strategy requires more attention and effort than simply buying and holding the stock.
If the price is above, anywhere above, $95 on the third Saturday of October, then the shares would be called away, and we would receive $95 per share. Assuming we bought the shares at $86.23, our return per share would be the capital gain of $8.77 ($95.00 - $86.23) plus the premium of $0.89 for a total of $9.66 or $966 for 1 contract/100 shares.
Adding the two dividend payments we would have received before the October expiry, the overall gain would total 10.66 ($9.66 + $1.00). That’s a gain of 12.4% (10.66/86.23) over 211 days. Annualized, it works out to 21.4% ((365/211) x 12.4%). Of course, our shares would be gone, so we would then need to repurchase them, or invest in a different stock.
Using the free TradeKing/IVolatility Probability Calculator, we can estimate the probability the price at October expiry will finish above $95: about 17.6%. The price may rise above and fall below $95 before expiry, but only the closing price on expiry Friday matters. Please note this calculator gives us probabilities, not promised results.
The same calculations will give us returns for the $90 and $100 strikes. In addition, we can look at the strikes for July expiry, which would include one dividend payment. To speed up the process, try the free calculator at Options Profit Calculator.
One final note: option prices can and do vary a great deal, even on steady stocks. The returns calculated above can and will vary, even from day to day, so become familiar with a stock and its options before acting. Learning about and using the options Greeks will provide additional insight and direction.
Adding a covered call to Chubb shares can make a significant difference. Using prices at the close of trading on March 21st and assuming a share price below $95 at October expiry gives us an annualized return of 2.3%, on top of the dividend yield of 2.3%. Altogether, that adds up to 4.6%, before considering the effects of the share buybacks.
We might say we’re doubling the yield. Alternatively, we might say this has the same income effect as doubling the number of shares we own. If the share price goes down, we will have at least reduced our cost basis by about 1%.
Whatever the case, this trade looks better with high volumes of contracts. Because the premium is relatively small, trading costs would consume much of the return on small volumes.
And, before entering any trade, we need to recognize that if Chubb beats the odds and trades at more than $95 at October expiry, then we won’t capture any of the value above $95. That will go to the buyer of our calls, who took on risk in the expectation or hope the price would close above $95.
Still, this example shows us we can aim for an annualized yield of 4.6% without going further out on the risk limb. It adds no downside risk, in fact, slightly reduces downside risk; it does increase upside risk, but if called our disappointment would be tempered with a sizable capital gain.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.