Building a High-Yield Portfolio with the Dividend Aristocrats
If you are an income investor, you want a portfolio full of companies with sustainable dividends. The S&P 500’s Dividend Aristocrats is a good place to start. But today I want to show you how to boost those dividends to even higher levels.
The Dividend Aristocrats
By definition, a Dividend Aristocrat must be in the S&P 500 index and have recorded dividend increases for at least the past 25 consecutive years. A company must also meet certain market capitalization and liquidity requirements to appear on the list.
The makeup of the Dividend Aristocrats differs substantially from the makeup of the S&P 500. Although the latter is highly weighted toward companies in the Information Technology sector, the Dividend Aristocrats have more coverage in income sectors like Consumer Staples. The current list of Dividend Aristocrats encompasses 67 companies across nearly every S&P 500 sector.
Read This Story: Dividend Stocks: Shelter from the Storm
The highest yielding company on the list is presently 3M Company (NYSE: MMM) at 5.3%. The lowest yielder is West Pharmaceutical Services Inc. (NYSE: WST) at 0.3%. The average yield of the list is 2.4%. That’s better than the yield of the S&P 500, but still not great for an income investor.
But we can turbo charge these yields. I am using the Dividend Aristocrats for this example, because they are some of the safest and most reliable dividend payers out there. But, you can use this strategy for just about any publicly traded company — even those that don’t pay dividends.
All About Covered Calls
We are going to use a covered call strategy. Fear not, this is not a risky strategy. It’s actually more conservative than simple stock ownership, and it can substantially boost your income.
Let’s quickly cover the basics, so everyone is on the same page. An option gives the right, but not the obligation, to buy or sell shares at a defined price and on or before a defined date. A person who buys a call option is buying the right to purchase 100 shares of stock. The person who sells a call is creating the obligation to potentially sell them.
Options define the price at which the trade would be executed (the strike price) and the date by which the trade would occur (the expiration date). There is premium (the cost) for each option, denoted by bid and ask prices.
If you own 100 shares of stock, you can sell a call against those shares (for most publicly traded companies). Or, you can use a buy-write strategy to sell the call at the same time you buy the shares, which reduces the cost of the shares. But the call obligates you to sell your shares at some point in the future if the price is above the strike price.
I favor using covered calls as a way of boosting income and lowering my downside risk. But the caveat with covered calls is that the upside potential is capped. Once a stock rises above the strike price, you no longer benefit from the rise. You gave that up in exchange for the certainty of the premium. The person who bought the call was betting on a rise above the strike price, while you are (usually) hoping your shares don’t get called away.
Illustrating the Strategy
There are different ways to use this strategy. A growth investor may ask for a higher strike price, preserving lots of upside potential for the trade. But an income investor may be satisfied with a high effective yield, while foregoing the potential for more capital gains. They will sell a call “closer to the money” (i.e., closer to the current price of the stock). We are going to consider the latter case.
I checked this strategy against even the lowest-yielder on the list. You can, in fact, get an effective annual yield (the dividend plus the annualized call yield) of 14.4% on West Pharmaceutical Services by selling a December call on shares, even though the company itself only yields 0.3%.
I am capping my annualized return potential at 20.8%, because the call I would have to sell to achieve this yield has a strike price of $280. With WST trading at $271.14, that doesn’t give a lot of upside, but you are trading that for a call premium which currently has a bid of $32.00. That’s money you would put in your pocket to supplement the paltry $0.76/share annual dividend yield.
However, there is a reason this particular trade wouldn’t be suitable for most investors. Recall that an option represents 100 shares. With WST trading at $271.14, if you open this trade with a buy-write transaction (reducing your entry point by the option premium of $32.00), you are still going to pay $239.14 per share. That’s an outlay of $23,914 per contract, which is a substantial amount of money considering that I recommend devoting no more than 2-3% of your portfolio to any single position.
A More Affordable Trade
So, let’s look at a cheaper stock on the list. The lowest share price on the current list belongs to Franklin Resources (NYSE: BEN), a financial company trading at $30.92 as I write this. So, the outlay on this trade is going to be about $3,000, which is far more affordable for most investors. Let’s look at a trade.
At present, the options for this company only extend out to July. The $32.50 strike price for the option expiring on July 21, 2023 (159 days from the time I am writing this) has a current bid price of $1.70. That’s already greater than Franklin Resources’ annual dividend of $1.20, and it’s only for 159 days (meaning you can sell another call then).
If you own at least 100 shares of Franklin Resources, selling this call would give you an annualized yield on your shares (again, the dividend yield plus the annualized call yield) of 16.5%. But remember, your upside will be capped at $32.50. If BEN shares are at $40.00 at expiration, you are still only going to get $32.50 for them. That’s the significant caveat you have to understand. You are giving up the potential of greater capital appreciation for the certainty of money in hand.
The other caveat to keep in mind is that this strategy doesn’t protect you from losses. However, it does mitigate them. If your BEN shares are $10.00 lower at expiration, you are still in the red.
The reason this strategy is more conservative than simply owning the stock is that you received a premium that offset some of that decline. Because of the $1.70 premium you received in this case, your loss would only be $8.30 for a $10.00 decline in the share price.
This strategy is not for everyone, but income investors can certainly benefit from such a strategy. If you are retired, for instance, and you value certain income above potential capital gains, this is a strategy that could benefit you.
Editor’s Note: Spooked by current market volatility? If you’re looking for a way to generate steady income with reduced risk, consider our premium trading service, Rapier’s Income Accelerator, helmed by our income expert Robert Rapier. He elaborates on how to reap exponentially more income out of dividend stocks. Click here for details.