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 BHP Billiton (BBL). 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 BBL to write about today? This is not a recommendation to buy this stock today. Demand for the ore that BBL mines around the world is currently in a downtrend. I believe this to be more of a correction to the long-term uptrend, however. When global economic recovery begins in earnest, BBL’s stock should represent an excellent opportunity for a long-term investor. We are in the early stages of a long-term trend of global urbanization in developing nations around the globe. BBL is well positioned to provide the essential infrastructure ingredients to support this trend. The company has great diversification, both from sources of sales and from the geographic dispersion of sales, producing petroleum (17%), energy coal (8%), metallurgical coal (12%) iron ore (22%), aluminum (8%), manganese (4%), stainless steel (4%), diamonds (2%), and other base metals (20%). It has customers on six continents with China accounting for 24 percent of sales. Unlike many of its peers, the success of the company is not tied to any one commodity. I also believe that a well-diversified needs to have exposure to commodities to take advantage of the long-term trend in global development.
BBL pays a dividend of 3.6 percent currently and has raised its dividend every year for nine consecutive years. Dividend increases over the past five years have averaged 24 percent. The last raise was for 20 percent on August 24, 2011, and I expect the company to continue the trend of rising dividends well into the future with a strong likelihood of increases averaging about 12 percent each year. I also expect its earnings to continue to rise by about the same rate.
BBL derives 91 percent of its revenue from outside the U. S. The company is very 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 28 percent, well below the industry average. Its capital structure provides ample flexibility for future investment and acquisitions when and where prudent.
The company has a profit margin of 33 percent and its return on equity is an exceptional 45 percent. Both are well above industry averages. When you add the expected growth in earnings of 12 percent to the current dividend of 3.6 percent you end up with an expected return of over 15 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 3.6 percent, would it make waiting for the eventual appreciation worthwhile? Let me show you how.
The closing prices on BBL stock and selected options on October 12, 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: $61.39
December Put; $55 strike $1.90
December Call; $70 strike $1.35
The assumption in these articles is that we want to own the stock of the subject company (BBL) 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 $61.39, then it should offer an even better value at a price that is eight to ten percent lower. So, we sell one November $55 Put for $1.90 and collect the premium of $190 or $181 net after a $9 commission (assumes that we use a discount broker). Thus far we have 2.9 percent return on our cash for two months. This equates to an annualized rate of return of 17.6 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 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 $181 net premium collected, the annualized rate of return would be 14.7 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 14 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 $55 we could end up being put the stock at that price. At that point our cost basis would be $53.10. I like BBL better at this price than at $61.39. That’s a discount from the current price of nearly 14 percent. I like buying stuff on sale, especially investments.
Now, let’s assume that we already own 100 shares of BBL 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 $70 Call at a premium of $1.35 per share, or $135. 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 $126. Using the annualizing method I explain in an earlier paragraph, this equates to an annual return of 10.2 percent. Now don’t forget that if we own the stock we are also receiving the dividend and BBL’s dividend yield is currently 3.6 percent. Add the two yields together and we now receive 13.8 percent yield on the stock. And this is if we bought it at the current price of $61.39. 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 at the link above.
I have chosen to keep all the subsequent articles shorter by referring back to this article for details and explanation.
There is one last item that I would like to add to this article that is different from some of 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 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 the cash (generally 8-10 percent on average) annually while waiting. 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 he or she wants to hold for the long term, at least with this strategy he 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 waiting 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, he would be down 50 percent at the bottom and need the stock to double just to get even. If he is 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 him down 25 percent at the bottom. Remember, he bought at ten percent below the top, using puts, so he couldn’t lose the full 50 percent in any event. Now he only needs 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 it all the way down to the bottom, collecting dividends and call premiums along the way. Now he is down 25 percent and ends up selling a call that gets exercised near the bottom and the stock is called away. But remember, he is selling calls that will net about ten percent above the stock price at the time the option is sold, therefore 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 the 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 the 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.