by Mark D. Bern, CPA CFA
Let me begin by pointing to a detailed explanation of the strategy that can be found in my previous article. 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 Teva (NYSE:TEVA). 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 Teva? I could apply this strategy to numerous other companies’ stocks, so why did I choose Teva to write about today? I have long admired the dominant position that Teva holds in the generic pharmaceuticals industry. Teva is the generic drug leader with both cost and distribution advantages. I believe that Teva has the potential to grow revenue and earnings faster than the average S&P 500 company, and likely at a rate which translates into 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.
The company also has a good record of increasing its dividend every year for the last twelve years, right on through the Great Recession. Those are the first two screens I use in looking for candidates for investment-- consistently rising dividends and above average earnings growth. And this company just happens to be in the health care industry where, with the aging populations of most developed nations, the future growth is almost assured.
The demand for its products is increasing and the company continues to expand its offerings as blockbuster drugs come off patent every year. The demand for Teva’s products will continue to grow globally for the foreseeable future, and the company has a sustainable advantage over competition. The advantages enjoyed by Teva, as mentioned above, extend primarily to distribution and low-cost leadership. The company has a dominant position that is unassailable, at least in the foreseeable future. That is the sort of position I want for my investments.
I expect the company to post increases in and earnings averaging about nine percent annually for at least the next eight years. This is due to a combination of the schedule of drugs coming off patent and the increasing size of the company's primary target market-- people over 65 years of age in developed countries. Teva has a great pipeline with about 80 drugs for which it may have the first generic on the U. S. market. This is more than any other generic drug company of which I am aware, and by a large margin. I also expect the company to continue raising its dividend every year. Having a debt to equity ratio of 27 percent in an industry that averages slightly over 50 percent provides ample flexibility to its capital structure to meet future needs for expansion and acquisition. That is an important factor.
With 38 percent of revenues coming from outside of the U. S., the company has developed a respectable global competitive footprint. While this is slightly below my preferred level of 40 percent, I’ll give this company a pass for two reasons. First-- pharmaceuticals, even generics-- tend to sell for higher prices in the U. S. than elsewhere given our relative affluence and the allowances available under insurance and federal programs. So, what this means is that on a volume basis Teva actually sells more than 40 percent of its products overseas. Second, generic drugs are far less likely to be hurt by government actions than branded drugs, since governments are trying to lower costs and generics generally cost much less than branded drugs. As a matter of fact, I suspect that a move is afoot, even beyond the U. S., to bring down health care costs by encouraging a migration to more generics. This should benefit Teva.
The company has a profit margin of 19 percent and its return on equity is also 15 percent. Compare that to a price to earnings ratio of 9.9, add a dividend yield of 2.2 percent, and what do you get? An expected return of about 12 percent compounded annually. Not bad, but I think we can do better.
If you could increase your cash flow to eight to ten percent per year instead of just 2.2 percent, would it make waiting for the eventual appreciation worthwhile? Let me show you how.
The closing prices on Teva stock and selected options on September 22, 2011 (the day prior to my submission of this article; I always use closing prices to be fair) were as follows:
Stock price: $35.26
November Put; $32.50 strike $1.38
November Call; $40 strike $0.061
The assumption in these articles is that we want to own the stock of the subject company (Teva) 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 $35.26, then it should offer an even better value at a price that is eight to ten percent lower. So, we sell one November $32.50 Put for $1.38 and collect the premium of $138, or $129 net after a $9 commission (assumes that we use a discount broker). Thus far we have 3.9 percent return on our cash for less than two months. This equates to an annualized rate of return of 23.5 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, 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 $129 net premium collected, the annualized rate of return would be 20 percent. I don’t think I will get much argument about that sort of return on cash sitting in an account while we wait for a bargain. Where else can you get a 20 percent annual rate on cash for a two-month holding period?
Now, let’s assume that we own 100 shares of Teva stock and would like to increase the yield. We do this by selling cover 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 $40 Call at a premium of $0.61 per share, or $61. 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 $52. Using the annualizing method I explain in an earlier paragraph, this equates to an annual return of 7.4 percent. Now don’t forget that if you own the stock you are also receiving the dividend, and Teva’s dividend yield is currently 2.2 percent. Add the two yields together and we now receive 9.6 percent yield on the stock. And this is if we bought it at the current price of $35.26. 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.
If this hasn’t made sense and you need a better explanation of the details of my strategy please refer to the original article I published on September 21, 2011 (see link above). I have chosen to keep all the subsequent articles shorter by referring back to this article for details and explanation.