By Mark Bern, CPA CFA
VF Corporation (VFC) stock remained above our target price in our first attempt to purchase the stock through the use of our strategy. Those who read my first article on VFC (here) will recall that we picked up $501 profit in about a month and a half without buying the stock. That amounted to an annualized return (calculated by a method explained in the initial article of the series which is linked in the third paragraph) of 21.8%. If that sort of return is of interest, please read on to understand how we achieved it and how I intend to achieve more of the same on VFC in the next few months.
The other stocks we are using in this series for exposure to the consumer products sector are Colgate Palmolive (CL) and Johnson Controls JCI). If readers would like to review my most recent articles on these two stocks you can find them here (for CL) and here (for JCI), and by using the search box in the upper right-hand corner of this page. Just type in the symbol and a list of recent articles will come up. Mine will use the words “Updated Enhanced Income Investing Strategy for ...” in the titles.
Let me begin by pointing to a detailed explanation of the strategy that can be found in my original article that I used to initiate this series (here). As you will see in the conclusion of this article, you may be able to collect in excess of 9% annually in cash while holding VFC stock. You may also get paid 8% to 10% in cash in your account while you wait for a better price. 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.
I should point out that I make use of options, but in a very conservative fashion. Approximately 83% of all options contracts expire worthless. That is why I do not recommend, as part of this strategy, to buy options. I only sell options myself because that is the side of the contract that wins 83% of the time. I like the odds to be in my favor.
But I also don’t sell options just because of the odds, I do so with a purpose: To buy great stocks with rising dividends at a discount and to collect extra cash income while I hold those same stocks long-term. My objective is to create at least 8% per year in cash payments from a combination of dividends and option premiums each year in addition to the long-term appreciation that quality stocks provide. I believe that a 15% total return is achievable and that is what I intend to demonstrate over the next two years with this series. I should also remind readers to never, ever sell put options on a stock that you don’t really want to own. If it’s a stock that you would buy anyway, great. Otherwise don’t fool with it.
In the original article, which was written on September 30, 2011, the price for VFC stock was $121.52 (prices and premiums in that article were quoted from the closing on September 30). We sold a November put option contract with a strike price of $115 selling for a premium of $5.10 per share. We received $501, after a commission of $9, for an immediate return on the $11,500 we held in our account as security of 4.38%. This equates to an annualized rate of 21.8% (using the methodology I explained in detail in the original article linked in the above paragraph).
I must apologize since these percentages are slightly higher than those reported in the first article because I used the stock price there instead of using the strike price which is more appropriate. Since the stock remained above the strike price on the expiration date of November 18, 2011, we did not get the stock on the first try. Had we been put the stock, or had the option been exercised, we would have been obligated to buy the stock at the strike price of $115. Our cost basis would have been $109.90 ($115 - $5.10 premium). This would have given us a discount from the stock price ($121.52) on the day we initiated the trade of 9.6%.
And that is what we are trying to do - get great stocks at bargain prices. Until we get the bargain we keep selling the puts to create income on our cash while we wait. Have you ever placed a limit order below the market and watched as the price didn’t quite get down to your target price? That used to frustrate me as well. Now I use put options to do the same thing but I get paid to do it. It’s much less frustrating for me. But now we need to do something with the cash we still have in our account. So let’s take another swing and see if we can make contact this time.
The current price of VFC is $128.67 (all prices and premiums quoted for this trade are from the closing on December 29, 2011). We still want to get VFC at a bargain price so my favorite put option contract is the May 2012 option with a strike price of $120 and a premium of $6.30. The February expiration contract would also work, but this one gives me a better discount if exercised plus a higher annualized return on my cash held in the account to secure the put.
The $621 net cash received from selling the put gives us an immediate return of 5.18% on our money and an annualized rate of 12.4%. That’s not a bad return on cash these days. If the put option contract is exercised we will be obligated to purchase 100 shares of VFC stock for $120 a share so we must hold $12,000 in our account until the option expires to secure the put. The nice part is that we just received $621 from the trade so we really only need to put up $11,379 of our own cash. Upon exercise of the option, our cost basis would be $113.70 ($120 - $6.30). If the option expires worthless, we just keep the $621 and sell another put with a target annual yield on cash of at least 8%.
After just two trades we will have collected a total of $1,122 on the original $11,500 cash in our account for a return thus far of 9.76% from September 30, 2011 through May 18, 2012, should the contract again expire worthless. We’ll still have another four months left to collect even more premium if we don’t get the stock. I would expect that we should be able to find another trade that will pay us another 5% or so. If so, we will have created a return on our cash of around 16% for the year. That could happen even if the stock remains range-bound the whole time.
On the other hand, if we get the stock at the discounted price we are still ahead of where we would have been had we just bought the stock outright back in September when the price was $121.52. We would have a lower cost basis and we would have collected an additional $501 on the stock, far more than the dividend would have yielded. Once we own the stock we’ll start selling calls and collecting the premiums to increase the yield while we hold the stock long-term.
I hope readers are enjoying the series and that you are just as interested to see how this experiment all turns out over the next two years. One last caution and I already said this once in this article before but I feel it is important enough to repeat. Unless you really want to own a stock don’t sell puts on it. Selling puts on stocks because of the premiums available only is the worst way to make a decision and usually ends up losing money. I use stocks in my strategy that I like and want to own for the long term.
For those who would like to see the first report card on how the strategy is doing, please check out the November summary article at this link here.