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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 7.5 percent annually in cash while holding Spectra Energy (NYSE:SE). If you find the returns mentioned in this article intriguing, I suggest you take the time to understand the full strategy by reading the prior article.

First, we need to answer a question: I could apply this strategy to numerous other companies’ stocks, so why did I choose SE to write about today? SE is a utility operating over 17,000 miles of pipelines. The company also owns a regulated distribution operation in Canada and has a joint venture with ConocoPhillips (NYSE:COP) known as DCP Midstream.

I like pipeline companies because their revenues are somewhat insulated from fluctuations in gas and oil prices. Having said that, the company does produce natural gas liquids that tend to fluctuate in price in line with oil prices, so the stock price does fluctuate more than the average utility. That may be viewed as a negative by some, but I believe that, in the long run, it will provide much more upside appreciation potential while at the same time the price has support from the higher-than-average dividend and steady income flows from the regulated portion of the company.

I also like that the company's pipelines are regulated, because that provides a more stable return as provided by the return on invested capital allowed by regulators. The company plans to spend more than $1 billion annually on growth projects, funded internally, which should provide a healthy, consistent increase in revenue and earnings. This is one of the anchors we need in our portfolio to reduce the overall volatility. While they are not good candidates for this strategy, other utilities that I like are Northeast Utilities (NYSE:NU), NSTAR (NYSE:NST), OGE Energy (NYSE:OGE), PG&E (NYSE:PCG), Westar Energy (NYSE:WR) and Wisconsin Energy (NYSE:WEC).

SE pays a dividend of 4.3 percent currently. The company was formed on January 3, 2007, as the result of a spin-off from Duke Energ,y and has paid a dividend in each year since it was formed. The last raise was for 4 percent on January 3, 2011, and I expect the company to continue raising dividends well into the future, with a strong likelihood of increases of at least 4 percent each year. I also expect their earnings to continue to rise by about 6 percent annually.

SE derives 36 percent of its revenues from outside the U.S., all of this from operations in Canada. I like the potential currency gains from this organization if the U.S. dollar continues to devalue against other major currencies. The company also has a healthy balance sheet with a debt-to-equity ratio of 118 percent, which is in line with the industry average. Its capital structure and cash flow provide ample flexibility for future investment and acquisitions when and where prudent.

The company has a profit margin of 22 percent, and its return on equity is 14 percent. Both are significantly higher than industry averages. When you add the expected growth in earnings of 6 percent to the current dividend of 4.3 percent, you end up with an expected return of over 10 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 4.3 percent, would it make waiting for the eventual appreciate worthwhile? Let me show you how.

The closing prices on SE stock and selected options on October 3, 2011, were as follows:

  • Stock price: $24.14
  • November put, $23 strike: $0.85
  • November call, $26 strike: $0.35

The assumption in these articles is that we want to own the stock of the subject company (SE) 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 $24.14, then it should offer an even better value at a price that is 8 to 10 percent lower. So, we sell one November $23 put for $0.85 and collect the premium of $85 or $76 net after a $9 commission (assumes that we use a discount broker). Thus far we have 3.15 percent return on our cash for less than two months. This equates to an annualized rate of return of 18.9 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 12 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 $76 net premium collected, the annualized rate of return would be 15.7 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 15 percent annual rate on cash for a two-month holding period?

But, of course, we want to own the stock, so if it drops down below our strike price of $23 we could end up being put the stock at that price. At that point our cost basis would be $22.15. I like SE better at this price than at $24.14. That’s a discount from the current price of nearly 8 percent. I like buying stuff on sale, especially investments.

Now, let’s assume that we already own 100 shares of SE 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 $26 call at a premium of $.035 per share, or $35. 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 $26. Using the annualizing method I explain in an earlier paragraph, this equates to an annual return of 5.4 percent. Now don’t forget that if you own the stock you are also receiving the dividend and SE’s dividend yield is currently 4.3 percent. Add the two yields together and we now receive 9.7 percent yield on the stock. And this is if we bought it at the current price of $24.14. 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.

One last item that I would like to add to this article that is different from my previous articles: Some of the comments to my previous articles have been extremely enthusiastic. I am pleased. Yet, I also believe that I must include a warning in all my subsequent articles to make sure that everyone understands that there are risks to every strategy, including this one.

First, as has been pointed out in the comment threads, there is always the possibility that the selling puts strategy may not result in the purchase of the desired stock in a rapidly rising market. An investor could miss most, if not all, of a run up. It is doubtful that the full run will be missed, however, since the market (including most stocks) correct by 10 percent or more usually once or more per year. For that reason, it is likely that the investor will purchase the stock at some point during a bull market, but they still may miss some portion of it (perhaps a large portion, especially in a bounce off a major bottom).

On the positive side of this equation is the fact that as most major bottoms occur, there is usually a day of capitulation. Capitulation days are generally heavy down days on which, if one has sold puts outstanding, the investor stands a good chance of being put the stock (purchasing at the bottom). There are no promises of that happening, but the odds are better under this strategy than following ones gut emotions. One other thing that helps offset the possible regret of missing a stock at a good price is that the seller of the puts will continue to earn a decent return on their cash (generally 8 to 10 percent on average) annually while they wait. Granted, that is not as good as hitting a 30 percent gain in a good year, but it sure beats sitting in a money market and earning zip.

Second, as has also been pointed out in the comment threads, it is possible to end up buying a stock when the stock market tumbles and having to ride it out to the bottom. If the investor is buying a stock in a company that they want to hold for the long term, at least with this strategy they will never buy at the very top. After all, we’re selling puts at a price of about 10 percent below the price when the put option is sold.

In addition, the investor has the opportunity to sell calls and, including dividends, receive an average of 8 to 10 percent in cash payments per year while they wait for the stock to rebound. If we have done our homework in picking a good company at a price that represents a good value, then the likelihood of a rebound is very strong. The only way to end up losing money is by selling the stock. If you hold, you’re getting paid well to do so and eventually you’ll be back in the money.

If the investor had purchased the stock outright at the top of the market and the market fell 50 percent, they would be down 50 percent at the bottom and need the stock to double just to get even. If they are selling calls all the way down, assuming the average length on most bear markets is about 17-19 months, the investor should have collected somewhere in the vicinity of 15 percent along the way, putting them down 25 percent at the bottom. Remember, you bought at 10 percent below the top, using puts, so you couldn’t lose the full 50 percent in any event. Now you only need half as much of a rebound to get even.

The third scenario is the worst case. If an investor sells a put near the top and ends up with the stock at a 10 percent discount from the high and rides in all the way down to the bottom, collecting dividends and call premiums along the way. Now you are down 25 percent, and you end up selling a call that gets exercised near the bottom and the stock is called away. But remember, you are selling calls that will net you about 10 percent above the stock price at the time the option is sold, therefore you should be selling at no less than ten percent off the bottom. That would result in a total of a 15 percent loss on the total of your transactions. Now compare that to most alternatives other than picking the tops and bottoms, which no can do consistently.

An alternative to riding a stock down is to use stop-loss limit orders. I recommend that investors consider using this strategy to save themselves the pain of riding a stock down during an overall market crash. Some long-term investors with low cost basis may not want to use this strategy due to the tax consequences.

The point is, while this isn’t the most lucrative strategy, it does bear less risk of loss than most alternatives. By taking most of the emotions out of the decision process, an investor improves their chances of producing consistently higher returns. And that is the whole point. I hope this explanation helps cure some of the over-enthusiasm. This is no get-rich-quick scheme. It is simply a systematic strategy that can help investors achieve market-beating returns over the long term.

Disclosure: I am long WR.

Source: An Enhanced Income Strategy For Spectra Energy