Our Long-Term, Investing For Increased Yield Strategy

| About: Cummins Inc. (CMI)

By Timour Chayipov and Mark Bern, CPA CFA

This is a strategy for long-term investors who want to buy, accumulate, and hold dividend-paying stocks of quality companies and retire living on the dividend income in the future. But there is more to this strategy than just buying and holding good companies and waiting for the dividends to increase. What we are going to do is show you how to extract some of your initial investment each year systematically and put that cash to work either in other quality dividend-paying stocks or more of the same stock(s) you already own in order to increase your future yield. This strategy will allow you to pull up to 20 percent of your investment capital out in the first year and then between five and ten percent per year in each year thereafter. We will also show you how this strategy will reduce your risk of loss as well. We are cautious investors, too, and we wanted to help others understand what has taken us many years to develop. Of course, none of our techniques are really new; but it took us time to understand and master them. We hope to spare readers of some of the more tedious experimenting and research by explaining things in plain English.

Just think about this concept for a moment. If you could take ten percent of your original investment back out of each stock in your portfolio and reinvest that money to reap even more dividend income, in ten years you would have reinvested all of your original money and your yield at retirement should more than double what it would have been if you had just bought and held. How much more depends upon how long you employ the strategy.

We will start out by explaining some terms and providing a little summary of the strategy. Then we will introduce a company that we think is ripe for implementing this strategy and also why we want to own the company's stock. Next, we will provide a detailed example of how to initiate this strategy. Following that, we will provide the possible outcomes along with the expected rates of return for each outcome. We hope you will enjoy this strategy and consider putting it to good use to build greater wealth for a great retirement!

We are going to use LEAPs (Long-Term Equity Anticipation options). These are options with greater than one year until expiration. The process is very straight-forward and easy to understand and we will explain everything in detail as we walk you through the example. This is really quite simple, so don't be alarmed by the terminology, we'll explain it all so that even a novice can understand. Once you are done reading this article options will no longer be that scary thing in the closet. The important thing to understand is that options are tools that, if used correctly, can enhance your portfolio returns and help you build more wealth with reduced risk. Remember, we aren't speculators and won't be asking you to accept more risk to seek higher gains. We just want to help you make your money work harder and smarter for you rather than for an investment advisor or bank.

Options are easy to understand: the seller (or writer) of a call option (frequently just termed a "call") is selling a right to the buyer for a price, called the premium. The buyer of the call pays the premium and in return has the right to purchase shares of stock from the call seller at a specific price (the strike price) on or before a specific date (the expiration date). The seller collects the premium and accepts the obligation to sell shares (each option contract is for 100 shares of stock in the underlying company) at the same pre-determined price and by the expiration date if the buyer exercises his/her right. About 80 percent of all option contracts expire worthless. That being the case, it should be obvious that the seller wins and the buyer loses in most cases because the seller always keeps the premium whether the option is exercised or expired. We will be sellers. We should mention at this point that many of the options that expire were originally part of a multi-option strategy where one part wins and the other part loses, commonly called spreads. But still, being on the right side is a good place to start.

The seller (or writer) of a put option (put) sells a right to the buyer of the put option in exchange for a premium (the price of the put). The buyer now has the right to sell shares to the put seller at a specific price (strike) on or before a pre-determined date (expiration date). The seller collects the premium and accepts the obligation to purchase shares at the same specified price on or before the expiration date.

What we are going to do is use the LEAP options to collect premiums while owning stock in a company and also collecting the dividends. We do not plan on having any of the options being exercised but will explain what happens if that is the case. There is really only one scenario where any option is likely to be exercised and you'll see why we won't mind when that happens when we get to the example and outcomes.

We start by purchasing a quality stock that is at or below the midpoint of its 52-week price range and represents what we believe to be a good value. If you already own the stock and its price is near that mid-point you do not need to purchase more; just use what you already own. The stocks that we recommend generally have a history or increasing dividends or a management that appears committed to doing so. Next, we sell a long duration deep out-of-the-money put contract and collect the premium. The term "deep out-of-the-money put" means that the strike price on the put option is significantly below the current price of the stock. It is usually near or below the 52-week low of the stock. We like this part because if the put option buyer decides to exercise their right to sell us the stock it means we are buying it at a very low price. Buying quality stocks at low prices is not a bad strategy by itself. And this is probably the worst outcome of this strategy! But this rarely happens.

Next, we sell a long duration deep out-of-the-money call option on the underlying stock and collect the premium on it as well. The term "deep out-of-the-money call" means that the strike price is significantly above the current price, most likely above the 52-week high. If the stock price goes up we will be obligated to sell at a good profit. Again, this is not a bad outcome. This usually doesn't happen either.

The key to the strategy is that we now have taken money out of our original investment in the form of the premiums collected from selling the LEAP options and, because of the long duration of more than a year, we have a lot of flexibility in when to "roll" or close our position for a profit and take out some more. This process called "rolling" is very simple also and it will become very clear how it helps enhance the performance of the strategy when we get into the example and the details. It allows us to take advantage of positive movements in the market to remove good profits and move back into positions when it is advantageous to do so. When share prices are at or below the mid-point of the 52-week range (and especially when market volatility is higher than usual) we create our positions (sell options). When the price rises to new highs or near the most recent high, we will often buy back our option positions and take the profits. If the price remains well within the boundaries of the strike prices of our sold options all the way through to expiration, we may let the options expire and sell new ones. If the price rises at the end of contract period near the expiration date, we will probably buy back our options (at a profit) and wait for a better time to initiate a new position. If the price drops below our put option strike price, we can either roll the position to a new further distant expiration or we can buy the additional shares and get a low cost basis. This will all become clear when we get to the outcomes at the end of the example. So, let's move on to the company description so we can get to the example and look at some of those realistic outcomes.

We have chosen Cummins, Incorporated (CMI) to use in the example. The current price is $96.29 (as of the market close on Friday, July 6, 2012) while the 52-week high is $129.51 and the 52-week low is $79.53. This fits our rule of using a company that is near or below the middle of its 52-week price range. Another reason we chose CMI for the example is simply that we feel that it is an excellent company with great long-term potential. Cummings designs, manufactures, distributes and services diesel engines for the truck, bus auto and industrial markets. It also is in the businesses of electric-power generation systems and engine-related component products. The company has customers in 150 countries serviced through independent distributors, dealers, and company-owned distribution operations. Foreign sales accounted for 59 percent of revenue in 2011. The company has a great growth track record over the past five years and we expect it to do well going forward, as well. Revenues have been growing at an average annual compound rate of 11 percent, EPS at 25 percent and dividends at 32 percent. While we expect these rates of growth to slow some, we expect that CMI will continue to outperform the majority of publicly listed companies.

The price is down from its highs because of softness in the Class 8, heavy-duty truck demand. Backlogs remain strong and the trucking freight volumes are holding up, but the slow growth environment in the economy is likely making many potential buyers hesitant to risk taking on the additional credit of nearly $100,000 to buy a new truck. The fleet on the roads today is aging and will need to be replaced, so this situation is just pushing sales into the future which will be good for CMI when the log-jam breaks.

Another factor in CMI's favor is the advances being made in engines that will run on propane. CMI already has engines commercially available in the light and medium truck sectors and more to come. This will position CMI to boost its market share from a current level between 40 and 50 percent in North America due to the lower cost of fuel based upon the abundant U.S. natural gas reserves. Building out the fueling network for trucks is a much easier project than doing so for cars. Once the capability reaches the marketplace, we believe that the infrastructure will follow quite rapidly due to the large profits that will be available to those first to market. That will lead to the inevitable transition from diesel to natural gas-fueled heavy-duty trucks driven by much lower operating costs. CMI may have a hard time keeping up with demand when that wave finally starts rolling. Now, let's move on to the example.

First, if we do not already own shares of Cummins, we need to buy 100 shares at the current price of $96.29. Next, we sell one January 2014 put option with a strike price of $85 and collect the premium of $14.10 per share. Then we sell one January call option with a strike price of $115 and collect the premium of $10.10 per share. Just to be clear, this is not a naked call because we own the stock and that makes this a "covered call," meaning we have the stock available in our account to cover the obligation to sell if the buyer exercises their right to buy the stock from us. We invested $9,629 (plus commission) to purchase the 100 shares of CMI and then collected $2,420 in premiums (less commission) so our cash outlay now stands at $7,209 or $72.09 per share. This amounts to a discount of 25 percent from the purchase price of the stock. We will also need to maintain $4,250 of additional cash or cash equivalents in our margin account to secure the put option. This reduces the potential total return to about 17.4 percent at the outset of the strategy. A "secured put" means that we have the buying power (money/margin) available in our account to purchase the stock if the buyer of the put decides to exercise his/her right to sell us the stock at the put strike price.

I know that some readers are going to look at that rate and complain that they can do better selling shorter term puts every month or two or separately selling calls against owned shares in the same manner. We like that method also, but the truth is that the return isn't always available every month or two. Whenever we have to skip a month we reduce the annual return significantly. I write another series about that strategy and we look for a cash return, including dividends, of 10 percent a year. The returns available vary considerable from one stock to another based upon the volatility of the stock. The biggest difference between the two strategies is that in my "Enhanced Strategy" series we are collecting short-term premiums, one at a time, while here we are collecting two long-term premiums at the same time. That difference will often make it worthwhile to use this options strategy on stable companies that do not offer enough premiums on short-term options to fit the other strategy.

Our cost basis on the stock is still $96.29 per share, but the amount we had to spend was 25 percent less. So, in a sense we have pulled $2,420 out of the stock we hold and have reduced the investment to $72.09. It does tie up additional funds to secure the put option, but the return is still adequate enticement from our point of view. Now let's look at the potential outcomes.

Scenario #1

The price of the stock rises to close above the call strike price at expiration in 2014. The stock will be called away at $115 and out total return will be calculated as follows:

  1. Gain on sale of stock $1,871
  2. Premiums collected from option sales $2,420
  3. Dividends collected on held stock $240

Total Income $4,531

  1. Return on capital required of $13,879 = 32.6 percent
  2. APR = 21.8 percent

Scenario #2

Stock price falls below put strike price at expiration (we assume the price falls to $5 below put strike). We are obligated to purchase another 100 shares of CMI at $85 per share. Now we have 200 shares of CMI but our total cash outlay has been $15,709 or an average of 78.55 per share. Here are the results of the transactions:

  1. Unrealized loss on 200 shares of CMI $(2,129)
  2. Premiums collected from option sales $2,420
  3. Dividends collected on 100 shares held $240

Total income $531

  1. Return on capital required ($18,129) 2.9 percent
  2. APR 2.0 percent

Scenario #3

Stock price remains between put and call strikes (we assume the average of the two strikes; $100). All of the options expire worthless and we keep the premiums and dividends collected.

  1. Unrealized gain on 100 shares owned $371
  2. Premiums collected on option sales $2,420
  3. Dividends collected on 100 shares held $240

Total Income $3,031

  1. Return on capital required ($13,879) 21.8 percent
  2. APR 14.6 percent

Now comes the fun part, in my opinion. We are going to compare each outcome to what would have happened if we had just bought the stock and held it instead.

Scenario #1

Stock price rises to above the call strike price (we'll assume that the price goes to the previous high of $129.51). We will still own the stock, will have collected the dividends and will have had used only the original invested capital of $9,629.

  1. Unrealized gain on stock $3,322
  2. Dividends collected on shares held $240

Total $3,562

  1. Total Return 37 percent versus 32.6 percent
  2. APR 24.7 percent versus 21.8 percent

Granted, this looks a little better, but it is only part of the picture. We need to look at the other scenarios to gain a perspective of the power of this strategy.

Scenario #2

The price of our stock falls below the put strike price (we assume $5 below the put strike price, the same as in the same scenario shown for the strategy to keep things even).

  1. Unrealized loss on our 100 shares held $(1,629)
  2. Dividends collected on shares held $240

Total $(1,389)

  1. Total Return Loss -14.4 percent versus gain of 2.9 percent
  2. APR Loss - 9.6 percent versus gain of 2.0 percent

This is where the lower risk shows up. Interesting isn't it? Would you rather make 2.9 percent or lose 14.4 percent? Is that extra potential 3 percent APR worth it? We don't think so, but everyone is welcome to their own opinion.

Scenario #3

The price of our CMI stock remains between the put and call strikes (we assumed $100 above and will do so again to be fair). In both cases we end up with a gain on the stock we hold, but look at the difference that the options make.

  1. Unrealized gain on stock held $371
  2. Dividends collected on stock held $240

Total $611

  1. Total return 6.4 percent versus 21.8 percent
  2. APR 4.2 percent versus 14.6 percent

Once again, the strategy vastly outperforms the buy-and-hold strategy. Overall, we like the potential returns from this strategy. And remember, each time you take some of that money out you have the opportunity to invest it elsewhere to increase your future yield even more.

Since this has gotten to be a very long article, we will continue with a Part 2 in which we will explain how to roll positions into the future, taking all or part of the potential gains early, depending on the price levels of the underlying stock. We will also explain a little more on how this strategy works in subsequent years to take even more of your invested capital out regularly so it can be reinvested for additional future yield. After all, the goal of this strategy is not really to increase current income but to increase future yield for retirement. Why not enjoy your golden years? Reducing potential losses is a key factor in building lasting wealth.

In future articles based upon this strategy we will skip the initial tutorial on options and some of the details included in these first two articles. For the sake of brevity in the future we will link those shorter articles back here for people who need to catch up if they wander into the middle of the series.

As always, we appreciate all comments from those who take the time to post them and will do our best to answer all questions to the best of our ability. We plan on writing future articles on companies that fit the profile for this strategy when we feel the time is right for such considerations.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.