Building A Capital Preservation And Income Portfolio Part 5

Includes: EPB, JNJ, PG, WMT
by: Mark Bern, CFA

By Mark Bern

<< Click to view Part 4

When I started this series with the original article I had planned to only write a four-part series. But after looking at the charts for the S&P 500 Index I decided that it might be worthwhile to extend the effort to include "what I would do next." So, in this and the next three articles I plan to explain my method of enhancing the income stream from the portfolio I have recommended. This really isn't my strategy as it has been in use probably since the first stock derivative was created. But it is fairly simple if you apply some ground rules and stick with them. In this article I will go into more detail with the rules that I apply and then make specific recommendations for each of the stocks that appeared in Part 1 of the series. The subsequent articles will include only an introduction and then get right to the specific recommendations. If you have read the first four articles you are well aware of why I recommended each of the 16 stocks contained therein. If not, please return to the link at the beginning of this paragraph to understand my arguments in favor of each company.

Many investors, especially those who buy and hold quality stocks for the long term write (or sell) call options and collect the premiums to increase (I like the term enhance) their income from their respective portfolios. I am one of those investors. If you haven't used this strategy yet you may want to read on as the rewards are substantial over the long term, especially if you compound your returns. If you are retired and are seeking an increased yield from your portfolio, this strategy is also worthy of your consideration. It is not for everyone, but it's always good to understand what the other guy is doing. First, let me say that I intend to keep this as simple and straightforward as possible. I have no ego to puff up by the use of complex terminologies or taking the strategy to the next level. This discussion is going to be very understandable, even for the beginning investor.

First of all, I have been successful myself in adding 6% or more to my portfolio in most years. The exceptions were in those years when it was plain that standing aside and just holding on was the best thing to do. A good example of a time period for standing aside and just holding my positions was from April of 2009 through April 2011. The rate of the rally was just too steep during most of that time to consistently apply the strategy. I used the strategy back in 2000 into 2002, but then got away from it for most of the interim years; pity. I started up again in June 2011 and have had great success. Here's the essence of what is involved.

First, the strategy involves selling (or writing) covered calls. The term covered call refers to selling to open a position of a call option contract (each contract is equal to 100 shares of the underlying stock) while already owning the shares of the company represented by the call option contract. In other words, if I want to sell a covered call option on Procter & Gamble (NYSE:PG) I must first own 100 shares or more of PG stock. When I sell the call option I collect a premium. The premium is the amount the buyer of the call option pays for the right to call the stock away from me at a predetermined price, called the strike price, any time before the contract expires. The strike price is a predetermined price, set in stone, which I would receive if the option contract is exercised. If the option is exercised I am, as the seller, obligated to deliver (sell) 100 shares for each contract I sold of the stock underlying the option contract. In this case it would be 100 shares of PG. The expiration date is also predetermined and is listed in the quotations for the options contracts available. There are many strike prices available for each expiration date for each stock available. It sounds confusing, but it's really not. Just take a look in Yahoo Finance for a quote on PG stock.

To the left of the quotation there are a number of tools listed, extending down the left side of the screen. At the bottom of the list you can look at recent financial statements. Near the top you'll find a link named "options." Click on the link. It will take you to the closest expiration month for options contracts on PG. The Call options will be listed on top and the Put options will be listed on the bottom. Sometimes it comes up with the call options on the left and puts on the right. Make sure you are looking at the "Call" options section. At the top of this section there are links for each month running from February or March on the left to as far out as January 2014 on the right. Any option that expires more than 12 months in the future is called a LEAP option (LEAP stands for Long-term Equity Anticipation). Mostly we will be using options with shorter expirations. But in some cases it is not possible to get a high enough premium unless we go out further. In these cases we will consider the risk involved (of possibly losing the stock or having it called away) relative to the return to determine whether or not it makes sense or if we should just sit tight with the stock. I'm greedy, but I'm not crazy.

If you already own one or more of the stocks from Part 1, this seems to me to be an excellent time to be selling calls on those stocks. The recent rally since the October low near 1100 on the S&P 500 has brought us back up near the high set in April of 2011 of 1370. Earnings have been good, but guidance for the first quarter has brought estimates down to near flat compared to 2011. That isn't the kind of forward-looking expectation that drives the market higher. We've had a very good run and I think it is near time for a breather. If the market does run up to make new highs I'd wager the highs won't be much higher than April 2011. My point is that one of the best times to sell covered calls is after a strong rally because the market usually needs a breather and, thus corrects or trades sideways for a time thereafter. I believe we are at one of those times. That is one of my primary rules: sell covered calls at what appear to be market tops but do not sell covered calls after a correction or prolonged sideways market unless the economy is weakening. That last part, "unless the economy is weakening," is not meant to be speculative. You need to have undeniable evidence that the economy is heading south. I don't have that evidence right now, but it doesn't apply since we have just experienced a great rally of almost 23% since the October low. As a matter of fact, the S&P 500 is already up 7.4% since the end of 2011. Another 5% or so and we'd already have a pretty good year and be hitting around 1400, about where some pundits expect us to end the year. I don't know where we'll end 2012, but I do know that we can't keep up the pace of 7.4% every 45 days. The market seems overbought to me at this point.

My second rule is that I want to sell calls with strike prices that are above where I expect the stock price to be by the expiration date. So, the further out I go, in terms of expirations, the higher the strike price. I start out with looking for close to 10% within three months and scale up or down depending upon the option duration. For example, if I sell a call option that expires next month I may drop the strike price down to 5% above the current price, especially if I think the market looks overbought.

My third rule (and this one is more flexible) is that I look for about 1% per month return from the premium. In other words, PG is currently trading at $64.48 (as of the close on Tuesday, February 14, 2012), so I will look for a call option that will provide me with a premium of about $64 for one month. Unfortunately, PG is typically a bad example because the stock isn't very volatile and its earnings growth is very predictable, so the premiums are generally lower than on a lot of other stocks. In the case of PG, there just isn't a call option I would like to sell at this time. Hopefully, as I run through the other stocks, I can illustrate a better example of applying this rule.

Others who use this strategy are invited to add their own rules that they use, and if they don't mind sharing them with the rest of us in the comments section below the article I'd be very grateful. So, now I'll provide my specific recommendations for each stock from Part 1.

Procter & Gamble has become so predictable that there just isn't enough premium to lure me into a trade. I don't want to risk losing this stock for peanuts, so my recommendation is to just hold tight and collect the premiums. If you haven't already bought PG I'd wait for a better price. I believe you'll have the opportunity to buy PG under $60 in 2012 if you are patient.

Johnson & Johnson (NYSE:JNJ) is another solid company and its price of $64.61 (this and all prices quoted in this article will be as of the close on Tuesday, February 14, 2012) is about 12% below the consensus 12-month target price. Once again, the company's earnings are so predictable that the premiums are too low to meet my minimum requirements. On either of these stocks, if I could sell a call option with a strike price above the 12-month price target that would provide me with an annualized 6% yield, I would commit to the transaction. Of course, if the expiration were three months away or less I would be satisfied with a strike price of about 5% above the current price. But since there is nothing available my recommendation is to hold on and collect the premiums.

Wal-Mart (NYSE:WMT) is currently trading at $62.22 a share and has a 12-month price target of $62.30. I'm not sure I believe the 12-month price target, although the stock has had a nice rally since the summer. The problem, once again, is that the premiums on out-of-the-money calls are pretty skimpy. The best call option, in my opinion, is the March option with a strike price of $62.50 and paying a premium of $0.83 per share. After paying a commission of about $9 to sell one contract, I'd be left with $74 which equates to a return of 1.19% in about one month (expiration date is March 16, 2012). I realize that the strike price is very close to the current price, but when you add the premium to the strike price you get $63.33. That is the price the buyer needs the stock to rise above by the expiration date to achieve a profit. That price represents an increase from the current price level of about 1.8%. That may not be much, but it is quite a bit more to tack on after the run the stock just had. And it represents an annualized growth rate of over 21%. I realize that Wal-Mart does not appear over-valued at a price/earnings ratio of 13.17, but it's not under-valued at this level either. Also, with retail sales reportedly adjusted downward to "flat" in December and coming in "below expectations" for January, it would seem that the rally in retail stocks may have been premature. If we can achieve a similar return for most of the rest of the year on WMT, we could easily increase our yield from this position by 10%. I recommend selling the March call option with a strike price of $62.50 for a premium of $0.80 or better.

El Paso Pipeline Partners LP (NYSE:EPB) is currently trading at $36.22. This is another stock that has a relatively high degree of predictability in earnings. Thus, the premiums are too low to warrant risking having the stock called away. If I sold a March call option with a strike price of $37.50 the premium would be about $0.20 a share. After paying the commission, I would end up with only $11 for a return of 0.3%. If I owned 300 shares I might consider the trade. Here's why: the commission at discount brokers for the first contract is about $9 (I pay $8), but commissions on any additional contracts are about $1.50 - $2.00 per contract (I pay $1.50); so if I sell 3 contracts at $0.20 I collect $60 less the commission of $12, or $48 for a return of 0.44%. That may not seem like a lot of difference, but if we annualize that 0.44% we end up with 5.28%. That may fall below my target of 6% for the portfolio, but it doesn't hurt the average as much as a goose egg. The point of the multiple contracts is that when I own more stock I can sell more call option contracts and reduce my commission cost per contract. That will up the yield. After all that, my recommendation is to hold tight for the time being on EPB and collect the dividends.

I'll keep an eye on these stocks for a while and report on them in the future if there are better call options available. Watch the comments because that is where I'll probably make any updated recommendations. Thanks for reading.

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Disclosure: I am long PG, JNJ, WMT.