As interest rates have remained low, in many cases actually negative, a common theme has emerged amongst investors. The idea has been to use dividend paying companies to supplement income that was once provided by bonds. This has been a very profitable trade as high dividend, interest rate sensitive sectors like utilities, telecoms, and REITs have been the darlings of the market over the last few years. It is very difficult to argue the rationality because these companies are attractive for several reasons:
· They are less economically sensitive
· Have lower volatility in earnings and cash flows
· Cash flows are consistent and more predictable
· Have long histories of increasing dividends
Every hot investment theme, even when it is sound and logical, eventually runs its course and gets too far ahead of itself. While not every investment has the same arc from boom to bust, there are similarities between what causes these themes to get extended and it is important to know when it is time to change strategies and stop riding the gravy train.
Before we get into the alternative strategy to dividend investing, it is important to understand how investment themes in general get overextended. The basic premise around this is that market forces create an opportunity based on investment needs and recent experiences. That opportunity is exploited by smart money and first movers. As the returns start to pile up and other investors come in, the story around the theme begins to take shape. This in turn drives more people into the investment.
However, even though there is a strong fundamental case for this theme, in the early-to-mid stages, there are still a lot of detractors that do not believe it can continue or that the majority of the "easy" gains have been made. Eventually, the investment theme continues to generate strong returns as each one of the negative arguments has been overcome and the last detractors give up and accept the theme. This usually ends in a final strong rally where the theme drastically outperforms other assets marking the top of the cycle. After the top is reached, the theme enters a time period, sometimes lengthy, of underperformance.
Let's take a look at a few investment themes that have followed this course in the recent past. Housing in the early 2000s driven by the need for stability after the tech bubble burst and fueled by easy credit. Oil in the early to mid-2010s driven by supply/demand imbalances and fueled by speculation. Gold in 2010 and 2011 driven by safety and fueled by geopolitical concerns and a repeat of the financial crisis in Europe (can anyone ever forget all of the cash for gold commercials).
While each one of these has differing degrees of over-hype and also differing degrees on the contagion effect it has on other asset classes, the prevailing idea is similar. So where does that put us today? Low interest rates have been around for almost a decade and every single year most analysts predicted that they would move higher. However, yields continued to move lower and even turned negative in a large part of the world, confounding detractors and generating strong returns. Now, the narrative has changed to "lower for longer" with many fundamental and logical reasons for why they will stay this way including global deflation, geo-political risks, slow global growth, etc.
The beneficiary of these low rates and the trendy investment theme has been investing in high dividend companies. The argument for this is very logical and understandable while investors would invest this way. Why invest in a 10-year Treasury at less than 2% and never get an increase in income when you could buy a dividend paying company and get a higher current income with the potential to increase payouts and have capital appreciation?
So why do we think we may finally be getting to the end of the high dividend stock rally? If you look at what happened in the beginning part of this year, traditional dividend payers outperformed dramatically. As you can see by the following chart through the end of June, utilities and REITs were some of the best performers. Additionally, at the very end of this chart, after "Brexit," you get this sharp move higher as the idea of "lower for longer" gains mass acceptance and global bond yields plummeted. Additionally, this sharp move higher was driven mainly by multiple expansion rather than increased earnings. Why is this important? Because the argument for why these high multiples were justified was because of low interest rates, or in other words, "This time it's different."
Interestingly, in the chart below, if you take a look at what has happened since, even though the market as a whole has done well, these same income sectors have begun to underperform.
Now we have had quite a few false positives in the past where interest rates began to move higher only to turn back lower (think about the "taper tantrum" of 2013). Additionally, this recent underperformance could just be mean reversion after the massive early year rally. While time will tell which is correct, it is still important to pursue other strategies to reduce risk and create true portfolio diversification.
So what is an investor to do if they require income and they want to limit exposure to bonds and high dividend paying stocks in case rates have bottomed and the relative outperformance has peaked?
An alternative strategy is to employ covered calls (also known as buy-write) on your portfolio. The idea is to own individual companies that pay income but are not as exposed to rising interest rates as some of the traditional high dividend sectors, and then sell covered calls against these companies. Here are the reasons it makes sense in the current environment:
· You can own companies with lower yields, but higher growth
· Higher volatility means higher option premium (your income)
· Not as exposed to higher interest rates
· Even if rates stay low, you can still participate in appreciation
The best way to illustrate how this works is through an example. We own United Healthcare (NYSE:UNH) in our portfolio and it just reported earnings on 10/18/2016 and was up 6.96% the day of the report. The stock pays a dividend yield of about 1.74% based on the 10/18 price while the S&P 500 pays about 2%. Additionally, UNH has grown its dividend by over 30% each year for the past 5 years. Here is an example of what the strategy would look like based on closing market pricing on 10/18/2016.
Annual Equivalent Yield
Return to Strike
As you can see, the current premium is about .43% and the option expires in one month. While .43% does not seem like that much return, on an annualized basis, it would be a much more attractive 5.3%. If you add in the 1.74% dividend you receive on the company, you now have taken a dividend growth company and transformed it into a stock that could potentially yield over 7%. Now, the 5.3% annual option income assumes that you can continue to get the same premium every month and that you are skilled enough to sell call options that expire worthless every time.
So what are the potential risks? The potential downside is that the stock price jumps significantly above $150 by expiration and you are forced to sell your shares at $150. In this instance, you would miss out on all of the upside of the stock above $150.61 (the stock price + option premium). I would characterize this scenario as an opportunity cost, rather than a true risk, since you will still be making additional profit from the 10/18 closing price. Another risk would be that if the stock price drops significantly, the option does little to protect to the downside, but you would still end up slightly better (by the 61 cent premium) than if you just held the stock outright.
In summary, while covered call writing does pose risks and is a bit more complicated than simply owning a stock, it does provide the potential to increase income from your stock holdings. If done correctly, you can turn a low-yielding stock into an income generator that rivals the income of other high dividend paying stocks. At a time when income investing could be in the final stretch of its outperformance, this may be a good strategy to consider for your portfolio.
Disclosure: I am/we are long UNH.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.