Many dividend investors demand insurance against dividend stock capital losses. An investor wants to minimize their income portfolio from catastrophic losses. Unfortunately the stock market has many unforeseen risks which can happen without warning. In this article I'll discuss a few ways I hedge, or insure, my dividend stocks to minimize capital losses while still receiving dividend income. Investing is like any other activity, one has to keep changing to new facts and new risks. If an investor does not watch their holdings, a 1929 market collapse can cause collateral damage to one's stock portfolio. Learning new hedging ideas is crucial as investors need income to pay for their living expenses. As my good friend Mr. Zimmerman said, "...he not busy being born is busy dying...". Learn how to insure a significant percentage of your stock portfolio and capital losses can be minimized in any scenario.
1. Insuring A Dividend Stock
AT&T (T) is a common stock held in many income portfolios. The stock hasn't matched the S&P 500 return over the past 10 years. The stock's dividend is increasing, on average, by 2% per year. AT&T has not provided much growth despite the economy's new smart phones, tablets, and gadgets. If an investor owns 1,000 shares of AT&T, he may be comfortable with a 10% loss. He is not willing to lose more than 10%, but wants the dividend income for living expenses.
A 10% loss would place AT&T at $27 per share. Purchasing a put option is a form of insurance against capital loss through a specific date, and effective at a specific strike price. AT&T's 4th quarter revenues grew at only a 3.64% year over year. It is likely the stock could fall if a new technology emerges to replace phones. AT&T needs an increase in revenues to support a higher dividend payout.
The investor can buy a put option to limit the total loss on his 1,000 shares. A put option represents the right to sell 100 shares, at a specific strike price, through a specific time frame. In this case, the investor could buy 10 put contracts, T Oct 2012 27.000 put (T121020P00027000). This purchase would cost $560 as of April 12th. The investor would own 1,000 shares of AT&T and 10 put contracts with a strike price of $27 per share. The expiration date is October 19th. The investor's shares are protected against capital loss below $27 per share.
2. Inverse Funds
Many investors own a diverse portfolio of income stocks. Southern Company (SO) is one of the largest utility companies in the U.S. The company provides electricity via four core south eastern units: Alabama Power, Georgia Power, Gulf Power, and Mississippi Power. Southern serves about 4.5 million retail customers. The dividend yield is 4.3% per year.
Inverse funds can protect aggregate stock portfolios during short term market declines. ProShares Short S&P500 (SH) is an example of an inverse fund. The fund's goal is to obtain 100% the opposite return of the SP500 for a given day.
Inverse funds, however, can only be used as a few days. This is due to the derivatives owned within the inverse fund. The ProShares Short S&P500 prospectus provides the following warning:
This means Southern shareholders could buy an inverse fund for a temporary hedging strategy, but this will not be effective for the long term.
3. Active Short Funds
I own many dividend stocks which will go down in the case of a worldwide market collapse. Investors have learned that 2008 can provide a financially embarrassing 37% loss. Inverse funds do not work for long term periods.
Enterprise Products Partners LP (EPD) is a prominent midstream partnership. The company has a toll booth business model as the company charges fees for midstream energy services such as storage and transport of natural gas, natural gas liquids (NGLS), crude oil, refined products, and petrochemicals. In the case of a market downturn, an actively managed short fund can provide gains when the stock market is experiencing a downturn.
Active Bear ETF (HDGE) can serve as hedge against a market that goes down. The exchange traded fund would, ideally, go up as the portfolio's long positions are going down in value. In essence, ideally Active Bear ETF would provide an offsetting gain as Enterprise Products Partners and other portfolio holdings are going down. The Active Bear ETF shorts stocks that the fund managers believe are over priced or likely to go down.
4. Stop Limit Orders
Shareholders in Annaly Capital Management, Inc. (NLY) want to insure their high yielding security against capital losses. Limit orders are always a choice. My favorite choice is a stop limit order. This combines the features of both a stop order and a limit order. This would allow an investor to ensure the sale of Annaly shares at a specified price.
Annaly is a mortgage real estate investment trust. Annaly has grown organically, with subsidiaries such as Shannon and Charlesfort, and through acquisitions such as Merganser and FIDAC. Annaly's charter mandates that at least 75% of its assets have either top investment grade ratings, U.S. government or agency guarantees, or, if unrated, are comparable to top rated investment grade assets. The remaining 25% of its holdings should at least have a BBB rating or higher (lowest investment grade per S&P500) and Annaly may invest part of this 25% into equities, derivatives or other securities which are consistent with its REIT qualifications.
Annaly basically uses leverage to fund its earnings and strives to maintain its debt to equity ratio between 8:1 and 12:1. Its debt to equity ratio was 5.4:1 on December 31, 2011. Annaly raises capital through debt and equity markets and in 2010, raised $600 million from a 4% convertible senior note issue and used the proceeds to fund investments. Annaly and its subsidiaries also enter into interest-rate hedging transactions as insurance against market declines.
Annaly strives to make sure that it is hedged against interest rate changes and prepayments risks and balances its portfolio to reduce volatility of investment returns. At the end of the day, the quality of Annaly's credit ratings and balance sheet significantly impact its ability to cost effectively tap into debt and equity markets so it works to make sure that its financial structure lets it stay ahead of the competition.
- For its fiscal year ended December 31, 2011, Annaly earned $3.56 billion as interest income from investments, $14.7 million from U.S. Treasuries and $6.9 million from other investments for a total interest income of $3.58 billion. It paid $480.3 million as interest on borrowings such as repurchase agreements, 4% convertible senior notes issued by the company and from other borrowings. As a result, the REIT earned net interest income of $3.1 billion for the year which was 37.4% higher than 2010 and 569% higher than 2007, underscoring the company's asset growth over the past five years.
- In 2011, Annaly had $882.4 million in realized losses from interest rate swaps and $1.8 billion in unrealized losses from the same. After factoring in other income items such as dividends from its subsidiaries and from the sale of securities, and after subtracting expenses and taxes, Annaly had net income of $327.6 million, significantly less than the $1.2 billion it earned in 2010 and even less than the $392.9 million earned in 2007. So while interest income increased significantly over the past five years, losses on interest rate swaps brought earnings down. As a result earnings per share fell to 37 cents from $2.04 in 2010. For the year, it generated $2.4 billion in cash from operations, down substantially from $10.9 million in 2010.
- Annaly ended the year with $109.6 billion in total assets, up from $83 billion in 2010. It had cash of $994.2 million, liabilities of $93.8 billion, mostly from repurchase agreements, and stockholders' equity of $15.8 billion, up from $9.8 billion in 2010.
- Since its inception, Annaly has paid out over $7 billion in dividends. Despite reduced earnings in 2010, Annaly paid $2.44 in dividends per common share. Annaly has regularly raised dividends from $1.04 in 2007 to $2.65 in 2010 until performance caused it to scale back dividends in 2011. As a REIT, Annaly is required to pay out a substantial portion of its earnings as dividends.
- Over the past six years, Annaly shares have cumulatively outperformed the S&P 500 Index by 92% and the benchmark BBG REIT index by 254%. As of April 12th, Annaly shares traded at $15.79 giving it a market capitalization of $15.4 billion (slightly below book value of $15.8 billion), a price to earnings ratio of 42.8x primarily due to low earnings per share in 2011 and a dividend yield of 14.1%. Shares traded within a one year range of $14.05 and $18.79 and are now closer to the bottom of their range and perhaps present a compelling capital appreciation and dividend opportunity.
5. Collar Options
Philip Morris International, Inc. (PM) is my favorite 2012 dividend stock. Philip Morris manufactures and sells cigarettes and other tobacco products. The company has a 28.1% international market share, excluding China and the U.S. Its portfolio includes Marlboro, Merit, Parliament, and Virginia Slims.
Philip Morris shares can be protected by implementing a collar option strategy. A collar option strategy utilizes a protective put and a covered call. Investors can sell a covered call to derive a credit income to pay for the cost of the protective put. A collar option strategy is popular because the strategy reduces the cost of purchasing insurance on the position. The negative aspect is the short covered call puts a limit on the upside price movement of the common stock.
I recommend hedging your portfolio against market declines. Just as an auto owner must buy auto insurance before a car accident, a stock owner must insure his portfolio before a market meltdown.
Disclosure: I am long EPD, PM.