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 Medtronic (MDT). 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 MDT to write about today? MDT is the largest, most diversified medical technology company in the world, with seven operating segments that produce and sell device-based medical therapies. Two of those segments, Spine and Cardiac Rhythm, are experiencing pricing pressure, but I believe that the aging population in developed countries and rising demand from emerging markets will benefit the company’s long-term prospects. Also, new products in the pipeline will help over the next year or two. I like MDT’s breadth of product offerings across so many medical therapies, since it reduces its dependence on any one product or line. My other favorites in the healthcare sector are Abbott Labs (ABT), Beckton, Dickinson & Co. (BDX), Johnson and Johnson (JNJ), and Teva (TEVA), about which I wrote previously.
MDT pays a dividend of 3.0 percent currently and has raised its dividend every year for 34 consecutive years. Dividend increases over the past five years have averaged 19 percent. The last raise was for eight percent on June 23, 2011, and I expect the company to continue their trend of rising dividends well into the future, with a strong likelihood of increases of about 8 percent each year. I also expect earnings to continue to rise by the same rate.
MDT derives 44 percent of its revenues from outside the U. S. The company 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 62 percent, roughly in line with the industry average. Its capital structure provides the necessary flexibility for future investment and acquisitions when and where prudent.
The company has a profit margin of 19 percent, and its return on equity is a reasonable 20 percent. Both are in line with industry averages. When you add the expected growth in earnings of eight percent to the current dividend of 3.0 percent, you end up with an expected return of over 11 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 3.0 percent, would it make waiting for the eventual appreciation worthwhile? Let me show you how.
The closing prices on MDT stock and selected options on October 7, 2011 were as follows:
- Stock price: $32.83
- January 2012 put, $30 strike: $1.45
- January 2012 call, $36 strike: $1.08
The assumption in these articles is that we want to own the stock of the subject company 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 $32.83, then it should offer an even better value at a price that is eight to ten percent lower. So we sell one January 2012 $30 put for $1.45 and collect the premium of $145 or $136 net after a $9 commission (assumes that we use a discount broker).
Thus far we have 4.1 percent return on our cash for three months. This equates to an annualized rate of return of 16.6 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 multiply 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 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. If we use an expiration of three months or longer we will simply use the normal method to annualize the return since options with good volumes should be available at least four times per year; for three month expirations we will, therefore multiply by four, etc.
Applying this method to the $136 net premium collected, the annualized rate of return would be 16.6 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 16 percent annual rate on cash for a three-month holding period?
But, of course, we want to own the stock so if it drops down below our strike price of $30 we could end up being put the stock at that price. At that point our cost basis would be $28.55. I like MDT better at this price than at $32.83. That’s a discount from the current price of 13 percent. I like buying stuff on sale, especially investments.
Now, let’s assume that we already own 100 shares of MDT stock and would like to increase the yield. We do this by selling covered 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 January 2012 $36 call at a premium of $1.08 per share, or $108. 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 $99. Using the annualizing method I explain in an earlier paragraph, this equates to an annual return of 13 percent. Now don’t forget that if you own the stock you are also receiving the dividend and MDT’s dividend yield is currently 3.0 percent. Add the two yields together and we now receive 16 percent yield on the stock. And this is if we bought it at the current price of $32.83. 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.
There is one last item that I would like to add to this article that is different from some of my earlier 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.