By Mark D. Bern, CPA CFA
I intend to explain how to enhance your income stream from investments, both cash and stocks. My methods are no secret, really. I suspect that they have been employed by firms on Wall Street for decades. After all, who always wins when it comes to investing? Those who sell the investments, right? Exactly!
But, with all the changes that have come about in the industry over the past two decades, even small, individual investors can win consistently too. You’ll need an account with a discount broker to make this work because reduced friction (costs associated with trades such as commissions) is a key. Let me assure you, though, that this is not a trading strategy. This is long-term investing with a twist that makes it easier to hold and reap the benefits of good choices over time.
When you are receiving an income stream over six percent on cash without having to commit your money for longer than six months and receiving an income of eight percent or better while you are waiting for assets to appreciate, can it get any better? These are the goals of this strategy and I believe they are attainable. If that sounds interesting to you, read on.
Before I begin, let me just confess that, while I am getting up in my years, I haven’t been using the techniques I am about to explain for very long. I have back tested them and am confident that they work, enough so, that I have deployed my own portfolio accordingly and intend to do so from now on.
But saying that something has been thoroughly back tested is like saying that the past is prologue to the future and that everything in the past will repeat. I can’t legally say that, and I don’t expect anyone reading this article to believe it. So, here is what I propose to do: I will explain my techniques in detail, first using a hypothetical example, then provide an example of how it would work using closing prices of a listed investment of the day prior to submitting this article and finally I will create a series of articles and regular updates, each on a particular listed investment to provide a fully diversified portfolio.
The initial portfolio will be created over the next two months and updated regularly. We can track the results together over the next two years. I won’t make any promises, but my goal is to consistently produce low double-digit returns and to increase the income from the portfolio by at least 400 basis points per year over the S&P 500 average dividend. Needless to say, that will beat long-term Treasuries handily, as well. In addition, I intend to do so with significantly less risk to capital.
In a perfect world (from a Wall Street perspective) we would all jump in and out of the market creating huge profits for financial firms in the form of commissions. Unfortunately, the real world, or a very large part of it, resembles that picture. So, the first thing I want to make clear is that we don’t put our money into anything unless we really believe in the long-term value creating ability of the underlying investment. In other words, if you aren’t sure a company will survive the worst of times, don’t buy any investments related to that company, especially for the purpose of creating a steady, sustainable stream of income.
That sounds like buy and hold, I know. But buy and hold is only a part of the strategy. This strategy is more like “enhanced” buy and hold. What is even more important is how you buy and how you sell (not out of desperation, but for a profit and because there are greener pastures elsewhere).
I can’t stress this next point strongly enough. Never, ever let emotions drive your investment decisions. It is hard to remain calm and collected while your investment portfolio is tanking, isn’t it? Well, stay tuned and I’ll help you understand how to lessen the pain significantly.
If your investment is highly unlikely to go bankrupt, very likely to increase in value over time, and pays you an annual income stream of between eight and ten percent can you learn to have some patience and trust your original investment thesis? I find that the income really helps. I don’t know when the market, or any particular investment, is going to go up or down or by how much. Neither do you and neither does anyone else. So let’s not pretend that we can time the market. Those who try to do so generally end up with returns below that of the broader market index (S&P 500). As a matter of fact, about 80 percent of all managed mutual funds perform worse than the S&P 500 index (after loads, distribution/sales fees, management fees and fund expenses).
If you own a well-diversified portfolio of individual equities and bonds, have chosen well, and keep turnover to a minimum you may actually do better than the market in general. But what I am going to explain should help you increase your returns over either of those options.
Most of us already know that buying options is a fool’s game. Historically, 83 percent of all options expire worthless. Who made money? Certainly those who bought the options did not, at least not consistently. Think about it for just a moment. Those who sell or originate the options are cleaning up. Now, while this does play into the strategy, please don’t run out and start selling options without understanding the risks and having a solid plan. This is only part of the strategy. You also need to understand the purpose of what you are doing.
In my strategy, there are only two purposes for individual investors to use options. Only two! Of course, there are other uses for options, such as hedging, but none of the others are used in this strategy.
Let me take a moment to say that I don’t write a newsletter, nor do I intend to start one. I am not going to give specific trade advice in my articles. I intend only to explain the strategy and report real time results on a hypothetical portfolio of investments. I am also not a shill for any newsletter, nor will I ever recommend one. The examples will include closing prices for the stocks and the lower of either the last trade or bid price for the options reported at the close of trading. I will not cherry pick intra-day prices to make results look better. I won’t have to do so because the results using the closing data will be adequate to prove my concept.
The two purposes for using options are: 1) Increasing income and 2) taking emotions out of your buy/sell decisions. The proper use of puts allows an investor to make their planned buys on down days when stocks are on sale. The other result of selling puts is creating an income stream from cash that is otherwise not invested. I’ll explain how in the example below.
The proper use of calls is to increase the yield from a portfolio of owned stocks that consistently pay a rising dividend. The key to this strategy is first choosing the companies you want to buy and hold and having the patience to collect a good income while you wait for your price. What do I call a good income on cash holdings? My target is eight to ten percent on average overall. Some stocks will allow more, others less, but to develop a properly diversified portfolio for the long term it is necessary to occasionally accept below average returns in the short term in order to reduce the overall risk and improve the consistency of returns over the long term.
Now for some ground rules and then the hypothetical example:
Let’s assume you have chosen a company whose stock you would like to purchase. What were your criteria for choosing that particular company? Here are some of my recommendations. You can add to this list if you need to but please don’t ignore any one of these items. In the end, we are all responsible for doing our own due diligence before we invest, so please accept my articles for what they are intended: examples, not recommendations. My basic rules to use in stock selection (I apply several other criteria in my own due diligence, but wanted to keep things simple here):
1. Below average debt to equity ratio for its given industry. It’s really not such a good idea to set a hard and fast percentage because the level you chose may be too high for some industries and too low for others. There is greater overall safety derived in comparing a company to its peers. You want to own companies that are generally better managed than their competition. This is one way to define management in terms of their use and management of debt.
2. Consistent record of paying and raising dividends. It is good to note that there are plenty of publicly traded companies whose boards of directors and management continue to raise the dividends being paid by their company every year. Some have done so consecutively for more than 50 years. Many continued to increase dividends right through 2008 and 2009 and there was never any doubt as to their ability to continue to pay dividends into the future. My rule of thumb here is to favor companies that were able to raise dividends right through the 2008-2009 great recession without skipping a beat and without needing to borrow to do so.
3. Payout ratio below the industry average. Again, stable industries such as utilities are less prone to large swings in demand for their products and are able to pay out a higher percentage of their income in the form of dividends. Also, companies with dominant market positions are also generally able to pay out higher dividends. The key is for the company to have a low enough payout ratio that there is room for upward expansion without disrupting management’s capital investment plans.
4. Profit margins in line with or greater than the industry average. This one is not always a hard and fast rule. I give a little leeway to companies that are the low-cost leaders in their sector as long as their return on equity and return on capital are at least in line with or exceeding the industry average. But, if their market leadership positions (and dominant market share) are not reliant on lower pricing to customers, they should have superior margins. This tells me that management is controlling costs and deploying capital efficiently.
5. Revenue and earnings growth above industry averages. This should be obvious.
6. A growing percentage of revenue coming from foreign sales and operations. This rule does not apply to regulated industries such as utilities. But, since the majority of economic growth has been created outside of the U. S. over the last ten years and that trend is likely to continue well into the future, this becomes a very important driver of both revenue and earnings growth. I prefer companies that have already established global operations and register 40 percent or more of sales from foreign sources.
7. Sustainable market leadership position. Obviously, we could get into some long discussions about how to define this one and it is really a qualitative assessment of the management and company’s proven ability to expand revenue while maintaining its profit margin. Those companies that fare well during recessions and generally come out stronger are the ones I like. If a company has been in business for over 50 years and continues to consistently increase revenues while maintaining or expanding its margins they must be doing something right, in my humble opinion. If you have other measures you prefer, by all means apply them, too.
Those are my base line guidelines for choosing which companies I want to own. The second iteration in this process requires the investor to assess the value of the company and to determine a price at which they would like to own the company. This is often the hardest part. But my strategy will help make this a little easier as well.
Let’s say you like company ZZZ at its current price of $18 a share. You believe it is already undervalued relative to its long-term earning potential. It’s okay to skip the first part of my strategy and just buy the stock if that is what you want. But why not be patient and bring down the price even more before you get in? How, you ask? By using cash secured put options, of course. By cash secured, I mean that you have the cash available in your account to cover the purchase of the stock represented by the options should the options be executed before they expire.
It’s mid-September and you look at the put option prices with a strike price five to ten percent below the current price. Let’s assume a strike price of $16 and an expiration date in October of the same year. That’s only a month away. Depending upon the volatility, the put could be selling with a premium of between 15 cents and 35 cents. Let’s assume the price is 25 cents. If you can find that premium only four times each year, you’ll earn $1 in premiums if you never buy the stock. If you can find the same premium six times a year, you could earn $1.50 in premiums. That provides you a return of between nine and ten percent without the risk of loss (If you never buy the stock what is your risk?). And remember, the expiration is only one month away. In theory, you may be able to find a premium at this level more than six times per year. So, what’s wrong with collecting eight to ten percent on cash on a short-term investment when all you can get from the bank is less than one percent?
Granted, the idea is not to sit back and just collect premiums. The idea is simply to buy the stock at a better price than you may otherwise. If the stock rises by ten percent over the next year and a half, it would then trade at $17.60. Assuming that you have collected six premiums before your option is finally executed and that you are buying the stock at approximately ten percent below the current price, you are now paying $16, but you also have collected $1.50 in premiums, giving you a cost basis of $14.50. So, now you own a stock that is trading at $17.60 a share and you paid only $14.50 for it.
I realize that I am not taking into consideration the friction, or commissions, and the taxes. I am only doing this to keep the example simple. We can incorporate actual performance into the future updates in real time. If you use a discount broker, friction doesn’t amount to much. Taxes will vary depending upon the individual investor’s income and tax bracket and where they live (state taxes vary considerably).
So, that is an oversimplification of the entry part of the strategy. But it also contains very conservative assumptions. When we get to the actual, real-time example below and in follow-up articles, you’ll see just how nicely this strategy works in the real world. Now let’s look at the income production and sale decision portion of the process.
I generally don’t like to buy stocks that pay a dividend lower than 2.5 percent. I really prefer stocks that pay more than 3.0 percent, but in order to round out the portfolio for proper diversification, we sometimes have to lower our standards a little. But, rest assured, the average yield on the portfolio should work out closer to the preferred 3.0 percent or more. But wait, there’s more! We can enhance that income stream considerably. Remember that my goal is to achieve an income stream that is at least 400 basis points above the average dividend for the S&P 500. So, to conform to that goal we need to achieve a total cash flow from dividends and premiums of around six percent per year. My findings thus far say we can do even better.
Now we begin the process of selling covered calls. In this case a covered position in options mean that you own the underlying stock represented by the options you’ll be selling. Again, let’s assume you own ZZZ company at $17.60, but because you did so by selling a put option, your basis is $15.75 ($16.00 strike price less the premium received of $0.25; the other premiums were just income and don’t affect the cost basis for IRS purposes).
Now, let’s also assume that you don’t expect the company’s stock to increase more than ten percent a year, so you start selling call options with relatively short expirations (four months out or less) with a rolling strike price set at near ten percent above the price at which the stock is trading when the option is sold. My rule of thumb here is that I don’t sell the option unless I can lock in at least an eight percent gain in less than four months.
Your first call option sold might have a strike price of $19.50. If the stock immediately rises more than ten percent the option may be executed. This is the worst case scenario (outside of bankruptcy or a disruptive technology that supplants your company’s products), and what is the result? You bought the stock for $15.75 and had to sell it for $19.50 less than four months later for a profit of 24 percent, plus you have another $1.25 per share (or 7.9%) that you collected in premiums, for a grand total of almost 32 percent in less than two years. And then you start all over with selling puts below the market price and the process begins anew either with the same company or another one that offers a better value at the time.
Now, for the expected scenario: You hold the stock for the long term collecting the dividend and premiums from selling your calls four times a year. Your yield is approximately 9 percent and rising each year (3.0% dividend + $1 in premiums or 6.3% = 9.3%, based upon your cost basis price of $15.75).
Remember one other thing: not only is your dividend rising each year, as the price of the stock rises the premiums on higher priced stock generally increase also. So, if your stock is appreciating, your income is likely to rise along with the price.
If the stock price becomes stagnant for a year or two (or even if the price drops due to a recession or correction) since the company raises its dividend each year, even during the bad times, your income may still increase, just not as much. In addition, it is quite likely that you will be able to sell more than four options a year, thus increasing the total premiums collected and increasing your yield. We’ll discover just how much more in the real-time examples and updates I’ll be posting over the next two years.
And that is what I mean by taking some of the pain out of the buy and hold strategy. When you’re collecting nearly ten percent while ten year Treasuries are paying around two percent, why not hang on and just enjoy the outstanding income?
Now for an actual example of a stock using closing prices on September 20, 2011 (the day prior to my submission of this article for publication) for the stock and both the put and call options at the close.
We start with stock selection. Remember, we’re looking for long term value in a company that we believe will appreciate from current levels that can also provide us with an above market rate of income. Those criteria help to narrow the list.
When looking for value I often consider companies in industries that are out of favor. One such industry is housing. While I’m not brave enough to consider a builder just yet, I do like the long-term value proposition posed by Lowe's (LOW) and Home Depot (HD).
My preference between the two is Lowe's, which I will explain. Both stocks are well off of their 2007 highs and because those highs were achieved in what I would consider an over-stimulated market environment, I don’t assume that those prices represented a fair valuation for the companies.
Lowe's got to around $35 a share back then. It’s more recent high of $27.45 is a more realistic measure of where the stock could be in a more normal economic environment. We don’t have a normal economic environment in housing at the moment, but we will have again sometime in the future (perhaps in three to five years). The current price of $ 19.92 (as of the close on September 20) represents a 27% discount already.
While new construction is going to stay down for a while, repairs by homeowners who opt to stay where they are rather than move (sometimes not by choice) and by banks that are “cleaning up” after foreclosures is on the rise. Natural disasters such as hurricane Lee, flooding in the Midwest and tornadoes require extensive repairs, as well. All these factors are likely to drive growth in the home repair and improvement business which is good for Lowe's.
Now, why do I prefer Lowe's over Home Depot? To start with, Lowe's is selling at a steeper discount than Home Depot right now. Home Depot is in the process of remodeling its stores to make them more appealing to women, which I believe is a good move, but that is the “current” effort. Home Depot has changed its focus several times in the last decade or so due to changes in leadership. Some changes were good, some no so good. Lowe's, in my opinion, has been more consistent in terms of management. I like that.
Lowe's P/E is current about 13.5 while Home Depot is about 15.5. I don’t believe that Home Depot warrants that much of a premium. I also believe that the difference between the two, on a long-term basis, is negligible. Therefore, I don’t think the premium represents greater long-term value. Edge: Lowe's.
Second, while Home Depot has made more progress in developing foreign operations, with only eight percent of revenue coming from outside the U. S. hardly makes them the winner in this area. Long-term I would expect the competition to develop overseas and to heat up, but it will be at least a decade or two before either one may emerge in a dominant position. Edge: Home Depot.
Third, Home Depot has a slightly better profit margin, four percent compared to three percent, but this is not a large enough difference to get excited about. Home Depot also has a better ROE, at 19 percent compared to Lowe's 11 percent. This is primarily due to the difference in capital structures. Home Depot carries more debt relative to equity than does Lowe's. Edge: Home Depot
Fourth, as long as I have broached the debt issue, let’s look at debt to equity. Lowe's have a clear advantage here in that there debt/equity ratio is only 39 percent compared to a ratio of 59 percent for Home Depot. This does not mean Home Depot is poorly managed, nor does it mean that they are over-leveraged. The industry average for consumer discretionary companies is in the mid-40s, so Home Depot is not in trouble. What it does mean is that Lowe's has more flexibility going forward in their capital structure. Home Depot is roughly twice the size of Lowe's. In my opinion, Lowe's is better positioned to be able to sustain a higher rate of growth over at least the next decade or two. Edge: Lowe's
Fifth, another major factor in my selection process is consistency of rising dividends. I believe that Lowe's’ capital structure and growth prospect gives them a better outlook for dividend growth in the future. But, more than that, it is apparent to me that Lowe's, as a company, is dedicated to the principle of rising dividends for more so than Home Depot. Currently, the yields are nearly the same at 2.8 percent and 2.9 percent for Lowe's and Home Depot, respectively. But, while Home Depot has increased its dividend for the last two years, Lowe's has consistently raised its dividend every year for 50 years. Edge: Lowe's
Since the strategy is based upon rising dividends I give the nod to Lowe's overall, even though both companies have their strengths.
So, now let’s take a look at applying the strategy to Lowe's. The closing prices on Lowe's stock and selected options on September 20, 2011 were as follows:
- Stock price: $19.92
- November Put; $18 strike $ 0.33
- November Call; $22 strike $ 0.54
Let’s assume that we are interested in buying Lowe's but would like to get it for an even better bargain. So, we sell one November $18 Put at a premium of $0.33 on September 20,2011. We need to have $1,800 in an account to cover the cost of the purchase of the stock if the option is executed before it expires in mid-November.
If the option expires worthless, we keep the $0.33 per share, or $33, premium less the commission of $9, for a total of $24. Thus far, we have a 1.33 percent return on our money over the next two months, or an annualized return of 8 percent. However, since we cannot assume that the opportunity to sell an option will be available every two months, or six times per year, I propose that we make an adjustment to the methodology used to calculate the annualized rate of return.
Instead of assuming that we can lock in that return for all 12 months, let’s assume that we can only find reasonably priced options that cover ten months out of each year when dealing with shorter term options (less than three months to expiration). The reason is quite simple. Even though most of the stocks we’ll discuss in my articles will have options available nearly every calendar month, some months do not have adequate trade volume to assure good trades. Also, every stock used in my article will have options trading at least quarterly with adequate volume.
Therefore, we can assume that if we sell options with expirations of three months or greater that we can do so consistently throughout the full twelve calendar months, while shorter durations will require an “adjustment.” Simply put, if we sell an option that expires in one month, we will assume the rate is available for ten months or simply times the premium by ten to annualize our rate of return. Similarly, if we sell an option that expires in two months, we will make the same assumption and times the premium by five to annualize our rate of return. This way, if we have errors, they should be on the conservative side.
Applying this method to the $24 net premium collected, the annualized rate of return would be 6.65 percent. Still, this is not a bad return on cash sitting in an account while we wait for a bargain.
Now, let’s assume that we own 100 shares of Lowe's stock and would like to increase the yield. We do this by selling covered call options. Since we own the stock in our account, to be entitled to the IRS treatment I mentioned above, we must sell the calls in the same account and be “covered.”
We sell one November $22 Call at a premium of $0.54 per share, or $54. Again, we have to subtract the commission on the transaction of $9 (we have to use a discount broker to make this work well) and end up with a net of $45.
Using the annualizing method I explain previously, this equates to an annual return of 11.3 percent. But wait! There’s more. Don’t forget that if you own the stock you are also receiving the dividend and Lowe's dividend yield is currently 2.8 percent. Add the two yields together and we now receive 14.1 percent yield on the stock. And this is if we bought it at the current price of $19.92. Just imagine what the return will be when we buy the stock on sale using the put option strategy! Or follow along over the next two years (or at least a few months) to see what the real-time results would be.
Watch for the update on Lowe's about this time of the month during November.
I hope this all makes sense and I promise to keep future articles in the series much shorter by referring back to this article for details and explanation.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.