By Mark Bern, CPA CFA
Well, we didn’t get put the stock on the first try, but we did collect the premium on the put we sold. Recall from my first article on Chevron (NYSE:CVX) that the stock price was $91.49 (all prices and premiums quoted as of the market close on September 26, 2011) while the premium on the November $85 strike put was $3.35. We collected $335 ($3.35 x 100) on the one contract that we sold, but we also paid a commission of $9 (assumed amount that is about the average of discount brokerage premiums; you can do better if you shop around).
That leaves us will $326 net of commissions which represents a return of 3.5 percent for 46 days (expiration occurred on November 10). If you annualized that return (using the method I explained in my original article in this series) you would come up with about 17.5 percent without owning any stock. That is the kind of return that makes this strategy work. We won’t get those every time, but often enough to keep me happy.
I will include information of call selection in this series in the future only after we have been put the stock. That will keep this series more focused upon the return to the complete strategy rather than mixing it up with other issues. We will build a portfolio of dividend-paying stocks over time and compare our return to the return of the broader market after two years.
Now I will focus on two topics: 1) next steps with Chevron and 2) explaining my views on developing a diversified equity portfolio. In earlier update articles on United Technologies (NYSE:UTX), Union Pacific (NYSE:UNP) and Intel (NASDAQ:INTC), I address other related issues, such as exit strategies and variations to the basic strategy. I have also tried to address other questions that were raised in comments to these articles. In future updates I plan to fully expand on the possibilities, the risks and other considerations that apply to enhanced income investing.
In my earlier article on Chevron I explained that I believe Chevron to be a well-managed, dominant company with exceptional upside potential. I like Chevron a lot, and think that it is a great investment for the long-term. At its current price of $101.83, I believe that the company still represents a good value. However, with all the uncertainty in the market today, I think the volatility will give us an opportunity to buy this company at a better price.
The stock is nearer the high end of its range in recent quarters, and the market just underwent a strong rally. My favorite put option on Chevron at the moment is the March 2012 $87.50 strike with a premium of $2.46. After the commission you are left with a return of 2.3 percent, or 8.0 percent on an annualized basis. The exercise date is March 16, 2012, so you earn the 2.3 percent in three and one half months. Not a bad return on cash these days.
We may get put this stock in March 2012 if the global economy weakens further and demand expectations for oil are lowered. If we do, we will have a cost basis of $85.04 ($87.50 - $2.46). Having said that, I would like to caution readers that there remains a possibility that we could see the markets swoon again due to stresses on the financial system caused by concerns over the sovereign debt crisis in Europe or a number of other non-company-specific factors. But I still maintain that the long term potential combined with the dividend of $3.24 (which would yield 3.8 percent at our cost basis of $85.04) would make the risk worth taking.
So, now I’ll discuss how I developed the allocations for this diversified equity portfolio. But first, I want to caution readers that equities alone do not make up a diversified portfolio. A well-diversified portfolio should also contain some fixed income assets, cash and possibly a small percentage in inflation hedges. It can also contain real estate, royalty trusts, ETFs, hedge funds, limited partnerships, or annuities.
The mix and allocation of the various assets within a portfolio are variables that differ between individuals depending primarily upon each investor’s investment horizon(s), goals, income requirements, and risk tolerance. In this series I am addressing only the equity portion of a portfolio and assume a relatively conservative, income-oriented investment goal with a growth component at least double the rate of inflation.
When constructing an equity portfolio (or equity portion of a portfolio), I start by doing an assessment of the various industries. I want to have a greater weighting or proportion of my portfolio invested in industries with better potential over the next 12 month period. I also want to create a mix that provides a target at least the minimum targets I have for income and total return.
I also want to create an allocation mix that does not depend too heavily on industries that have high correlations under different economic conditions (i.e., not too heavy on stocks that are dependent upon the business cycle). I consider broad categories of stocks that have high correlations as a category and split the universe into 12 basic categories: Consumer Products, Retail, Transportation, Utilities, Technology, Energy, Industrials, Communications, Natural Resources and Commodities (less energy), Financials, Healthcare, and REITs. I require my portfolio to contain selection from at least eight, preferably ten or more categories.
Now I’ll get into the category weighting that I have used in constructing this portfolio. I should point out that the weightings will vary over time depending on the timeliness of the various industries that make up the categories. Right now I believe that the categories that have the most potential for growth over the next 12 months are Energy, Technology, Industrials, and Healthcare. I can’t always hit my target weightings by category because I like to trade in round lots, and the prices of the various stocks I select often make it impossible. But I can always get close. Next, I will try to explain my allocation for each category.
I like Utilities for stability and income. Over the last ten years Utilities have outperformed the S&P 500 through consistency. So that is always an anchor. But utilities don’t usually have active trading of options. This tends to keep my allocation to utilities lower than it might otherwise be, and right now I have only targeted a four percent allocation.
Healthcare, despite the new legislation, I believe will continue to outperform the broader market indexes but we have to be more selective to avoid companies that could be impaired by the legislation if it is implemented. But due to the consistent long-term growth nature of this category I have established a target weighting of 14 percent.
Energy, especially integrated oil at the moment, offers excellent potential, in my opinion, due to the continued expansion of demand in developing countries like China, India and Brazil where every few years the combined middle class expands by a number similar to the population of the U.S. These are people who have never had electricity before and are just now beginning to taste the comforts that we have taken for granted for several generations. The increased demand for energy, even with all the attempts to improve conservation, will continue rise for the next few decades and could create shortages in supply for oil and coal. I like the potential for oil better than coal right now primarily due to the higher environmental concerns and the environment that creates here and in other developed nations. My target allocation for energy is 12 percent.
Consumer Staples and Consumer Discretionary could be separate categories, but I combine them into one category, Consumer Products, and choose the companies that have the best long-term potential. In this case I like the Consumer Staples companies more because of the defensive nature and growth in developing countries. I have a combined allocation for these two categories of 15 percent.
Retail, in my view is not the same as Consumer Products. Companies like P&G, Pepsi, and Coke are more defensive than most retail companies and more resilient during difficult economic environments. But retail has a lot of potential in the right economic environment and we should be getting closer to that state. Again, we have to be more selective in this category right now, but because of the potential growth I have allocated eight percent to retail.
Another defensive category is Communications, because it acts more like a utility, as people are less likely to cut off their phone or cable service than to cut back in other areas, like dining out, travel, and other forms of entertainment. It doesn’t hurt that the dividends are also elevated relative to other categories, either. But the prospective growth is also rather low so my target for this category is limited to five percent.
The Financials category is a great example of one that is out of favor. There are some bargains to be had here, but we have to be very selective, because some of the companies that have been beaten down the most may deserve it. I have an allocation for Financials of ten percent based upon the potential growth when the global economies stabilize. The winner could win big but there is also the risk that we could pick a potential loser, so I have not weighted the category higher.
Transportation is relatively cyclical, similar to Industrials and retail, but less so than in the past. This is because of the rapid growth in developing countries and the associated appetite those countries have for raw materials and food. Of course, much of what goes into countries like China comes back out again in the form of finished goods for the end markets in the U.S. and Europe. All that movement of raw materials and finished goods requires transportation. Different segments of this category perform better and pay higher dividends in a more robust economic environment, but rail seems to stand out right now as it is becoming more consistent and holds a significant cost advantage over trucking. My category target for Transportation is five percent.
Industrials do best during the second stage of economic expansion after a recession. Industrials also include a number of companies that benefit from infrastructure spending. The infrastructure build out going on in developing countries continues to drive performance by many of the companies in this category, and this situation should remain intact for another decade or more. My target for the Industrials category is 15 percent.
That leaves us with three categories: Technology, Natural Resources and Commodities, and REITs. I’ll do this through a process of elimination. I don’t think the time is quite right for REITs because, in my opinion we have about another year to go before the glut of foreclosures begins to subside. Then the process of reducing the inventory overhang will take another 12 to 18 months, at least. That’s just the housing portion. The other areas have better prospects, but I believe commercial is still not out of the woods yet. The other problem is that when interest rates finally do begin to rise so too will expenses for many of the companies in this category. So, I’ve decided to wait on REITs for now.
Natural Resources and Commodities have had a great run. I’m just not convinced that the trend can continue much longer. The demand will continue to be high but the stockpiling seems to be abating and I expect demand to level off. I may be wrong, but I’m staying clear due to perceived risk. That leaves us with Technology.
The Technology category is benefiting from pent up demand, and I believe the trend will continue. It is also benefiting from the continued expansion of demand in developing countries. The growth that I referred to in the section about Energy also relates to Technology. My target for the Technology category is 12 percent. That, in a nutshell, is my thought process on how I developed the allocation for the hypothetical equities portfolio that I am trying to build with my enhanced income investment strategy.
Disclosure: I am long UTX.