There are three words to describe the goal of every long-term stock investor. Those three words are income, income, income.
Income in the form of dividends is often what differentiates a winning long-term stock investor from just an average buy and hold stock market player.
You see, dividends are the difference between outsized returns and just average returns for the well diversified stock market portfolio.
However, in today’s world, finding high-yielding consistent stocks can be very difficult. Often high dividends go hand in hand with higher risk or even plunging share prices.
The current environment has forced successful investors to look for ways to “juice” or increase there returns beyond just simple dividends.
Fortunately, there is a simple way to increase your returns beyond just dividends. This method can be used to enhance the income of nearly any dividend paying stock. As well as turn any portfolio into an income creator even without dividends.
Most investors know about this method, however, very few actually use it in a consistent manner to juice their dividend returns.
First, let’s take a look at dividends and why they are so critical to a long term stock market investor’s success.
There is no doubt about it that stock dividends are a huge part of stock market profits. In fact, 40% of all the S&P 500 advances over the last fifty years can be ascribed to dividends.
Smart, long term investors use this information to grow their own long term portfolio.
Obviously, it takes more than just earning dividends to build wealth in the stock market. It takes the power of dividend reinvestment.
Dividend reinvestment entails using the proceeds from dividends to purchase more shares rather than simply taking the cash. Huge portfolios have been built over time using the dividend reinvestment method.
The reason this happens is due to the power of compound interest. Some people say that Einstein was noted as stating that compound interest is the most powerful force in the universe.
Compound interest is the earning of interest on interest. Dividend reinvestment takes advantage of compound interest by reinvesting the dividend proceeds into the stock.
Dividends have recently become even more critical for stock investors. This is because of the ultra low interest rate atmosphere. The low interest rates have made the search for returns very difficult. Dividends are among the only tools that are still providing consistent high yields among traditional investments.
4 Critical Rules For Finding Winning Dividend Stocks
- Know The Ex- Dividend Date
This is the most important date for dividend investors. The ex dividend date is the first day after a dividend is declared that the investor will not be entitled to collect the dividend. This means that investors who wish to collect the dividend MUST purchase the stock prior to the ex-dividend date.
- Dividend Frequency Is Critical
Most stocks pay dividends quarterly. Some stocks pay dividends annually or semi-annually. Other companies, particularly those designed to pay investors via dividends, pay monthly dividends.
You may be asking what it matters. Well, with all things being equal, the more frequent the dividend, the better. You see with dividend reinvestment, the more frequently you are paid, the faster your money compounds on itself.
- Beware of Pay Out Ratios Above 100%
Stated simply the payout ratio is the ratio of dividends in a specified period divided by the company’s reported earnings over the same time frame. The way it’s calculated is the per-share dividend as the numerator and the earnings per share (EPS) as the denominator.
Here’s an example. If a company earns $1.00 per share and pays out $0.30 per share, the payout ratio is 30%. If this same company paid out $1.15 in dividends per share, the payout ratio would be 115%
While, on occasion, companies may exceed the 100% dividend payout ratio in their zeal to keep increasing dividends, this is not sustainable.
Be very cautious investing in companies with a greater than 100% payout ratio.
- Yield Is A Function Of The Stock Price
This is a critical and often overlooked fact about dividend investing. Let me explain with an example.
If a stock sells for $100 and pays a $5 per share dividend, the yield is 5%. If the same stock fell in price to $50.00, the yield would be 10%.
Therefore, it’s crucial to make sure that the high yielding stock you are considering isn’t high yielding because of a plunging stock price.
Another thing to keep in mind is something called effective yield. Effective yield is personal and based on the price you paid for the shares.
Now that we understand the basic premise of creating income via dividend reinvestment, here’s how to juice your income even more.
As we stated earlier, today’s low rate environment makes juicing your returns even more critical for growing wealth in the stock market.
The safest, although not stock investing strategy is completely safe, to juice income is via writing covered calls.
Covered call writing is the selling of calls against shares of stock that you already own. Therefore the calls are “covered” by the stock in your portfolio.
One call option offers the buyer the right to buy one hundred shares of the stock for a particular price during a pre-determined time frame. By selling the call option, you are selling the right to the buyer to purchase one hundred shares of stock from you at the agreed upon price. This price is known as the strike price.
Traditionally, the time frame is monthly but weekly options are also available.
For every one hundred shares of stock, covered call writers sell one call option. Being covered tremendously reduces the risk when compared to “naked” call writing. Naked call writing means selling calls without owning the stock first.
When you sell a call option, you receive the amount the buyer paid for it, less commissions in your account.
This option premium is the income that you get to keep.
As a mental exercise, imagine the call option you sold were $5.00. Since an option represent one hundred shares of stock, you will instantly receive $500 minus commissions in your account. Times this by 1000 shares and ten options, you would earn $5000, minus commissions!
Just imagine how this simple strategy can ramp up your returns!
Sound Too Good To Be True?
I know this sounds too good to be true and you are thinking “what’s the catch?”
Well, the catch is by selling the call, you are obligating yourself to sell your one hundred shares of stock at the strike price of the call. This mean the buyer can purchase your one hundred shares at anytime during the life of the call option at the strike price. If the buyer decides to purchase your shares at the agreed upon price, this is called exercising the option.
If the price of the stock climbs higher the strike price of the option, it is likely that you will be forced to sell your shares to the option buyer.
As you can see, this will reduce your upside gains dramatically. However, with a very slow climbing, neutral or falling stock, covered calls can enhance your return during the same period.
Stated simply, a covered call can offset downside risk due to the premium received or add to upside gains. BUT, you are accepting the cash today in exchange for any gains above the strike price of the call option.
Here’s A Basic Example without taking commissions into account
You own 100 shares of XYZ at $33 per share
You investing premise is that XYZ will stay below $35 per share over the next month.
You sell 1 call option with the strike price of $35 for $500. The premium is instantly deposited into your account. You are now obligated to sell your shares at $35 during the life of the option should the option be exercised.
Now several things can happen
1. The Stock Moves Higher Than The Strike Price
If XYZ shares move above $35 on or before the expiration day of the option ( the 3rd Friday of every month) the purchaser of your option will likely exercise it, automatically buying the shares from you at $35 per share. This means that $3500 will be deposited into your account from the sale of the one hundred shares. You now have $3500 plus the $500 option premium equaling $4000 to reinvest or spend.
2. The Stock Stays At or Below The Strike Price
If XYZ stays at or below $35 by the expiration date, then the call option expires worthless to the buyer. This means you get to keep the entire premium paid, minus commissions, of course. Now you can go ahead and do the same thing at the same or different strike price for the next month.
Selling covered calls on dividend-producing stocks that are “stuck” in a range can be a great way to juice your income!