As the market continues to trend higher traditional defensive plays are always overlooked because they are considered to be too boring due to their low volatility. Coincidentally these types of companies usually pay respectable dividends and have excellent financials. My favorite company in this category is Procter & Gamble (PG). I know this name gets a lot of criticism for being boring and unexciting, but to be honest if watching paint dry makes me consistent money, then I guess I enjoy watching paint dry.
Procter & Gamble this past quarter posted revenue of $22.14 Billion, which was an increase of about 3.7% from the same quarter the year prior. P&G currently has $4.4 Billion in cash on hand and has a book value of about $23.34/share; this puts the price/book value at around 2.90. P&G posted EPS of $3.40/share, which gives the company a P/E ratio of 19.85. Last but certainly not least, P&G has a dividend that is currently yielding around 3.07%, which is above the S&P 500 average yield of 2%. P&G is also one the few companies that has consistently increased the dividend payout year over year for the past 55 years.
The chart below compares P&G to four of its main competitors from a products standpoint as well as from a comparable investment grade perspective. After comparing P&G to peers it is easy to see that P&G at its current price is in the middle of the pack compared with its peers.
Procter & Gamble
Kimberly Clark (KMB)
There is no denying that I like P&G, but I would like P&G whole lot more at an even cheaper price. For the past two years P&G has continued to trade in a very defined price range. The stock has traded between $60 - $70 per share regardless of market activity for almost the past 24 months. Even during the S&P credit downgrade last summer the stock still traded in this range and only broke the bottom end of it for a very short period of time. Compared with the broader market the stock performed very well during the period.
This type of sideways action provides an excellent opportunity for a naked or cash secured put seller. The current market price of $67.50/share is approaching the top of the current range, which would suggest that the stock should begin to start retracing back toward $60/share. If that is our assumption now would be a great time to find some put options that look attractive from a seller's perspective.
Selling naked or cash secured puts on a stock like this is an attractive investment because it gives the trader the ability to go out and pick an entry price via the options strike price, not to mention that as the seller you are paid to wait for the stock to come down to your predefined price point. My general rule when selling put options in these types of situations is that I want to try to find a strike price that is close to what I believe is the stock's current price support level. My second rule is that I try to only sell puts that are somewhere between 100 - 200 days out into the future and generate a total return of 3% - 5% on what my total investment would be if I were put to the stock at or before expiration.
The trade that I currently like that fits within my parameters is the OCT 2012 $62.50 put option. The current price of the option at the $62.50 strike is around $1.80/share ($180/contract), which would generate a total return of 2.88% on the total investment amount. As a side note it is important to remember that depending on the type of account that you are trading with your margin requirement will be different, thus affecting your account's return on capital. That is why I always just assume that I will be put to the stock when calculating my ROI, I find it to be a more conservative approach, even though my actual return on capital invested (margin requirement) is usually much higher.
Since this stock is approaching the top end of its range and with the market continuing to move up P&G should continue to sell off based on the assumption that the stock is indeed range bound and the overall market is trading in the shares of P&G for something more exciting. With these two factors being the case the market should continue to put downward pressure on the stock, which in turn should push the OCT $62.50 option's premium up. If the OCT $62.50 contract gets to a price of $2.00/share ($200/contract) I would be a seller of this contract. This would generate a 3.20% return on the total capital needed to buy the stock. This ROI is calculated by simply dividing $2.00 (premium received) by the strike price $62.50 (potential purchase price).
Selling the P&G OCT put at the $62.50 strike for $2.00/share would put the trader's actual breakeven point at $60.50/share. At that price the multiples that I mentioned above become much more attractive. The P/E ratio would decrease to 17.79 below the average for P&G's peer group and this new entry point would also increase the dividend payout to 3.43% from the current 3.07%.
Executing this trade gives the trader really two outcomes that I believe are equally beneficial.
- The stock continues to go up with the broader market and hits its resistance level of $70/share. In this situation your put options that were sold expire worthless and the trader keeps the $2.00/share premium that was received. This will generate a 3.20% return on the total investment cost or $200 for every option contract that was sold at the $62.50 strike. Compared to buying the stock outright at its current levels ($67.50 at the time of this article) the overall gain from $67.50 to $70 is a 3.7% return on investment. The option strategy does not generate the same return, but allows for a very comparable return for far less risk.
- If the stock pulls back from its current levels and goes back to $62.50 or even $60 per share (low end of the range) your put option is exercised and the trader is obligated to buy the stock at the $62.50 level. The trader is still able to keep the original $2.00 premium that was collected for doing the trade, which will help offset the overall purchase price and decrease the breakeven point. At this level the trader is able to reap a 3.43% dividend rate and has the ability to buy this excellent stock at the bottom end of its 24-month range.
Both of these situations generate positive results and make sense for someone who wants to initiate a position in P&G. In my opinion compared with its peer group P&G provides the greatest return on capital and is the best overall value if bought correctly.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in PG over the next 72 hours.