Hedging 8 High Yield, Low P/E Stocks

 |  Includes: AVP, DIA, FII, HCBK, LLY, LMT, MRK, PBI, RRD
by: David Pinsen

In a recent Seeking Alpha article ("8 High Yield Stocks from the S&P 500 with Lowest P/E Ratio"), Dividend Screen presented the results of his screening the S&P 500 for stocks with dividend yields of 5% or greater and single-digit forward P/E ratios. In this post, we'll look at the hedging costs and VectorVest Dividend Safety scores for those stocks. With respect to Dividend Safety, VectorVest defines it as ...

An indicator of the assurance that regular cash dividends will be declared and paid at current or at higher rates for the foreseeable future.

To see the VectorVest's Dividend Safety analysis for any dividend-paying stock, you can enter its symbol and your email address on VectorVest's home page, and they will email you their analysis of the stock.

It turned out that three of these high-yielding, low-P/E S&P components had Dividend Safety scores greater than 50, which is considered "good" on VectorVest's scale of 0-99. I've included the updated yields and Dividend Safety scores for all eight stocks in the table below, along with the current costs of hedging them against greater-than-20% declines over the next several months, using optimal puts.


For comparison purposes, I've added the SPDR Dow Jones Industrial Average Trust ETF (NYSEARCA:DIA). First, a reminder about what optimal puts are, and why I've used 20% as a decline threshold. Then, a screen capture showing the optimal puts to hedge the comparison ETF, DIA.

About Optimal Puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance Ph.D. to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

Decline Thresholds

In this context, "threshold" refers to the maximum decline you are willing to risk in the value of your position in a security. You can enter any percentage you like for a decline threshold when scanning for optimal puts (the higher the percentage though, the greater the chance you will find optimal puts for your position). I have used 20% thresholds for each of the securities below. Essentially, 20% is a large enough threshold that it reduces the cost of hedging, but not so large that it precludes a recovery.

The Optimal Puts for DIA

Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of DIA against a greater-than-20% drop between now and June 15, 2012. A note about these optimal put options and their cost: To be conservative, Portfolio Armor calculated the cost based on the ask price of the optimal puts. In practice an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask.

Click to enlarge

Hedging Costs As Of Tuesday's Close

The hedging data in the table below is as of Tuesday's close, and is presented as a percentage of position value. The yields and dividend safety ratings are as of Tuesday's close as well. Bear in mind that the yields below are annualized, but the hedging costs below aren't.



Div. Yield

Div. Safety

Hedging Cost

(NASDAQ:RRD) R.R. Donnelly 7.19% 45 14.5%**
(NASDAQ:HCBK) Hudson City Bancorp 6.21% 45 12.6%*
(NYSE:FII) Federated Investors, Inc. 6.36% 44 13.6%*
(NYSE:AVP) Avon Products, Inc. 5.55% 48 6.33%*
(NYSE:LMT) Lockheed Martin 5.23% 56 3.79%**
(NYSE:LLY) Eli Lilly and Co. 5.42% 61 1.88%*
(NYSE:MRK) Merck & Co. Inc. 4.87% 55 2.70%*
(NYSE:PBI) Pitney Bowes 8.22% 44 5.59%*
(DIA) SPDR DJIA 3.17% 58 3.63%**
Click to enlarge

*Based on optimal puts expiring in April 2012.

**Based on optimal puts expiring in June 2012.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am long puts on DIA.