In range bound markets, 90% of the return comes from dividends.
– Vitaly Katsenelson, author of Active Value Investing: Making Money In Range Bound Markets (Wiley, 2007), on CNBC’s Closing Bell, Tuesday February 16
In last week’s Client Note, I declared the end of junk phase of the rally, drew the analogy to 2003-2004, and suggested that the rest of 2010 may very well be choppy and range bound. If that proves to be correct, the kind of stocks that will perform best are different from what performed best from March 2009 through January 2010.
During the junk rally, the highest risk stocks, like Citigroup, B of A, commodities and emerging markets, performed best. But in a range bound market, high quality, dividend paying stocks are likely to outperform. These kinds of stocks are not sexy and you will not make 25% a year with them. But in a stingy market, their stable businesses and especially the guaranteed returns from their dividends could well be your best bet.
With that in mind, I added two high quality, high dividend stocks to the portfolios last week: AT&T (T) and Verizon (VZ). Of course, we are all familiar with these companies and know what they do. In fact, most of us are clients of theirs with our cell phones. Combined, the two dominant wireless providers have more than 176 million cell phone customers. Their combined market value is almost a quarter trillion dollars. Both are attractively valued at around 12 times earnings estimates for 2010. Best of all, each pay a dividend of around 6.5% annually. Hence, even if the stocks do nothing, we can just collect the dividend and return 6.5%. Not bad.
In order to juice our return on these positions, I began selling covered calls on them today. In selling these calls, we cap our gains but collect the option premiums up front. If the stocks increase by more than 20%, they may be called away from us in January 2011. If not, the calls will expire worthless and we can sell more calls on them again next year.
This is a conservative strategy of taking money up front in exchange for capping our gains. I know that when many of you hear “options” you think “risk”. But in this case we are the ones selling the options and it is the buyer who is speculating with them.
On average, it looks like we will be able to get about 40 cents a share for selling these calls, adding another 1.5% to our annual return. Combined with the 6.5% dividends, that works out to an 8% return even if the stocks go nowhere. This is a very low risk 8% given the quality of the companies and their businesses. The only downside risk is that the stocks decrease in value.
Best of all, this 8% is real discretionary income. The dividends are deposited in our account every quarter and the income from selling the calls is available for our use immediately. For retirees or investors desiring increased income, the money can be transferred from their brokerage account to their checking account and spent as desired.
Also nice is the 15% tax rate on dividends, courtesy of the 2003 Bush Tax Cuts, through 2010. However, it seems likely that Obama and the Democrats will not renew these tax cuts next year, at which time dividend income will be treated as ordinary income and taxed at your marginal tax rate.
All in all, this is a very attractive strategy for a range bound market and in any market for retirees or others desiring current income. It is a rare investment that can yield 8% in income with the kind of safety that this strategy can. No high quality apartment, office or retail property in the states of California, New York or Florida can offer that kind of yield. Neither can treasuries, munis or high quality corporate bonds. Many junk bonds can but you are taking on far more risk.
For those of you who are interested, I offer an Income Strategy in which I build a diversified portfolio of high quality, dividend paying stocks, on which I then sell covered calls, for retirees and others seeking current income. Income from dividends and option premiums are transferred from the brokerage account to the checking account once a month or every three months.
It is one of the best strategies for living off of your money at attractive yields without eating too much into your capital. It doesn’t have to take any of your time as I manage and administer the account (which is custodied in an account with your name and address on it at Scottrade which I have no access to). It is a recipe for Financial Freedom for those who have saved up a nest egg and are looking to spend their time and energy enjoying life or pursuing other interests.
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