How to Really Juice Your Investing Returns

Investors have incredibly short memories. In the blink of an eye, they've quickly forgotten many of the lessons of the two most recent stock market crashes, namely the dot-com bust and the subprime blowup.

Think back to the dot-com era. Stocks like eBay (Nasdaq: EBAY  ) , Cisco (Nasdaq: CSCO  ) , and Yahoo! (Nasdaq: YHOO  ) were valued at huge multiples of their earnings. The theory was the Internet was going to change the world, and these companies were going to generate massive profits far, far into the future.

Well, as we now know, the Internet did change the world. Can you imagine life without it? Without the Internet, how would we find the answers to such questions as "Daddy, if the Earth is round, how come we don't fall off it?"

But what the Internet didn't change were the fundamentals of investing. Sure, it made it much easier for us to gather timely information about a particular company, read annual reports, and listen to conference calls, but it didn't change the two core tenets of investing, namely ...

  1. Buy low.
  2. Sell high.

Did you buy stocks at the height of the dot-com bubble? If you did, hopefully you learned a very valuable lesson. Valuation always matters.

The same greedy mistake
Fast-forward to the subprime crash. This one was a little different and somewhat harder to predict. Precrash, many stocks, including financials like Citibank (NYSE: C  ) and AIG (NYSE: AIG  ) didn't appear overvalued based on their reported earnings at the time.

But the warning signs were there. House prices had peaked in 2006. Adjustable-rate mortgages had begun to reset at higher rates. Subprime borrowers were unable to refinance. Delinquencies were soaring.  

Then, in mid-2007, Bear Sterns announced that two of its mortgage investment funds had collapsed, wiping out more than $1.6 billion in capital.

Yet, despite a wobble in the face of the first Bear Sterns shock, the stock market continued on its merry way. The Dow peaked at just over 14,000 in October 2007 and was still over 13,000 in May 2008.

Collectively, we ignored what was staring us right in the face. Were we stupid? Or naive? Or just plain greedy?

I say we were greedy. And I also say, right now, we're in danger of making the same greedy mistake.

A market riding for a fall
Since its March 2009 bottom, the S&P has jumped more than 35% higher. Stocks like Bank of America have positively flown into the stratosphere, up more than 400% in the same period of time. In short, it has been a fantastic time to be invested in the stock market.

But the easy money has already been made. Now comes the really hard part: making money in a stock market I think could be riding for a fall.

My reasons are simple ...

  1. Valuation. The S&P 500's price-to-earnings ratio based on expected 2010 as-reported earnings is over 25. Just like the dot-com boom, valuations are expecting an awful lot of good economic news some way into the future.
  2. Unemployment. It's still running at 10%. Worse, when the calculation includes people who have stopped looking for work and people who work part time but want to work full time, it stands at over 17%. With unemployment riding so high, I expect the economic recovery to be tepid.
  3. Interest rates. Although the Fed rate remains effectively at 0%, 10-year Treasury yields have recently jumped from 3.2% on Nov. 30 to just over 3.8% -- a significant 19% increase in only five weeks. Continued rising interest rates will likely dampen any economic recovery.

Margin of safety
Lest you think I'm a big, bad grizzly bear without a bone of bull in my body, let me assure you otherwise.

I'm bearish on the economy, yet still bullish on certain stocks. Not all stocks, mind you. For example, I'm steering well clear of economically sensitive sectors like financials and most retailers.

I'm also steering clear of highly valued stocks, even if they are quality players like Amazon.com (Nasdaq: AMZN  ) and Google (Nasdaq: GOOG  ) . Paying 50 and 25 times their respective forecast 2010 earnings is not my idea of a margin of safety.

Juice your returns
Where I am seeing value is in higher-yielding stocks. For example, take a look at these "boring" value stocks ...

Stock

P/E Ratio

Dividend Yield

Altria

13.2

6.7%

Merck

10.7

3.7%

Vodafone

12.5

5.7%

Johnson & Johnson

14.0

3.0%

Source: Google Finance.

In this low interest rate environment, the dividend yields alone set my pulse racing, although admittedly that's not difficult for this middle-aged man.

But it gets even better. Over at Motley Fool Pro, we're using options to further juice our returns. Specifically, we're selling covered calls on some of our portfolio stocks to potentially (a) generate even more income or (b) sell our stocks at what we believe to be attractive prices.

And when used with already high-yielding stocks, covered calls can really boost your investment returns. We see it as a strategy ideally suited to today's unique stock market and economic conditions.

If you'd like to learn more about Pro and how you too can use covered calls to juice your investing profits, simply enter your email address in the box below.

No bears were harmed in the production of this article. Pro analyst Bruce Jackson does not own any of the stocks mentioned in this article. Google is a Motley Fool Rule Breakers selection. Amazon.com and eBay are Stock Advisor picks. Johnson & Johnson is an Income Investor choice. Motley Fool Options has recommended a bull call spread position on eBay. The Fool's disclosure policy is not economically sensitive.


Read/Post Comments (5) | Recommend This Article (16)

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 22, 2010, at 1:00 PM, langco1 wrote:

    the greatest false stock rally since 1930 is over and the result now will be the same as it was then..years more in a depression....

  • Report this Comment On January 22, 2010, at 1:07 PM, goalie37 wrote:

    There are far fewer stocks that I believe are undervalued compared to a few months ago, but I agree that there are some still out there. I own JNJ (one of your picks). I would also suggest looking at General Dynamics at 10x earnings.

  • Report this Comment On January 22, 2010, at 1:19 PM, goalie37 wrote:

    My last post doesn't seem to show up. Sorry if this duplicates it.

    I agree that there are far fewer bargains than there were a few months ago. I own JNJ (one of your picks.) I would also suggest looking at General Dynamics (GD) trading at 10x earnings.

  • Report this Comment On January 22, 2010, at 3:16 PM, langco1 wrote:

    the rout in the stock market is on!

  • Report this Comment On January 22, 2010, at 7:17 PM, rookie2009 wrote:

    mo...the best spec bet on pot legalization!!!

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