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 3M (MMM). 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: I could apply this strategy to numerous other companies’ stocks, so why did I choose 3M to write about today? 3M has a diverse product line that spans electronics, health care, telecommunications, industrial, consumer, office, and safety. We’re all familiar with the Post It Notes and other adhesive products, but most of what 3M makes goes into or on the outside of other things that we use every day. The company is, in my humble opinion, the poster child for recognizing value created in research and introducing new products into the market.
Long-term, 3M is definitely a keeper from where I stand. I consider 3M to be an industrial company for diversification purposes. My other favorites in this sector are BHP Billiton (BHP), Dover Corp. (DOV), General Dynamics (GD), Illinois Tool Works (ITW), Parker Hannifin (PH), Emerson Electric (EMR) and United Technologies (UTX) (see previous articles on EMR and UTX).
3M pays a dividend of 3.1 percent currently and has raised its dividend every year for 53 consecutive years. Dividend increases over the past five years have averaged four percent. The last raise was for five percent on February 8, 2011 and I expect the company to continue its trend of rising dividends well into the future with a strong likelihood of increases of about six percent on average each year. I also expect its earnings to continue to rise by about nine percent on average annually.
3M derives 63 percent of its revenues from outside the U. S. The company continues to increase its share of overseas markets and is well-positioned to take advantage of global economic growth no matter where it occurs. The company also has a healthy balance sheet with a debt to equity ratio of 32 percent, nearly one third of the industry average. The company generates about $4 billion of annual cash flow. Its capital structure provides ample flexibility for future investment, research, dividend increases and acquisitions when and where prudent.
The company has a healthy profit margin of 15 percent, almost 50% above the industry average, and its return on equity is a strong 27 percent. When you add the expect growth in earnings of nine percent to the current dividend of 3.1 percent you end up with an expected return of over 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 3.1 percent, would it make waiting for the eventual appreciate worthwhile? Let me show you how.
The closing prices on 3M stock and selected options on October 4, 2011 (the last business day prior to my submission of this article; I always use closing prices to be fair) were as follows:
Stock price: $72.01
November Put; $67.50 strike $2.99
November Call; $77.50 strike $1.63
The assumption in these articles is that we want to own the stock of the subject company 3M 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 $72.01, then it should offer an even better value at a price that is eight to ten percent lower.
So, we sell one November $67.50 Put for $2.99 and collect the premium of $299 or $290 net after a $9 commission (assuming that we use a discount broker). Thus far we have 4.0 percent return on our cash for less than two months. This equates to an annualized rate of return of 24 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 $290 net premium collected, the annualized rate of return would be 20.1 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?
But, of course, we want to own the stock so if it drops down below our strike price of $67.50 we could end up being put the stock at that price. At that point our cost basis would be $64.51. I like 3M better at this price than at $72.01. That’s a discount from the current price of over ten percent. I like buying stuff on sale, especially investments.
Now, let’s assume that we already own 100 shares of 3M stock and would like to increase the yield. We do this by selling cover call options. Since we own the stock in our account, generally brokers will require that we must sell the calls in the same account to be “covered.”
We sell one November $77.50 Call at a premium of $1.63 per share, or $163. 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 $154. Using the annualizing method I explain in an earlier paragraph, this equates to an annual return of 10.6 percent.
Now don’t forget that if you own the stock you are also receiving the dividend and 3M’s dividend yield is currently 3.1 percent. Add the two yields together and we now receive 13.7 percent yield on the stock. And this is if we bought it at the current price of $72.01. 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 3M during late November or early December. The title will be something like “Enhanced Income Strategy: 3M Update #1”.
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. I have chosen to keep all the subsequent articles shorter by referring back to this article for details and explanation.
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 one's 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 8-10 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 ten 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 8-10 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 ten 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 ten 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. Thanks for reading and I wish you all a successful investing future!