High Dividend Stocks and Option Trading

by

Brad Castro

Granted, those investors have had to wait roughly 17 years to get this kind of dividend yield, but in hindsight, it would’ve been a tremendous investment. A 25% dividend paid out each year, and backed by one of the strongest and most resilient brands in the world. 25% returns from dividends alone.

In that kind of context, what do daily, weekly, or even annual fluctuations in the share price really matter? Year in and year out, 25% returns. Over and over and over. Actually, the 25% dividend is just a snapshot number. Presumably, the dividend will continue to grow at some kind of rate, and each time the dividend gets raised in the future, the yield on those long term investors’ holdings also gets ratcheted up. What will the yield payout be in another 17 years?

The McDonald’s example is a classic, beautiful, and ideal example of dividend growth investing at its best. The best and safest high dividend stocks aren’t the ones with high yields now (especially when those yields are the result of a collapse in share prices which frequently presage dividend cuts), but rather the stocks of strong, stable, and growing businesses with more modest current yields who regularly raise their dividends.

Still not a believer? For similar examples of high dividend stocks produced by dividend growth investing, check out this February 2009 post from the Dividend Growth Investor blog, definitely one of my favorite investing blogs (and while you’re there, be sure to subscribe to the RSS feed).

Dividend Growth Applied

As an investor, the company’s 25% dividend increase corresponds to a 25% increase in your own dividend yield. That is, if we assume you purchased your shares when the company was paying the $0.16 annual dividend ($0.04 divided by $0.16 = 25%).

So far so good. But let’s look at a slightly different scenario. Suppose instead that you had purchased your shares earlier, back when the annual dividend was only $0.12/share (or $0.03 a quarter). From your perspective then, the company’s 25% dividend boost ($0.04 divided by $0.16) is actually a 33% boost for you ($0.04 divided by $0.12).

This is a crucial and profound concept to grasp—companies calculate the dividend increase based on the current dividend yield while the individual investor calculates it based on the original rate when the shares were first purchased. That means that even a modest dividend increase can still represent a significant increase for long term investors.

[And none of this, by the way, takes into account another powerful investing compounder — the practice of reinvesting your dividends.]

The power of long term dividend growth investing is enormous. The stock of any company with increasing dividends will eventually become a high dividend stock. I don’t understand how anyone who truly grasps this concept could ever invest in index funds or ETFs. And forget the capital appreciation fantasies of being an early investor in Microsoft or Dell. There is a much easier and realistic approach to building wealth through investing—dividend growth investing.

I would even go so far as to say that a portfolio of high dividend stocks constructed over the long term is the most efficient and predictable path toward the ultimate objective of all investing — namely, financial independence and steadily increasing wealth.

Dividend Cuts

Just look at how income investors in financial stocks were decimated during the bear market of 2007-2009. Doesn’t that more or less refute as impractical the old notion of buy and hold dividend growth investing?

On the contrary, it only reinforces the validity of it. Dividend safety is an issue every long term investor must factor in when evaluating an investment.

I dedicated an entire article to the importance of investing in only high quality companies (strong balance sheets, consistent profits, and long term competitive advantages), but it’s such an integral part of investing success that perhaps I should reiterate the importance of quality investing in every article.

True Investing

With all due respect, most investors are actually traders—either passively through mutual funds administered by fund managers who overtrade on their clients' behalf, or actively through self directed accounts where the quest is primarily for short and intermediate term “opportunities.”

There’s nothing wrong with trading. But if you’re trading and you think what you're doing is investing, chances are there will be enough inconsistencies and contradictions in your approach that your long term success is doubtful.

Traders who think they're investors are most likely guilty of one overarching sin (and I mean that in a lower case, nonjudgmental fashion) — the sin of impatience. They want the immediate benefit of high dividend stocks without having to wait for their real investments to mature into high dividend stocks.

True investing is nothing less than purchasing a business, or partnering with others to jointly own a business, because you believe in the long term prospects of that business. It isn’t looking for junk at a garage sale with the intention of auctioning it later for a higher price on eBay. I realize that a common definition of value investing is purchasing an asset for less than its intrinsic value. But that philosophy means any stock is a potential buy so long as it trades low enough.

For me, true value investing, or true investing for that matter, is a long term commitment. It should be the result of careful analysis and a conviction that what you’re buying, or buying into, is the single best long term business opportunity you can identify at that moment. If you’re truly investing in the stock of a company, you should approach it with the same level of gravity and commitment as though it were a family business.

And if more people viewed stock investing in this manner, I’m confident that there would be a lot more portfolios comprised of high dividend stocks (or high dividend stocks in the making) that thrive in the good times and successfully weather the bad times.

The Role of Options in a Portfolio of High Dividend Stocks

[For a more indepth discussion of this process and its ramifications, please see the related site articles, "Adjusted Cost Basis with Options" and "Buy and Hold and Cheat."]

But in the context of high dividend stocks through dividend growth investing, here is the salient point: when you lower your cost basis, you also increase the effective dividend yield on your stock. That increased dividend yield is completely separate from the actual dividend growth of the stock itself.

And, it gets a little complicated here, but it’s important to note that the percentage by which you lower your cost basis is more or less identical to the percentage by which you increase your dividend yield—provided you reinvest the option income (similar to receiving perpetual rebates on your stock holdings) in more shares at the current dividend rate.

An exaggerated example for illustration purposes only: suppose you purchased $10,000 worth of stock that paid a 10% annual dividend, or $1000 a year. And then, over time, suppose you were able to generate $5000 of option income, lowering your cost basis to $5000, or by 50%. You’ll note that your total dividend payout hasn’t actually increased, but your adjusted dividend yield has seemingly doubled from 10% to 20%.

However, if you were to reinvest the $5000 cash you now have in additional shares of stock at the current dividend yield, that would bring your total adjusted investment amount back up to $10,000, but now you would be earning $1500 a year (the original $1000 payout plus 10% of the reinvested $5000, or $500). So now your effective dividend yield is 15%, which represents a 50% increase from the original rate, or the same percentage by which you lowered your cost basis in the first place.

And, of course, if the company you invested in continues to raise their dividend, your rate would obviously be even higher.

What does all this mean in the end? It means that certain option trading strategies, when employed carefully and conservatively, can substantially improve an already superior investing approach. It means that high dividend stocks and dividend growth investing are still the way to go, but now you can speed up that process considerably.

Final Thoughts

The great benefit of a Leveraged Investing approach is that it can function as a crude time machine. It won’t send you directly back to 1992 and allow you to fill up your brokerage account with shares of MCD, but it can nonetheless shave years off the compounding growth process of your investments.

Disclaimer: This is not a personal endorsement of or recommendation to purchase shares of or enter into any option contracts involving MCD. While I hold definite opinions about the company and the stock, every investor must do his or her own due diligence and make his or her own determination. The preceding example is for illustration purposes.