The Dividend Stock Catch-22

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Includes: GIS, MCD, VZ
by: Parsimony Investment Research

Summary

Investors should remain calm through all this volatility and focus on finding great stocks at good prices.

There is no need to chase stocks higher and put your capital at significant risk.

A cash-secured put strategy (selling puts) will help you generate income on your favorite stocks with a built-in margin of safety.

I really like this dividend stock...but not at this price!

Have you ever said that to yourself while researching stocks for your portfolio?

It happens to the best of us.

Why?

Because we all want to buy stocks at a good price...it's investing 101.

Benjamin Graham popularized the term "margin of safety" in the 1950's and it basically means that you should only try to buy stocks that are currently trading below their intrinsic value (hence providing you with minimal downside risk if you are correct in your value). In other words, it gives you a little cushion when investing.

The problem is...it's not always possible (especially with dividend investing). Because high-quality dividend growth stocks tend to trade at a premium...but chasing stocks these higher all but eliminates any margin of safety and tends to add downside risk to your capital base. However, if you want to collect the dividend of a high quality growth stock, you have to own the stock! It's the ultimate catch-22...

Catch-22 Dividend Stocks

Just doing a quick scan of our dividend universe for stocks with high Dividend ratings and high Safety ratings reveals a significant list of high-quality candidates.

That said, it's easy to build your "wish list" of stocks that you want to own.

The hard part is finding a list of stocks that you want to own at the current price!

Why chase a 3% annual dividend yield by buying an overvalued stock that could have 10% downside? Clearly, not a good risk/reward trade-off.

Here are few examples of Catch-22 Dividend Stocks that shouldn't be anywhere near your "buy" list right now (even though they are probably on your "wish" list!). All these stocks have had impressive rallies recently and currently trade at significant premiums to their long-term historical valuation metrics (which has caused their current dividend yield to drop well below their respective 5-year avg. yields - despite some nice dividend hikes along the way).

  • General Mills Inc. (NYSE:GIS) - General Mills is up 30% over the past 12 months, which has caused its dividend yield to drop to 2.5% (an 18% discount to its 5-year avg. yield of 3.1%).
  • McDonald's Corp. (NYSE:MCD) - McDonald's is up 30% over the past 12 months, which has caused its dividend yield to drop to 2.9% (a 10% discount to its 5-year avg. yield of 3.3%).
  • Verizon Communications (NYSE:VZ) - Verizon is up 24% over the past 12 months, which has caused its dividend yield to drop to 4.1% (a 14% discount to its 5-year avg. yield of 4.7%).

In other words, if you bought these high-quality stocks today, you would be getting below average dividend yields with higher probability of capital loss (i.e., no margin of safety).

The Cure for the Catch-22

We think that selling cash-secured puts on these high-quality dividend stocks is a nice cure for these Catch-22 stocks. It allows investors to generate income while mitigating downside price risk. Cash-secured puts essentially act as a limit order for dividend stocks you want to add to your portfolio (but you get paid to put the order in!).

If you sell a put, you have an obligation to purchase the stock at a predetermined price (strike price) on or before the expiration date (if the buyer of the put option wants to sell you the stock). Clearly, the risk is that the stock drops significantly below the strike and you are forced to buy the stock at a price well above market.

Here are our two risk management rules of put selling:

  1. Only sell put options on stocks that you want to own at the price you want to own them - With a put selling income strategy (focused on out-of-the-money puts), you get paid to wait for the price you want on a stock. If the price never drops to your strike, you get to keep the premium (income) as a consolation prize. Your downside is owning the stock at the strike price (keep that in mind as you analyze the ideas below).
  2. Don't sell "naked" - Just because options offer you leverage, it doesn't mean that you have to use the leverage. We recommend securing your short put position with cash (i.e., don't sell on margin). If you aren't willing to risk the cash to back it up ... don't sell the put!

The two main things to focus on when considering a cash-secured put opportunity are Premium Yield and Margin of Safety.

  • Premium Yield (%) - The premium yield is the expected return on capital assuming that the option expires worthless (out-of-the-money).

Premium Yield % = option premium / (strike price - premium)

  • Margin of Safety (%) - Margin of safety is the percentage that the underlying stock could decline that would still allow you to break-even on the option trade.

Margin of Safety % = (stock price - break-even price) / current stock price

Note that there is always a negative correlation between Premium Yield and Margin of Safety: The higher the Premium Yield for a given strike month, the lower the Margin of Safety.

Cash-Secured Put Examples

Let's look at some specific examples using the Catch-22 stocks mentioned above. Remember you only want to write a put on stocks that you would like to own (at the right price, of course).

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Our "Buy Zone" for General Mills is currently $60.00-$66.00 As such, we recommend selling the Oct16 $67.50 put, which equates to a $66.16 break-even price (i.e., net purchase price if exercised) and a premium yield of 2.0%! This trade has a margin of safety of 8.1% and you can collect income equivalent to ~80% of GIS's 2.5% annual dividend yield in ~3 months!

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Our "Buy Zone" for McDonald's is currently $106.00-$116.00 As such, we recommend selling the Sept16 $115.00 put, which equates to a $113.18 break-even price (i.e., net purchase price if exercised) and a premium yield of 1.6%! This trade has a margin of safety of 6.4% and you can collect income equivalent to ~55% of MCD's 2.9% annual dividend yield in ~2 months!

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Our "Buy Zone" for Verizon is currently $47.00-$51.00. As such, we recommend selling the Oct16 $52.50 put, which equates to a $51.38 break-even price (i.e., net purchase price if exercised) and a premium yield of 2.2%! This trade has a margin of safety of 7.2% and you can collect income equivalent to ~53% of VZ's 4.1% dividend yield in ~3 months!

CONCLUSION

A cash-secured put strategy is a great cure for the dividend stock Catch-22. As you can see from the examples above, with this strategy you can generate more income (vs. holding the stock and collecting the dividend) with a nice built-in margin of safety (i.e., more income with less risk).

If you are not familiar with options yet, do not get discouraged by this article. The cash-secured put strategy is actually very simple and easy to implement once you learn the basics (which are fully covered in our new course).

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Parsimony Advisors, LLC makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Parsimony Advisors, LLC will be met.

Disclosure: I am/we are long GIS.

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.