By Mark Bern, CPA CFA
3M (MMM) 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 3M will recall that we picked up $290 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 next paragraph) of 21.5 percent. 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 3M over the next several months. The other stocks we are using in this series for exposure to the industrial sector are United Technologies (UTX) and Emerson Electric (EMR). If readers would like to review my most recent articles on these two stocks you can find them 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 “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. 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 3M stock. You may also get paid eight to ten percent on 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 percent 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 percent 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 eight percent 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 percent 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 October 4, 2011, the price for 3M stock was $72.01 (prices and premiums in that article were quoted from the closing on October 4). We sold a November put option contract with a strike price of $67.50 selling for a premium of $2.99 per share. We received $290, after a commission of $9, for an immediate return on the $6,750 we held in our account as security of 4.3 percent. This equates to an annualized rate of 21.5 percent (using the methodology I explained in detail in the original article linked in the above paragraph).
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 $67.50. Our cost basis would have been $64.51 ($67.50 - $2.99 premium). This would have given us a discount from the stock price ($72.01) on the day we initiated the trade of 10.4 percent. 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, too. 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 3M is $81.73 (all prices and premiums quoted for this trade are from the closing on December 30, 2011). We still want to get 3M at a bargain price so my favorite put option contract is the January 2013 option with a strike price of $80 and a premium of $9.10. The July expiration contract would also work, but this one gives me about the same discount if exercised but a higher annualized return on my cash held in the account to secure the put. The $901 net cash received from selling the put gives us an immediate return of 11 percent on our money and an annualized rate of 10.2 percent. 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 3M stock for $80 a share so we must hold $8,000 in our account until the option expires to secure the put. The nice part is that we just received $901 from the trade so we really only need to put up $7,099 of our own cash. Upon exercise of the option, our cost basis would be $70.90 ($80 - $9.10). If the option expires worthless, we just keep the $901 and sell another put with a target annual yield on cash of at least eight percent.
After just two trades we will have collected a total of $1,191 on a total of $6809 cash we’ve had to hold in our account for a return thus far of 17.5 percent from October 4, 2011 through January 18, 2013, should the contract again expire worthless. We’ll have taken over 12 months to collect that return so to annualize we simply divide the return by the total number of months the cash was held in the account (15.5) and then multiply by 12 and we get an annual return of 13.9 percent. That’s not a bad return on cash in this market!
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 $72.01. We would have a lower cost basis and we would have collected an additional $290 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, 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.
I wish you all a healthy and prosperous New Year!