Many dividend investors have stocks on their wish list of excellent, dividend-paying companies that always seem to be overvalued. In this case, an investor looking to purchase undervalued shares based on P/E ratio or yield is hardly ever able to initiate or add to his positions. Some recent examples of "perennially overvalued" stocks include such dividend stalwarts as Coca-Cola Company (KO), and McDonald's Corporation (MCD) (especially before the stock corrected by about 11% roughly 2 months ago).
While patience is one of the main virtues of a successful investor, it can be very frustrating to let months or even years go by while waiting for a perennially overvalued stock to drop enough to become reasonably valued. While it is almost never a good idea to buy a stock that one perceives to be overvalued, there is a downside to remaining on the sidelines of a quality company for extended periods. During this time when one is not invested, the investor misses out at the very least on an opportunity to diversify his portfolio into the desired company. He also misses out on a compounding, growing stream of dividends if the money allocated to the future purchase of the stock is sitting in cash in his brokerage account earning zero interest.
Like the recent history of MCD has shown, many times patience is rewarded by a correction when investors can buy into an excellent company at a reasonable price. For example, one could have bought MCD for $97.51/share on May 2nd, at a P/E ratio of 17.5 of expected 2012 earnings (consensus earnings for MCD are $5.58/share according to TD Ameritrade). If one was patient and waited for MCD to correct, he could have bought MCD for $86.32/share on June 4th, at a much more reasonable P/E ratio of 15.5. While this situation is good news for anyone looking to purchase shares of MCD, what about a quality stock like KO, which has not corrected significantly for the past year or so?
One solution to this problem is by using a conservative option strategy of selling puts that both allows you to receive the equivalent of KO's dividend while also only obligating yourself to purchase KO stock outright in the future if it drops in price far enough that it becomes a good value. As an example, let's say that you want to buy KO to add to your portfolio of dividend stocks, but that you believe that it is overpriced today (July 5th for the purposes of this article, when KO closed at $78.45) and want to wait for a correction. According to data taken from Morningstar, we also know that KO is likely to pay $1.02/share in dividends between now and the end of 2012, as the company pays a dividend of $0.51/share per quarter currently and usually raises it in the first quarter of each year.
Using this data, let's take a look to see if there is a put option we can sell on KO that will provide $1.02/share for the rest of 2012. According to Morningstar, KO had the following prices for puts expiring in January 2013 as of the close of trading on July 5th:
KO Jan 19 2013 Puts
Looking at the these prices, it appears that we can sell a put on KO with a strike price of 70 for $1.08/share, roughly the amount that one would receive in dividends if one purchased KO today and held it for the rest of 2012. Let's say that after doing due diligence on KO, it appeared that KO was undervalued at $70/share, and that you would be happy to purchase 100 shares of KO at that price. After selling the put, only two scenarios could occur at expiration in January 2013. First, if KO is above $70/share at expiration, you simply get to pocket the $108, giving yourself a "dividend" from KO without having to purchase the currently overvalued stock outright. If KO is below $70/share when the option expires, you must purchase 100 shares of KO at $70/share, which is much better than simply purchasing 100 shares of KO today for $78.45/share and collecting the dividend. In this case, you also get to keep the $108 you initially received for selling the put on KO. What's not to like?
What are the risks?
There is no free lunch in investing, and this statement applies equally to selling puts. Although the put selling option strategy described above is more conservative than owning KO outright at current prices, it does have its risks. The first risk is that KO has a price below $70/share in January 2013 when the option expires and you are forced to buy 100 shares at that price. However, if you believe that KO would be undervalued at $70/share and would have been willing to purchase the stock at this price anyway, this risk is not so bad. The second risk is that KO will take-off from its current price to a much higher price. The upside of selling the put is only $108, while the upside from buying 100 shares of KO at the current price would likely be higher in this case. For this reason, the options strategy described above is best used for quality companies that are currently overvalued. If you believe that a company is undervalued at current prices, owning the stock outright would be the better decision.