Owning Disney With A 4.6% Yield

| About: The Walt (DIS)


Disney has had an exceptional investment past.

For the income investor, shares have been more difficult to own due to the low comparative dividend yield.

This article demonstrates a way to both own shares and generate a much higher yield.

Over the past decade or so, shares of Disney (NYSE:DIS) have performed exceptionally well. The topline growth was reasonable - coming in at just under 5% per annum - but the true drivers of shareholder return were the other components. You had margin improvement and share buybacks to go along with a much higher valuation multiple. This allowed 5% revenue growth to turn into nearly 18% share price appreciation. And moving forward the expectations for growth are very much intact.

Yet there are a couple of "hiccups" involved that could give specific investors pause. For one, an exceptional investment history does not also indicate an exceptional investment future. In fact, depending upon how the past was formulated, the successful investment past could actually inhibit future returns. In the case of Disney, as compared to a decade ago, you now have a much higher profit margin, a slightly higher payout ratio and higher valuation. These things propel investor returns for past holders, but can stunt future gains. A higher margin means growing from a now improved base, and a higher valuation makes future P/E expansion less and less likely.

Of course a counter argument to the now higher "investment bar" for Disney relates to price. After reaching $120 in mid-2015, today shares are exchanging hands closer to $97. This still means that shares are trading slightly above the company's recent historical average multiple, but it nonetheless indicates that shareholders have a better opportunity at catching business performance moving forward.

A secondary consideration that often comes up for a good deal of investors, especially those focused on income, relates to the dividend yield. Disney is an especially good example of this, as the dividend history hasn't exactly been inviting for those looking for a reasonable cash flow. For a long time the dividend was paid annually and had been frozen on several occasions. Only recently did the company switch to a semi-annual payment. And to be sure, the "current" yield only works out to 1.5% or so based on today's price.

In viewing this, a good deal of investors missed out on a perfectly good investment opportunity due to a below average dividend yield. Yet this doesn't have to be the case. You're not forced to chose between owning the stock with a low cash flow yield or not owning it at all. You have tools in your investing toolbox, like selling covered calls as an example. Let's explore a possibility to get a better feel for what I mean.

As of this writing, the January 20th 2017 call option with a $115 strike price has a bid of about $3.15, call it $3 to account for transaction fees and fluctuations. This means that you would receive ~$300 upfront for agreeing to sell 100 shares of Disney at a price of $115 within the next year. Note that unlike dividend income, this premium could be taxed at ordinary rates.

Now one of two things happen if you decide to make this agreement: either the option is exercised or it is not. Let's think about the first alternative. If the option is not exercised, you still receive the ~$300 upfront and you still hold shares of Disney, just as you had planned to do all along. You would likely go on to collect ~$142+ in dividend payments, for a total cash flow of ~$442+. Based on an initial $9,700 investment this equates to a yield of just under 4.6%.

A lot of people like to point out that selling a covered call does not prevent you from losing money, which is true. Yet I would contend that this is largely a short-term, or traders mindset. In this particular scenario I'm only referring to shares you'd be happy to own regardless. So regardless if the share price increases 15% or decreases 15%, you planned on owning anyway. In this scenario, if the option is not exercised, selling the covered call will always result in a higher return.

The second scenario is where a more tangible risk comes into play. If you option is exercised, you're forced to sell at a price of $115 - regardless if the going rate is $116 or $130. The risk here is that you could be forced to sell below the future market value. That is, in receiving the upfront premium you're also agreeing to "cap" your return during that time period. If you planned to hold regardless, this is a much larger risk.

Yet this too, in my view, can be mitigated. No one is forcing you to sell a covered call, and especially not forcing you to sell at a given strike price. That is, you have the ability to select what, when and if at all you'd like to make that agreement. As such, it logically stands that you'd only want to make an agreement in which you're happy with either outcome. In this case, if the option is exercised, you'd be forced to sell at $115.

So you'd collect the ~$300 upfront premium, receive $11,500 for your shares and could also collect some dividend payments along the way. Your total return would be in the 21% to 23% range. Sure, someone simply owning the shares could have a return of 30% or 40%, but a 20%+ annual gain still provides a great foundation for building wealth. The key is being happy with the agreement, as someone will always be getting richer faster.

In short, many investors are turned away from solid businesses due to a low or non-existent dividend yield. Disney is certainly no exception, with a yield of "just" 1.5%. Yet that doesn't mean that income investors cannot own the security. By selling a covered call you could both own shares and dramatically increase your cash flow. In this particular case, you could agree to sell at $115 which in turn could provide either a 4.6% yield or 20%+ annual gain. Naturally you want to be happy with either outcome, but both scenarios could appear reasonably attractive.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.