By Mark Bern
Sigma Aldrich (SIAL) develops, manufactures and distributes a wide range of chemicals globally. The company sells more than 130,000 products in 166 countries. SIAL tends to be less affected by economic problems than most peers and has an earnings resiliency that I like very much. The company is, in my opinion, financially stable and very well managed. The company has earned a premium valuation to the market with its history of steady growth even during troubled times.
Earnings per share (EPS) have increased for nine consecutive years, as have cash flows per share (CF/S). Dividends have been raised for 29 consecutive years. Average increases in EPS, CF/S and dividends per share over the last 10 years were 13.5%, 13% and 14.5%, respectively. With the continued weakness in the global economy I would expect those rates of increase to fall somewhat into the 10% to 11% range.
The shares are appropriately valued with the current P/E of 18.1 and share price of $65.23 (as of the market close on January 12, 2012). So, I wouldn't chase the shares if they rise in price. However, if the price should drop 10% or more I would consider adding this issue. It is a long-term, double-digit grower that deserves consideration as a core holding.
The dividend isn't especially good at 1.2%, but the growth will help that undesirable quality over time. In addition, an investor can sell out-of-the-money call options of six months duration or less and a strike price of more than 10% above the current price to achieve an additional 3% to 5% income annually. Currently the June 2012 call option with a $75 strike price sells for a premium of $1.20 (bid) and $1.35 (ask) per share. Selling that call at $1.25 would produce a 1.8% return over less than six months.
If you have cash sitting in your account and would like these shares, but at a discount to the current price, you could consider selling a put to provide current income on your cash while you wait and provide a discounted cost basis if the shares drop enough for the option to be exercised. Let me give you a couple of examples for SIAL from the closing prices on January 12, 2012.
My favorite is the June 2012 put option with a $60 strike price selling for premiums of $3.10 and $4.00 (ask). We assume that we could get the bid premium of $3.10 (which is always more likely, even though we don't know for sure what the market will do tomorrow) and investor selling this put option contract would receive $310 (less commission) on this trade (once cleared) and be obligated to purchase 100 shares of SIAL at $60 per share should the option price fall and be exercised between now and June. If you use a discount online broker your commission should be less than $10 for the first contract and it drops precipitously for each additional contract. There are two outcomes: the investor gets put the stock (option exercised) or the option contract expires worthless. Historically about 80% of all option contracts expire worthless, so the more likely scenario is the latter.
Let's look at what happens in the first case. The option is exercised and the investor purchases 100 shares of the stock at $60, but has a cost basis of $56.90 ($60 - $3.10) for tax purposes. There will also be an exercise fee/commission, usually between $15 and $20. The actual price, after commissions and fees, should be no more than $57.20 ($60 -$3.10 premium +$0.10 commission + $0.20 exercise fee). This represents a discount from the current price of 12.3%.
The second outcome (the more likely) is that the option expires worthless and all the investor gets is the $3.10 (less commission of $10) or $300 net return on his or her cash for a little over five months. This provides a return of 5%. Assuming the investor can do this again over the remainder of the year, the annualized return is 10%. In today's low interest rate environment a 10% return on cash in your account seems pretty good.
Of course, there are risks involved in every investment strategy. The two that pose the most serious concerns are: 1) missing a big rally in the stock and 2) catching a falling knife (market crashes and investor is obligated to purchase the stock at $60 no matter how low it has fallen).
There are several ways to look at these problems. In the first case, I missed some good appreciation but I still made a profit. The glass-half-empty investor would get upset at this outcome, but I never get upset at taking a double-digit annualized profit from any trade (my glass is half full). In the second case, if the investor had bought the stock outright instead of selling the put he or she would get caught in the downdraft as well and would likely lose more. The glass-is-half-empty investor would complain that he could have sold the stock and cut losses. The reality is that the seller of the put could also buy back the option to close the position and cut losses and probably lose less if each instrument were sold at about the same time. Let's take this a little further.
Let's say the stock dropped to $58 in April or May and the economy looked like it was coming apart so the investor decides to bail. If the stock had been bought at the current price the loss would be $7.23 ($65.23 - $58). With the expiration date now closer the time value of the option contract has decayed significantly and the premium will fall nearly in step with the stock price. Let's assume that the time value is still $1.50 by this point (a fairly safe bet). If the investor wanted to buy back the put option, the investor would have to pay the $2.00 that the option was in the money ($60 - $58) plus the remaining time value of $1.50 or a total of $3.50 plus commission. The total loss would be $360 less the original cash received when the option contract was sold at $300, or $60.
I won't go through all the permutations of the returns since the readers can probably follow the example above to calculate the results for themselves, but the second option contract I like is the June 2012 put with a strike price of $65 with a premium of $5.00 and $6.10 (ask). Obviously, the return is higher if the option expires worthless and the discount is less if exercised, so the question becomes, which is more important to the investor.
If this sort of investing strategy appeals to you but you'd like more details and examples, please consider reading some of articles from a series I am writing based upon this strategy. You can find a list of article links here.
Alternatively, if you are just interested in companies that consistently raise their dividends, you can find a list of focus articles at this link.