If you rely on bond interest or stock dividend payments for current income, you're probably looking for answers. With short-term treasury bills yielding 0.25%, five-year CDs paying 2.25%, and the average S&P 500 stock only offering a 2.3% dividend yield, it may be tempting to reach for extra yield by buying shares in dubious companies. Don't.
Investors in oil refiner Valero (NYSE: VLO) learned their lesson the hard way. In 2006 and 2007, business was booming; refining spreads were wide, the company generated millions in free cash flow, and it nearly doubled its yearly dividend payment from $0.32 to $0.60. Valero retained its dividend policy, and throughout 2009, it had an attractive dividend. But eventually, the commodity nature of the refining business caught up with the cash flows. Earlier this year, the company was forced to cut its dividend by 66%.
Instead of investing in marginal businesses because they have a 4% yield, consider writing covered call options on good or great businesses that have a less flashy yield, to generate a higher "manufactured yield" and boost returns.
Covered calls made simple
If you own 100 shares of a good or great business, or if you're looking to acquire them, you may be able to write (or sell) covered calls on your shares and be paid option income for your troubles.
Here's a quick example of how it works: You own 500 shares of Buccaneer, Inc., maker of creamsicle-colored athletic gear and eye patches (clearly a great business), run by the legendary Bucco Bruce. The stock trades for $25, and after thorough analysis, you're OK with selling at $30. Checking the options markets, you see that call options with a $30 strike price expiring in three months pay $2.75.
Because each call option covers 100 shares, that $2.75 is actually $275. But since you'd be willing to sell all 500 of your shares, you could write five call options and be paid a total of $1,375 for a promise to sell your shares if the stock price reaches or exceeds $30 by the end of the three month period.
If Buccaneer Inc. stays below $30 by the time the options expire, you get to keep the $1,375 and your shares in the excellent business. You could then write a second round of covered calls if you still wish to sell your shares.
If, instead, the stock rises to $30 or higher by the option expiration, your shares will be sold ("called away") at the strike price. Taking into consideration the option premium you were paid, your net selling price is $32.75 (the $30 strike price plus the $2.75 in premium you demanded).
The downside of swashbuckling with covered calls
Of course, if creamsicle becomes the summer's hot new hue, Buccaneer brand eye patches will sell like crazy, and the stock could soar well beyond $30. In such a case, you'd be missing out on some prime profits. Writing covered call options swaps the stock's upside above the strike price for an option premium. Before you take the plunge, be certain that your predictions of color popularity are spot-on.
With missed upside as their main danger, I'd consider covered calls a low-risk strategy. If you're able to write new calls every few months, adding 4% to 8% in option premiums can have a great impact on your returns. This added yield should make stocks paying a pedestrian 2% dividend yield look much more attractive for income-minded folk willing to manufacture a higher payment.
5 stocks with high manufactured yields
Which 2% yielders, with the help of call options, may be able to help quench income-seeking thirst right now? I searched for strong companies with below-market dividend yields that earn high profit margins. Among the companies that passed muster, five stuck out above the rest as good or great businesses that, when combined with a covered call strategy, could offer great results.
| Company |
Dividend Yield |
Profit Margin |
|---|---|---|
| 3M (NYSE: MMM) |
2.4% |
15.7% |
| Aflac (NYSE: AFL) |
2.2% |
10.8% |
| J.M. Smucker (NYSE: SJM) |
2.5% |
11.1% |
| Molson Coors Brewing (NYSE: TAP) |
2.3% |
25.3% |
| UTX (NYSE: UTX) |
2.2% |
7.9% |
Source: Capital IQ, a division of Standard & Poor's.
J.M. Smucker (whose headquarters is located on Strawberry Lane), sells more than $4 billion worth of jams, peanut butter and ice cream toppings. Recently, shares sold for $65, and $70 call options expiring in April 2011 could be written for $1. If you bought the stock and sold the covered call, you would have a potential sell price on your shares of $71 -- 9% above current prices.
In February, you should get a $0.40 dividend payment; when combined with our $1 call premium income, that makes for a 2.2% yield in just four and a half months. Best of all, we retain the next $5 of potential share price appreciation. Pretty tasty for a stable business, especially when you can write another call option after April and earn even more of a premium!
Aflac, whose supplemental insurance policies are ubiquitous in Japan and growing nicely in other markets, recently sold for $54 per share. May 2011 $60 call options recently paid $2.25, offering an effective yield of 4.2% in just more than five months. If shares jump and are called away at the $60 strike price, you'll have earned a return of 15.3% ($6 in share price appreciation, and $2.25 in option premium) -- even higher, if we include the quarterly dividend that Aflac will pay in March. If shares stay below $60, you've still got ownership in a very profitable business with another dividend coming in June, and you can write more covered calls if you choose.
The Foolish bottom line
Finding solid businesses selling for reasonable prices remains the key to success in investing. But for income-minded investors, manufacturing a higher dividend using covered calls should expand the universe of potential candidates to include some 2% yielders that may normally fall under the radar.
To learn more about the profitable options strategies we've been using in real-money portfolios for years, simply enter your email address in the box below to receive information on Motley Fool Options, plus our free options guidebook.
