In a recent article we put together a list of great companies and proposed a simple strategy (placing silly buy limit orders) for buying these companies at fire discounts, should we get another market meltdown.
The list of stocks was generally well-received by readers that raised two main objections to the strategy:
- The proposed limit orders are so low that there will only be executed if we get another market collapse as in 2008, and the probability of such a collapse is very small.
- The proposed strategy requires having lots of cash on hand, and cash earns close to nothing these days.
The first comment is very worrisome to me, as it indicates sentiment is still bullish, and with such sentiment the market bottom remains elusive. My position, echoed by Alan Greenspan on NBC's Meet the Press about one month ago, is that whether the U.S. goes into recession mostly depends on what happens in Europe -- and the news that we are getting from overseas is not great these last few weeks.
As for the second point, retail investors often forgets that cash is a position in and of itself. In fact, one advantage that retail investors and hedge fund managers possess over mutual fund managers is that they can raise cash, while the latter group needs to be fully invested at all times. For example, holding cash was a great strategy during the 2008 financial crisis. By the same token, only a few positions (short equities; long Treasuries and gold) would have produced better returns than cash these last couple of months. I doubt that any of these three positions represent large shares of most investors' portfolio.
That being said, we revisit the proposed list of stocks and offer a simple option strategy that allows investors to earn a decent return while waiting: selling out-of-the-money puts on these companies with expiration dates in January 2011.
We previously explained how the put-selling strategy can reward investors with a 7% to 10% expected annual return. The trick is to sell puts on companies that you would be happy owning in your portfolio, because the truth is you might end up being assigned the stock. Since the list of stocks was generally well received, that should be no concern here.
Let us illustrate how the put strategy works, using Abbot Labs (ABT) as an example. Investors can collect between $0.88 and $0.90 for selling a put on ABT with strike price $40 and expiration date January 21, 2012.
A put option is the right to sell 100 shares of a stock at a given price (the strike price) by a given date (the expiration date). By selling a put, investors collect a premium right away -- akin to collecting a dividend stream up-front. At expiration date, one of the following two outcomes are possible:
- If the stock closes above the strike price, the put will expire worthless. Profits are equal to the premium collected up-front.
- If the stock closes below the strike price, investors will be forced to buy the stock at the strike price. Their cost basis for the stock will be the strike price minus the put premium. Note that investors should only sell puts on stocks they are willing to buy, as the chance exists that they will in fact have to buy them on the expiration date.
Abbot Labs is a diversified pharmaceutical company with operations in drugs, nutritional products, diabetes monitoring devices, and diagnostics. ABT has a strong balance sheet and a high dividend yield of 3.8%. It is generating healthy cash flow from its operations all over the world, and trades at a P/E ratio slightly above 10. Morningstar gives a 5-star rating to ABT, while S&P's rating is 4 stars.
The 52-week low and high for ABT are $44 and $54, respectively. On April 30th 2009, the stock placed a bottom at $41. Finally, it closed at $50.43 last Friday.
We propose selling a put contract on ABT that expires on January 21, 2012 with a strike price of $40, below the current 52-week low. Per contract, investors would receive between 88 cents (the bid) and 90 cents (the ask).
If ABT closes above $40 on January 21, 2012 (as we expect), the rate of return on investment is equal to 2.25% for 4 months if using the mid-point between bid and ask spread, or 6.75% on an annualized basis.
If ABT closes below $40 at expiration date, investors will have to buy 100 shares for each put contract they sold. Note that because they collected close to $1 per contract, their cost basis to buy ABT will be slightly above $39, which looks cheap since ABT's earnings should not drop much even if we end up going into a recession.
We now augment the previous table to show how much premium investors can collect to sell a put contract that expires on January 21, 2012 and with strike price the buy limit order in the second column. For example, for Altria (MO), the proposed strike price is $20.
|Company||Buy Limit Order||Put Premium ($) - Exp date: Jan 2011||Div. Yield % |
|Abbot Labs||$40||0.87 (bid) - 0.90 (ask)||3.8|
|Altria Group||$20||0.43 - 0.45||6.2|
|Philip Morris (PM)||$50||1.13 - 1.15||3.9|
|Procter & Gamble (PG)||$50||0.81 - 0.83||3.4|
|Colgate-Palmolive (CL)||$65||0.73 - 0.82||2.6|
|Clorox (CLX)||$55||0.90 - 1.25||3.6|
|Kimberly Clark (KMB)||$55||0.75 - 0.85||4.2|
|Kraft Foods (KFT)||$25||0.31 - 0.35||3.4|
|Coca-Cola (KO)||$50||0.50 - 0.52||2.7|
|Disney (DIS)||$20||0.40 - 0.41||1.3|
|Chevron (CVX)||$70||1.89 - 1.95||3.3|
|Hess (HES)||$40||1.52 - 1.56||0.7|
PS1: The premium collected is the greatest for companies that have high dividend yield. Altria and Kimberly Clark are such companies.
PS2: Risk-averse investors can place (silly) sell limit orders on puts. For example, I just entered a $1 sell limit order on MO to sell the $20 put that expires on Jan 21, 2011.