The Quest For Yield (Part 5): Building Your Income Portfolio

Investors seeking income face an array of unappetizing choices, especially if they want to keep risk very low.  For those with the right attitude and time frame, there is a very attractive solution, but it requires a little work.

Combining well-chosen dividend stocks and covered calls can create income of 8-10%.  The risk is quite reasonable.

This strategy can be part of a portfolio for a conservative, income-oriented investor.  In this article I will explain how I do this for clients, showing you how you can do it for yourself if you wish.

Background

It has been almost a year since my last installment in the Yield Quest series.  I had expected the next article to discuss bonds, particularly the ladder approach I favor in the current market.  I held off on this, because the strategy is appropriate for so few investors -- people who are in wealth preservation mode.  Most of us still need to do some wealth creation.

My mission in this article is to explain the best income-oriented approach for conservative investors in the current market environment.

Do You Qualify?

Let us suppose that you are a risk-averse investor with a ten-year (or longer) time horizon.  There are various high-yield bonds, but they also have high risk.  At the time I am writing, investment grade corporate bonds (ten years) yield 3.3% and the equivalent Treasury note is under 2.2%.

Here is the qualification test -- hardly anyone can pass it!

You cannot look at your brokerage statement, the daily mark-to-market, the monthly mark-to-market, or anything else for ten years.

This is what you would do with a bond portfolio.  You buy expecting to collect the coupon and the principal at maturity.  It is a simple test, yet a difficult one.  The bond investor does not worry about daily marks.

Psychologically, people cannot do this with stocks.  In the pre-Madoff days honest investment advisors could create a partnership vehicle (something we might call The OldProf Bond) and investors would enjoy the regular income stream.  Nowadays we cannot market partnerships.  The good side of this is that every investor has an account at a major firm -- full SIPC and other insurance, complete transparency, and a fiduciary relationship with the firm.  The investment advisor cannot withdraw funds or create deceptive statements.  This is all good -- very good.  People need not worry about fraud.

The downside is that some investors check account balances too frequently, reacting to short-term performance, and second-guessing every trade.

To emphasize -- the dividend + covered call approach is excellent, but it has volatility.  If you bought a bond, it would also have volatility and probably significant capital losses over the next ten years.  If you want to be a successful income investor, you need to be open-minded about the approach I am recommending and the baseline comparison of a ten-year bond.

The Current Opportunity

The obsessive concern over Europe has created a wonderful opportunity for the yield-oriented investor.

1. Stock prices reflect a severe recession scenario.
2. Europe-related volatility affects many stocks where there is no logical connection.
3. Implied volatility in stock options is very high -- very good for those selling call options.

This is not an article about Europe, but it is a story about grasping opportunity.  I have explained the following in past articles:

1. Why most stories on Europe will be misleading;
2. How to profit from the Europe confusion;
3. How to play the extreme volatility.

The market swings this week continue this theme -- knee-jerk reactions to stories that motivate traders, but have little effect on the ultimate resolution, or most US stocks.

How to Play the Swings

This wild environment is great for establishing your income portfolio.

Here are the simple steps:

1. Find a good dividend stock (discussed in detail in Part 3).  I know that most readers do not click through to the old links, but you really should do this before implementing this strategy.  My dividend article highlighted both sources and techniques.
2. Make good choices of calls to sell.  I discussed this in Part 4.

There are many ways to go wrong with either of these strategies, most importantly by a blind quest for the maximum yield.  Buying utility stocks, for example, is like buying a long-term bond.  You may get your yield, but at the end of the ten-year period you will probably not get your principal back.

My choices for yield start with the underlying stock value.  To give the flavor of this, I recommend this discussion between two of my favorite sources, David Van Knapp and Chuck Carnevale.  This fine interview captures the key points, especially this quote:

DVK: In your experience, what are the top two or three mistakes that individual investors make? How do FAST Graphs help them avoid these mistakes?

CC: First and foremost, I believe they tend to focus way too much on price and way too little on the intrinsic value of their holdings. Consequently, they tend to have a penchant of wanting to sell when they should be buying and vice versa. In my experience, stock price volatility is not only unpredictable and therefore unreliable; it's also a tremendous generator of emotional extremes.

Of course, I am referring to fear or greed. Although I feel that fear can be the most dangerous emotional response, greed is not too far behind. Naturally, emotions tend to lead to activity. And as Warren Buffett once so eloquently put it: "Inactivity strikes us as intelligent behavior."

There is a difference between "buy and hold" which has gotten a bad name, and monitoring with adjustments.  Sometimes doing nothing is the right move.

An Example

Here is a trade that I did today for clients who participate in our Enhanced Yield program.  I acted despite impending earnings tomorrow to capture extra call premium.  I think the stock is cheap, but I have no specific opinion about earnings.  I might have done better or worse tomorrow.

I bought Abbott Laboratories (below 52) and sold the JAN55 call for $0.75.  The stock has a yield of 3.6%.  If I could do the call sale once each quarter that would be another $3 in income, almost 6% additional income.  If the stock rallies, as I expect, I will get an additional gain.  If it closed above the strike, the $3 profit in one quarter would generate nearly 6% and I would move on to the next trade.

There is downside risk in any stock purchase, which is why I study valuation in making my choices.

Conclusion

There are many opportunities like this.  I made several similar trades today.

There are also many pitfalls -- mostly from blindly seeking the stocks with the highest yield.

Comments

[GotLife]

Has worked well for me over the last two years of a full commitment to these strategies. Selling a sort term put at a price you deem a bargain gives you the same discipline of an open limit order. However, you also gain the premium that reduces your entry point and time to decide. The second factor can work to both your advantage and disadvantage but for me personally, I find the time beneficial to either execute, roll forward or allow expiration depending on all the other factors involved in any acquisition decision.

[Ido138]

Ant thoughts on using cash secured puts to do the buy? Seems it would generate cash and help deliver bargains.

[Proteus]

Actually, I hadn't thought about professional management costs vs DIY efforts, but definitely there is no free lunch in DIY. Buying Eddy's stocks year after year might give you 1% over the market with only modest effort, but more than that - selling calls has timing and liquidity concerns, so clearly that's harder.

I know a number of people that have chosen professional management over DIY - my point was more that having a complete hands-off approach right now (doing neither) seems to be the worst of all possible worlds.

[oldprof]

Proteus -- As you and other regular readers know, I am a big Eddy fan. Our methods for stock selection are very similar, so we have several names in common.

He publicizes more of his choices than I do!

So -- what about doing well with almost no work? For someone with your background and skill, this may be true. I try to write in a way that empowers people.

There may be others who conclude that it is a good idea, and they would rather pay a modest flat fee for professional management.

If no one drew this conclusion, I would be doing something else!

But yes -- astute investors who are willing to do some work can read my articles and generate extra returns:)

Thanks,

Jeff

[Proteus]

A very good strategy; improving returns and reducing volatility. I assume you have figured out which calls to sell to optimize performance.

I note Abbott Labs is also on the Crossing Wall Street buy list. I suspect one could do pretty well with almost no work by combining their buy list with your idea of selling covered calls.