The Single Best Strategy To Buy A Correction

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Includes: AAPL, DE
by: Parsimony Investment Research
Summary

This correction will probably not be as broad and deep as many anticipate.

Investors should remain calm through the volatility and focus on finding great stocks at good prices.

A cash-secured put selling strategy will help you generate additional income as you patiently wait for your watch list stocks to trade into the "Buy Zone".

The pullback/correction that everyone has been waiting for is here...so what are you going to do about it? All major indices are now down 5%-10% each and we believe that investors should start targeting which stocks they want to buy.

We just don't believe that a major correction is in the cards. We could be wrong, but the "buy the dip" strategy has worked very well for the past few years and we think it will continue to reward investors. The economy is fairly stable and we think the low interest rate environment will persist for the foreseeable future. Couple that with the record levels of cash on the sidelines and the fact that investors really have no where else to put their money...and its easy to see why stocks will likely continue to catch a bid on small pullbacks. All that said, there is some real value out there in certain sectors and asset classes.

This article highlights a cash-secured put selling strategy. We often use a cash secured put strategy to generate income while we patiently wait for the "Buy Zones" on high-rated stocks that we are stalking (i.e., stocks we would love to own at a cheaper price).

Generating Income in a Down Market

We think that selling cash-secured puts on high-quality dividend stocks is a great strategy for an income investor in a down market. It allows investors to generate income while mitigating downside price risk. Cash-secured puts essentially act as a limit order for dividend stocks you want to add to your portfolio (but you get paid to put the order in!).

If you sell a put, you have an obligation to purchase the stock at a predetermined price (strike price) on or before the expiration date (if the buyer of the put option wants to sell you the stock). Clearly, the risk is that the stock drops significantly below the strike and you are forced to buy the stock at a price well above market.

Here are our two risk management rules of put selling:

  1. Only sell put options on stocks that you want to own at the price you want to own them - With a put selling income strategy (focused on out-of-the-money puts), you get paid to wait for the price you want on a stock. If the price never drops to your strike, you get to keep the premium (income) as a consolation prize. Your downside is owning the stock at the strike price (keep that in mind as you analyze the ideas below).
  2. Don't sell "naked" - Just because options offer you leverage, it doesn't mean that you have to use the leverage. We recommend securing your short put position with cash (i.e., don't sell on margin). If you aren't willing to risk the cash to back it up ... don't sell the put!

Great Put Selling Candidates

We have written several popular series over the past few months that have highlighted some stable, high-quality dividend stocks to keep on your radar. The goal is to buy these great stocks at good prices.

While these lists are by no means exhaustive (there are literally hundreds of decent candidates out there), it should give you a great start on your diligence. As discussed above, the downside to a put selling strategy is owning the stock at the strike price. So we only sell puts on stocks that we want to own! Note that not all stocks are "optionable," but most mid and large capitalization dividend stocks are.

Choosing the Right Strike

Choosing the right strike price in a put selling strategy, like any investment decision, comes down to risk and reward. All else being equal, as your margin of safety (your cushion between the current stock price and your strike price) decreases, your premium yield increases (because the risk that your option will be exercised increases).

Ideally, we like to choose a strike price where the break-even price of the option trade will be close to or in our "Buy Zone" for that stock. In addition, we prefer utilizing options with expiration dates that are at least 3-6 months out to reduce trading costs. Note that the annualized option premium yield can oftentimes be approximately equal to the dividend yield on the stock. So you can essentially generate the same income without the downside risk. Let's look at a couple of examples:

AAPL is a stock that we feel every investor should own. As with any investment though, you should try to buy it on a dip. That said, AAPL is now down over 20% from its recent high and historically the stock has been a great buy on short-term pullbacks.

Our "Buy Zone" for Apple Inc. (NASDAQ:AAPL) is currently $105.00-$115.00. As such, we recommend selling the Dec15 $100.00 put, which equates to a $94.80 break-even price (i.e., net purchase price if exercised) and a premium yield of 5.5%! This trade has a margin of safety of 15.8% and you can collect income equivalent to ~286% of Apple's 1.9% dividend yield in ~4 months.

Apple has a Value Rating over 80 as the company currently trades at a discount to several of its long-term average trailing valuation multiples (P/Sales, P/Earnings, and EV/EBITDA). In fact, after today's selloff, Apple is trading under 12.0x forward earnings, representing a 20% discount to its 5-year average P/E. At the net breakeven price of the put trade ($94.80), the valuation of your position would be 10.4x forward earnings. Which is just downright silly cheap for a company like this.

From a dividend perspective, the Company pays a below average dividend yield of 1.9% and short dividend track record. That said, the company has a relatively low payout ratio (23%) and we believe Apple will continue to offer investors a profitable combination of healthy dividend hikes and share repurchases in the future. In fact, AAPL just increased its dividend by 10% last quarter and repurchased $10 Billion of stock!

Deere & Co. (NYSE:DE) is down significantly today as the company guided lower for 2016. Our "Buy Zone" for Deere is currently $82.00-$88.00. As such, we recommend selling the Dec15 $80.00 put, which equates to a $76.30 break-even price (i.e., net purchase price if exercised) and a premium yield of 4.8%! This trade has a margin of safety of 15.8% and you can collect income equivalent to ~169% of Deere's 2.9% dividend yield in ~4 months.

Deere has a Value Rating over 70 as the company currently trades at a discount to several of its long-term average trailing valuation multiples (P/Sales, P/Earnings, and EV/EBITDA). In fact, after today's selloff, Deere is now trading below 1.0x sales and 15.0x forward earnings. The breakeven price of the trade above of $76.30 would equate to a forward P/E multiple of ~14.3x revised FYE 2015 EPS estimates of $5.33.

From a dividend perspective, Deere pays a decent dividend yield of 2.9% and has increased its payout to shareholders at a compound annual rate of 15% over the past 10 years. In addition, the company has a relatively low payout ratio (32%) and we believe Deere's dividend will be safe through the earnings cycle.

Summary

Income investors should not be fearful of a pullback or a correction. A market pullback is the best time to buy great stocks on sale. In our opinion, the best way to prepare for a market correction is to make sure you have a list of stocks you want to buy as well as the price you want to buy them. If you have properly diligenced these stocks (and Buy Zone prices), you'll be prepared to "buy the dip" when it happens and with a cash-secured put strategy you can build in a nice margin of safety.

Disclosure: I am/we are long AAPL, DE. 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.