As most of my readers already know, I'm a big fan of income-oriented strategies and while I'm just 18 years old, I do believe it's high time to think about my retirement plans and nest egg. The reason why I'm so concerned about this matter is because of the colossal tax pressure many Belgian households have to endure these days. Unfortunately, most of them are financially challenged and don't have the time, knowledge and funds to invest in stocks at all. Consequently, they believe they are incapable of generating growing income streams, and that's why a lot of them go to their 'truthful' advisor, thereby paying tonnes of annual fees for low-quality management. Throughout this article, I'll highlight the strategies I currently favor to ensure my future retirement plans, how I manage our portfolio, and what stocks I'm looking at right now.
The Best Strategy I've Tried So Far
Covered-call writing has probably contributed the most success to my investment portfolio so far, thanks to the amazing amount of control and flexibility that you have with this strategy. Ironically, when I discovered the pros and cons of this approach last summer, I thought it would remain a secondary component of my overall portfolio as I primarily focused on dividend growth and value investing. Fortunately, I proceeded with it and since the beginning of this year, it's been the driving force behind both our future income streams and portfolio returns.
There's A Notable Difference Between Dividends And Option Premiums
In essence, by selling covered calls we are paid a premium for undertaking a contract obligation. We only count the time value component of that premium as profit. If the strike price is in the money, we get some protection of that time value profit. Basically, in return for being capped on the upside, the premium is a cushion that will help us cope with potential price declines since it lowers our cost basis and breakeven level.
Whereas dividends are linked to corporate activities and subtracted from the share price on the ex-dividend date, option premiums are dictated by the market and won't affect the share price of the security that we sold an option on. In addition to this positive note, option premiums are not subject to a similar dividend tax (here currently 30% for Belgian stocks and a total 49.5% for foreign dividend payments), making them even more attractive.
You Have To Know The Pros And Cons
When investors hear about the returns that covered-call writing can produce (my goal is 2%-4% each month), they get super excited, thinking it's a free lunch. Although one-month returns of more than 2% are no exceptions, we need to master all the three components that will set us apart from the average investor in order to make the most money possible. Those three factors are stock price selection, strike price selection and position management when entering a trade. If we stick to these guiding principles, we can further enhance our chances of trading success to the highest level. When it comes to stock price selection, we always look for reasonably priced stocks that institutional investors pay attention to.
In-The-Money Calls Are Indispensable To Successful Covered-Call Writing
As far as the end result is concerned, we can partially determine the risk that we face in advance by choosing an appropriate strike price. From a more conservative stance, I don't like to move forward with trade setups that don't offer the right risk/reward ratio, so I often select the most hated strike among all strike prices: the in-the-money calls.
Every investor loves to get his hands on additional profits, even if that implies he's incurring the greatest risk. For sure, in a bull market with chart technicals looking stunning that's the most ideal position to take. But what if the market is volatile, bearish or simply moves sideways? That's when the in-the-money call kicks in, yet so few covered-call writers grasp the benefits from it immediately as we agree to sell our shares at a lower price than our cost basis. But in the end, the initial time value returns are the same like the ones of the out-of-the-money calls.
(Source: Options Beginner)
The distinction between the two is that additional profits can be made if you sell an out-of-the-money with no protection of your initial time value return. That being said, the least we can say about the in-the-money calls is that they are unnoticed, yet, under certain circumstances, they will be indispensable for your portfolio.
As it relates to position management, we have our exit strategies in place to control various situations. Most covered-call writers struggle with questions like what if the price of the underlying security goes down or what if the price goes through the roof. They just go into their trades, lean back, undergo price fluctuations and hope for a happy outcome on expiration Friday. As a consequence, they will eventually miss out on intermediate opportunities, when in fact, they could have instituted several exit strategies to improve their final return. Being prepared to act appropriately when entering your trades remains a fundamental pillar of covered-call writing and the calculations must come first and must make sense. I've actually written a Word document that concentrates on this topic, making various situations come alive.
(Source: Author's work)
Preview Example: Galapagos
In order to give you some color about how exit strategies function, let me give you a preview example. Let's assume that we bought shares of Galapagos (GLPG). With a flat moving average, the stock moves up and down and we often see oversold and overbought situations. In other words, this stock proves to be a good security for our system.
All of a sudden, the price of the stock starts to decline and the value of the options contracts that we sold has gapped down as well. There's still ample time left before expiration Friday, so how can we improve our trade? Let's evaluate the steps that you should consider after entering your covered-call positions:
Hypothetically, the trades I will be using to illustrate how it works:
- On February 14, 2019 I bought 100 shares of Galapagos
- On February 14, 2019 I sold an in-the-money call with a strike price of 90 euros for 6.35 euros
- On February 27, 2019 the price was 85 euros and I bought it back for 1.75 euros (27% of the initial value)
- On March 4, 2019 the price popped back up to that same 90.35 euros
- On March 4, 2019 I sold the same option (same strike price) for 4 euros
Consequently, we've created two income streams by just being prepared to react when necessary.
Let's take a look at the graph. We sold an options contract when the price was slightly overbought and we bought back that same contract when the price was oversold. We waited for the stock to go back up again and sure enough, it did! We sold that same contract when the price was at approximately 90 euros (slightly overbought).
(Source: Author's work)
By instituting this exit strategy, our profit increased from 6.67% to 8.78%, or an additional 2.11% in the same month. That's an additional annualized return of 25%.
Covered-call writing remains the #1 cornerstone of my income-oriented portfolio to efficiently compound my profits, but that's only been possible by studying the three major components of stock selection, strike price selection and position management. Although stock selection has the most obvious influence on your results, the odds of success are elevated once you control your trades through the use of exit strategies.
The risk of turning this strategy into a risky one by being greedy is a fatal error. Therefore, you have to set your one-month goals and whether you've reached your intended goals, or exceeded them, it doesn't matter as long as you generate those cash flows consistently.
Buy And Hold Investing
Besides being fond of the short-term capital gains from selling options, there's nothing better than long-term ownership in the best companies led by competent management, knowing their visibility will bring forward sustainable value creation. Therefore, buy and hold investing, which encompasses value investing and dividend growth investing, is the second component of my overall investment portfolio. While Seeking Alpha is one of the best (if not the best) place to browse through dividend ideas provided by authors like Dividend Sensei, Brad Thomas, Jussi Askola and many others, I'd like to zero in on the small cap space and especially some of the Belgian family businesses I currently invest in.
Long-Term Performance Of Small Caps
Over the long run, small caps have clearly outperformed the broader market, which comes along with several robust fundamental strengths. Compared to the S&P 500 (SPY), Dow Jones (DIA), S&P 600 (IJR) and the Nasdaq 100 (QQQ), the Belgian small cap (rather micro cap) index in particular performed really well over the past 19 years.
The first advantage to smaller businesses is management's flexibility to adapt more quickly to changing market conditions than cumbersome blue chips, thereby triggering exponential sales and cash flow growth. Adding to higher than average growth rates, small caps happen to fly under the radar for a long period of time, whereas blue chips are frequently purchased by well-known funds, creating opportunities for value investors who want to buy stock at discount.
(Source: Seeking Alpha)
Of course, there are risks you need to take into account before diversifying into smaller companies. If you are a long-term investor, then we'll have at least one feature in common: patience. The main disadvantage to small caps is the low amount of liquidity these stocks tend to have. Remember December of last year when every single stock got hit hard and in particular small caps as liquidity was drying up?
Meanwhile, only patient value investors can then do great business by loading up on undervalued stocks. So, for me, low liquidity isn't an unbridgeable hurdle and bargain hunters should use it in their favor when sentiment is depressed. That implies that you have to stomach the price fluctuations in times of elevated volatility and bear markets if you want to incorporate small companies as part of your buy and hold portfolio. Also, with the damaging impact of trade wars, small caps are more prone to economic shocks because of their smaller scale.
Another element that plays a key role in determining the best stocks is the difference between family businesses and non-family firms, which now forms the basis for my stock picking process.
Two years ago, Credit Suisse issued a report containing information about the share price performance of large family-controlled businesses compared to the MSCI World index, which indicated an outperformance of 47% over the past decade. Generally speaking, this additional return was due to first and foremost the expertise of families, which is passed down from the current generation to the following, and their intention to focus on the long term instead of thinking about bonuses and being under massive pressure. So, most family businesses score above average on quality.
It's well worth to check upon some statistical data as well. There are three things I'd like to elaborate on:
- Debt funding
- Cash Flow Generation
As Credit Suisse's report points out clearly, family-controlled firms produce higher margins, thus, higher cash flows than their non-family-owned rivals. Admittedly, a difference of 190 basis points in EBITDA margins is hard to ignore, given the average achieved since 2006 is 150 basis points.
2) Debt funding
Although interest rates are expected to remain low in the next coming years, I'm circumventing companies that are way too leveraged. With gearing coming in at 1.4 times EBITDA in 2017, family-owned businesses outpace non-family-controlled firms primarily due to their risk aversion. Spending less cash on buybacks lies at the root of a significantly lower debt level as family firms look to opportunistically reinvest their cash flows in their operations. Consequently, thanks to their conservative balance sheets and focus on operational efficiency, family businesses can sweat out the next financial crisis more comfortably.
As it relates to credit ratings, family businesses still retain a rock-solid track record as 24% of family-owned companies are rated A– or higher, which is almost double the percentage for non-family-owned companies.
3) Cash Flow Generation
In search for the best companies, it's quite obvious that we pay attention to sufficient cash generation as this enables a company to invest in new products, in new production facilities, to acquire suppliers or competitors, to pay out dividends or to buy back stock. This in turn brings forward above average value creation and thus total shareholder returns.
When calculating the Cash Flow Return On Investment (CFROI), we combine two vital factors, namely cash flow and investments. The higher the return, the more efficiently management is running a business. The graph above shows that the returns generated by family businesses surpass those of non-family businesses easily, while they didn't experience a huge decline in their cash flow returns during the latest financial crisis.
Combining Small Caps And Family Businesses
Putting the advantages of investing in small caps or micro caps and family businesses together, we should be able to outperform the broader market over the long haul, unless we don't make non-emotional and fundamentally sound investment decisions. As highlighted at the beginning of this article, I mainly participate in Belgian stocks. Let me go through them with you and discuss what stocks I consider the best and what criteria they must meet before I risk one penny of my hard-earned money. Those guidelines can be applied on US companies as well.
- Family ownership: at least 50%
- Undervalued, based on my DCF modeling or expected growth rates (required FCF Yield of at least 7%)
- Bright long-term prospects
- Secured dividend payments
#1 VGP: Logistic Real Estate Developer
VGP, currently one of the most hidden gems you can find on Euronext Brussels and focused on logistic real estate, contributes the most dividends to our buy and hold portfolio. Two weeks ago, the company released its annual results which came in ahead of my expectations, although the dividend could have been hiked even more from €1.90 to €3.50. Though, during the conference call, management explained that the funds will be used for several projects being in the pipeline. Based on the analyst estimates, VGP's EPS is poised for rapid growth over the next three years. With an earnings yield of over 20% by 2022 and low indebtedness, investors seeking sustainable dividend growth should watch VGP closely. (Source: Author's work based on the company's financial statements)
With a free float of just 37% and a proven track record, VGP does meet my requirements and after taking into account the potential of its landbank, I feel comfortable with my stake of 907 shares.
Currently, VGP represents 9.7% of our overall portfolio and I'm looking to add even more if opportunities present themselves. Along with WDP, another outstanding logistic REIT player, real estate currently contributes more than 30% to our regular dividend income. And from a historical point of view, REITs have formed the backbone of dividend investing for many years thanks to their predictable rental income streams and wide economic moat.
#2 Ter Beke: Digesting The Takeovers
Ter Beke, which operates in the fresh food industry, is yet another company that has been flying under the radar for quite a long time. Over the past decade, Ter Beke's sales growth has been pretty flat before management started to pursue accretive takeovers.
As a result, its top line has grown substantially over the past two years, however, one-off expenses counterbalanced this quantum leap, leaving profit margins at low levels. For this year, I expect the situation to normalize, resulting in notably higher free cash flows that can be used to pay down the debt burden.
From now on, Ter Beke's leverage is expected to plummet from 2.42 times EBITDA in 2018 to 0.96 by 2021 thanks to growing FCFs. Today, 6.8% of our overall portfolio is dedicated to this company and I am willing to add more to the 289 shares I already own. Based on its bright prospects and anchored family ownership of 67%, Ter Beke is a perfect buy and hold stock that will fuel our regular dividend streams.
My price target, based on my conservative DCF modeling, stands at €183.71, representing upside potential of 32.2% from today's levels.
(Source: Author's work)
#3 Sioen Industries
The last company I'd like to boost my exposure to is Sioen Industries, a Belgium-based textile solution provider. Just like Ter Beke, Sioen's management took several steps to diversify its business by chasing after lucrative takeover plays.
That seems to pay off since Sioen's board of directors decided to raise the dividend by more than 11% last year as a result of strong margins and economies of scale. I'm currently long with 822 shares, but I feel it won't take long before the undervaluation melts away, so I'm watching today's price action closely to load up on new shares.
(Source: Author's work)
In my opinion, shares are worth at least €29.80 and management's proven track record supports my bullish view on the stock.
Heading into the coming years, I've chosen covered-call writing and buy and hold investing as the most appropriate vehicles to ensure my future retirement plans. By selling covered calls, we can target initial one-month returns of 2%-4%, and depending on what strike price you are using, you can benefit from additional share price appreciation. As always, when executing a particular strategy, we need to master all the pros and cons.
As pointed out in this article, putting small caps and family businesses together is likely going to deliver outstanding results over the long haul. As opposed to covered-call writing, we can only reap the fruits of value investing by being patient and making thorough non-emotional fundamental investment decisions. In the Belgian spectrum, I'm looking to purchase more VGP, Ter Beke and Sioen.
Disclosure: I am/we are long VGP, TER BEKE, SIOEN. 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.