Dividends on steroids
At risk of sounding like a drug addict, we like to introduce a juicy concept to potentially boost your passive income. We are all familiar with dividends, am I right? Nothing beats lazing at home and yet witness our account “magically” being credited with money.
But what if we could double a 3% dividend-yielding stock into 6%, without having to increase our risk profile? It is like injecting our investments with steroids to make them work harder.
I know that we often do not associate steroids with a positive connotation, but let’s take the physical dangers of steroids out of the equation for a moment and trust me when I say that if you used steroids in a properly controlled manner under a doctor’s supervision (in this case the doctor is yours truly!), you will find that they can provide remarkable results that is a sure cure for income anemia.
I will show you step-by-step a simple strategy you can adopt to build a conservative income portfolio with the proper usage of “steroids”.
This is a concept we termed as Dividends on Steroids or DOS for short. It mainly involves investing in US-based dividend-paying aristocrats using an added element of call-option writing (what the hell is that? We will provide a brief explanation when we explain the process in step 4). The deployment of the DOS strategy will substantially boost the income and yield rates of the investments at zero-additional risk to the investor (the only downside is potentially making less money from capital appreciation).
It sounds like a winner to me already!!! Before we get overly excited, running to the nearest pharmaceutical to pump ourselves up with steroids, let’s review the methodology in a step-by-step process:
Before I proceed, a word of caution. The below strategy involves the usage of derivatives such as options for US stock counters. The notional amount of investment in a single stock might be substantially large as well. If you are fine with taking calculated/measured risks, then do read on to see how one can effectively double the yield of a stock.
STEP 1: Hunting for the right candidate
The focus should be on finding high-quality companies where the dividend payments are relatively safe. Ideally, these companies should have a strong track record of not just maintaining the dividend amounts paid each year but demonstrate the ability to increase such dividend payments every year.
One should focus on a variety of metrics such as pay-out ratio, cash flow yield, net cash/debt position, etc to ascertain the reliability of the companies’ dividend-paying track record.
STEP 2: Accruing a fair value
Once we have identified a high-quality dividend-paying company, we then proceed to ascertain a fair value of the counter using our proprietary cash-flow/dividend discount model as well as other valuation metrics such as Price-to-earnings ratio and Price-to-book ratio, etc.
Most of our dividend-paying selections should minimally generate a yield of 3%/annum before implementing our steroids prescription. Post-steroids, we should expect the annual all-in yield to be in excess of 5-6% at the minimum. We look to target 8-10% dividend yield using the DOS strategy which we will further elaborate from STEP 4 onwards.
STEP 3: Taking the plunge
We have identified an ideal dividend-paying candidate whose share price is currently trading below its fair value. How big a discount the current share price is relative to its fair value we have derived from STEP 2 is a discussion topic for another day.
Let’s assume that we are comfortable buying into a stock at its current price level (below our calculated fair value) based on fundamental criteria. We can also choose to deploy technical analysis as a secondary criterion in our entry process to help minimize transaction costs.
However even if we are 100% wrong on the technical interpretation, that should not have an impact on our entry strategy which is based on fundamental valuation. Having pulled the trigger and purchase a stock, we are now a proud investor of a company that pays a dividend yield of 3%/annum at the minimum (our basic criterion for stock consideration) while we wait for the market to realize its fair value.
Let’s move on to Step 4 where the actions start to get heated up.
STEP 4: Deploying the steroids
This is the part where we start deploying our steroids! We have made the stock purchase at a certain market price. Let’s use USD47 as an example. We determine that the fair value of the counter is USD51 based on our fundamental-based fair value calculation.
While we are not certain how long it will take the market to recognize the stock value of USD51 (could be 1-day, 1-year, 10-years or never), making us 8.5% return on our investment, we have already ascertain in STEP 1 that the company has the ability and track record to pay our required dividends, in this case, at least USD2/annum, giving us a “guaranteed” yield of 4.3% on our investment cost of USD47.
However, instead of being satisfied with the 4.3% yield, we can “write” a covered-call option at a strike price of USD51 (with an expiry of 1-year) and immediately receive a call premium, which can be considered as our “additional dividend”.
Before we engage in the scenario analysis, let me do a very basic introduction of what “writing/selling” an option entails.
Basic option introduction
1.Buy a call option of a stock.
We will buy a call option of a stock when we want to take a bet that the share price of the stock will go up. For example, we can buy an at-the-money call option (strike price of the option is same as the stock price), paying a premium which is a fraction of the cost of the stock itself. When the price of the stock goes up, our return on our cost will be significantly magnified vs. buying the equity itself.
2. Sell a covered call option of a stock you own.
Let’s assume we already own a stock ABC. We can sell a “covered” (because we already have ownership of the stock) call option at a level above our cost. For example, if we purchased a stock at USD100, we can choose to sell a covered call option at USD110 for a duration of 3 months, generating an immediate call premium.
This call premium can be regarded as our “additional dividend”. There is theoretically no additional downside risk to this strategy which is at the core of what we will be engaging. We will explain further in our scenario analysis below.
3. Buy a put option of a stock.
We will buy a put option when we are negative on a stock. I shall not go deep into the details of buying put options in this write-up
4. Sell a put option of a stock.
We will provide an example of this in our bonus step. Essentially, selling a put option allows us to receive a put premium upfront (another additional dividend), concurrently waiting to buy a stock that we like at a lower price vs. current level.
For example, let’s assume we like ABC stock at a current level of USD100. Instead of buying the stock outright, we can choose to sell a put option on the stock at a level of USD95 and receive a put premium upfront.
Upon expiry of the option, if the stock price is above USD95, we not be obligated to purchase the stock and the full premium will be our profit. If the price is below USD95, we will have to purchase the stock at USD95. This strategy shall be explained in more detail in our bonus step.
Scenario analysis
Going back to our example of purchasing a stock at USD$47/share after determining that its fair value is at least USD$51/share. There are 3 scenarios that can happen next:
Scenario 1: Stock trades from USD47 to >USD51 after 1-year
Let’s assume that after 1-year, the stock trades at USD55/share. However, your total return will not be 17% (capital appreciation) + 4.3% (dividend yield) = 21.3% total return. Instead your return is 8.5% (capital appreciation) + 4.3% (dividend yield) + 4.3% (call premium) = 17.1% total return.
The stock will be “called away” or sold when it hits above USD51/share, hence you will not be able to enjoy any additional returns in excess of USD51. However, the 1-year holding return will still be a very decent 17.1% in this scenario.
Scenario 2: Stock trades between USD47-USD51 after 1-year
Let’s assume that after 1-year, the stock trades at USD50/share. Your “unrealised” return in this scenario is 6.4% (capital appreciation) + 4.3% (dividend yield) + 4.3% (call premium) = 15% total return. Part of the return is “unrealized” (capital appreciation) as you have not sold your stock position (unlike scenario 1 where a forced selling took place), while the dividend yield and call premium income would have been securely credited into your account and are “realized”.
You can choose to 1) sell your stock at USD50 to realize the capital appreciation return or 2) rinse and repeat the whole call-option writing process and proceed with another round of call-option selling to generate further income from call premiums.
Scenario 3: Stock trades below USD47
Let’s assume that after 1-year, the stock trades at USD42/share. Your “unrealised” return is a loss of 10.6% (capital depreciation) + 4.3% dividend yield + 4.3% (call premium) = -2% total loss.
Your unrealized losses have been reduced to -2% as a result of the realized income from the dividend as well as call premium. Hence your new break-even cost has been sufficiently reduced to USD43/share (USD47 – USD2 (dividend) – USD2 (call premium)).
The stock remains in your possession and you can then choose to repeat the call-writing process again, this time with the call option strike price at USD47/share for Year 2, generating a call premium of 4.3% again for the second year.
The breakeven cost for the share now drops from USD43/share to USD39/share (USD2 dividend and USD2 call premium). If the share appreciates >USD47/share, the stock will be “called away” and the total return over a 2-years horizon will be (USD47-USD39) = USD8 or 17% or c.8.5% simplified annual return.
BUY-WRITE strategy
The BUY-WRITE strategy clearly increases our income potential through the added call premium while maintaining the risk profile of our investment. Recall that we made our investment decision from a fundamental/technical standpoint and we are comfortable to be a proud owner of a 4.3% dividend-paying stock at USD47/share.
The risk profile, in this case, is not in any way negatively affected by our covered-call strategy. We are still exposed by significant downside risk if the share price of the counter we invest in declines in a substantial manner. Like all value investors, you are committed for the long-haul (in this case for the duration of 1-year) and are not affected by the significant price fluctuation of the stock.
Remember that it is the dividend + option premium income stream that we value and as long as the dividends are at no risk of a decline, we can ride out rough price times without concern.
BONUS STEP: Generate income on stocks we do not own
The main appeal of the DOS strategy is the ability to increase our cash income potential by 2-3x without increasing the risk profile of our investment. In a nutshell, this strategy involves going-long on a dividend-paying stock and writing a covered call option on the counter to generate call premiums that are immediately credited into our accounts. Our cash income generation is no longer solely dependent on dividends but also on the call premiums which we write on our stocks.
However, this strategy involves taking a position in a stock. We could also employ a naked call option writing strategy but this is again a topic for another day. What if we could generate option premiums without having to own the stock directly? We can deploy a strategy called put option writing.
Imagine STOCK A currently trading at USD100. While we like the stock at USD100, we will preferably like to buy the counter at a price of USD90 as a margin of safety. We can deploy a strategy of writing a 1-year put options at a strike price of USD90 and collect a premium of USD3 as an example.
Within a 1-year duration, if and when the price declines to USD90 and below, we will be obligated to take ownership of the stock at USD90 (even if the price might have corrected significantly below the USD90 price). In this strategy, we collect a put option premium of USD3/share while we wait for the price to drop to an attractive level of USD90 before taking ownership of the stock.
Our breakeven-level is thus significantly reduced to USD87 vs. taking ownership of the stock at USD100. What we are missing out in this strategy is the opportunity cost of share price appreciation and dividend income (since we do not own the stock).
Conclusion
The above is a simple strategy that engages the use of options to juice up the dividend potential of a dividend-paying stock. While it might look attractive, do be warned that this strategy might not be suitable for most retail investors. The reason is due to the significant capital outlay.
To be able to “write” a SINGLE covered-call option, that will entail one owning 100 shares of a US counter, since each option is equal to 100 shares. For a stock such as Apple (not a high dividend-paying stock) which currently trades at around USD265/share, one will need to first own at least 100 shares of Apple in order to execute the “covered call strategy”. 100 shares of Apple = USD26,500.
Hence, the outlay on a single stock could be pretty substantial.
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