Building A Capital Preservation And Income Portfolio, Part 6

Includes: AWK, MCD, PEP, VZ
by: Mark Bern, CFA

By Mark Bern, CPA, CFA

<< Click to view Part 5

In Part 5 of this series I introduced the concept of selling call options to enhance the income from a conservative, dividend-paying portfolio. For the detailed, simply to understand basics on that strategy please review Part 5. The emphasis of this series remains buying and holding stocks that will preserve an investor capital while throwing off a decent dividend income stream. Parts 5 through 8 are for those investors who would like (or need) to earn more than 3.8% from their portfolio. The objective of selling call options is to increase that income to a range between 8% and 10% per year.

This article will simply concentrate on the four companies first recommended in Part 2. Those four companies are American Water Works Company (AWK), McDonald's (NYSE:MCD), Verizon (NYSE:VZ) and PepsiCo (NYSE:PEP). If you haven't read Part 2 of the series, what you will find there is my reasoning behind why I want to own each of these stocks.

Part 5 covered guidance for selling calls on the four companies introduced in Part 1. Those four companies are Procter & Gamble (NYSE:PG), Johnson & Johnson (NYSE:JNJ), Wal-Mart Stores (NYSE:WMT) and El Paso Pipeline Partners (EPB). There was only one recommended call option to be sold in the prior article, due to the low premiums available at the time of the article. I intend to provide updates, probably in the comment section of each article, if there are call options with premiums that meet my requirement available on a particular day.

American Water Works (NYSE:AWK) continues its steady climb with an occasional pullback here and there, as is normal for any industry leader. The current option contract for March expiration (March 16, 2012) with a strike price of $35 is currently trading at a premium of $0.30 (bid) and $0.40 (ask). If we assume that we could sell a call at the bid price of $0.30 per share we would collect a premium of $30 for one month (all quotes in this article were taken between approximately 2:19 p.m. and 2:45 p.m. EST on Thursday, February 16, 2012). After a commission of $9, we would net $21. This equates to a return of 0.62% in one month or 7.4% on an annualized basis.

Since I believe we are in the midst of the market taking a breather and AWK is trending lower in the short term, I feel that this is a good risk. After all, for the buyer of the call option to make a profit, they would need the price to exceed $35.20, a 5% increase from today's price in just one month. A good move for this stock in a month's time is usually less than 3%. My recommendation is to sell the March call option with a strike price of $35 at a premium of $0.30, or higher if you can get it.

McDonald's (MCD) seems to have stalled over the last month and a half or so, after a sustained, year-long rally from its 52-week low of $72.89. The stock is currently trading at $99.40 and seems to be having difficulty staying above $100. This stock also climbs regularly, but the recent rally seems overdone and the stock price at nearly 19 times trailing earnings is due for a good pause. The March $100 strike call option with a premium of $1.06 and $1.08 (ask). Assuming that we can sell the call for the bid premium of $1.06, we would collect $106 per contract. After assuming a commission of $9 for the first contract, we net $97 for a return of 0.98% in just one month or 11.7% annualized.

This one doesn't have much room for error built into it, though. I think I'd wait on this one until I could sell a call that would require at least a 3% rise in the month to make it profitable for the buyer. My recommendation on MCD is to hold tight for now and collect the dividend. I do think we'll get an opportunity to sell a call option on this one over the next week or two, though, so stay tuned.

Verizon Communications (VZ) has remained range-bound for most of the last year, with the price fluctuating between $35 and $40 for most of the year, with a drop down to its $32.28 low in August 2011. The current price is $38.11 and the trailing 12-month P/E is 44. The current premiums are not very enticing, and I would like to see the stock over $39 when I sell a call so that we are closer to the top of the range. My recommendation is to hold VZ stock and collect that nice 5.3% dividend until we get a better opportunity.

PepsiCo (PEP) has already fallen from its recent short-term high of $67.19 of January 3, 2012 down to its current price of $63.01. That represents a drop of 6.2% already. I'd like to see the price back up above $66 again before I sell a call on PEP. The guidance provided by the company for 2012 seemed cautiously optimistic, but included 8,700 layoffs. Even though the company beat earnings estimates for the 4th quarter, the guidance caused the stock to fall off. I wish I'd been prepared to make a recommendation just before the earnings announcement; it would have been different. As it stands, though, my recommendation is to hold tight and collect the dividend on this dominant food company.

In summary, I am making only one recommended call option sale on AWK. In retrospect, I may have decided to write these articles a week or two later than I should have, since the market seems to be trending lower and may not provide the opportunities to sell calls that I had hoped. We'll just have to see what tomorrow brings, as the volatility seems to be rising and things could change quickly.

>> Click to view Part 7

Disclosure: I am long PEP, MCD.