Last week for Spring Break, I had the good fortune to take my family to Miami and then on a cruise to the Eastern Caribbean. It was a great experience with many memories made. On our first day, I took my two daughters to South Beach where we went swimming in the waves, which is a passion of theirs and mine. As those of you who are familiar with the area, often in the afternoons the winds will make the water extremely choppy and that is how it was that day. Every time a wave passed, a new one came rapidly, with little time for a break, which was tough for my 4-year old who I hold on to along with her floaty. I thought that was a decent analogy to the current market environment. We don’t have perfect tailwinds but instead need to scratch and claw and keep our heads above water with smart decision making, effective tactics, and prudent discipline.
The stock market isn’t dirt cheap overall, bonds are a reasonable alternative, and the overall economic outlook isn’t super optimistic. With that said, there is also quite a bit of pessimism out there and this has been the most forecasted recession in history, so I think there could be potential to outperform some of the more dire projections. In times like this, we at TTCM like to utilize tactics to enhance returns and reduce risk. We do this by first identifying an undervalued stock and then we will employ either covered calls or cash-secured puts to create an optimal strategy for what we are trying to do.
Currently, there is an undervalued stock trading at $44.83 per share, or roughly 8.9x forward earnings. The company generates very high returns on capital employed so would be defined as high quality, although the stock is also cheap in value, which is reasonably unique in this market. The company also has a large equity stake in another globally famous brand that is worth way more than what it is valued at on the balance sheet. The stock pays a quarterly dividend of $0.94 per share, which is an annual yield of 8.38%. The dividend will likely grow slowly over the next decade, as this is a rather mature business, with some long-term growth projects that will still take time to develop. Because we like the stock, but aren’t overly bullish on the market, and would love mid-teen returns if the stock is flat, we are going to use the following strategy:
Buy 100 shares at $44.83
Sell 1 January 24 $45 call for $2.80
On a trade like this, there are two possible scenarios if you hold the option till expiration.
- A) If the stock is above $45 at expiration, you will have collected $2.82 for dividends (3 quarters worth in 282 days), which equates to about 6.3% on the share price. You will also have collected another $2.80 from selling the covered call, which equates to another 6.24%. Although you’d also make $0.17 of appreciation, the options and dividends alone get you about a 12.5% return in 282 days, or 16.23% annualized. This is a pretty staggering return for a stock that just needs to stay flat or better, and in this example we would be selling the stock at any price above $45, so we’d settle in cash.
- B) If the stock is below $45, you’d still have made the 12.5%, or 16.23% annualized, minus any decline on the stock. For instance if the stock close at $42, you’d still be up nearly $3 per share, as your breakeven on this trade is $39.21 factoring in dividends. Just as attractively, we can go ahead and sell another call next year and continue reducing our cost basis and adding more income.
These are the types of trades we employ every day for our clients, which very few investment advisers do. In a phenomenal bull market, it may not matter, but I don’t think we are in that environment currently. I think we are much more likely to be in a choppy ocean of a market, needing to scratch and claw to generate really attractive returns, and that is what we are built to do. Stocks can fluctuate greatly within a given year and often their prices don’t reflect intrinsic value. Over time, stock prices and intrinsic values do tend to converge but effective hedging and income-generating strategies such as this can give you massive advantages. I hope you found this example interesting and everything is based on real-time data and numbers.