Here's the Call That Really Pays for Itself
By Steven Smith
TheStreet.com Staff Reporter
01/14/2004 01:07 PM EST
URL: thestreet.com
Options
Leverage dividends by using the proceeds to purchase options.
Current low option volatility and prices will reduce your risk.
Since the dividend tax-reduction bill was passed last May, nearly 229 companies have either initiated a dividend or boosted its payout. At this point, 370 members of S&P 500 are currently paying dividends, an 18% increase from 2001, according to data from Standard & Poor's.
Companies have been quick to respond to the removal of double-taxation as a means to deliver shareholder value, and those S&P 500 stocks that pay dividends gained a healthy 31% in 2003. But investors have been reluctant about adding these warhorses to their stable of stocks.
Instead, their renewed infatuation with grabbing the next "10-bagger" has bid up the prices of non-dividend companies, which as a group are up 57% over last nine months. The telecom, biotech and Internet sectors, which dominate this category, have racked up some of the biggest gains. "I'm afraid the value of diversification has been quickly forgotten," said Matthew Shapiro, president of MWS Capital Consultants, a Chicago-based money management firm.
Buying stocks solely for dividend income is anathema for many investors. "People's attitudes won't change overnight, and with the recent resurgence of the market -- and tech in particular -- the benefits of dividends are not getting the focus they deserve," said Harold Blazcik, chief equity strategist with JMP Securities, a New York-based firm. Blazcik thinks 2004 will see the value of dividends recognized and rewarded as stocks that pay dividends should also deliver higher share prices.
Options Investing, Texas Style
Looking to bridge the gap between chasing outsized capital appreciation vs. building a diversified stock portfolio, Shapiro suggested a unique strategy he has dubbed the "Double Texas." The strategy involves buying dividend-paying stocks, and using the proceeds of the dividend payout to buy LEAP options, or Long-term Equity Anticipation Securities, on the same underlying equity. (For those interested in the etymology, the name is derived from the practice of overly optimistic Texas ranchers buying cattle futures in conjunction with expanding their herd count. This became known as a Texas Hedge, which of course is no hedge at all, but rather a doubling down.)
So why is Shapiro proposing what at first glance seems completely counter to the concepts of risk reduction and portfolio diversification? "I'm interested in building long-term balanced portfolios for my clients. Options provide an opportunity to get people invested in stocks that they may currently be overlooking," he explained.
Admittedly, this tactic is targeted to relatively young, aggressive investors who tend to focus on the glamour sectors such as technology stocks, as a way of broadening their holdings while maintaining an aggressive stance. "Too many people pigeonhole dividend-paying stocks as 'boring' or unable to deliver large price gains. I'm afraid some investors' portfolios are becoming unbalanced in the pursuit of short-term appreciation," said Shapiro. He thinks that by using the leverage of the low cost of options to boost potential returns of certain stocks, investors will be enticed into adding these names to their holdings.
"No one can honestly predict where a stock's price might be in two years, and if you don't need the immediate income, that money can provide a better return if reinvested in options," concluded Shapiro.
(I should also point out that investors buying stocks in a margin account won't qualify for the lower 15% tax rate. Dividends paid to margin accounts are actually paid to the broker/dealer firm, which then passes on an in-lieu payment that is considered income and subject to a tax rate as high as 35%.)
And the Value Is Where?
The second and crucial part of implementing a dividend reinvestment option plan, or Double Texas strategy, is the fact that option prices are currently trading at historically low valuations.
The key is to identify stocks with an annual dividend at least nearly equal to the cost of buying a LEAP call option with at least one year until expiration, and whose strike price is within 10% to 15% of the money.
For example: With BP (BP:NYSE) trading at $49.70, you can buy a January '05 call with the $55 strike price for just $1.50. The company pays an annual dividend of $1.73 a share, more than covering the cost of the call.
Compare this strategy with a traditional Dividend Reinvestment Plan, where the proceeds are used to buy additional shares of the underlying stock. At current prices, 100 shares of BP would buy you just 3.7 additional shares. But with a Dividend Reinvestment Option Plan, or DROP, you can spend the same money and control an additional 100 shares of BP. Granted, the call is currently 12% out of the money, but it should be noted that the oil giant's shares gained some 25% over the last 52 weeks. Also, since the dividend payment would actually be $23 more than the cost of the call option, that money can be used to offset some of the commission costs involved in the transaction.
Matthew Shapiro actually advocates buying calls with as many as two years remaining until expiration, but I found using one-year LEAPs allows an investor to buy calls one strike nearer-to-the-money and maintains a more symmetrical match of illustrating the application of a one-year dividend to a one-year option.
The table below lists 10 companies, their current share price, their annual dividend payment and the strike price of a January 2005 LEAP call option. It represents a small sample of dividend-paying stocks and an example of how one can start building a diversified portfolio using the Double Texas, or DROP, strategy.
DROP (Dividend Reinvestment Option Plan) Candidates
Company Price Jan.'05 Strike Price Annual Dividend
Bank America (BAC) $78.50 $85 call-
$2.70 $3.20
Bristol-Myers (BMY) 29.50 35 call-
0.90 1.12
Con-Edison (ED) 42.80 45 call-
2.05 2.24
DaimlerChrysler (DCX) 46 50 call-
1.20 1.62
Dow Chemical (DOW) 41.50 45 call-
1.80 1.34
Entergy (ETR) 56.10 60 call-
1.60 1.80
Kinder Morgan (KMP) 47.05 50 call-
1.20 2.64
Pitney Bowes (PBI) 40.80 55 call-
1.30 1.20
PNC Financial (PNC) 53.60 60 call-
1.30 2.00
Sara Lee (SLE) 21.10 25 call-
0.30 0.75
Source:TSC Research
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Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to steve.smith@realmoney.com. |
