Covered Call

A popular strategy amongst investors looking to generate extra income from their portfolios is to sell a covered call option on stock that they already own in their investment portfolio.  Selling covered calls can be a good way to generate regular income on stocks that do not even pay dividends (but you can use this income producing strategy on dividend stocks too).

First, lets look at how this strategy works.  In this example, you own 100 shares of XYZ company in your investment account, it pays no dividend, and while you expect it to increase in price over time, it isn’t gaining in price very quickly, so you’d like to generate income with the stock until it hits your target sell price.  To do this, you sell a covered call option contract against your 100 XYZ shares (your 100 shares “cover” the contract as collateral).  In this scenario, somebody pays you cash that goes into your investment account, and no matter what happens next, the cash is yours to keep.  The terms of the contract are very simple – you promise to sell your 100 shares of XYZ to the person who holds the contract at the price specified in the contract, by the date the contract expires – this last term is very important. 

To continue our example, lets say XYZ company is currently selling for $20 per share, and you sell a call option using your 100 shares of XYZ stock as collateral with a strike price of $25, and a contract expiration date two months from now.  You receive $1 per share for your covered call contract, or $100 total, which is deposited into your investment account.  As long as the stock is less than $25 over the next two months, you will keep your stock, and the $100 you got for selling the contract.  In this case, you will be able to to do the same thing again after two months, up to six times per year.  In this example, you would be able to generate up to $600 in option income over the course of a year, from a stock that was just sitting in your online trading account.

What if the stock had risen above $25?  In this case, you would most likely have to sell your stock to the covered option calls contract holder (this is done automatically by your online broker), for $25.  So in this case, you would get the $25 per share for your stock, plus the original $1 per share that you kept from the sale of your option contract, for a total of $26 per share (or $6 per share gain from your $20 starting price) – not a bad profit for two months of risk in the stock market.

In order to execute this strategy, you will need to sign up with your stock broker to trade options in your account.  This strategy is so so conservative, that many brokers actually allow you to sell covered call contracts in your retirement IRA account.

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Stock Options Basics

Put options give an option buyer the right to sell 100 shares of an underlying stock at the strike price that the option contract was written for. While the put option buyer is not obligated to exercise the contract, if the buyer does exercise the contract, the option seller is obligated to pay the contract price for 100 shares of the underlying stock from the contract buyer, on or before the expiration date of the contract. Put option buyers are betting that the price of the underlying stock will move down. A put option becomes more valuable when the price of the underlying stock goes down.

are one of the most versatile trading vehicles available. Options on stocks are highly leveraged derivative investments, with a very well defined risk/reward profile.

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Stocks That Pay Dividends

Stocks that pay dividends can be a good alternative for investors either seeking regular income from their investment portfolio, or more consistent returns from their stock investments.  An investment in stocks that produce consistent dividends can be an ongoing source of profits for your portfolio.  These are some of the characteristics that these income producing investments provide:

1. Stocks that pay dividends can represent a single company, or they can be many companies under the organizational structure of a holding company, trust, closed end mutual fund, ETF, etc.  It is important to note that a majority of companies do not qualify for dividend investing for the simple reason that they do not pay dividends.
2. Companies that pay dividends do so because their management teams and boards of directors make a conscious, regular, and most importantly – discretionary – decision to pay their shareholders a dividend.  While most companies do this quarterly, there are many stocks that pay monthly dividends.
3. Dividend stocks typically have policies in place that promote the ongoing payment of dividends.  So while the decision to pay a dividend is at the discretion of the management team and board of directors, they typically have a goal of managing the company in a way that preserves, protects, and in many cases, grows the dividend income streams for their shareholders over time.
4. In many cases, stocks that pay dividends represent companies that are large, and more established (i.e. they have been around for a while).  These companies have created consistent, stable cash flows with very predictable earnings.  For example, utilities are a great type of stock that pays a dividend, they have a steady, predictable, source of income, expenses that are understood (and that can usually be passed along to their customers if expenses go up unexpectedly), which leads to a stable source of profits to pay dividends with.
5. Stocks in general are volatile, but stocks that pay dividends are usually lower in volatility than the overall stock market.  This is because investors are confident enough in the earnings of these companies, and the income they produce on a regular basis for their shareholders, that they reward this stability with lower price volatility, due to the justified view that these stocks are safer than average.
6. There are also tax advantages to owning dividend paying stocks.  Capital gains only trigger a taxable event when these stocks are sold, just like regular stocks.  The key tax advantage is that right now, the maximum federal income tax rate for dividends is only 15%.  This tax rate is lower than the tax rate you pay on bond interest, which is usually taxed at the same rate as your salary.  15% is typically much lower than your marginal tax rate for other sources of income.

As you can see, stocks that pay dividends have characteristics that set them apart from the overall stock market.  These income producing stocks may have a place in your investment portfolio.

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Stocks That Pay Monthly Dividends

While you have probably heard about stocks that pay dividends every quarter, did you know that there are many stocks that pay monthly dividends?  When many income investors think about investing for dividends, they naturally look at safe, stable companies like McDonald’s(MCD), Proctor & Gamble(PG), and IBM (IBM), which have a long history of paying quarterly dividends.  These types of dividend stocks are usually financially stable, have a lot of liquidity so they are easy to buy and sell, and have enough income and cash reserves to cover their dividend payouts to investors every three months.

There are a couple of issues that investors in these type of quarterly dividend stocks should consider.  First, the investors income stream is exposed to a single company for each stock that they own, and second, depending on the mix of stocks in the investors portfolio, the dividend income can be very lumpy (i.e. most of the dividend money arrives in one month of the quarter, leaving the remaining two months with very little cash coming in.

Stocks that pay monthly dividends are an alternative that can provide regular, consistent, income to investors, and overcome the two main issues highlighted above.

First, monthly dividend stocks are typically traded on regular stock exchanges, and have enough liquidity for investors to easily buy and sell them.  Stocks that pay monthly dividends are usually trusts, closed end mutual funds, and other investment vehicles that actually own a portfolio of income producing assets.  This benefits investors because they get the diversification of the underlying portfolio owned by these companies, so investors are not as exposed to single company risk as they would be if they owned a single company that paid a quarterly dividend.

Second, since the income stream from stocks that pay monthly dividends comes three times as often as the cash flow from their quarterly brethren, the income is not going to be as lumpy.  This is a significant benefit for investors that need regular income, like retirees that need a passive source of retirement income to meet their monthly needs. 

One of the obvious items that investors considering purchasing stocks that pay monthly dividends over a company that pays a quarterly dividend is understanding the assets that are held by the monthly dividend company.  While this adds an extra research item, it is very easy to find this information in the standard government filings that publicly traded companies have to file with the SEC.

Stocks that pay monthly dividends are a great tool for people looking for consistent regular income.  Since these stocks may be new to you, just click on this link for a list of monthly dividend stocks.

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Monthly Dividend Stocks

Monthly dividend stocks can be a good idea for income investors to create a steady income stream.  If you are looking for regular income, you may want to consider monthly dividend stocks.  Thats right, there are stocks that pay monthly dividends.  These monthly dividend stocks are just like their quarterly dividend stock brethren, but they pay out their dividends – you guessed it – on a monthly basis.

Many people interested in income investing have stocks that pay quarterly dividends in their portfolio, as these are the most common type of dividend paying stocks.  Depending on the dividend payment dates, this can lead to inconsistent monthly income – for example you get a lot of dividend income in the first month of the quarter, and very little dividend income in the last month of the quarter.  One way to smooth this out is to buy stocks that issue dividends in different months of the quarter.  Another way to set up a more steady income stream is to put monthly dividend stocks in your portfolio.

Most stocks that pay monthly dividends are investment trusts, closed end funds,  or holding companies that own many income producing securities, that issue the income from these investments in the form of  a monthly dividend.  The list of monthly dividend stocks is nearly 300 long.

Adding stocks with a monthly dividend payment can help smooth out the monthly income in your portfolio.  Click on the link above for a list of monthly dividend stocks.

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Dividend Investing

Dividend investing is for people seeking income from their investments, who are also willing to take on a little more market risk than bonds offer in order to try to achieve growth in both their principal and the dividend income provided by their dividend stocks, not just by chasing the highest dividend stocks.  A successful dividend investor knows that this strategy can help them stay ahead of inflation.

One of the first steps in dividend investing is identifying companies that are in a position to not only maintain the dividend that they are paying out to their dividend investor base, but can also as a dividend growth stock opportunity.  A good way to determine if a stock fits this criteria is to look at it’s dividend payout ratio.

Dividend Payout Ratio

The dividend payout ratio can be calculated in a number of ways, so we’ll look at two of them and let you decide which one to use for your dividend investing screens (my favorite dividend payout ratio calculation is the second one).

The most popular way is calculated by dividing the annual dividend a company pays out per share by it’s annual earnings per share.

Dividend Payout Ratio = Annual Dividend Per Share / Annual Earnings Per Share

These numbers are readily available at most popular financial web sites, and can be included in dividend investing screens at sites like MSN Money.  Using this version of dividend payout ratio calculation, a level of 50% or lower is considered good.  So, this calculation is pretty easy, and the data is readily available, but for good dividend investing principals, it has a flaw…

The problem with the above calculation is that EPS has some noise embedded in it that can mis-lead a dividend investor into buying a company that is not a dividend growth stock candidate.  In my view, good dividend investing stocks’ dividends need to be paid out of the ongoing cash operating profits a company generates, and due to  GAAP accounting rules, EPS contains more than this.  For dividend investing, it is better to use annual free cash flow (FCF) instead of EPS in the dividend payout ratio calculation.

Since free cash flow takes into account both expenses and capital outlays, it shows how much cash is left over from company operations to apply to dividend payouts.  With the inherent noise in EPS taken out of the dividend payout ratio calculation, a level of 60% – 65% or lower can be considered good for dividend investing (obviously lower is better in either method of calculating dividend payout ratio).

Dividend investing can be a profitable endeavor when you use the right tools.  If you’re a dividend investor, please leave a comment on how you screen for good dividend stocks.

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Earnings Yield is a very popular, and useful, tool for investors who try to beat the market with value stocks investing. 

Earnings Yield

Earnings yield can help value stocks investors in their quest to find good solid companies that are currently relatively cheap.  Using indicators like return on invested capital (learn how to calculate ROIC), can be helpful in finding a list solid companies, and once you’ve identified this list, earnings yield can help you determine if the company is cheap enough to buy right now, after all, that is what value stock investing is all about.  Earnings yield does this by dividing a company’s annual earnings per share (you can use a trailing 4 quarters view of EPS for this if you’d like) by the company’s current market price per share.  This number is expressed as a percentage, which makes it easy to compare with bond yields.

How to Calculate Earnings Yield

There are a couple of ways to calculate earnings yield.  Since you don’t find this number in a lot of free online stock screeners, I’ll cover both methods, and you can decide which one you want to use. 

The first way to calculate earnings yield is to take the inverse (1/x) of the P/E ratio.  Since P/E ratios can be found in most financial publications, web sites, and stock screening tools, it is very easy to find this number, and invert it on a calculator or in a spreadsheet, to give you the earnings yield.  This method is very simple to use, and gives you a quick view of how cheap (or expensive) a stock is.

The other way to calculate earnings yield is a little more involved, but gives you a better understanding of how a company is valued relative to it’s earnings.  This form of earnings yield was written about by Joel Greenblatt in his book, “The Little Book That Beats the Market”.  The earnings yield he created is useful in comparing companies with different tax rates and levels of debt.  Greenblatt’s earnings yield formula is:

Earnings yield = pre-tax operating profit (EBIT) / Enterprise Value

So, in this case, the numerator (EBIT) comes from the income statement, and the denominator (Enterprise Value) is calculated by adding the market value of all equity – both common and preferred – to the value of all interest bearing debt that the company owes.  The value of equity is just the shares outstanding multiplied by the price of the stock, and interest bearing debt can be found on the company’s balance sheet.

I like Greenblatt’s method of calculating earnings yield better than the more popular E/P method, since it gives a more accurate view of what is happening inside of a company, and also gives a more balanced view when comparing multiple companies to each other.

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Business revenue growth is a very important fundamental analysis indicator used by investors for picking good value stocks.  To start with lets go over the difference between business revenue and total revenue.  Business revenue is income, or sales, that comes from the primary activities for a given company, whether it is organized as a corporation, partnership, sole-proprietorship, etc., doesn’t matter, business revenue is the same across all types of companies. 

Business revenue does not include other types of revenue that may be included on a given comany’s balance sheet like incidental or non-operating revenue.  Some examples of the types of revenue streams will help you see the difference between non-operating revenue and business revenue.  One example would be incidental revenue earned on a deposit in a demand bank account – this type of revenue is not associated with business revenue generated by the primary activity of the company.  Another type of non-operating revenue that needs to be filtered out of the total revenue number might be from a manufacturing company owning or leasing a building, and sub-leasing a portion of the building that it is not using to another company – again, this is not business revenue, but would show up in the top line number on an income statement.

The focus of your value stock picking should be on business revenue growth, also known as net sales growth.  Examples of business revenue would include a manufacturing company or a bakery selling goods, or an accounting firm or a consulting firm selling services.

Business revenue growth is calculated by dividing this periods (typically quarterly or annual) net sales by last periods net sales and subtracting 1.  This gives you the percent growth, or reduction, in business revenue.  Above average business revenue growth combined with the company efficiency you can find by learning how to calculate ROIC, is a great way to filter stock candidates down to a manageable list.

Good value stocks have business revenue growth that is greater than the company’s peers in it’s industry.  It should have consistent multi-year growth, if there is an anomally in the annual growth rate, make sure you understand why – it could be anything from a recession that took out all company’s growth, to the introduction of a game changing technology that the stock will have a hard time recovering from.

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What is Return On Equity?

Return on equity is a popular fundamental analysis technique to measure how efficiently a company uses it’s shareholders’ investment to produce eanings.  The formula to calculate Return On Equity (ROE) is straightforward:

Return on Equity (ROE) = Net Income / Shareholder equity

Obviously this is a much simpler formula than how to calculate ROIC (return on invested capital).  Some investors would answer the “What is Return On Equity?” question by stating that return on equity is an easy and readily available way to compare different companies profitability.  A company with a high return on equity is more likely to be capable of generating cash organically (internally). For the most part, the higher a company’s return on equity compared to its industry, the better.  You need to look at ROE relative to the industry the company your evaluating is in, because not all high ROE companies make good investments.  For example, companies that require little very little assets, like consultants, will have high ROE’s relative to capital intensive companies.

So, hopefully this helped you understand what is return on equity.

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Value stock investing is an investment strategy that looks for stocks which are undervalued when compared to a value you calculate with various fundamental analysis indicators.  While the description may sound a little complicated, you will see that with a little practice, fundamental analysis for value stock investing is not as difficult as it sounds, in fact, with readily available online tools, finding good value stocks is easy.

First a little history – value stock investing was popularized by Benjamin Graham and David Dodd, and their 1934 book, Security Analysis, remains popular to this day – many bookstores still stock this one on their shelves.  Famous investors like Warren Buffet and Mario Gabelli have made fortunes using the value stock investing strategy to find under priced stocks to buy.

Value stock investors look for stocks with strong fundamental characteristics, such as business revenue growth, cash flow, earnings growth, book value, and cash flow.  All of these items, and more, are found on company’s quarterly and annual reports.  The key is finding stocks that sell at a bargain price vs. their underlying quality based on these fundamental metrics.  Value stock investors constantly seek out companies that are currently incorrectly valued (i.e. undervalued) by the stock market and therefore have the potential to increase in share price when the market corrects its error in valuation.  Some good value stocks pay higher dividend yields due to their lower price relative to the dividend that they pay (there are even monthly dividend stocks that fall inot this category).

Since value stocks are under priced, this means that they are out of favor with the market, which makes value stock investors contrarians by definition.  Buying value stocks can, at times, be tough psychologically, because in many cases, you are buying companies or industries that are receiving a lot of negative press.  Right now there are companies and industries that you can read about in the news, where nearly every article you read in the business press, or every story about them you watch on television, is very negative.  As I write this article in Spring, 2009, there is a recession in full swing, with banks, housing stocks, and REITs all being whacked the most by the business media.  These are the types of areas where value stock investors are prospecting for good companies with good fundamantal characteristics, that are having their stock prices dragged down with the rest of the companies in their industry.  A good tool for determining if a stock is undervalued is to look at it’s earnings yield.

With the tools, resources, and articles posted on this website, value stock investing will become another tool for you to use in your successful online investing activities.

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