By Mark D. Bern, CPA CFA
Let me begin by pointing to a detailed explanation of the strategy I'm using that can be found in my previous article (here). As you will see in the conclusion of this article, you may be able to collect in excess of nine percent annually in cash while holding Intel (NASDAQ:INTC). If you find the returns mentioned in this article intriguing, I suggest that you take the time to understand the full strategy by reading that prior article.
First, we need to answer a question: Why Intel? I could apply this strategy to numerous other companies’ stocks, so why did I choose Intel to write about today? I have always liked the dominant position that Intel holds in the microprocessor business. I also like Moore’s Law and admire how Intel has applied that law to its business model, perhaps better than any other company on earth (my opinion).
But, more than that, I believe that Intel has a bright future. No, it’s not going to grow by 30 percent a year. But it is very likely to grow consistently and has proven itself able to contain costs and produce rising earnings. It also has a good record of increasing its dividend every year for the last eight years, right on through the Great Recession. How could it do that?
The demand for its products is increasing and the company continues to extend its brand and reach into new applications that are growing rapidly. Intel is not just for computers any more. The demand for what Intel does will continue to grow globally for, well, beyond my lifetime, I suspect. And the company has a sustainable advantage over competition. The advantages enjoyed by Intel extend to technology, distribution, marketing, and cost barriers. The company has a dominant position that is unassailable, at least in the foreseeable future. I like that.
I expect the company to post increases in revenues and earnings in the high single- to low double-digit area for at least the next five years. I also expect the company to continue raising its dividend every year. At a mere five percent, Intel’s debt to equity ratio is extremely low, providing ample flexibility to its capital structure to meet future needs for expansion and acquisition. I like that, too.
With 80 percent of revenues coming from outside of the U. S., the company has developed a global competitive footprint matched by few companies in any industry. They have operations and distribution capabilities wherever the demand arises. Intel is able to take advantage of growth no matter where it may occur. I like that.
The company has a profit margin of 25 percent and its return on equity is also 25 percent. Now, compare that to a price to earnings ratio of 10, add a dividend yield of 3.8 percent, and I ask you: What is there about Intel not to like?
Now, if you could just earn eight to ten percent per year instead of just 3.8 percent, would it make waiting for the eventual appreciation worthwhile? Let me show you how.
The closing prices on Intel stock and selected options on September 21, 2011 (the day prior to my submission of this article; I always use closing prices to be fair) were as follows:
- Stock price: $21.94
- October Put; $20 strike $ 0.28
- October Call; $24 strike $ 0.20
The assumption in these articles is that we want to own the stock of the subject company (Intel) but would prefer to buy it at a lower price and collect some income on our cash while we wait for our target price to materialize. If the stock offers a good value at its current price of $21.94, then it should offer an even better value at a price that is eight to ten percent lower.
So, we sell one October $20 Put for $.028 and collect the premium of $28, or $19 net after a $9 commission (assumes that we use a discount broker). Thus far we have .9 percent return on our cash for less than one month. This equates to an annualized rate of return of 10.4 percent.
However, since we cannot assume that the opportunity to sell an option will be available every month, or 12 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 articles 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, meaning that we may actually do better in the real world rather than worse.
Applying this method to the $19 net premium collected, the annualized rate of return would be 8.7 percent. Still, this is not a bad return on cash sitting in an account while we wait for a bargain. Where else can you get over eight percent on cash for a one-month holding period?
Now, let’s assume that we own 100 shares of Intel 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 October $24 Call at a premium of $0.20 per share, or $20. 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 $12.
Using the annualizing method I explain in an earlier paragraph, this equates to an annual return of 5.5 percent. But wait! There’s more. Don’t forget that if you own the stock you are also receiving the dividend and Intel’s dividend yield is currently 3.8 percent. Add the two yields together and we now receive 9.3 percent yield on the stock. And this is if we bought it at the current price of $21.94. 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 Intel about this time of the month during October.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.