Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
Increase Profits with Covered Calls
04/11/2013 7:00 am EST
Covered calls provide extra opportunities for investors to see returns on the stocks they already own, say Stefan ten Brink and John Pearce of Van Hulzen Asset Management.
Nancy Zambell: My guests today are Stefan ten Brink and John Pearce, managing directors of Van Hulzen Asset Management. They have a very interesting strategy on writing covered calls, getting dividend income as well as option income for their clients. Gentlemen, why don't you tell me what covered calls are and what they will do for an investor?
Stefan ten Brink: A covered call is an option that you write on the stock to generate income. Let's say you buy 100 shares at $50, and you will sell it at a certain point in time in the future to another investor. The investor pays you a premium for that.
Let's say you buy it at $50. You want to sell it in January 2014, maybe at a 55 strike price. That means you need to sell the underlying security at 55 when it is above 55, and you will receive premium today of let's say $5. Your total profit, when it will be called away, will be $10 on the $50 stock, so you make a nice 20% return.
Nancy Zambell: So $5 from appreciation and $5 from the premium.
Stefan ten Brink: Exactly.
Nancy Zambell: The reason that you are using this covered call strategy, rather than just doing all long positions, is?
Stefan ten Brink: The main reason is that we feel that that the historical relationship of total return is a little bit out of whack. It used to be very normal that most of the total return of 100 years in history of the stock market comes from income-i.e. dividends. It used to be normal that an investor would get 4% to 5% in dividends.
Because of the credit bubble and the huge bull market we had over the 80s and 90s, this relationship pushed income down to where the S&P (yield) is now around 2%. But people still expect the same total return of 8% to 10%.
What we do in writing the option and generating the extra income is reshaping the total return ratio in our favor. Let's say half of the total return comes out of income.
Nancy Zambell: I see that in your top ten holdings that you have a lot of technology stocks. Is that a favorite for you right now?
Stefan ten Brink: No, we do our bottom-up work. I mean, what we screen for are companies in the large-cap space. They should have stable business models, pay dividends, and a good stable occasional return on the business model. Technology companies happen to be there, and we try to get extra income out of a Microsoft (MSFT) or an Intel (INTC) to write calls.
Nancy Zambell: What is your average dividend yield of your holdings right now?
Stefan ten Brink: On the portfolio, we get around 3% dividend yield, so that's 50% higher than the current S&P is paying.
Nancy Zambell: How have your returns been compared to the S&P 500?
Stefan ten Brink: Over the long run, we outperform around 3% on an annualized basis. The most important thing is, we do it with two-thirds of the risk (or the volatility) of the S&P.
That's not to say that we will outperform every year. We think receiving a return can be done in different ways, and we think this is a better way to be in the stock market than to be long only and dependent on price appreciation.
Nancy Zambell: In your top holdings, I don't see anything like REITs or MLPs. Do you have any of these in your portfolio?
Stefan ten Brink: It's not in the call portfolios. We invest in REITs and MLPs for selected clients, but that's not part of the covered call strategy, since we are unable to write options on them.|pagebreak|
Nancy Zambell: In terms of high-paying dividend stocks, there are a lot of those right now-some as high at 10% or 15%. Is there a particular reason why you may be staying away from those, other than the ones who are not REITs or MLPs?
Stefan ten Brink: Yes, that's an interesting question. When I see a high dividend yield, two things can happen. The stock is very cheap, or the dividend will be cut soon.
John Pearce: One thing we pay a lot of attention to is not only what the dividend yield is, but the company's history of increasing that dividend over time, and also its payout ratio.
For example, Altria (MO) has a really attractive dividend, but a very low dividend growth rate. And their payout ratios are a bit higher, which means they're less likely to be able to grow that dividend as fast as other companies have.
Qualcomm (QCOM) has a 2.2% dividend yield. It's grown its dividend very strongly in the past, and its payout ratio is only 30%. It has lots of capacity to continue to grow that dividend.
Nancy Zambell: That's a good point. So investors should really pay attention to more than just the actual yield itself. What I'm hearing you say is, look at growth and the consistency of the dividend. And your portfolio is based primarily on fundamentals, is that correct?
Stefan ten Brink: That is correct. We are first and foremost equity investors and pay a lot of attention to the fundamentals. We like consistency in returns and consistency in payouts.
Nancy Zambell: I also notice that you favor setting price targets when you buy the stocks. I've been a big advocate for that my whole investing life. Can you talk about why you do that?
Stefan ten Brink: It's a good point. I mean otherwise you run the risk of falling in love with the stock. We figure it is important to know when to enter a stock, and we also think it is important to know when to exit a stock.
Stocks can become overvalued or undervalued. In our covered call strategy, we tend to write our strikes at the price where we think the market is fairly valued on the stock. When it gets called away, we will just let that happen and find another idea that's going to be a nice total return both on the price appreciation, as well as on the income side. That's what keeps us fresh and on top of the fundamentals.
Nancy Zambell: It's a good discipline. You also run the Iron Horse Mutual Fund (IRHIX). Do you follow the same strategy within that fund?
Stefan ten Brink: The managed account and mutual funds are two different ways to get invested, but the fund is run by the same people, and the underlying investment process is the same.
Nancy Zambell: Risk management in today's stock world-with the market going up, up, and up-most people have not been thinking about risk. They've been thinking about return. Do you want to comment on why risk management is so important in today's world?
John Pearce: I'll make a comment about that actually, Nancy. It's a very different environment than it used to be.
I think people agree universally that you have to be invested in stocks. In the long term, it's the highest returning asset class. You have to have stock exposure and allocation to equities. But in today's environment, most economists agree that returns will be more in the mid-single digit range instead of the 12% to 15% that we got back in the heyday.
It's really important to be more careful and have a little more downside protection and as much yield as possible. So covered calls make a lot of sense in this environment.
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