In uncertain markets, dividends can give you a critical investing edge.
As you can see from the chart on the left, just mindlessly investing in dividend-paying stocks can give you more than a 2:1 annual advantage in your investments.
Of course, here at PSW, we teach the art of selling options premiums – something that turns virtually any stock into a "dividend" payer. For example, MSFT is only a small, 2% dividend-payer but a fairly solid cash-machine of a stock that we don’t feel is likely to go bankrupt overnight so it makes for a nice safe staple in a long-term virtual portfolio. But MSFT is also a very poorly-run company that hasn’t grown in 20 years but we can make it a much more interesting stock by simply selling covered calls.
For example, we buy MSFT for $24.23 and we sell the Sept $24 calls for .77. This lowers our effective basis to $23.46 and selling the call puts us in no special danger – we are simply agreeing to sell MSFT for $24 on expiration day in September (the 17th). Should the stock be called away from us, we make a .54 profit or 2.3% of our net $23.46 cash investment in less than 30 days. That works out to a 26% annualized ROI and, even if we get called away, we can simply buy the stock again and again and sell calls every month. Of course, you can optimize all this with timing and we favor stocks that are on sale – this is just a very simple example of how our most basic options strategy can drastically boost your annual returns on any stock in your virtual portfolio.
Let’s say you don’t want to mess around with MSFT every month. You can simply sell the 2012 $22.50s for $4.40, that drops your net entry from $24.23 to $19.83 and getting called away at $22.50 would be a profit of 13.5% over 17 months PLUS you would be getting your .52 annual dividend so let’s call it .75 more for a total profit (if MSFT holds $22.50) of $3.42 or 17.25% – 1% a month certainly beats what the banks are offering these days! Not as sexy as the 26% ROI you make by working the trade every month but you do get a built-in cushion that drops your break-even price to $19.83, which is a full 18% below the current price. So MSFT would have to fall 18% (not including the .75 dividend) before you are even behind on this trade.
Would making 1% a month on your entire virtual portfolio have enhanced your lifetime earnings? If so, you should probably be using this strategy whenever possible, right? Here’s a nice chart showing average annual S&P results for each decade:
| Price Change |
Dividend Dist. Rate |
Total Return |
Inflation | Real Price Change |
Real Total Return |
|
|---|---|---|---|---|---|---|
| 1950’s | 13.2% | 5.4% | 19.3% | 2.2% | 10.7% | 16.7% |
| 1960’s | 4.4% | 3.3% | 7.8% | 2.5% | 1.8% | 5.2% |
| 1970’s | 1.6% | 4.3% | 5.8% | 7.4% | -5.4% | -1.4% |
| 1980’s | 12.6% | 4.6% | 17.3% | 5.1% | 7.1% | 11.6% |
| 1990’s | 15.3% | 2.7% | 18.1% | 2.9% | 12.0% | 14.7% |
| 2000’s | -2.7% | 1.8% | -1.0% | 2.5% | -5.1% | -3.4% |
| 1950-2009 | 7.2% | 3.6% | 11.0% | 3.8% | 3.3% | 7.0% |
Notice the inflation the Government keeps denying is a actually 3.8% for the past 60 years and is still 2.5% despite all the talk of deflation. That means, if your money isn’t doing SOMETHING to make at least 2.5%, you are falling behind every day. Of course, putting your money in the market for the past 10 years hasn’t helped, without dividends that would have cost you an additional 2.7% of your cash! Notice that in EVERY decade, our very simple combination of dividends plus call selling would have kept you above both inflation and market dips – IN THE LONG RUN.
I emphasize IN THE LONG RUN both because it’s a great Eagles song and also because most investors are way too short-term focused and forget to look at investments as…. well, investments. Using a simple Compound Interest Calculator, you can take $10,000, add just $5,000 a year for 30 years at the average real total return (ABOVE inflation) of 7% and that nets you $581,487.76 inflation-adjusted dollars to retire on. This should be the base goal of any investor – simply make sure you have a conservative base to build on.
Keep in mind that selling covered calls adds no risk other than you may, potentially miss a big move up in the stock as you have already promised to sell it for "just" (in the MSFT example) a 26% annualzied ROI but are there ANY decades where the market gained 26%? No, of course not. Just change that 7% figure in the calculator to 17% and watch what happens when you hit the "calculate" button – $4,898,165.34!!! Don’t you think this is a strategy that deserves some of your attention?
Is this realistic? Of course it is! If people would get their head out of the short-term trading BS and concentrate more on their INVESTING, the World would be a far better place. Few people plan for the far future but look at this chart of what 8% in a Roth IRA can do for your children’s children. Do you need a new Mercedes or do you need to leave a family legacy?
Hopefully, I’ve done enough to get your attention so that now we can look at some boring, slow-moving, dividend-paying stocks in a better light. It’s all well and good to have fun playing the short-term market moves but, without a solid base in your virtual portfolio that is delivering consistent annual returns, the risks can be unacceptable. Short-term trading can be wonderful as we can hedge our longer-term positions against market downturns or we can take advantage of aggressive up moves in the market that will be calling away our longer positions but, in both cases, the short-term trading is the fine-tuning that is meant to lock in those 8% annual returns (hopefully better!) that will make you a family legend for generations to come.
In the grand tradition if KISS (Keep It Simple, Stupid), let’s start by looking at the Dow’s top dividend players. We like the Dow because it’s easy to hedge with our Mattress Plays (see "The Stock Market Parachute" as well as commentary in our Strategy Section). T, VZ, BA, HD, KFT, MRK and PFE are generally the best payers and, in establishing a long-term virtual portfolio with a dividend strategy, it’s good to keep an eye on your diversification. Since we are selling covered calls as well, we also take into account which option sales give us the most bang for the buck and, of course, which stocks represent a good value at the current prices. That knocks MCD, XOM and CVX off our list as they represent more of a gamble and, if we are going to gamble – we can do A LOT better than 3%.
I’m not going to comment extensively on these stocks, they are Dow components and will mainly rise and fall with the index and there are thousands of articles written on each stock so let’s just say I think these should hold up well this decade and leave it at that as far as fundamentals go:
BA has the worst dividend (2.6%) of our Dow group but I also think they are the best long-term value. The Dreamliner WILL get built and sold – it’s only a matter of time. $64.60 for the stock can be knocked down $13 with the sale of the 2012 $60 calls for a net entry of $51.60 and a nice 16.3% if called away at $60, which is 7% below the current price. Pocketing an additional $1.68 dividend against the net $51.60 increases the annualized return to 15%.
Good time to remind you: We do not necessarily get called away at $60 – we can execute our Rawhide Strategy of "Rollin’ rollin’ rollin‘"… Had we sold, for example, the August $60 calls and decided we did not want to get called away, we could still roll the net $4.60 caller out to 2012 and collect net $8.70. Presumably, we would have a far lower basis and you will find this happens over the years as you build your virtual portfolio as it would only take 8 rounds of collecting net $8.70 against your BA shares to lower your net basis to zero – at which point collecting $1.68 in dividends starts seeming like a great deal! And what do you do with the cash? Buy more dividend-payers of course!
This is how we "compound" our virtual portfolios over the years, we sell options and collect dividends and use them to buy more stocks that we can sell options and collect dividends against. That brings up another thing we are not discussing here – the naked put sale! This is the key to our Buy/Write Strategy (see "How to Buy a Stock for a 15-20% Discount") and I am 100% in favor of it but this is a post for the IRA crowd, who do not get the full benefits of selling the naked put side (and are often not allowed to) so we’re concentrating on the basic strategy – feel free to ask if you are interested in the more advanced versions.
HD has a nice 3.4% dividend while we wait for the housing market to come back (if ever). At $28.17, they simply don’t have a good strike to sell in 2012 so I prefer a shorter-term play, selling the Jan $27 calls for $2.65 for a net $25.52 and a call away with a $1.48 (5.7%) profit in just 5 months. Note that 1% a month is a very good goal on the underlying security while our dividends give us a bonuse to get us into that 15% range….
The rest of this post is for Members Only and can be found under the Virtual Portfolio Tab.
