Without Dividends And Covered Calls, You're Not Investing

Includes: AAPL, MCD, TWX
by: Rocco Pendola

Recently, I asked the lady at one of my favorite Indian restaurants if they cook with ghee. She replied, You're not cooking Indian if you're not using ghee! And it's true, in many of life's ventures, you sell yourself - and the venture - short by not utilizing the proper tools.

For example, you can take up cycling and not wear cycling-specific clothing. You'll be able to ride and probably even see some benefits in the process, but if you slap on some spandex, I can guarantee you'll have a better, more rewarding experience. The same type of logic applies to investing.

That's why it boggles my mind to read articles on Seeking Alpha where people talk down the idea of investing in dividend-paying stocks and writing covered calls as core investment strategies. Let us consider covered calls first.

If You're Not Writing Covered Calls, You're Not Investing

Of course, you could buy and hold plenty of stocks and, over the long-term, set yourself up for retirement with them by doing nothing other than buying and holding. You could, for example, do that with Apple (NASDAQ:AAPL). That, however, is akin to riding a Colnago in baggy basketball shorts.

Say you're lucky enough to own 400 shares of AAPL. In 2011, you saw the shares increase from $329.57 (Jan 3, 2011 close) to $405.00 (Dec 31, 2011 close). That's a 22.9% move. Of course, you collected no dividends on that position (and I hope you did not whine about it). Now, we'll make an incredibly conservative assumption for 2012: AAPL ends the year around where it is as I write this - $533.00. That's a 31.6% gain in 2012. As an aside, that "conservative" assumption should give you a quick whiff of awe, particularly if you think $600.00 is in the cards this year.

Nobody will scoff at 22.9 or 31.6% increases. That's pretty sweet, but, by not writing covered calls against your position in AAPL, you're truly leaving money on the table. Look at how things change if you employ an incredibly conservative ("I am afraid to get my shares called away") covered call strategy on your 400 shares. You could write each one of these calls today.

  • Sell AAPL March $570 call. Collect $2.00 ($200).
  • Sell AAPL April $600 call. Collect $4.65 ($465).
  • Sell AAPL May $630 call. Collect $4.40 ($440).
  • Sell AAPL June $650 call. Collect $4.45 ($445).

That's $1,550 worth of covered call income on what is, again, an ultra-conservative strategy. And it ups your hypothetical 2012 return on AAPL to 35.4%. Get even a hint more aggressive and you generate income that an AAPL dividend could likely not even come close to touching. Heck, writing four March $570 calls brings in about $800. And they expire in 10 days, which is actually only seven trading days.

If You're Not Collecting Dividends You're Not Investing

I know. It sounds like I am contradicting myself. In one breath, I berate the notion of Apple paying a dividend. In the next, I say If you're not collecting dividends ... blah, blah, blah. Remember what I said about the situation, as a lover of dividend-paying stocks:

Let's consider a dividend from a retail investor's perspective. $10 a share has been tossed around. Today, that's a roughly 2% yield. If you own 100 shares, you would collect $1,000 over the course of a year on an AAPL dividend. Compare that to McDonald's (NYSE:MCD) where it's reasonable to think mere mortals could have collected 500 to 1,000 shares over time. At a dividend per share of $2.80 (2.8% yield), you take in between $1,400 and $2,800, annually, in MCD dividend income.

Endpoint - If you want dividends, you should have been building positions, over time, in dividend-paying blue chip stocks. AAPL is not a dividend-paying blue chip stock. It is an innovative hyper-growth machine in perpetual start-up mode that needs to stay that way or die.

I keep about 30% of my portfolio in three distinct areas: Short-term speculative trades, long-term speculative investments and just plain solid companies that, for one reason or another, do not pay a dividend. Roughly 50% of it sits in dividend-paying stocks. As I scale into these positions, I see that allocation steadily increasing and likely hitting 75% or so by the time I am ready to touch the money (or so goes the plan).

So let us consider a regular old run-of-the-mill stock with and without its dividend.

Time Warner (NYSE:TWX)

In 2011, not counting the dividend, TWX returned 12.3%. In 2011, it paid out, in four installments, a total dividend of $0.94 per share. For the record, the company increased its dividend for 2012 to $1.04 per share. That's a positive sign for long-term investors.

When you include the dividend in that calculation, the 2011 return on TWX increases from 12.3% to 15.3%. You squeeze an extra 3% out of TWX from the dividend alone. And that does not include the additional income you could have generated by writing covered calls against a position in TWX four times throughout the year. If you squeezed just $50 out of each covered call, that additional $200 in annual income brings your return to more than 20%.

12.3% to 15.3% to more than 20%. Holding a stock. Getting a dividend. Writing covered calls. If you could turn a 12% or 15% gain into a 20% gain with minimal risk, on a stock you would likely hold onto anyway, why would you not use the tools that can get you there?

Seems like a no-brainer to me.

That strategy, along with regularly scheduled, methodically-consistent investments in stocks you have to reason to believe in, sits at the heart of how I invest my money. It also serves as the overarching theme in my weekly option investing newsletter for long-term investors.

Disclosure: I am long AAPL, TWX.