By Mark Bern, CPA CFA
Emerson Electric (EMR) 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 EMR (here) will recall that we picked up a $171 profit in less than two months 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 22.8%. 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 EMR in the next few months.
The other stock we are using in this series for exposure to the industrial sector is United Technologies (UTX). If readers would like to review the most recent updated article on this stock please follow this link here.
Let me begin by 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 EMR 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.
On September 30, 2011, the price of EMR was $41.31 (all prices and premiums quoted are as of the close of the market on that day). We sold a November put with a strike price of $37.50 for a premium of $1.80. We received the $180 (one contract equals 100 shares; $1.80 x 100 = $180) less the commission of $9 for a net of $171 return on cash in our account held to secure the put option contract until expiration of 4.56%. That works out to an annualized return (using the method explained in detail in the original article linked in the above paragraph) of 22.8%. These numbers are slightly different from the first article on EMR since I used the stock price instead of the strike price to calculate and didn’t use my own methodology for annualizing the return. Please accept my apologies for any confusion this may have caused.
Had the stock price dipped below $37.50 and held there through the expiration date we would have been put the stock, or obligated to buy 100 shares of EMR at $37.50. That would have resulted in a cost basis of $35.70 ($37.50 less the premium of $1.8). Not bad considering that the price of the stock on the day we entered into the trade was $41.31. But we didn’t get the stock, so we need to put that money, plus our gain, back to work again.
Right now I like the June 2012 $45 strike put option contract with a premium of $3.50 ($341 net of commission) which provides us with a simple return of 7.6% on the trade over the next six months. I only need one contract to balance our portfolio’s diversification. When we annualize the rate we find that we have locked in a 15.2% return on our cash. If the stock drops below the strike price of $45 at expiration we will be obligated to purchase 100 shares of the stock at $45 per share. This means we will need $4,500 of cash in our account to secure the contract. Our cost basis would be $41.50 ($45 - $3.50). This is still very near the price we would have paid on the original trade date back in October of $41.31 and substantially below (11% discount) the current price of $46.59.
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.