In a previous article, I demonstrated why a company like Prudential (NYSE:PRU) might be worth a closer look. The premise was not complicated: You have an above-average dividend yield, a strong commitment towards retiring shares at a comparatively low valuation, and the prospects for growth in the years to come. In effect, a security like this fits the bill as far as what a "low bar" investment might look like. That is, the company doesn't have to perform spectacularly for investors to do well.
Granted, this is merely a starting point, not an end. Despite how attractive a security may appear on the surface, it's paramount to think about the business on a deeper level. As Buffett would say, "time is the friend of the wonderful company, the enemy of the mediocre." Quite often mediocre businesses can appear comparatively attractive, while the best businesses routinely trade at a premium.
For this illustration, let's suppose you're comfortable with the business and like the prospects the security offers — two separate assessments.
When I last wrote, the share price for Prudential was around $72; today's mark is closer to $75, but the general construct still holds. You could simply buy shares, hold, and see what happens in the years to come. This strategy works overwhelmingly well in many instances. However, you might have different ambitions for your portfolio. For instance, instead of thinking primarily about total returns, perhaps you're looking to generate substantial cash flow instead. Let's look at two ways you could consider doing this.
At the time of this writing, the most recent bid for the January 20th 2017 call option with a $75 strike price was $6.50; call it $6.40 to account for fees and fluctuations. This means that if you owned 100 shares of Prudential, you could agree to sell them in the next 10 months at effectively today's price. Now why would anyone make this agreement? That's simple: the primary focus would be on immediate cash flow. Note that I am not recommending this strategy, but instead demonstrating what could be available for varying portfolio goals.
If you make this agreement, one of two basic things happens: Either the option is exercised or it is not. If the option is not exercised, you keep your starting option premium ~$640 and 100 shares to go along with likely dividends (~$280 or more) as well. The cash flow derived from the scenario would be about $920 - good for a yield on today's cost of about 12.3%.
Now some might point out the idea that selling a call option does not protect against loss, which is true. Yet it should be underscored that the downside is mitigated, not increased. Whatever happens with the option, you get to keep your ~$640 option premium (which can be taxed differently than qualified dividends). Should shares decrease to $60, your total return during the period would be negative. Yet you still would collect a 12%+ yield.
When Coca-Cola (NYSE:KO) pays a 3% dividend and the share price goes down 10%, you still call it a 3% dividend. The same thing applies here: regardless of what happens to the share price, the option premium is actual cash available to you from the get-go. Further, it is more than what you would receive from holding shares by themselves.
The true risk is to the upside. Should the option be exercised - as would be the case with a share price above $75 - you begin to "cap" your gain. In this situation, you would receive $7,500 for your 100 shares (less frictional expenses), keep your $640 option premium and may also receive dividends along the way. Your total return would be 8.5% to 12.5% depending on the dividends collected.
If share price bids jumped from $75 to $90, tough luck, you're "stuck" selling at $75. In this case, you might be kicking yourself for putting in extra work to cap your gain at say 10% instead of realizing a 20% return. This is a very real risk and ought to be considered for every agreement.
Yet I would contend that it's important to put this in context. Sure, your opportunity cost would be high in this sense, but your 8% to 12% gain in 10 months isn't exactly something to get disturbed by. If you could consistently do this, your wealth accumulation would increase dramatically over time. So here's an agreement where you could collect a 12% cash flow yield or else receive a 8% to 12% total return in less than a year.
Of course, you're not bound to this single agreement. By agreeing to sell at $80, as an example, you could receive a 9% yield or else agree to a 12% to 16% total gain in the same period. Note that I have no affinity for this expiration date, but it makes comparisons easy. Or agreeing to sell at $90 could mean receiving a 5.6% yield or else agreeing to a 22% to 26% total gain. The point is that there are ways to significantly increase an already above average cash flow stream.
Moreover, you're not even limited to owning shares and agreeing to sell them in the future. You can do the same type of thing on the other side by making agreements to buy. For instance, let's suppose that you're perfectly content to buy shares of Prudential at $72.50. You could set a limit order at this price, or you could get paid for making an agreement. I'll use the same expiration date for comparison purposes.
By selling the January 20th, 2017 put option with a $72.50 strike price, you could receive an option premium of ~$685 or so. This means that you have to set aside $7,250 (prior to the premium received) in order to buy 100 shares of Prudential. Same as with the call option, either this agreement is exercised or it is not.
If it is not exercised, your $7,250 that you set aside is "released;" available once more to be deployed as you see fit. In addition, you received $685, good for a return of 9.4% in 10 months. The risk here, presuming you truly want to own shares, is that the share price moves materially higher and you're "stuck" with a return of "just" 9.4%. In my view, no great tragedy, but an opportunity cost nonetheless.
If the option is exercised, you would now own 100 shares to go along with your $685 in option premium. The return depends on the timing of the exercise (whether or not you receive dividends) and the end share price. In this way, your return could be negative. But remember this is what you were originally after: owning 100 shares of the company. This is why it's important to be content with either side of the agreement.
Naturally, you're not bound to just this single strike price (or expiration). You could agree to buy at $60 and generate an immediate 5% cash flow yield or at $50, good for a 2% immediate yield. The cash flow decreases as the strike price declines, but so does the likelihood of the option being exercised.
In short, Prudential the security has a handful of positive attributes that fits the idea of a potential "low bar" investment. Of course, this is not enough to make a partnership decision. Next you want to think about the business and determine whether or not you believe in the prospects. From there, if a positive view is met, you have a variety of ways to think about partnering with the business. You could buy and hold shares, own shares and agree to sell or agree to buy at a lower price. Which one you choose (if at all) ought to be reflective of your underlying ambition.
Disclosure: I am/we are long KO.
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.