Enhanced Income Strategy For Lowe's - Update 2

| About: Lowe's Companies, (LOW)

By Mark Bern, CPA CFA

In our first attempt to buy Lowe's (NYSE:LOW) we failed to get the stock. But in our second attempt we sold a put and got the stock. I must admit that we are not faring well against the buy-and-hold position on this stock. When we initiated the series with LOW in the first article of the series I felt that the stock was severely undervalued. The stock price then (September 20, 2011) was 19.92 and jumped to the current $28.34 for a gain of 42.3% over the past 11 months.

I believe that my assumption about the valuation appears to have been correct. But what do I think about the valuation today? It appears to be only slightly overvalued at this time. I have felt that way about the company ever since the price passed the $27 level. The next move reflects that assumption.

But first I should take a moment to detail the results we have had on LOW thus far. In September 2011 we sold a November put option on LOW with a strike price of $18 and collected a premium of $0.33 per share, or $24 (after commission) for a return of 1.3%. Admittedly, since I included LOW in the original article (link to article is in the 1st paragraph) and the company name did not appear in the article title, I missed selling another put or two during the interim. I'll just have to make for my negligence in the future, between now and September 2013 when I intend to conclude this series. Had we gotten put the stock we would have been sitting pretty with a cost basis of $17.67 a share ($18 - $0.33). Alas, it was not to be.

In March we sold a put option on LOW for July 2012 expiration with a strike of $28 and a premium of $1.16. I sold two contracts to complete the diversification allocation in the services/retail sector. The options were exercised, leaving us with a cost basis of $26.84 ($28 - $1.16), just below my target price of $27.

Now that we own 200 shares of LOW stock we need to enhance the yield to compete with the buy-and-hold strategy. Today (August 29, 2012) LOW stock had a nice move up to $28.34 (+$0.49, 1.76 percent) for the day. This may be a little on the early side, but I believe that the upside potential from here is going to be muted for a few months as I believe there will be some overhead resistance until Congress deals with the fiscal cliff approaching. I do expect that at least a temporary fix will be achieved to buy more time but that it could continue to weigh on the economy until a more permanent solution is declared. The housing market is picking up a little but I also don't expect any major positive surprises in this area until at least next spring. So, there you have my reasoning and now I'll give you my next move.

I want to sell a call option for January 2013 with a strike price of $30 and collect a premium of $1.07 per share. This will provide us with a yield of 3.5 percent (net of commission) over the next five months for an effective APR of 8.3 percent. If our stock were to be called away from us at $30 we would generate a return of ten percent over the current stock price (including the premium net of commission). Our cost basis on the 200 shares that we own is $26.84 ($28.00 - $1.16 premium collect of the exercised put options). Our total gain on the position would be $4.14 (including premiums and commissions), or 15.4 percent.

Assuming that the stock price is still below the $30 strike price, as we expect, the call options will expire worthless and we will initiate another position in January or February 2013.

I believe that I must include a warning in my articles in this series to make sure that everyone understands that there are risks to every strategy, including this one.

First, as has been pointed out in the comment threads to previous articles, there is always the possibility that the selling puts strategy may not result in the purchase of the desired stock in a rapidly rising market. An investor could miss most, if not all, of a run up. It is doubtful that the full run will be missed, however, since the market (including most stocks) correct by ten percent or more usually once or more per year. For that reason it is likely that the investor will purchase the stock at some point during a bull market, but they still may miss some portion of it (perhaps a large portion, especially in a bounce off a major bottom). On the positive side of this equation is the fact that as most major bottoms occur there is usually a day of capitulation. Capitulation days are generally heavy down days on which, if one has sold puts outstanding, the investor stands a good chance of being put the stock (purchasing at the bottom). There are no promises of that happening, but the odds are better under this strategy than following one's gut emotions. One other thing that helps offset the possible regret of missing a stock at a good price is that the seller of the puts will continue to earn a decent return on their cash (generally 8-ten percent on average) annually while they wait. Granted, that is not as good as hitting a 30 percent gain in a good year, but it sure beats sitting in a money market and earning zip.

Second, as has also been pointed out in the comment threads, it is possible to end up buying a stock when the stock market tumbles and having to ride it out to the bottom. If the investor is buying a stock in a company that they want to hold for the long term, at least with this strategy they will never buy at the very top. After all, we're selling puts at below the price when the put option is sold. In addition, the investor has the opportunity to sell calls and, including dividends, receive an average of 8-10 percent in cash payments per year while they wait for the stock to rebound. If we have done our homework in picking a good company at a price that represents a good value, then the likelihood of a rebound is very strong. Practically the only way to end up losing money is by selling the stock. If you hold, you're getting paid well to do so and eventually you'll be back in the money. If the investor had purchased the stock outright at the top of the market and the market fell 50 percent, they would be down 50 percent at the bottom and need the stock to double just to get even. If they are selling calls all the way down, assuming the average length on most bear markets is about 17-19 months, the investor should have collected somewhere in the vicinity of 15 percent along the way, putting them down 25 percent at the bottom. Remember, you bought at ten percent below the top, using puts, so you couldn't lose the full 50 percent in any event. Now you only need half as much of a rebound to get even.

The third scenario is the worst case. If an investor sells a put near the top and ends up with the stock at a ten percent discount from the high and rides it all the way down to the bottom, collecting dividends and call premiums along the way. Now you are down 25 percent and you end up selling a call that gets exercised near the bottom and the stock is called away. But remember, you are selling calls that will net you about ten percent above the stock price at the time the option is sold, therefore you should be selling at no less than ten percent off the bottom. That would result in a total of a 15 percent loss on the total of your transactions. Now compare that to most alternatives other than picking the tops and bottoms, which no one can do consistently.

An alternative to riding a stock down is to use stop loss limit orders. I recommend that investors consider using this strategy to save themselves the pain of riding a stock down during an overall market crash. Some long-term investors with a low cost basis may not want to use this strategy due to the tax consequences.

The point is, while this isn't the most lucrative strategy, it does bear less risk of loss than most alternatives. By taking most of the emotions out of the decision process, an investor improves their chances of producing consistently higher returns. And that is the whole point. I hope this explanation helps cure some of the over-enthusiasm. This is no get rich quick scheme. It is simply a systematic strategy that can help investors achieve market-beating returns over the long term.

Thanks for reading and I wish you all a successful investing future!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.