Dividend Investors: Improve Your Yield-On-Cost

| About: The Procter (PG)

There's an ongoing joke between David van Knapp and Norman Tweed in the comments section following many dividend investing articles that Norman "can't" buy certain stocks because he can't get a 4% dividend yield at the time of purchase (see their 10/19/11 comments as an example). However, he can and he should. Here's how:

I've been an avid reader of Seeking Alpha ever since I first discovered it a couple of years ago. I spend most of my SA reading time about dividend investing. I've started to feel like I know many of the active authors and active commenters because they consistently reinforce for us novices the nuances of their particular dividend investing strategies. I typically don't comment because I don't feel as though I can add much to their collective wisdom. Having said that, I do think I can help Norman and any others who want a particular stock but the dividend yield just doesn't quite meet their hurdle rate.

The solution is well known among options investors but is rarely talked about among the dividend investors: learn to sell puts! This is a higher return, low risk way to increase yield on cost (YOC) compared to limit orders.

Selling a cash secured put is easy and low risk. I won't go into much depth here about the executional details and nuances because it is so thoroughly covered in other places, for example Double Dividend Stocks often writes about it. I will limit this article to describing the basic concept.

Let's say you want to own Procter & Gamble (NYSE:PG) stock, but only if you can get a 3.5% dividend yield (half way between Norman Tweed's and David van Knapp's hurdle rates). At the time of this writing, PG closed at $63.03 and its dividend is $2.10/yr for a yield of 3.33%. You would need the stock price to go down about $3, to $60, in order to get a 3.5% dividend yield. You could set a $60 limit order and wait and wait and wait all the while not collecting any dividends.

Is this really the best approach? I don't think so. Instead, today you could sell the April 2012 62.5 put and collect $3.10 per share. Between now and when the put expires on April 20th (which is 166 days away), P&G's stock price will go up, down or sideways. Let's explore what happens in each scenario.

The Price Goes Down Scenario
If the stock price goes down to $62.50 or lower, the stock will be "put" to you for $62.50/share. Your cost basis will be $59.40 because you will pay $62.50 for the stock but you still have the $3.10 you collected from selling the put. This gives you a 3.53% dividend YOC ($2.10/$59.40). What could be easier?

Some people will argue that this is risky because if the price has dropped to $55 at April 20th, you lost $4.40/share on this trade (the difference between the stock price and your cost basis). I don't agree with this argument because you would have lost slightly more with a $60 limit order. And importantly, this approach provided an opportunity for you to get in at a price anywhere between $60 and $62.50 with a 3.5% YOC, which you could not have done with a limit order!

The Price Stays About the Same or Goes Up Scenario
If the price is above $62.50, then nothing happens and you keep your $3.10. This is a 5.2% return ($3.10/$62.50) in 166 days, which annualized is about 11%. Not too bad. Now you repeat the process. Select a strike price a few months out that achieves your yield goal, sell another put at that strike and month, collect another couple of dollars per share, and wait. You will either be "put" the stock and get your 3.5% YOC or make another nice return on the premium you collected. Keep doing this until you are eventually put the stock. Compared to a limit order, you still meet your yield goal but you have the potential to get the stock sooner, at a much higher price, and you are collecting the put premium while you wait.

Some people love to argue that because it's a cash secured put (meaning you have to keep enough cash in your account to buy 100 shares of the stock per contract if/when it is "put" to you), that it ties up too much capital. However, it's the same thing with a limit order. You always need to have enough cash to buy the stock. Other people will argue that if the stock price goes up, it's frustrating because you may not get the stock by selling puts or you don't need to sell a put because you will eventually get the stock when the price has its inevitable downturn. My response is that this is true for both selling puts and for limit orders; however, with the puts, you can get the stock sooner and/or at a higher price without sacrificing your yield criteria because the put premiums you collected lowered your cost basis.

Next Steps
So Norman and others, learn to sell puts. It's not hard and it's not risky. Whether the stock goes up, down or sideways, you come out ahead compared to a limit order. You will eventually get "put" the stock at the dividend yield you want and you get to collect the put premiums while you wait.

Disclosure I'm a retired P&Ger, so yes, I'm long PG.