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 ten percent annually in cash while holding Chevron. 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 Chevron (NYSE:CVX)? I could apply this strategy to numerous other companies’ stocks, so why did I choose Chevron to write about today? First, let me be blunt and say that there were very few companies that I would like to own for which the strategy would work today. Some days are like that. But I do like Chevron, and here’s why.
Chevron is the second-largest energy company in the U. S. and among the largest in the world. Chevron has one of the better prospects for increasing production of the major oil producers. The company is likely to grow earnings fairly consistently if the price of crude does not fluctuate too dramatically (which is a big if). But I think that every investor needs to own at least one or two energy stocks to maintain a well-diversified portfolio. Chevron also has a good record of increasing its dividend every year for the last 24 years, right on through the bursting of the Internet bubble and 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.
Energy use is growing globally, and continued future growth in demand is pretty well assured. There may be times of slower growth, but over the long term, growth is a given due to developing countries’ expanding appetites for more of everything, especially energy. I also like the geography of Chevron's production: Most of its new production is coming from politically stable areas (relative to the Middle East) such as the Gulf of Mexico, Australia, Africa, Kazakhstan, and Southeast Asia. The company has a sustainable position within the industry, at least in the foreseeable future. Of the major energy companies, Chevron is one of my favorites for those reasons.
I expect the company to post increases in earnings averaging about 8 percent annually for at least the next six years. This is primarily due to a combination of expected production increases and oil prices trending higher due to demand. I also expect the company to continue raising its dividend every year, probably also in the 8% per year area. The payout ratio is 25 percent, well below the industry of over 30 percent. Having a debt-to-equity ratio of 10 percent in an industry that averages slightly over 30 percent provides ample flexibility to its capital structure to meet future needs for expansion and/or acquisition. That is an important factor.
With 58 percent of revenues coming from outside of the U. S., the company has developed an excellent global competitive footprint. Chevron has a profit margin of 11 percent, in line with the industry average, and its return on equity is 21 percent, well ahead of the industry average of about 15%. Compare that to a price-to-earnings ratio of 8, add a dividend yield of 3.4 percent, and what do you get? An expected return of about 11 percent compounded annually. Not bad, but I think we can do better.
If you could increase your cash flow to 8 to 10 percent per year instead of just 3.4 percent, would it make waiting for the eventual appreciate worthwhile? Let me show you how.
The closing prices on Chevron stock and selected options on September 26, 2011 were as follows:
- Stock price: $91.49
- November put; $85 strike: $3.35
- November call, $100 strike: $1.68
The volatility of energy stocks, especially oil producers, has been significantly higher than that of the overall market, due to fluctuations in oil prices. This is one of those stocks where you have to aware of the relative price movements and watch the trends of externals that affect the stock -- in this case, the cost of oil. You also want to be aware of the stocks price's ranges, and how much it has increased or decreased in price in any given 30-60 day period.
Taking a look at Chevron’s 1-year chart, we can see that there were two moves of over 10 percent during 30-day periods. In December 2010 the stock rose about 13 percent, and in August of 2011 it dropped about 14 percent. Otherwise the stock has swung less than 10 percent in any given 30-day period. I realize that we are taking options position that will expire in over 30 days, but less than 60 days so we are taking an above-average risk, due to the volatile nature of the stock, to either own the stock (which is what we want) at a lower price or to have the stock called away. In the latter case, it is a case-by-case situation that each investor needs to make for himself. Whether the potential for increased yield is worth the risk or not is a personal choice.
The assumption in these articles is that we want to own the stock of the subject company (Chevron) 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 $91.49, then it should offer an even better value at a price that is 8 to 10 percent lower. So we sell one November $85 put for $3.35 and collect the premium of $335, or $324 net after a $9 commission (assumes that we use a discount broker). Thus far we have 3.5 percent return on our cash for less than two months. This equates to an annualized rate of return of 21 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 10 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 10 months, or simply multiply the premium by 10 to annualize our rate of return. Similarly, if we sell an option that expires in two months, we will make the same assumption and multiply 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 $324 net premium collected, the annualized rate of return would be 17.7 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 17 percent annual rate on cash for a two-month holding period?
Now, let’s assume that we own 100 shares of Chevron 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 $100 call at a premium of $1.68 per share, or $168. 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 $159. Using the annualizing method I explain in an earlier paragraph, this equates to an annual return of 6.9 percent. Now don’t forget that if you own the stock you are also receiving the dividend, and Chevron’s dividend yield is currently 3.4 percent. Add the two yields together and we now receive 10.3 percent yield on the stock. Since this is if we bought it at the current price of $91.49, 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.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.