An Enhanced Approach To Dividend Growth Investing

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Includes: BEN, FHN, GIS, HBAN, IPG, LM, LNC, SIG, STI, TJX, TUP, UNM
by: The Bell Curve Investor
Summary

Dividend growth investing is an effective way of earning compelling total returns.

Enhanced strategies can add significant income above the dividend.

Enhanced strategies can also reduce risk in the process.

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We are dividend growth investors at heart. Recently, though, we've been experimenting with alternative approaches to generating additional income from our investing process. Other professionals tend to focus on the covered call strategy, where the investor sells call options at strike prices above the basis of a preexisting position enhancing the overall yield of that position. If the stock price rises about the call option's strike price before expiration, the shares may be called away. Otherwise, the investor keeps the shares. In both cases, the investor keeps the premium income earned from the sale of the call options.

Since we are more focused on building our portfolio by acquiring shares, we've been experimenting with the cash secured put strategy. We sell put options which gives the buyer the right to sell shares to us at an agreed upon price. We set the price to be below the current market price of the shares. If the share price stays above the put option's strike price before expiration, the buyer holds onto their shares.

However, if the price falls below the put option's strike price, we may become obligated to purchase the shares at the agreed upon price. We are very comfortable with this outcome because it enables us to acquire the shares we want at prices we want to own them. In both cases, we keep the premium income earned from the sale of the put options. Given the risk profile of put options, we cash secure the position by placing enough cash in an account to immediately purchase shares if the buyer of the put option exercises and assigns stock to us.

Market-Actionable Opportunities

To find opportunities, we track a universe of hundreds of companies that not only pay dividends but also have consistent histories of growing those dividends annually. Our review process considers over 40 fundamental and technical metrics across seven categories to determine which companies deserve a deeper look. We look at business growth and profitability, management effectiveness, leverage and financial health, dividend meaningfulness, safety, and growth, volatility, momentum, and valuation. After recently completing comprehensive fundamental and technical analyses on that universe, we identified 12 opportunities worthy of the attention of fellow long-term dividend growth investors:

  • Franklin Resources Inc. (BEN)
  • Interpublic Group of Companies (IPG)
  • Legg Mason (LM)
  • Lincoln National Corporation (LNC)
  • SunTrust Banks (STI)
  • Tupperware Brands (TUP)
  • Unum Group (UNM)
  • TJX Companies (TJX)
  • General Mills (GIS)
  • Huntington Bancshares (HBAN)
  • Signet Jewelers (SIG)
  • First Horizon National Corporation (FHN)

Since these opportunities are for new additions to our portfolio, the cash secured put strategy fits quite well.

Analyzing a Cash Secured Put Opportunity in Legg Mason

Chart LM data by YCharts

As of the writing of this article, the market is offering shares of LM at $27.06. Despite the headwinds at the company, with net fund flows sharply moving toward asset managers practicing passive management, we like the price of the shares and would consider purchasing a lot of 100 for $2,706 plus fees. In our first year of ownership, we would expect to earn a $1.32 dividend per share, or $132, representing a yield of 4.9%. Alternatively, we could sell the JAN 18 27 puts. If LM drops by just six cents by January 18, we would be assigned shares at the slightly lower price of $27 and earn the same dividend generating a slightly stronger yield.

In addition, we would earn another $120 in premium income for our trouble, about 90% of the annual dividend in 41 days without yet owning the stock. Even if the stock does not fall to our desired price and stays above $27 through January 18, we still keep the premium. The cash secured put strategy can be effective at enhancing returns from dividend growth investing. We've applied the same analysis to each of our twelve opportunities.

Selected Cash Secured Put Opportunities

Symbol Price BuyZone Strike / Exp. Imp. Volatility Premium Return on Cap.
BEN 32.24 $28 - $34 JAN 18 30 PUT 33.2% $0.50 14.8%
IPG 22.64 $20 - $23 JAN 18 20 PUT 29.8% $0.50 20.2%
LM 27.06 $35 - $39 JAN 18 27 PUT 35.3% $1.20 39.6%
LNC 56.40 $52 - $60 JAN 18 55 PUT 39.8% $2.15 34.8%
STI 56.94 $49 - $57 JAN 18 55 PUT 35.9% $1.45 23.5%
TUP 34.97 $24 - $37 JAN 18 30 PUT 47.0% $0.35 10.4%
UNM 32.25 $38 - $44 JAN 18 30 PUT 49.7% $0.80 23.7%
TJX 45.29 $45 - $51 JAN 18 45 PUT 32.9% $1.65 32.6%
GIS 38.48 $39 - $43 JAN 18 37.5 PUT 35.0% $1.30 30.9%
HBAN 13.42 $11 - $18 JAN 18 13 PUT 32.6% $0.37 25.3%
SIG 38.55 $50 - $73 JAN 18 35 PUT 59.5% $1.35 34.3%
FHN 15.12 $13 - $19 JAN 18 15 PUT 33.6% $0.55 32.6%

Sources: Options Brokerage, Proprietary Analysis

Selecting Appropriate Strike Prices

In the table above, our BuyZone is the result of a series of calculations that estimate the price at which we want to own shares. This range is based on common fundamental analysis valuation metrics including variants of P/FCF, P/E, P/B, and enterprise value/EBITDA multiples as well as the dividend yield and other valuation metrics. To us, a stock becomes interesting when its price falls to within the buy zone while still meeting all of the fundamental criteria mentioned earlier.

We selected strikes that are just below current market price to maximize option premium. We also selected expiration dates with enough time to have meaningful premium and with a short enough time frame to benefit from a decline in the value of options as they approach the expiration date (all else being equal).

Assessing Implied Volatility

In the table above, we identity the level of monthly price volatility expected by the market as implied by that option. This value is derived from the Black-Scholes options pricing model and should be available on stock and options trading platforms. As of the writing of this article, implied volatility in the market is currently high relative to most of this year, as shown by this chart of the VIX.

Chart ^VIX data by YCharts

More importantly, implied volatility is generally higher than realized (historical) volatility. As a result, options are often overpriced relative to the actual movements of the underlying stock price, creating higher probability profit potential.

Estimating Premium Earned

To estimate premium earned, we start with the current bid price of the puts - where the market is willing to buy. This value represents the actual amount of money per share put into our account. For LM, the $1.20 premium will generate $120 in income when we sell 1 put contract.

Calculating Return on Capital

We use return on capital to determine how efficiently capital is working. To calculate return on capital, we divide the amount of premium earned by the capital put at risk to earn it. For LM, the calculation is 1.20 / 27, which computes to 0.044, or 4.4%. Since this return is earned over a 41-day period, we annualize the return by multiplying 0.044 by result of the number of days per year divided by the days to expiration. For LM, the calculation is 0.044 * (365 / 41), which computes to an annualized return of 39.6%.

Here is our formula in full form:

Return on Capital = (Option Premium Earned / Strike Price) x (365 / Days to Expiration)

Other professionals may show higher returns on capital for the same situation because they subtract the premium earned from the strike price in the first denominator. We agree with that calculation, too. The premium is collected up front and therefore already earned; that capital is no longer at risk. For simplicity, and to be conservative, we share the above calculation.

Prioritizing and Selecting Opportunities for our Portfolio

We invest under capital constraints and must prioritize the opportunities in front of us. Due to our portfolio construction and risk management policies, we'll proceed under a limitation of no more than $10,000 in new capital at risk and no more than $5,000 in any single position. To prioritize our opportunities, we rank each opportunity in descending order by return on capital. The top six opportunities each have returns on capital of over 30%.

Symbol Contract Capital At Risk Return on Capital
LM JAN 18 27 PUT $2,700 39.6%
LNC JAN 18 55 PUT $5,500 34.8%
SIG JAN 18 35 PUT $3,500 34.3%
TJX JAN 18 45 PUT $4,500 32.6%
FHN JAN 18 15 PUT $1,500 32.6%
GIS JAN 18 37.5 PUT $3,750 30.9%

While LM and LNC look like amazing opportunities, we must pass due to capital constraints. We have a preexisting position in LM; adding to that position would violate our capital constraints.

There is one more issue with these opportunities - they all expire at the same time, which concentrates market risk. Diversification of near-term expiration dates can help mitigate this risk. Unfortunately, the only stock with weekly options, in addition to monthly options, is SIG.

Symbol Contract Capital At Risk Return on Capital
SIG JAN 11 35 PUT $3,500 32.2%

Instead of selling the Jan 18 35 PUT, we can sell the Jan 11 35 PUT. We would endure lower risk (34 days instead of 41) and earn less premium as a result ($1.05 vs. $1.35), though the return on capital remains strong at over 30%. We accept this trade-off because it reduces risk and enables us to earn more premium from a second position.

With $3,500 in capital committed to this position, we have up to $6,500 remaining. While GIS boasts strong prospects, we see better value (in the options) elsewhere. This leaves FHN and TJX, each with the same return on capital. Moreover, they also may possess the same capital at risk if we scale a position in FHN by a factor of three by selling three contracts instead of one. We chose TJX over FHN because of its lower entry point relative to our BuyZone estimates, recent strength in earnings power as evidenced by the chart below, our belief that retail woes are overblown, and the fact that a rising interest rate environment has yet to fully materialize in bank income statements and balance sheets.

Normalized PE Ratio - FHN vs TJX

Conclusion

The long-only dividend growth investing strategy has treated us well for decades. Our experiment has proven that there are ways to enhance returns while further reducing risk. When combined with fundamental analysis, technical analysis, and market awareness, options empower dividend growth investors to buy the right companies at the right time and for an acceptable price by embracing and managing volatility, rather than avoiding it altogether.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in TJX over the next 72 hours. 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.

Additional disclosure: I am/we are long SIG and LM.