Hedged Dividend Strategies: Buy the Stock, Short the Index, Gain Inflation Protection

Includes: APA, BPT, CSJ, EDV
by: Serge d'Adesky

Today, the average retiree who is no longer working is stuck between a rock and a hard place. He is told by investment advisors to overweight bonds over stocks due to his limited number of years to recover from any dramatic stock market plunge.

Yet safe investments in bonds are producing returns that are at best breakeven with inflation and at worst inexorably losing ground. Many retirees feel the government official measure of inflation does not accurately reflect the inflation they experience in the costs of food, transportation and medical services. If you believe the folks over at ShadowStats.com, real inflation - measured in the way the US government used to measure inflation - is actually running in double digits already: Around 11% instead of the 3-4% the government cites.

Whatever the case, most safe bond funds are paying around 3-4%. Going longer out on the time scale to 30 year bonds can up the interest rate by a point or two, but at the risk of an enormous drop in principal once interest rates eventually move higher. Drops of 17% in bond principal values for every 1% rise in interest rates make long term bond investing an exercise in masochism.

Here's a strategy that offers a partial solution, featuring:

  • a high current royalty or dividend
  • the possibility of increasing returns that outpace inflation
  • a hedge limiting the risk inherent in a sudden market collapse
  • a steadier constant balance within the investor's portfolio, important if an unexpected emergency requires a dip into savings.

The idea is to first pick a great dividend paying stock, with solid fundamentals,whose long term prospects you like. One of my favorites in Prudhoe Bay Trust (NYSE:BPT). With no long term debt, an obligation to pay out over 99% of profits as royalties to its unitholders, and at least a 14 year constant stream of oil revenues based on proven reserves, it doesn't get much safer than that.

click to enlarge images

Prudhoe Bay (<a href='http://seekingalpha.com/symbol/BPT' title='BP Prudhoe Bay Royalty Trust'>BPT</a>) 20 year graph

Prudhoe Bay unitholders are entitled to 16% of the first 90,000 barrels to come out of the ground on a field. The last year for which I found daily production number is in late 2009 when, according to Reuters, Prudhoe Bay was producing an average of 400,000 barrels per day. Even assuming a very steep 9 percent decline each year, this would mean production would not reach a point where it would impact unitholders until the year 2024.

In other words, if you do the math, you will see that unitholders are entitled to approximately 1/4 of a barrel of oil in dividends each year, or 1/8 of a barrel after taxes and extraction costs. (These are rough approximation of the actual calculations that must be performed by BPT to apportion royalties, but accurate enough to be meaningful). With oil price hovering around $110 a barrel today and a stock price around $116, that's a very attractive proposition. This is likely to hold true over the next 10 to 12 years.

Some analysts on this blog and elsewhere have written studies showing negative real returns on Prudhoe Bay based on natural oil depletion rates and a discounted net present value calculation. Their conclusions, in my opinion, rest on two fallacious assumptions. First, they assume that oil prices will not increase in the future. With finite global oil resources, a world population growing by about 273,000 people every day, and the emergence of a voracious middle class in 127 countries of the world, I find that assumption seriously misguided. Secondly, they do not account for the close to 3 billion barrels of "unproved" reserves recently estimated to lie in the Prudhoe Bay fields, in addition to the 2 billion odd barrels of "proved" reserves. As oil prices increase worldwide and technology improves, it is very difficult to believe a portion or all of these reserves can not or will not be tapped.

Actually, my own belief is that we will see a peaking of the heyday of big oil sometime in the next 7 to 10 years, due to the emergence of new technologies. The cautious investor will pay attention to these trends as they emerge, and reduce or liquidate his oil holdings as appropriate at that time.

So if you agree with my logic thus far, you might consider that BPT is the perfect combination of growth and dividends. A whopping quarterly dividend of about 8% at the time of this writing, and a stock that has risen an average of 16% a year over the last 21 years, is pretty close to the perfect investment.

Still what if oil prices plummet? This is where I like to apply a somewhat complex strategy, but one that greatly improves "alpha" - the return on investment - yet actually reduces risk. I call it my BDVSH ("Buy the Dividend, Short the Hedge") strategy.

The BDVSH strategy consists of :

  1. Find and buy a good dividend stock (in this case BPT).
  2. Identify an index that is correlated to it, either being affected by the same forces or being a direct cause of the underlying stocks behavior.
  3. Whenever that index for the hedged security makes a lower low (initial point constitutes the first level), short that security in an equal amount to your main long position. If you are using more than one hedge to accommodate for several causal factors, short the full original amount, not a fraction thereof, for best results.
  4. Close the indexed hedge whenever it makes a higher high, or surpasses your original starting point. This is to avoid margin calls, and to allow you to cash in on trading profits.

Confused? Take a look at a weekly chart of BPT, matched up against two co-related stocks: Apache Oil (NYSE:APA) and iShares Barclays 1-3 Year Treasury Bond Fund (NYSEARCA:CSJ).

Buy the Div Sell the Hedge Strategy with Prudhoe Bay

Since BPT'S fortunes wax and wane mainly on the price of crude oil, we chose APA as a correlated stock. Apache is a worldwide oil exploration company whose fortunes are also tied to the price of oil. An oil ETF, such as OIL, might make an even better hedge, and could be used instead. When it is not available, I use APA as a good proxy.

(In developing this strategy, one of the risks is in being unable to borrow the shares of the company in which you wish to short. So you must be sure to choose a hedging candidate that is available in large volume and therefore always readily available to short. )

Prudhoe Bay, like all high-dividend or royalty stocks, can be expected to move inversely to interest rates. The higher the interest paid by CDs, the less attractive BPT's royalties appear to the investing public, and vice-versa.

We want to find an index we can short, so we can use the portfolio's intrinsic long value - held in BPT - to provide the margin we need for shorting. CSJ fits the bill nicely. When CSJ's index is dropping, short term interest rates are rising, and we would expect, BPT will tend to fall. Since CSJ is affected by interest rates yet moves in the same direction as BPT, it makes a good hedge candidate to short.

(Since developing this graph, I've found an ETF that fits the bill even better than CSJ. That is Vanguard Extended Duration Treasure ETF (NYSEARCA:EDV). The results, using this hedge, are even better.)

The beauty of this strategy is the fact that you do not need to halve your investment in order to accomplish the hedge. Nor do you need to come up with 10 - 20 % of portfolio fund to cover the cost of purchasing a put option.

When you establish a short, you immediately set a covering close purchase just a few ticks above the point where you shorted. This prevents you from ever becoming seriously under water in your short position and needing to come up with more money to cover margin.

In this example, a buy and hold customer who purchased BPT in June of 2008 and held until today would have realized a net return of 72% after all costs. Pretty sweet! But that presupposes the investor was willing to grit his teeth through the horrors of 2008 when he saw his $80 investment drop by almost 50%. Many - I would say even most - investors lose their nerve a long time before that.

If instead, the same investor had deployed this BDVSH strategy, he would have sold APA short at $131. That short position, at the time of BPT's lowest value, had gained 60% in value. Looking at this overall portfolio position, the investor would have seen himself better off!

If you follow the strategy through, you will see that it generates overall returns of about 122%, after all trading costs. This is assuming original costs of 1.25% to buy and sell BPT originally through a broker, and prearranged discounted costs of around $35/ trade for the hedging positions. If you are implementing this strategy for yourself, your costs may run considerably less.

A buy and hold position risks loss of the entire investment if the underlying security fails. Because of the hedges we show here, what you lose in one security will usually be made up for in the other. The relationships are not exact, and the hedges will never be perfect. A 20% drop will not always be matched by a 20% rise. Often there will be a slight time discrepancy between the investments. But the strategy does permit you to greatly reduce your chances of loss.

Please be warned: It is probably impossible to hedge out all risks. In the case of most stocks, it is the management risk. Cases of fraud or product failure could send a stock plummeting, even though its correlated industry index does not budge, or may even rise. But you have that risk even with a buy-and-hold approach.

In the case of BPT it would take a major earthquake or perhaps a terrorist attack on the oil fields to send the stock plummeting, without necessarily having any negative impact on Apache or crude oil prices.

Just as with a buy-and-hold approach, I would recommend stop limit positions set well below daily and weekly fluctuations to reduce the risk from "black swan" events.

This strategy is not complex in theory, but it does require that you pay close attention to your holdings. But the returns are worth it. In the case of BPT, we are generating an additional 15% per year in the example above. Yet we are greatly reducing our risk of loss.

Usually, in investing, a strategy of KISS (Keep It Simple, Stupid) is best. But there's always that exception that validates the rule. That's the case with our "Buy the Dividend, Sell the Hedge" strategy.

Disclosure: I am long BPT. My company Northstar Strategic Investment, Inc, uses this and other strategies to service our customers.