Make Money in Health Care -- It's Your Call

Picking stocks is hard. The deck is stacked against stock pickers statistically -- I'll tell you why in the next paragraph. But I want to reassure you that investing isn't a loser's game. You can win, but you need to consider all of your options. One strategy you that can help tip the scales back in your favor: covered call writing. This strategy isn't a thing of wizardry or shouting options pit traders, it's an easy-to-master tool that can be used in conjunction with healthy, well-run, fairly valued stocks -- the kind that aren't prone to blowups or other damaging derring-do.

You probably won't pick a winner
Eric Crittendon, director of research at hedge fund Blackstar Funds, conducted a study that shows 25% of stocks are responsible for all of the market's gains. Effectively, 75% of stocks work against your quest for returns. Viewed another way, Crittendon shows that one in five stocks is a significant winner, but the same proportion is significant losers. Yes, we're equally likely to choose a big loser as we are a big winner.

And middle of the pack that does nothing. We've got a 60% chance of picking a stock in that category. This means that almost 80% of the time a pick will be a dud or a detractor. Those odds are not good. Covered call writing allows us to boost the returns of the middle 60% of stocks -- those we're statistically most likely to pick.

How covered call writing works
A covered call is simply the combination of two investments: a block of 100 shares of stock and a written call option on the same stock. When we introduce the call option to share ownership, it changes the risk and reward profile of our position. When you own a stock, your risk is the price you paid for the stock -- it could go to zero. Your reward is the stock's gain. When you write a covered call, your downside risk is offset slightly by the option premium you are paid. In exchange for that premium payment, you agree to forego the stocks upside beyond the strike price (if the stock rises that far, the call will be exercised and you'll be obligated to sell).

Normally, agreeing to forego a stock's upside in exchange for a small upfront payment wouldn't seem like a great idea. But when you couple the strategy with Crittendon's research (namely that we've got a 60% chance of picking a dud stock), it doesn't seem as crazy. And the fact that we can write covered calls that expire at three-to-four month intervals, we can collect a series of premium payments over the course of a year. These payments, along with dividend payments and the mild stock appreciation we allow ourselves by writing out of the money calls, a covered call option strategy can be a conservative and consistent way to boost returns.

What to look for in a call candidate
Remember, writing covered calls involves owning 100 share blocks of stock, so first and foremost you need to find a stock that is on solid financial footing and has a pretty good business.

The next thing you should look for is a "fairly valued" stock. Given that stock valuation is more art than science, look for candidates that you think are priced about right (given market efficiency, that's most stocks) or have mild upside. You don't want wildly underpriced stocks -- if you find one along the way, just buy it outright and not forego its upside.

In the health-care sector, there are many candidates that fit this bill. Here are some healthy, fairly valued, and profitable covered call candidates:

Company

Debt-to-Capital

Forward P/E Ratio

Operating Margin

Baxter International (NYSE: BAX  )

39%

13

22%

Gilead Sciences (Nasdaq: GILD  )

36%

10

52%

Intuitive Surgical (Nasdaq: ISRG  )

0%

30

39%

MedcoHealth Solution (NYSE: MHS  )

56%

15

4%

Merck (NYSE: MRK  )

24%

9

20%

Thermo Fisher Scientific (NYSE: TMO  )

12%

14

13%

VCA Antech (Nasdaq: WOOF  )

34%

17

15%

Data provided by Capital IQ, a division of Standard & Poor's.

A tech covered call you can write today
Of the candidates above, Motley Fool Rule Breakers recommendation Intuitive Surgical sticks out as a great candidate for covered call writing. The company has a dominant position in the robotics-assisted, minimally invasive surgery niche thanks to its first-mover advantage and large installed base of da Vinci systems. As procedure volumes grow, Intuitive is able to sell more accessories to facilitate procedures, and this revenue is a boon to cash flow. But as the installed base gets larger, maintaining a high growth rate will be more difficult. With shares priced at 30 times estimated 2011 earnings shares look fairly priced. As for downside, international growth, recurring accessory revenue, and a huge cash cushion should provide some protection.

Purchasing shares today, at $332, and writing July $350 call options will pay you $19 in option premium. With just over 130 days until expiration, you can earn $18 in share appreciation and $19 in option premium if Intuitive Surgical shares rise to what I think they are worth. That amounts to a 11% return if exercised -- and the $19 in option premium you're paid acts as downside protection because you won't lose money unless Intuitive Surgical shares drop more than 6%.

The bottom line
Crittendon's research implies that finding solid businesses on firm financial footing won't necessarily translate into successful investing. But investors who embrace the fact that most stocks are middling performers and willing to augment returns with the use of a covered call strategy, winning investment returns are just a step away. To learn more about the profitable options strategies we've been using in our portfolio's for years, simply enter your email address in the box below to receive information on Motley Fool Options and get a copy of our free "Options Edge" guidebook.

Bryan Hinmon doesn't own any shares mentioned in this article. He is an analyst with Motley Fool Options. Intuitive Surgical is a Motley Fool Rule Breakers recommendation. Thermo Fisher Scientific and VCA Antech are Motley Fool Inside Value recommendations. Gilead Sciences and MedcoHealth Solutions are Motley Fool Stock Advisor recommendations. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has a disclosure policy.


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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 March 10, 2011, at 11:09 AM, jtrivasi wrote:

    I like this strategy, but at ~$328/share, you'd have to commit ~33k in order to write 1 call option.

    That price may be too high for a lot of new investors.

    You might want to try a stable, yet cheaper stock.

    It's not healthcare, and it's more volatile (and has more problems) but you could test out the strategy on something like Citigroup with an investment less than $500. (I'm sure there are many better ticker symbols out there---it was just an example).

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