Stabile stock prices, nice dividends, and strong returns. That is what most dividend stocks have offered investors over the past three years. Just looking at some of the most popular dividend stocks, Altria (MO), Kraft (KFT), Philip Morris International (PM), AT&T (T) and Wal-Mart Stores (WMT), one can easily see that these stocks have performed well in addition to be less volatile than most sectors. While higher beta stocks like Apple (AAPL), Chipotle (CMG), and Priceline (PCLN), have been the market's best performers, the consumer staple sector has offered strong returns with much less volatility.
Unfortunately, while most investors would love to get double digit returns without worrying about various macro-economic risks here and abroad, the days of double digits returns in traditional consumer staple stocks is likely coming to an end. While companies like Altria and Walmart look reasonable valued at 11-12x fairly reasonable estimates of next year earnings, these stocks have had huge runs, and their future growth prospects remain fairly average. Also, since retail and institutional investors alike have invested significantly in this sector over the past several year, it is unlikely significant new capital allocation to this sector will occur in the near-term. A 5 year chart shows most dividend stocks are at or near their 2008 highs.
In this environment I think it is important to look at how you can benefit from owning these strong and fairly stable companies that still offer strong dividends. Even though volatilty levels are at the lower end of the range of their two to three year range, the vix is still higher than it has been historically over most longer periods of time. I think this sets up a nice opportunity for dividend investors to use covered calls to get some extra income.
The core reason I would recommend this strategy today is because I believe that most of the popular dividend stocks like Altria are at reasonably valued, but not overvalued. Also, if you look at the chart of stock like Altria, they tend to run-up into the ex-dividend date then fall back in the next couple weeks. If you were to sell an out of the money call $2 above the stock price the week before your stock goes ex-dividend, you can generate some nice income with little risk of being called away from your stock.
Here's how the strategy would work with Altria. Atria's next ex-dividend date is March 13, 2012. Therefore, in between today and March 12, I would sell the April 31 dollar call for 10 cents. Since the company's goes ex-dividend in March and this strike is about 4% out of the money, my thesis would be that the stock will not likely rise four percent in a month after going ex-dividend. While this sounds like only a little bit of extra money, this strategy would offer an investors an extra 40 cents a year per share to their $1.64 dividend, and would mean investors would be getting a likely total annual income of between 7-8% a year in income rather than 5-5.5%.
To conclude, while dividend investing is harder today than it has been in the past, I do believe that many of the strongest performing consumer staple stocks remain reasonably valued at 12-13x an average estimate of next year earnings. Also, despite positive economic news in the U.S., the economic outlook remains uncertain, and interest rates are likely to remain low for at least another year. In this environment I think finding ways to get extra returns without excessive risk can be done successfully.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
