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Tom Armistead
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I'm a well-informed retail investor and post on SA in order to expose my thought process to critical examination and comment from readers. It makes me a better investor. I'm particularly proud of bullish macro articles posted in 2009 and later, in which I presented ideas that encouraged me to... More
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  • Portfolio Review And Strategy Change 8 comments
    Dec 7, 2012 12:07 PM | about stocks: MMM, OXY, JNJ, TRV, CB, GE, ITW

    As the market slogs along toward the end of the year, I've been conducting a strategy review and have now started to transition toward a strategy I think of as "Dividend Growth and Yield on Steroids."

    Briefly, after much experimenting with a screener, I've concluded that dividend stocks, whether high yield or dividend growth, are likely to outperform the market going forward, not so much based on total return as based on reduced volatility and lower drawdowns in declining markets.

    In order to give the strategy some pop, I'm implementing it with diagonal spreads. Rather than buying the shares, I control them by means of deep in the money LEAPS. Covered calls are sold against the resulting positions, as a way of funding the time cost, and replacing the dividend income that would normally accrue from owning the shares. I expect that this will amount to about 2.5 X leverage on the results I would achieve by owning the shares.

    Recent trades involve new positions in 3M (NYSE:MMM), Occidental Petroleum (NYSE:OXY) and Johnson & Johnson (NYSE:JNJ). Healthcare and Energy were not previously represented in my portfolio, which has been overweight Financials (insurance companies) and old Tech.

    Performance year to date has me ahead of the S&P 500 by about 7%, not that much considering the volatility of the existing portfolio. Hence the change to a less volatile type of stock.

    Many of the most profitable trades have developed to where they consist of vertical or diagonal call spreads with both legs deep in the money. I closed all but one of these positions today, on the grounds that from where they are they amount to the sale of low-cost, out of the money puts, not an activity I consider rewarding. Closed with fine profits were Chubb (NYSE:CB), Travelers (NYSE:TRV), Illinois Tool Works (NYSE:ITW) and General Electric (NYSE:GE).

    Using StockScreen123, I've combined Dividend Growth and Dividend Yield into a Screen that backtests very well for the past 5 and 10 year periods. It produces an equal weight portfolio that varies from a low of 26 to a high of 60 depending on market level. Looking at the past, it has a tendency to produce more prospects when market levels present buying opportunities. Right now, it produces 56 prospects, compared to 60 as of December 2008.

    I'm picking from among those prospects, using FastGraphs as a tool for quick analysis. I'm holding position size small, in order to get a decent level of diversification. I'm starting with sectors where I'm underweight or not exposed.

    Disclosure: I am long MMM, OXY, JNJ.

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Comments (8)
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  • Robin Heiderscheit
    , contributor
    Comments (1914) | Send Message
     
    Good stuff Tom thanks. If you like the TARP banks here, consider buying the warrants (6+ yrs to expiration!) and write calls against them. I have been doing in with BAC and less successfully with PNC.
    7 Dec 2012, 02:35 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (5360) | Send Message
     
    Author’s reply » Robin, I like TARP warrants but not big banks. Typically I'm drawn to these high beta financials that trade for less than book like a moth to the flame. So I go over my results for the year and stuff like MMM and ITW and CB and TRV I have these huge returns and high beta financial I have these hopes, that and an ongoing argument with Mr. Market.

     

    I have the HIG warrants, and plan to sell covered calls against them when the stock ever gets to where I'm showing a profit. Slight problem, my broker won't treat the warrants as covering the calls, so I will have a maintenance requirement. If you have portfolio margin that's less of an issue.
    7 Dec 2012, 05:58 PM Reply Like
  • The_Hammer
    , contributor
    Comments (3998) | Send Message
     
    hey tom did not incorporate low beta into your screener?
    dividend stocks can still be volatile in price.
    7 Dec 2012, 02:46 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (5360) | Send Message
     
    Author’s reply » Hammer,

     

    The beta for the screen itself worked out to .86, with a max drawdown of 38% compared 52% for the S&P 500. Maybe I should still put in beta as a requirement, the LEAPS diagonal spreads are easier to handle if the stock doesn't head South too fast.
    7 Dec 2012, 05:46 PM Reply Like
  • Alan Johnson
    , contributor
    Comments (166) | Send Message
     
    Tom,

     

    Very interesting approach and thanks for sharing.

     

    Would you feel comfortable disclosing how deep you go (strike prices) on the LEAP calls?
    30 Dec 2012, 10:42 AM Reply Like
  • Tom Armistead
    , contributor
    Comments (5360) | Send Message
     
    Author’s reply » Alan,

     

    I use 80% of the current share price as a target for the strike on the LEAP. That works out to 4:1 leverage. At that level, quoted spreads are often wide, so you have to have an opinion of how much you are willing to pay.

     

    I try to collect enough premium from the covered calls to offset the time cost of the LEAPS, plus provide some income in the static case.

     

    As a practical matter, it's a good idea to hold at least 30% and 40% would be better in cash while running a portfolio along these lines, so the leverage is quite a bit less than 4:1 when the operation is run prudently.
    30 Dec 2012, 10:54 AM Reply Like
  • Alan Johnson
    , contributor
    Comments (166) | Send Message
     
    Thanks, Tom. A couple of years ago I experimented with this type of approach. Oddly enough, 80% is about where I landed in terms of the optimal strike price (based on growth assumptions in the underlying over the period the LEAP is in effect).

     

    I combined the LEAP calls with the underlying (1 LEAP for every 100 shares of underlying) as a means to "blend" with my existing strategy.

     

    But at the time the approach did not go over favorably with my clients who were willing to give it a try; it ended up adding more volatility to their portfolios than they were comfortable with.
    30 Dec 2012, 11:11 AM Reply Like
  • Tom Armistead
    , contributor
    Comments (5360) | Send Message
     
    Author’s reply » The volatility is troubling. I'm primarily an index investor: my wife and I own quite a bit of Vanguard S&P 500 index fund, plus at times some mutual funds which probably track the index over time, less the expenses, that was mostly what you could get in the 401k's we had access to while in the accumulation phase.

     

    So the LEAPS strategy is conducted in a discretionary account which might be 20% of total liquid assets. It made quite a bit of sense in 2009 and even up until recently, in that risk/reward was good if you could stomach the volatility.

     

    I have some 529 plans for my grandchildren and took them to 40% cash around the time a few months ago when SPY hit 142.

     

    What it amounts to is, if the market goes down I have quite a bit of cash to deploy. If the market goes up, the leverage should make the discretionary portfolio perform well enough to compensate for the cash holdings.
    30 Dec 2012, 11:38 AM Reply Like
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