Investors love stocks that pay dividends ... and rightly so. Dividends have accounted for over 40% of the total annual return of the S&P 500 since 1926, and more than 100% of the returns over the past 10 years (the infamous "lost decade").
Despite the popularity of dividends among investors, there are several cash rich companies out there that are being stingy with shareholders (see list below).
Investors would be wise to follow these cash rich companies very closely. We think that these companies will eventually start distributing cash to shareholders as the economy stagnates in an effort to boost share price. A dividend announcement (quarterly or one-time) would likely lead to a significant rise in share price as investors chase the yield.
Creating a Synthetic Dividend By Selling Puts
The companies listed above generate a ton of cash and have very strong balance sheets. As such, we believe these companies are great put selling candidates.
We think that selling cash-secured puts on high-quality stocks is a perfect strategy for an income investor in a down market. It allows investors to generate income while mitigating downside price risk.
If you sell a put, you have an obligation to purchase the stock at a predetermined price (strike price) on or before the expiration date (if the buyer of the put option wants to sell you the stock). Clearly, the risk is that the stock drops significantly below the strike and you are forced to buy the stock at a price well above market.
Here are our two risk management rules of put selling:
- Only sell put options on stocks that you want to own at the price you want to own them - With a put selling income strategy (focused on out-of-the-money puts), you get paid to wait for the price you want on a stock. If the price never drops to your strike, you get to keep the premium (income) as a consolation prize. Your downside is owning the stock at the strike price (keep that in mind as you analyze the ideas below).
- Don't sell "naked" - Just because options offer you leverage, it doesn't mean that you have to use the leverage. We recommend securing your short put position with cash (i.e., don't sell on margin). If you aren't willing to risk the cash to back it up ... don't sell the put.
The table below highlights some specific recommendations for the stocks listed above. On average, investors can earn a 7-month yield of 4.6% with a margin of safety of 19.3%. This is a great way to generate income while keeping an eye on these cash rich stocks.