Doubling Your Dividend Aristocrat Yield

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Includes: ABT, ADM, ADP, AFL, APD, BDX, BF.B, CAH, CINF, CVX, JNJ, KO, MMM, T, XOM
by: Eli Inkrot

Summary

The Dividend Aristocrats are companies that have not only paid but also increased their dividends for 25+ years.

Many investors own these securities and collect a reasonable yield.

This series will illustrate how you can double that cash flow.

For income investors, there are literally thousands of available securities from which you could choose. To narrow down the possibilities, often we'll look at companies that have not only paid but also increased their dividend payments for many years. Here at Seeking Alpha, we know that the place to go for such a list is David Fish's catalog of Dividend Champions, Contenders, and Challengers - focusing on companies that have increased their yearly payment for at least 5, 10 or 25 years.

Yet even in this instance, there are still hundreds of securities. To whittle down the list a bit further, you could focus on just the "Dividend Aristocrats." This brings the total number of securities down to 50 or thereabouts.

When thinking about increasing income through the years, a good portion of these companies usually makes the cut. Investors flock to the stable and ultimately increasing dividend income that these sorts of securities can provide. It's your typical list of Coca-Cola (NYSE:KO) and Johnson & Johnson (NYSE:JNJ) type companies.

With these companies, you generally start with a 2%, 3% or 4% dividend yield. And that's where a lot of investors stop. You buy, you hold and it can work quite well for many years to come. Yet I would like to highlight some additional possibilities. I am not necessarily advocating this route, but I find it prudent to explore all types of options (in this case literally) that are available to you.

This four-part series will focus on how you could double the cash flow you receive from owning Dividend Aristocrat companies. That means instead of collecting 3% from Coca-Cola, we're looking at 6%. Instead of 4% with Exxon Mobil, (NYSE:XOM) we're thinking about collecting 8%; that sort of thing. Naturally you might not prefer this route, but at the very least, I'd like to present it as a possibility.

For this series, I'm focusing on owning a security and selling a covered call - that is, agreeing to sell your shares in the future for an upfront premium. This will be part one covering the first 12 Dividend Aristocrats listed alphabetically. Let's get to it and then I'll explain it as we go:

Company

2/1 Price

Annual Dividend

Strike

"Net" Prem

3M (NYSE:MMM)

$148.74

$4.10

$160

$4.90

Abbott Labs (NYSE:ABT)

$37.28

$1.04

$42

$0.93

ADP (NASDAQ:ADP)*

$81.96

$2.12

$87.50

$2.10

Aflac (NYSE:AFL)

$57.00

$1.64

$62.50

$1.23

Air Products (NYSE:APD)

$125.88

$3.24

$145

$3.95

Archer Daniels (NYSE:ADM)

$34.53

$1.12

$40

$1.21

AT&T (NYSE:T)

$36.15

$1.92

$35

$1.93

Becton, Dickinson (NYSE:BDX)*

$143.31

$2.64

$160

$2.65

Brown-Forman (NYSE:BF.B)*

$97.50

$1.40

$100

$2.35

Cardinal Health (NYSE:CAH)*

$79.75

$1.55

$87.50

$1.55

Chevron (NYSE:CVX)

$84.63

$4.28

$92.50

$4.75

Cincinnati Fin (NASDAQ:CINF)*

$57.27

$1.84

$60

$1.90

Click to enlarge

The first column shows the company, all of which have not only paid but also increased their respective dividend payments for at least 25 years, often much longer. The second column shows the share price at the time of writing and the third column illustrates the annual dividend yield based on the current quarterly payment. That's our baseline. You could buy shares near the "2/1 Price" and expect to receive the annual dividend (or more) in the coming year.

In order to double that yield, you're looking for an option premium that would also pay you that amount. Note that this doesn't work out perfectly, so I have selected premiums that are close to the annual dividend yield. In each instance, I first looked for the January 2017 call option. (I have no affinity for this date, but it makes annual comparisons rather straightforward.) However, this expiration date is not always available.

In the cases where the strike price and premium represented do not indicate the January 2017 expiration date, I have denoted this with an asterisk. The five asterisked companies have option expiration dates between July and September of this year. This actually makes a more cautious case in these instances.

The "strike" column tells you at what price you would be agreeing to sell your shares. The "'net' premium" column represents the most recent bid for that strike price as of this writing, less $0.25 for transaction expenses and fluctuations.

Keep in mind that options trade in "round lots" of 100 shares and that option premiums can be taxed at different rates that qualified dividends. I'll spell out an example from above to make the table clear.

Let's say you owned 100 shares of 3M, which would presently have a market value of around $14,900. You could hold your shares and collect the annual dividend (perhaps $410 or more) as many investors do. An alternative possibility would be to agree to sell your shares in the next year for $160. In exchange for making this agreement, you would receive ~$490. For someone looking for additional upfront cash flow, this sort of thing could be interesting. For someone who suspects the business might be much better in the future, you might not be interested in capping your expected gain.

Here's a table using the same information as above, but consolidating the pertinent information:

The second column - dividend yield - is probably what you are accustomed to seeing. The third column - premium yield - details the amount of cash flow that you could receive by selling the option listed above. The last column - max gain - details the top gain that you are agreeing to based on the strike price and premium received. Note that this number does not include dividend payments received along the way.

It's reasonable to suspect that you would receive dividend payments along the way, but it's more cautious to assume that you would just receive the option premium and sale price. To see what the true maximum gain would be if you did receive dividend payments along the way, you could add the dividend yield to your total gain.

This table gives you a bit of insight into what is presently available if you wanted to double your cash flow yield. You could receive the equivalent of an entire year worth of dividend payments upfront by agreeing to sell shares at a 2% to 19% gain. As you can see, the attractiveness of doing so varies significantly from security to security.

Let's look at the big picture to give you a better feel for the process. Not that you would construct a portfolio this way, but imagine you held 100 shares of each security listed above. Today's liquidity value - the price at which you could sell all of those stakes - would be about $98,400. If you held on to the shares you could expect to generate $2,700 (or more) in annual dividend income. This method of holding a collection of wonderful partnerships can work quite well.

Yet let's imagine that you want to generate more than $2,700 in cash flow - for living expenses, discretionary purchases, further reinvestment, you name it. If you wanted to double this cash flow, you could look at selling covered calls with premiums that basically match the annual dividend payments.

If you sold each call option listed above, you would receive ~$2,900 (less fees and potential taxes) for making these agreements. The total price at which you would be agreeing to sell would be $107,200.

Now a few things can happen: none of the options are exercised, some are exercised or all of them are exercised. Let's keep it simple and look at the extremes.

If the options are not exercised, you keep the shares just as you had planned on doing. In turn, you would receive the $2,700+ in dividend payments just as you would have anyway. The difference is that you also got to keep the ~$2,900 in upfront option premium. Tax considerations have to be made, but in this scenario, you effectively doubled your Dividend Aristocrat yield. If the options are not exercised, and you plan to hold anyway, this is clearly a preferable outcome.

If the options are exercised you would be forced to sell at $107,200 - regardless of how much higher the market value might be. You still collect the ~$2,900 upfront premium. In this case, you're agreeing to cap your total gain at about 11.9%. This is prior to thinking about collecting dividends.

If the options were exercised in a few months or at the end of the period, you would also receive dividend payments. In this case, your maximum gain would increase to about 14.7%. Something in-between could likely occur - some exercised, some not - but we're keeping it simple. So that's the basic agreement involved. If the options are not exercised, you could double your cash flow. If the options are exercised, you're agreeing to a gain of 12% to 15%.

A lot of people talk about the downside risk - selling covered calls do not prevent from loss. Yet I'd contend this is more of a short-term or "trader" concern. If you plan to hold the shares anyway, receiving more income is not a risk and indeed is more favorable. The real risk is to the upside. If shares appreciated by say 25%, you're "stuck" collecting a 12% to 15% gain. This is why it's paramount to be happy with either outcome.

The idea is not to provide a comprehensive review of the available options and strategies. Instead, with this series I wanted to point out a subset of what is available. If you hold a Dividend Aristocrat company, this series will illustrate how you can double your yield by agreeing to potentially sell your shares. In many cases, you could double your annual cash flow by agreeing to sell at a reasonably higher (10%+) price. That's not talked about very often, but nonetheless, can be another tool in your investing toolkit.

Disclosure: I am/we are long KO, CVX, XOM, T, JNJ.

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.