Thursday, October 28, 2010

IBM Growth and Income Machine

Selling Covered Calls - an illustration for income investors.

TheMadam has always considered the income from writing covered calls a gift.   But there are criteria that should be employed when using this strategy to supplement your income.

One of my rules, as you may recall from my website, is to always invest your money in an instrument that pays you something while you hold it.   For both my income portfolio and my growth portfolio, I always try to employ that rule.

Covered calls are no exception.  When you write or sell (these terms are interchangeable) a covered call you covey the right to buy your stock to another person at a certain strike price and within a certain time frame.  You must remember that the person who buys your call does not have to buy your stock from you.  The option is totally the buyer’s.  Therefore, you always want your underlying stock to be a good one.  The stock should make money, have no more debt than other companies in its industry and pay you a dividend.

In October of 2008, I decided I wanted to own IBM.  At the time IBM paid a dividend of $2 per share per year and at the price I paid (100 shares at $81.60 and 100 shares at $77) the dividend yield was about 2.5%.   Now 2.5% is only ½ of the yield that I count on for my income portfolio so I need to make more money on either call premiums or capital gains from selling the stock to meet my goals.   But IBM has a history of increasing its dividend over time so that fact was a positive.  And its debt to equity ratio was within the range of comfort.  Further more, if the market tanked again like it did in March of ’03 I was pretty sure IBM would not go out of business.  You always want to be comfortable with the underlying stock in case you are stuck with it for a while.

IBM also seemed to be a good pick for my growth portfolio.     I have bought and sold IBM several times over my investing career and I was ready to buy again.  I decided not to reinvest the dividend because I needed the income to live on and I decided to write calls on it at ever increasing strike prices.   I was confident that the dividend, plus the call premium would more than meet my 5% income goal and I was also confident that if the purchaser of my call wanted IBM at the strike price that I would receive enough capital gain to meet my growth goal of 7%. 

Listed below are the actual transactions over the past 14 months on those two IBM buys.  So this is not just an illustration, is it actual history.

     10-27-2008  Buy 100 Shares net cost                       $8,258.95
     11-19-2008  Buy 100 Shares net cost                       $7,708.95

     Total amount invested                                              $15,867.90

    Income from dividends
        3-10-2009    $ 50.00
        6-10-2009    $100.00
        9-10-2009    $  55.00
      12-10-2009           $  55.00

    Total income from dividends $260.00

    Income from writing calls
        10-27-2008    $390.29  strike price  $85
        11-19-2008    $290.29    strike price   $85
        11-24-2008    $265.29  strike price  $90
        01-26-2009    $135.29  strike price $100
        01-28-2009    $150.29  strike price $100
        03-23-2009    $100.29  strike price $110
        04-02-2009    $  80.29  strike price $115
        07-13-2009    $ 95.29   strike price $110
        07-27-2009    $100.29  strike price $125
        10-12-2009    $ 95.29   strike price $130
        11-04-2009    $ 96.29   strike price $130
        12-21-2009   $139.29  strike price $130

    Total income from calls     $1,938.48

Capital gains from sale of first 100 shares when the buyer of the call exercised their right buy at $110.

Total gain from sale           $2,831.81

My income yield over this 14 months has been 13.85 % well exceeding my 5% goal and the capital gain of the most expensive 100 shares was 17.85% again well above my growth goal.

Moral of this story is covered calls are an excellent strategy for income investors provided you invest in an underlying stock with great fundamentals.  Please note,  this is not a recommendation to buy IBM stock especially since it is selling at just about it’s all time high.  If my last 100 shares gets taken, I would be thrilled because there always another stock to invest in and write calls.
Very Truly Yours,
TheMoneyMadam

TheMoneyMadam is on vacation

Dear Students of income investing.

I will be on vacation until Thursday November 4, 2010.

Our subjects to study regarding income investing will be learning how to measure if companies make money and learning how to determine if they can pay interest on their debt.

More next week.

Very Truly Yours,

TheMoneyMadam

Tuesday, October 26, 2010

More Balance Sheet Issues to Consider.

This post is a continuation of your studies into the balance sheet of your stocks.

You are investing for both current and future income; right? So you selected companies that pay you dividends or bought a bond to pay you interest. As you watch the markets gyrate up, down, and sideways, you are concerned that, at this point in your life, you cannot afford to have your investments go belly up.

Your safest move is to make sure you invest in companies or lend your money to companies with a solid balance sheet. Companies with a solid balance sheet have the reserves to pay their dividends when times get tough and enough cash flow to cover their interest payments.

For instance: could diaper rash cause your investment to lose value? Yes. Look at the woes of Proctor & Gamble (PG.) Could Europe's troubles affect the value of your holdings in Coca Cola (KO?) Yes. Look at the slide of the Euro dollar and find that KO may suffer from that occurrence. 

Each of these companies is a hold because they have strong balance sheets and constantly increasing dividends.

I am not asking you to be an economist. The point of this post is; if you invest your money in a company that pays a good dividend and increases that dividend over time and has a cash reserve to get through tough times, your income is most likely safe even though the stock price moves up and down. Plus it is highly unlikely that your investment will go "belly up."

Your  job as a worried income investor and as a student of income investing is to determine the balance sheet strength of your investments by learning the D/E ratio of each of your investments.
Read my previous post on learning how to determine the debt to equity ratio (D/E ratio) of your investments.

Very Truly Yours,

TheMoneyMadam

Monday, October 25, 2010

Learn about Debt to Equity ratios to screen for stocks.

Let's determine if you selected income producing investments with a good balance sheet.




What does that mean? 

How do you determine if your investments have a good balance sheet?

I use many sources to help me determine how to invest. I am trying to narrow my work for you and I recommend that the quickest way for you to get an overall view of your investments' balance sheet strength is to determine the debt to equity ratio (D/E ratio.) 

Go to any financial information site such as your brokerage site maybe at Schwab or Fidelity or use Daily Finance or MoneyCentral.  Type in the symbol of the company in which you have an investment.

Now look under the category Fundamentals or Financial Results. Every site has information on the stock's financial results.  Look through this area and you will find a number called the debt to equity ratio D/E ratio.


Debt is measured just like your personal debt.  How much money does the company owe.  Equity is the value of each share.  Therefore if the debt to equity ratio is 1, the company has a dollar of debt for every dollar of equity.  


Generally speaking, I prefer companies with a D/E ratio less than 1.  However, some companies need to carry a lot of debt to fund major equipment purchases.   If you have a company with a D/E ratio greater than 1 but like all the other aspects of the company, your next assignment is to compare this company with a similar company and to learn about the industry average D/E ratio.   


A good example of this research is to compare Caterpillar (CAT) and Deere (DE).  Each company carries a lot of debt because their equipment is so expensive they cannot pay cash.  CAT has D/E ratio of 2.91 but DE has a D/E ratio of 3.9 and the industry average is 2.2.  So I would pick CAT rather than DE.

I want to emphasize, again, our rules for income investing.  Buy a company that makes money, shares it with you in a dividend, increases the dividend over time and has a strong balance sheet or a low D/E ratio.

Review every stock you own and decide if you have solid companies.  You'll be happy you did your homework.

Very Truly Yours,

TheMoneyMadam

Sunday, October 24, 2010

Helen asks; what is a covered call?

Options are difficult. Unless you are studying to pass the series 7 securities license, do not bother to learn all the permutations of options.  If you are interested in creating additional capital gain income from owning stock in a company, then you should learn about covered calls.
An example may be the best way to start.
If you own 100 shares of a company let us use Caterpillar symbol CAT and you bought it today at $65.50 you will own a company that pays $1.70 per share this year in dividends alone.  In addition, you should be aware that the dividend has consistently increased over time. So your stock is one that meets all of TheMoneyMadam’s four criteria for buying a stock.

To increase your income from CAT, you can sell a call to another person which gives them the right to buy your CAT stock. This is a covered call.  Yes, someone will pay you money for the right to buy your stock at more than you paid for it.  
Today I bought CAT for $65.50.  I sold a covered call for $1.57 per share.  Someone paid me $1.57 for the right to buy my CAT stock for $72.50 between now and November 20, 2010.  I hope they do.  I get $1.57 per share from the covered call.  I get $.44 a share in the dividend to be paid in August, and I get $7.00 per share of profit (the difference between what I paid for CAT $65.50 and what the buyer of my stock will pay me $72.50.)  In 4 months, I will have made 13.8%.  

A covered call is an option contract and it means that the other person will pay you in this case about $1.50 per share so that is $150 for 100 shares for the option to buy  CAT at $72.50 before the end of November. They pay you right away.  However, they are not obligated to buy the shares so you could end up owning the stock if it is at or less than $72.50 in November. 
You, the seller of the call, are obligated to sell your shares at $72.50 if the buyer wants them.  Of course, the buyer will not buy your shares unless the stock is greater than $72.50.  Who cares? You will receive the $1.50per share plus any dividend that is paid between now and November and you get the gain between buying the stock at 65.50 and selling it at 72.50.  If you are stuck with CAT, you get a great company with a good dividend and little debt for that kind of company.
Helen, do you understand it?
Yours Truly, TheMoneyMadam

Four Criteria for Buying an Income Stock

When an income stock is so good that I want to own it, I call it a Dividend Machine.  Below is a description of my approach to finding Dividend Machines.


Which stock should I buy? Use these four criteria.

  1. Select a company that makes money; measured as EPS(earnings per share.)  
  2. Select one that pays a 3 percent dividend but never greater than EPS
  3. Pick a company that has increased the dividend year year for at least five years. 
  4. Always select a fundamentally sound company D/E 1 or less.

Rationale:
               So many investment opportunities promise to make you money and can be very tempting but investing is risky business and you need to invest in a company that already makes money in order to reduce your investment risk.   When the investment currently makes money,you have a very good chance of getting your money back and an even better chance of reaping a gain.

               It is common sense that getting income from your investments will help your investment grow.  Just reinvesting dividends over time in the right company yields compound growth.  Young investors tend to want quick gains but you do not have to give up income to get growth or give up growth to get income. 

               Strong,consistent companies do not pay out more money in dividends than they make in earnings.  

               Growth and income are nice but you also want a company that is not going to go bankrupt.  Just like individual people,and governments, a lot of debt on the balance sheet is risky.  Balance sheets with a typical amount of debt for that industry are good.  And, sometimes you can find a company with no debt and a lot of cash and assets.

               When possible, you want to make back your investment plus your dividend income plus some kind of growth.   Growth is what makes capital gains.   You can sell covered calls against your holdings for capital gain or you can sell at a profit.
Implementation:

               You have to come up with a stock idea.  Watch the TV business shows, read the Wall Street Journal and Barrons.  Barrons lists stocks that are about to pay a dividend.  Pick one of those stocks and look at the stock quote page in Barrons. On the right side of the table, you will see estimates of future earnings.  Choose companies with increasing earnings expectations. 

           Once you select a stock in which you have an interest, use stock screening tools provided by your broker, or free sites like dividendinvestor.com or nasdaq.com or money central.msn.com or daily finance.com to find out about your company.  Dividend per share, earnings per share and growth rates are very easy to find. Although debt to equity ratio is easy to obtain, you should visit the fundamentals section to learn more about the balance sheet, dividend history, and growth history.  
 Decide what you are going to pay for the company or companies you have selected. This action is the most painful. Pay too much and you may take a while to get a capital gain.  Paying too little and maybe information about the company has not yet become public and the low stock price might suggest it is going lower.  Using the growth/income strategy you can offset this risk by earning income while you wait for the trouble to pass.   
 Charting is helpful when deciding at what price to pay for your stock.  Look at the highs and the lows and determine when to buy.

I invite you to contact me at TheMadam@themoneymadam.com if you need some help. 

Now start implementing your plan.
Very Truly Yours,

TheMoneyMadam

Three streams of income


TheMoneyMadam’s strategy for creating steady, ever increasing income from investments uses stock and bond investments.

Once you convince yourself that at least part of your invested money needs to create income, you should seriously consider my strategy.

Three income streams are all you need to create steady, ever increasing income.  

One income stream is dividends.  Always buy stock in a company that pays a dividend. Make sure the dividend per share is greater than the company earns per share.  My monthly cash flow, money I need to pay my basic bills, comes from companies with at least a 3percent dividend yield.  Moreover, I select companies that have a history of increasing the dividend every year.   

I recommend companies with a strong balance sheet.  A strong balance sheet means the company has little or no debt and will continue to pay the dividend and increase the dividend over time.
My second income stream is interest from bonds.   Buying a bond means you lend your money to a company or a government.  Although currently bonds are quite expensive, you can still find a few bonds yielding enough to supplement your cash flow and give you some risk diversification.  Buy bonds of the same companies you research for dividend income. However, always buy your bonds at par which is usually $100 per bond or preferably at a discount. Never put all your eggs in one basket.  Buy multiple bonds with varied maturities for instance one bond might mature in 3 years, another in 5 years, and another in 7years.   This spreading out of the bond maturities is called “laddering” bonds.

For investors with high taxable income and or investors who have their savings in non-retirement accounts, buying the bonds of a government particularly of a state, county or city is a good option.  Like a corporate bond, you want to lend your money to an entity that is highly likely to pay you back.  Look for insured municipal bonds or bonds from states like Indiana or Texas.  These states are in better financial shape than California.

My third income stream comes from an option strategy referred to as “selling covered calls” or sometimes referred to as “writing covered calls.”  When you own at least100 shares of a company, that company has a good story, and good growth potential,another stock buyer may want to buy it from you at a set price called the strike price.  They think the stock price is going to be higher in the future than it is when they pay you for the call option.   You sell to someone the right to buy your stock at a set price over a period of time.  They pay you for this right.  If your stock’s price is greater than the strike price, the buyer of the call will exercise their option to buy your stock.  As long as the strike price is higher than you paid for the stock, you make income from the call option and from the capital gain.  I recommend selling calls that expire in 90 days or less. If the price of your stock is equal to or less than the stock price, the option expires and you still own the stock.  You pocketed the income from the call and if you selected your stock carefully, you still own a solid company that pays a dividend while you wait for the next chance to buy a stock.  
I have a blog post on IBM that illustrates the way this works.

These three income streams can create steady, ever increasing investment income. 
Check in often as I continue to teach about these income streams and give recommendations on stocks, bonds and covered calls.

Very Truly Yours,

TheMoneyMadam