5 Stocks for Strong Income

During times of economic uncertainty, owning top-quality companies that pay safe and growing dividends is one way to ride out the storm. Dividends not only provide regular income to investors, but they keep management focused on creating steady shareholder value and deploying cash intelligently.

Managers at firms such as Johnson & Johnson (NYSE: JNJ  ) , Procter & Gamble (NYSE: PG  ) , and Coca-Cola (NYSE: KO  ) take great pride in the fact that they've increased their dividend each year for decades running. However, yields still average less than 3% for dividend-paying U.S. stocks, so dividends alone are not likely to propel your portfolio far into the black during topsy-turvy markets.

But if you add writing covered call options to large, dividend-paying stocks, you have a safe and celebrated strategy for creating both extra income and better returns.

Covered calls 101
When you own at least 100 shares of a stock that has options available on it, you may write (or sell) covered calls on your shares and be paid option income.

Here's how it works: Suppose you own 300 shares of Fool Me Once, Inc. The stock trades at $30, and you'd be happy to sell your shares at $35. Looking at the options on the stock, you see that the $35 strike price call options expiring in three months bid $3 per share.

In other words, you're paid $3 per share when you write the call options, or $900 since you own 300 shares, and you're obligated to sell your shares if the stock price increases to $35 or above by the options expiration date. And then you wait.

If Fool Me Once, Inc., is below $35 by the time your options expire, you simply keep the $900 and keep your stock. You've made income and can now write new covered calls if you wish. If the stock is above $35 by the option's expiration, your shares are called away from you (sold from your account) at $35. Adding the $3 per share that the options paid you, you obtained a net sell price of $38 -- more than you were willing to sell for.

The downside of covered call options is that, if the stock soars beyond your expectations, you may end up leaving money on the table. If Fool Me Once, Inc., soars to $45 by the time the option expires, you'd still have to sell your shares at $35 for a total income of $38 per share. Missing extra upside is the main risk of covered calls, so the strategy is best for stocks you don't believe will suddenly take off.

With minimal risk, though, writing covered calls can pay 4% to 6% a year, or more, in extra annual income to your portfolio. Add that to a 3% dividend payment, and you're raking in some strong income before you even consider any share price appreciation.

Five stocks for income
So which companies are good candidates for a covered call strategy right now? I ran a CAPS screen for five-star stocks that pay at least a 3% yield, then went through the list and dug for some of the strongest among the bunch. These are large, leading companies that look reasonably priced and offer safe dividends. They're also stocks on which a Foolish investor seeking still more income can write covered call options.

Company

CAPS Rating (out of 5)

Dividend Yield

P/E

3M Company (NYSE: MMM  )

*****

3.4%

11

Johnson & Johnson

*****

3.1%

13

McCormick & Co. (NYSE: MKC  )

*****

3%

16

PepsiCo (NYSE: PEP  )

*****

3.1%

15

Conoco Phillips (NYSE: COP  )

*****

3.4%

4

McCormick & Co., the spice and herb giant, recently traded at $32. Its $35 call option expiring June 2009 was bidding $1.50 per share. If you bought the stock and sold the covered call, you would have a potential sell price on your shares in June of $36.50, or 14% above today's price in six months.

Meanwhile, the covered call option itself pays you a 4.6% effective yield ($1.50 in an option payment divided by your $32 purchase price) over the next six months. Over this same time, you'd also receive another 1.5% in dividend payments from McCormick & Co., bringing your total potential income over the six months to 6.1%. That's rather spicy.

3M, the diversified Dow Jones component giant, recently traded at $60. The $65 strike price call option for April was paying $2 per share. In this case, you would earn an 11.6% return in four months if your stock is called away from you at $65. Plus, you would receive at least one dividend payment. The call option, meanwhile, pays you an effective 3.3% yield in just four months ($2 divided by your $60 purchase price). Finally, if 3M reaches April's option expiration below $65, you keep your shares, you keep the option income, and you can write new covered calls.

Make sure you're ready to sell
Writing covered calls for extra income is a reliable strategy, especially when used on strong stocks selling at reasonable prices. Covered call income can smooth out and pad your returns in up and down markets and can be generated steadily. Just make sure you're ready to sell a stock if it gets called away on you.

We're teaching about and using covered call strategies in the new Motley Fool Pro real-money investment service. We're also building a long-term stock portfolio and using other option strategies for income and better buy and sell prices on our stocks. If you would like to learn more, simply enter your email below.

Fool analyst Jeff Fischer owns none of the securities mentioned in this article. Johnson & Johnson, PepsiCo, and McCormick & Co. are Income Investor selections. 3M and Coca-Cola are Inside Value selections. The Motley Fool owns shares of Procter & Gamble. The Fool has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (157)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 10, 2009, at 12:40 PM, KDohermann wrote:

    Thanks for explaining this concept so simply. I used to work for a financial planner and was always thoroughly confused by his explanation of concepts like this. Thanks for the enlightenment and opportunity to prosper even further.

    Speaking of my love for the Fool. I recently decided to get life insurance and guess where I learned everything that I ever wanted to know ... fool.com of course. I love this site!

  • Report this Comment On January 10, 2009, at 9:20 PM, Padrego wrote:

    Are dividends from your stock still qualified (for reduced tax rate) if you are covering calls with that stock?

  • Report this Comment On January 12, 2009, at 11:45 AM, TMFFischer wrote:

    '08 - Congratulations on graduating, and thank you for your comments!

    Padrego: I believe writing covered calls on a stock does not change how the dividends are taxed, but you should ask your broker or a tax expert to be sure. Best, Jeff

  • Report this Comment On January 12, 2009, at 7:41 PM, EBerg13 wrote:

    When talking about high income stocks, what about Royalty Trusts or American trusts like BPT and Mesabi Range Trust. BPT is paying 14% at present and Mesabi is at almost 25% on a 4.4 P/E

    I wish someone would discuss these more. Info is very hard to find.

  • Report this Comment On January 14, 2009, at 11:37 AM, jt20002009 wrote:

    Hi, I'm sorry for my english. I just want to say that articles like this make people sufer and loose and helps to send us directly to the desastrous that we are in. A simple scenario is not suposed in the article. Ok, you buy the stock for $30, you sell the call option for $3, and what happens if the stock, 3 months later, finishs at $15? Impossible? Well, see NVDA, AAPL, PBR See WMT a few days ago!!!!! loosing 7 % in ONE DAY!

    Please, don't do it any more.

  • Report this Comment On January 15, 2009, at 9:54 AM, teebob21 wrote:

    JT -

    Fluctuations of share price are an inherent risk any time you purchase a stock. If you are uncomfortable with that, you should not be investing in equities. For the dividend income investor, a 50% fall in share price would be great news. 3M is a good buy when it's paying 3.5% with a P/E of 11, it would be an incredible bargain if the price were to fall 50%, and the stock was paying 7% annual dividend yield. An income investor does not care one bit about day-to-day fluctuations of price, and should buy more of these blue chip stocks on such a hard fall (provided that the fundamentals continue to be strong).

    As for writing the covered calls, it is clear from the article that even with the capital loss of a 50% price cut, the call writer will be assured of his income from writing the calls in every situation except when the stock surges above his chosen strike price.

    The true risk in this strategy (in my opinion) comes from writing calls for shares at a price that would not result in a capital gain sufficient to make investments capable of replacing the loss of dividend income. If I sell $10,000 of a stock paying 5% a year with a gain of $250 on the sale, I still would need to make up the $250 of income I would have otherwise earned by holding tight. I'd now need to find an investment paying 2.5% or better.

    This is a solid approach to income investing. Stay Foolish, and don't be greedy and this works nicely.

  • Report this Comment On July 24, 2012, at 11:18 PM, nolte1231234 wrote:

    Jeff,

    I've been doing some digging on good stocks with high, proven, sustainable dividends and came across this old article. Have you written anything recently with an updated list of good candidates? I know WM is one good one...

    Thanks,

    Nick

  • Report this Comment On July 24, 2012, at 11:23 PM, nolte1231234 wrote:

    I meant to say I've been searching for stocks with high, sustainable dividends that are good candidates for the covered call strategy.

    Thanks,

    Nick

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