Covered Calls

Covered Calls

Similar to the legendary Rodney Dangerfield, Covered Calls don't "get no respect!" Although investors should always consult with their advisor, the Covered Call Investment Strategy has many appealing components, and may offer advantages to the classic "Buy-and-Hold" philosophy hammered into the psyche of the public by index fund providers. Indeed, much like Rodney Dangerfield, investors may come to love this strategy.

First let's have "the talk." If you are investing in the stock market it is by its very nature speculation, and as 2022 clearly demonstrated, it can be EXTREMELY volatile. Volatility is ten-letter word for "risk" or "loss" or "sleepless night" or "anxiety." Basically the opposite of a Bull Market, which can be summarized also with a single word: euphoria. 

 

Investors need to internalize the FACT that holdings in the stock market can and do fluctuate, and a "linear return" is fallacy in the short-term. On any given day, the markets can swing in multiple percentages up & down. As 2022 taught us, these downward trends can be sustained for months. For those old enough to remember to the 1970s, with the wrong economic policies these trends can be sustained for YEARS. That's the bad news.

Now on to the good news. Given that there are a limited number of places to put your hard-earned money in life (gold, stocks, bonds, real estate, and business ownership come to mind) there is a good chance some or most of your liquid assets will be held in the stock market.

 

Without diving too deeply into "the history of Wall Street," the stock market offers (generally) almost daily liquidity, established exchanges, and highly-regulated firms. All the major governments of the world are immersed in the global stock exchanges. So with that said, there is a reasonably good chance that owning a basket of stocks over time will turn out well.

As a Portfolio Manager (PM), my job is to select those securities which I have studied and researched which I believe with a high-level of confidence offer a solid rate of return for my clients. From a mechanical perspective, I also want to add a couple layers of additional protection. One, as frequently discussed on this blog, are dividends.

 

Dividends are cash payments companies make to their shareholders typically on a quarterly basis. It is a reminder to corporations as to who they work for, ie you. It also, obviously, a return on investment for the shareholder doled out at recurring intervals. Timing is notoriously tricky, but I believe it is better to get returns drizzled out over time than pray for a rainstorm.

Second, let's start embracing Covered Calls. Covered Calls are Call Options written (sold) on existing stock positions. These contracts are traded on similar hours as the underlying stocks themselves. Each Call Contract represents 100 shares of the underlying stock. So for example, if you own 1,000 shares of XYZ, then you could write up to 10 contracts on that position.

 

Part of the Portfolio Manager's job is to determine the likely TIME and LENGTH of that Covered Call. That is extremely challenging. It is often the confluence of volumes of data, and of course greed. How much do we think the stock will go up over a certain amount of time? Are we more concerned about losing the stock or leaving money on the table? How much is the premium paying? What is the likelihood of expiration without losing the stock?

A LOT of variables go into deciding the best course of action, and a lot depends on the client's goals. Ultimately, investing boils down to cash flow. Covered Calls are unique in the investing world in that you are paid UP FRONT for the premium on a contract in the future. Investors know with certainty how much they will be paid the moment the contract is sold. Cash from a Covered Call sale is deposited into investors' brokerage account instantly. And to segue to the third layer (first dividends, second Covered Calls),  that premium cash can then earn additional interest in very nice 5% Treasury Bills currently.

The art & science of Covered Calls is tricky, and like most things in life experience is probably the best teacher. One would think the primary goal is to maximize the premium return without getting the stock called away, but that is not always the case. There are also times where the stock WILL get called away by buyers who want to capture the dividend from investors. The biggest challenge for the PM starts with "the talk."

What is the client's annual return needs vs. wants vs. probability of accomplishing that goal? Is a $30K annual withdrawal on a $500K account reasonable? What is the implied risk? Can a client mentally forgo additional alpha if XYZ stock was purchased at $125 with Covered Calls written at $150 and the stock subsequently spikes to $175? Or like 2022, clients have a low cost basis and have been raking in dividends, premiums, and capital appreciation for years and suddenly find themselves down 15%, 20%, 25%. What then? This is why "the talk" is so important.

In summary, if you're on board with actively investing in the stock market I believe utilizing a Covered Call strategy makes sense for a lot of reasons; from security selection, cash flow certainty, hedging and tax-loss harvesting to name a few.

 

One of the greatest challenges, and one humans throughout time have been really, really bad at, is moderating greed. Adding layers of risk protection goes out the window the moment we say: "Well I'm gonna close out that contract and hold the stock now because it just keeps going higher. I don't want to miss out!" Letting hedges lapse is dangerous business.

By definition, employing a Covered Call strategy almost always involves getting some positions called away. That is the nature of the beast. But if 2022 taught us anything, it is that markets are inherently volatile and in any given year long-term investors can be subjected to gut-wrenching selloffs. I like having three (3) layers of added protection when investing in the stock market, that's probably why they call me "Mr. Covered Call!" If this strategy sounds appealing to you we should talk.

 

 

 

Back to Basics

Back to Basics

When all else fails, investors can always go back to basics; own dividend-paying monopolies with powerful, lasting brands across multiple sectors. Save regularly, or better yet religiously, and also keep a healthy stash of seed capital in risk-free U.S. Treasury Bills earning that juicy ~5% interest.

This Bear Market will end as every other bear market ended, when, however is unknown. Some clues will be that the Federal Reserve stops hiking rates, inflation stabilizes or falls, and/or an increasing number of stocks begin to hit new 52-week highs.

The latter point is almost always a sign we have exited a Bear Market. So for those weary investors beaten to a pulp by bad economic policy and the Fed tightening the screws on you, hang in there. Continue to build positions and keep an eye out for the end of the bear. Until then, it is back to basics and avoid the Risk of Ruin.

 

Tokenization

Tokenization

Tokenization of assets is the springboard of capitalism. Ever since the establishment of the Amsterdam Stock Exchange in the early 1600s, the world's first official stock exchange, capitalism has taken flight and created a system of joint ownership of various assets. This allowed for virtually anyone to own a piece of a company without being personally responsible for its fate, yet this owner could share in any potential upside via an increase in the share price or as the early mining stocks in America proved, dividends from said share(s).

Here at ILAF we are always at the forefront of financial technology and innovation. Well kinda. But as financial farmers with a deep respect for ownership of assets that grow large over time, we would be remiss if we didn't talk about the advent of a *new* kind of financial development: tokenization.

Tokenization is the process of splitting either a real physical asset (such as a car, real estate, or even comic book) or increasingly non-fungible digital assets into identical pieces or shares or tokens of ownership. For all intents, what is occurring is a ledger system which is extremely NON-crypto in the sense that there is no ambiguity as to an asset's provenance. Crypto is probably one of the biggest fallacies of all time; it is eminently clear who owns what, what they paid, and when the item was purchased. Fungible assets, however, have anonymity by definition; think gold, physical paper cash, and oil for example.

One massive market that has been overlooked for decades, save perhaps for the avant-garde, haute couture world that Sotheby's and Christie's have built their empires on...paintings and sculptures. People of a certain generation, for generations, have stored their wealth in art. Primarily paintings. But for the past several decades as the older generations pass on and their collections are broken up and reconstituted by others as the wheel of time turns, a new store of wealth has emerged. Composed primarily of what loves were enjoyed in the past, or what loves where unobtainable in the past, a host of collectibles including classic cars, baseball cards, watches, and comic books have emerged.

Why would the comic book emerge as one of the hottest stores of value? Arguably in 1938 with the publication of Action Comics 1, a new generation of art, culture, and value was created with Superman's debut. Batman followed in Detective Comics 27. A host of other heroes soon joined the ranks. And in the early 1960s as culture itself changed dramatically, Marvel Comics launched the Fantastic Four. In quick succession The Hulk, The Amazing Spider-Man, The Avengers, etc. followed. So began the continuity of a medium that has influenced, often defined, culture for nearly a century. Those early pieces of paper are now worth millions. Perhaps billions. What does this have to do with tokenization? Read on fellow financial farmers.

I was recently introduced to a platform called Rally which has successfully tokenized collectibles into distinct pieces of collectible ownership. The implications of this should be vast, as there are a finite number of old goods...ie there are only so many X-Men 1 graded CGC 9.4 (13 to be exact) available in the world. Granted "new" old collections are sometimes found, but they are increasingly rare. Limited supply of high end goods, regardless of the category, usually prove good for their underlying owners over time, especially if there is consistent demand by a growing population. The item becomes a store of value.

Bitcoin is all the rage in terms of tokenization; but the true unleashing of value, in my opinion, will be in the vast untapped value trapped in collectibles...at least as long as the living generation valuing the assets lives; will a Monet always be a Monet? Only if each succeeding generation values the artwork as much, or more, as the previous generation. Unlike bitcoin though, tokenization of collectibles offers the owners a piece of tangible asset; the value, of course, is always in the wallet of the beholder.

 

Dividend Streams

Dividend Streams

Are you converting deal flow or sales or income from your profession into recurring cash flow? By selecting a basket of dividend-paying stocks which pay quarterly dividends you can stagger dividends into "paychecks" to help supplement your income or build an asset base for retirement.

Here's how it works: Screen for quality dividend-paying stocks you'd like to own. From that master list, which should include a couple dozen stocks, consider picking out handful from various non-correlated industries. For example, from the master list pick a couple from energy, some from consumer, some from tech, some from medical, some from aerospace, etc.

Your final list obviously can have as many stocks as you'd like, but having about a dozen stocks paying four times a year would result in 48 dividend payments per year. If you stagger them both by industry and payment date you could receive a dividend payment ("paycheck") every couple weeks from a diversified base of holdings.

What's nice about setting up a dividend stream is that you can tailor the stocks in the portfolio to the specific industries you enjoy investing in, offset the dividend payment dates to concentrate or separate the dividend stream as you'd like, and also mix-and-match the holdings to include either more value stocks or growth stocks or even form a hybrid of that...plus...many dividend stocks increase their dividends over time. 

Done successfully you should be able to establish a recurring dividend stream that gradually increases over in time in terms of both value of the underlying asset base and the value of the income stream.

Compound

Compound

Usually when someone says "invest," what they really mean is "compound." It has often been quoted that Einstein remarked that the power of compounding was beyond human comprehension. That very well may be true, but seeing something visually should offer some understanding of the phenomenon.

Consider the leading image of this post; it is almost an ideal example of what is possible over a long-term (10 years) with a stock that compounded some 1070.36% (ten-bagger in Wall Street parlance) earning the holder a $107,048.51 profit from an original investment of $10,000.

What's nice about this example is that it includes the purchase date and hold date exactly, the purchase price, end price, dividends, and the average annual total return. Those factors are very telling.

Successful compounding almost always involves 3 vital factors: security selection, holding time, and either additional paid-in capital or dividends. These 3 variables, when working in concert, can produce extraordinary results as the above indicates; for every $1 invested the owner received $11.70 in return a decade later. For every $9.60 paid per share in 2009, $6.80 was returned in dividends alone!

These are the growth stars every investor and portfolio manager should constantly be on the look for while screening for stocks. How do you find them? With questions! Does the company offer consumable products that need to be continuously repurchased? Does the company pay a dividend? What rate? What is the growth rate of the dividend? How stable is the dividend? Is this company a monopoly? What's the competition like? Is their product dangerous or subject to regulation?

There's an old adage that Financial Famers like you who read this blog know well, "invest your time before your money." The fruition of these words can be found in results like the above example which can have a meaningful impact on an investor's life both now and in the future.

High Returns from Low Risk

     Well fellow financial farmers an investor after my own heart has finally codified what we have intrinsically know for years; that it is possible to achieve high returns from low risk. How? Frequent readers of this blog (thanks Mom & Nana!) know that the effects of compounding create a virtuous anomaly in investment returns. This alpha anomaly is the result of exponential returns from consistently adding shares via dividends, buybacks, and other shareholder-friendly actions which are natural occurrences when consistent strong cash flows are administered by prudent corporate management.

     Pim Van Vliet goes back many decades and crunches the numbers for us to prove this point in his new book "High Returns from Low Risk." He compares high volatility stocks with low volatility stocks (referred to as "beta" in the Wall Street world.) From this he backtests multiple scenarios which pictorially reveal what happens to "boring" investors over time...although even those dice-throwing, card-counting, wheel-spinning risky investors do well too IF they have the ability to HOLD positions over long periods of time.

     What's the take-away? Invest for the REAL long time and don't be afraid to put money in your financial farm in positions which have traditionally been labeled "boring." This book is a great read for those who wish to Invest Like A Farmer.

Dividends

Above is the per share dividend growth for Procter & Gamble over the past 60 years. As financial farmers, it is imperative we consider the impact of dividends on a financial farm; indeed, dividends have historically accounted for 42% of a portfolio's return!

Much of Wall Street is laser-focused on obtaining Alpha (positive returns), yet you rarely hear the "fast money" discussing boring dividends. Or Yield on Cost. Or the Dogs of the Dow. Boring doesn't make for flashy news, but it sure does make for a fat stack of benjis on your farm! Don't underestimate the true goal of investing: cash flow.

Yield On Cost

     One of the most fascinating concepts of compounding interest is the concept of Yield On Cost. For those who aspire to Invest Like A Farmer it could be said that this is THE fundamental concept. Yield On Cost is calculated by dividing a company's current annual dividend payment by the original purchase price. It is expressed as a percentage; so for example if you bought Altria at $30 a share 5 years ago and the stock now pays a $0.61 per quarter dividend the Yield On Cost is 8.13%.

     Yield On Cost differs from a dividend yield in that a dividend yield is the current annual dividend divided by the current share price; so in the above example of MO, the dividend yield is ($0.61 X $ =$2.44/yr divided by $66/share) is 3.69%. The significant difference here is that Yield On Cost factors in the benefits of reinvested dividends over time.

     For financial farmers this is particularly important because ad believes in Dollar Cost Averaging and selecting stocks that Pay You To Own Them, the Yield On Cost is a favorite barometer over time of the true success of an investment in your portfolio.

     A carefully constructed portfolio ultimately takes on a life of its own; dividends are typically paid quarterly and reinvest. Over multiple years, and even decades, these dividends provide a healthy backstop to inevitable stock market cycles and economic booms and busts; ultimately the "farm" generates recurring income that seeds additional investments which generate additional cashflow themselves and so forth. This virtuously cycle compounds and should reveal a very, very positive Yield On Cost over time.

Ratchet Up the Cash Flow

One of my favorite investing books of all time is Rich Dad Poor Dad which if you've had an opportunity to read outlines the basic principle of defining what an asset is, and recommending ONLY purchasing assets. Simply put, Kiyosaki defines an asset as something that pays YOU to own IT. I think that is an accurate description.

And although some may disagree, the stock market is probably one of the greatest inventions ever because it allows investors at almost every level of the economic spectrum to buy assets in the form of ownership interest(s) in companies that pay dividends.

By Kiyosaki's definition, however, many, many stocks do not qualify as assets because they pay no dividend. As financial farmers, we like dividends. It is one of the tenets of our philosophy.

So with that said, 2015 has proven to be an excellent year to literally stock up on dividend paying stocks which saw their valuations get crushed in August only to rally back through October; little mention has been made of the increasing number of companies RAISING their dividends while also buying back shares and cutting costs as well. 

Pure growth investors heap piles of…scorn…on those who invest in dividend paying, cost-conscious, shareholder friendly companies, but the long-term benefits are obvious; a steadily rising left to right stock price.

The opportunity of a lifetime comes across my desk about once a month, and ratcheting up cash flow has consistently been one that stops by to say "hello." Boring, enduring brands with monopolistic presence, pricing, and products are tough to beat over rolling 10-year periods. Take a look as some of the most boring businesses in the S&P 500 YTD…very juicy cash flow indeed.

Great Returns Breed Complacency

If there has been one truism consistent in the investing realm it is that great returns breed complacency. Many of you who have chosen to Invest Like A Farmer have realized significant gains over the past several years by investing in large, monopolistic companies with healthy dividends. Now what?

Yearly, or better yet on a quarterly basis, financial farmers should survey the farm and conduct a thorough review of holdings, seed capital, and expected harvest returns. Action isn't necessarily warranted, but rather a game plan, no matter how perfect on paper, should be routinely reviewed in the field to see if execution is proceeding as planned. Course corrections may or may not be warranted.

Those who survived any of the numerous "setbacks" in the markets over the past decade (or longer) well remember the pain of a correction and the ensuing panic which destroys accumulated wealth in the stock market. Seed capital is best to have on hand sitting in the silo well in advance of a downturn, though it may draw little interest in the interim.

Multiple prosperous years don't necessarily warrant a change in strategy, but rather a top-level review of holdings, seed capital (cash) available, and coming cash flow needs. As readers of this blog well know, I champion having a healthy silo of seed capital at the ready. It has tremendous value in terms of peace of mind and potential to invest when the economic winds change.

Selling into weakness is not a pleasant experience, one that many old farmers can recall with a tinge of heartfelt pain. Make hay while the sun shines, but silo some of those gains too.

DJIA: 15,258.24   S&P 500: 1691.75   NASDAQ: 3781.59   OIL: $102.87   GOLD: $1,339.20  10-YR: 2.63%

Yikes! Well after a week of getting trounced in the markets over concerns over a possible government shutdown, it is always valuable to take a step back and look at the big picture. Continuing the theme of investing like a farmer, I wanted to provide some historical reference so today’s investor can take a meaningful look back at current events and put them into an accurate context (a financial farmer's almanac!)

For me, a lot of my investing experience has been influenced by Warren Buffet’s annual Berkshire Hathaway shareholder letters, Edwin Lefevre’s “Reminiscences of a Stock Operator” chronicling the life of trading legend Jesse Lauriston Livermore, and finally the Crisis of 1837.

As Livermore famously said, “Nowhere does history indulge in repetitions so often or so uniformly as in Wall Street.” To that end, I think it is vital to read arguably the best account of the Crisis of 1837 by Edward M. Shepard. This literary gem reads like it could have been published just yesterday, but recounts events over 175 years ago. I think you'll find we could substitute out many of the names and dates of the Crisis of 1837 with nearly EVERY other crisis, panic, crash, or recession. The similarities are too numerous to be taken for granted. If you don't have time to read it all today, print it out and bring it with you to read over the coming week (consider it a homework assignment.)

The combination of the above influences, along with personal trading experience, has led me to form the Invest Like A Farmer theory. This theory is loosely based on a “Buy and Hold” concept, but I refer to it more as a “Buy and Grow” approach to investing in which an individual investor’s core portfolio is built along the following general guidelines:

1. Boring is undervalued. Look for companies with established brands. If they are exclusive, finite, hard-to-get, vital, addictive, and/or monopolistic, so much the better.

2. I prefer companies that pay me to own them. Specifically, I want to buy companies that pay quarterly dividends that have historically risen over time.

3. Of the four possible outcomes; high margin, high volume is best.

4. A steadily moving higher and higher left to right stock chart is a good thing. The inverse is not.

5. Inevitably, and by definition, more time is spent holding a losing position than is necessary. Don't be afraid to cut your losses; the financial farmer has a healthy understanding and respect for the risk of ruin.

In summary, I look for boring, dividend paying companies that have a high margin, high volume business with steadily increasing left to right stock charts. I’m not afraid to cut my losses early to help avoid the risk of ruin.

Don't let the word "boring" fool you; boring is the new "sexy" in terms of potential portfolio earnings power. Spectacular earning results come from "boring" companies all the time.  In regards to dividends, I'm a big believer in getting "paid out" on your investments on a consistent basis; this is a big part of investing like a farmer. These dividends are literally your crop yields and a large part over time of your total return.

High margin, high volume revenues typically translate into what a financial farmer is looking for; profits! The combination of these two elements is generally a healthy sign for your financial farm (portfolio.) The high margin and high volume company usually transforms its profits into a higher and higher left to right stock chart, which is an indication of both success and momentum. I'm a strong believer in historical chart growth and expansion, it visually helps us recognize success.

Finally, cutting, trimming, and slashing losses from a portfolio can be hard to do, especially if we have an emotional tie to the respective company; the financial farmer needs to value his or her farm, however, over any one particular crop. There is a reason for crop rotation and also for letting fields stay fallow on occasion. The guideline I typically like to use is a short-term drop of a pre-established percentage would trigger either an outright sale or partial reduction. There is nothing to say you can't buy back a position in the future; time, winds and weather are always changing. With that said, however, the financial farmer who indeed wants to Invest Like A Farmer has a healthy understanding and respect for the risk of ruin. The risk of ruin, simply defined, is the point of no return. It the point where your financial farm (portfolio) ceases to exist because it is bust. It is paramount to avoid the risk of ruin.

All of these themes are going to be discussed much further in the blog in the future, but I wanted to provide a general overview today to help the reader navigate further posts with the help of a little historical background and context of the Invest Like A Farmer theory.

I hope you've enjoyed today's post and that it helped add to your understanding of the Invest Like A Farmer theory that I espouse.

Enjoy your weekend!