If you use any strategies that combine equity positions with option hedges or cash generators, you need to know how to pick the right stocks. So covered calls, protective puts, covered straddles, and many more strategies should be opened on the best possible companies and their stocks.
Picking stock just for maximum yield (on both options and dividends) is unwise because it is likely to expose you to greater volatility and market risk. Options trading is not isolated from stock performance, and that grows from well-picked companies – meaning fundamentally strong, consistent, and competitive companies. Weak companies often reveal higher than average dividend yield and option premium, but not always for good reasons. These can be danger signals that every trader should know.
Dividend achievers and dividend aristocrats
Companies increasing dividend per share for `10 years or more are called dividend achievers; those increasing dividends consistently for 25 years or more are called dividend aristocrats.
These are important and distinguishing features for one reason: These companies with exceptional dividend record also tend to out-perform the market in the long term. Not all, but most, have demonstrated lower market risk and consistent returns in the stock prices, dividends, and options.
As a starting point, checking the status of dividends per share is a strong indicator. But it is not the exclusive test of whether a strong dividend record is enough.
Growing dividends and growing long-term debt
Dividend should always be understood in the context of how a company funds those dividends. You might have noticed that some companies report net losses in certain years but continue to raise dividends. Is this accomplished from cash reserves or from somewhere else?
Observing ever-higher dividends per share over many years is only half of the total equation. Also check the status of the debt-to-capitalization ratio. Total capitalization is the combination of long-term debt and stockholders’ equity. Dividing long-term debt by total capitalization reveals the percentage of total capitalization represented by debt.
If this ratio is increasing over several years, it is a red flag. The more a company relies on debt and the less on equity, the more future earnings will have to be used for debt service, and the less will be available for expansion and dividends.
Some companies take on increasing long-term debt to finance dividends when earnings are not high enough to do the job. As the ratio approaches 100%, equity shrinks to near zero. To see examples of where this leads, consider the recent history of one-time solid Blue Chips General Motors, Eastman Kodak and Sears. All of these saw their long-term debt outpace equity and cause bankruptcy.
When dividends increase but a corresponding increase in long-term debt occurs at the same time, those higher dividends are not positive signs. The dividend trend along with the long-term debt trend tells the real story.
The problem of higher dividends
Is a higher dividend always good news? No.
You need to evaluate the recent history of the stock price as well as dividends per share. If the share price falls many points, the dividend yield moves up and becomes a larger yield. For example, a $50 stock paying a $2 dividend yields 4%. If the stock falls to $40 per share, that $2 translates to a 5% yield.
A move from 4% to 5% looks pretty good at first glance. But why did the stock price fall 10 points?
If the most recent earnings report included a negative revenue or earnings surprise, that could be the cause for the loss of share price. If the company’s guidance is revised to forecast weaker future revenue and earnings, that also brings down the share price. In this situation, the dividend yield is not as positive as it appears at first glance.
The yield you earn is fixed
Some investors with equity positions in a company’s stock tend to track dividend yield often, even daily. This makes no sense.
The yield you earn is going to be based on what you paid for shares of stock. No matter whether the stock price rises or falls, the true yield is the dividend per share, divided by your basis and not by the current price.
The dividend trend is useful for determining whether to keep the position in your portfolio or to purchase additional shares for increased option hedging or cash generation. But your yield remains unchanged.
Dividend yield as a starting point in picking stocks
Options traders who also hold equity positions must decide which stocks to acquire for options trading. A popular method is to compare option yield based on premium value and time to expiration. This is not the best method for deciding which stocks to use for options trading; the higher premium often translates to higher volatility. Translation: Higher-yielding options premium equals higher market risk.
For some traders, that higher risk is acceptable. But for most, a consistent and reliable level of yield from options trading makes more sense. To pick the best stocks, use dividend yield to narrow down the list of candidates. You will find that if you select only those stocks yielding 4% or more, you end up with a very short list. When a test of the long-term debt trend is added, the list shrinks again. Adding in annual P/E range, revenue and earnings, the final list will come down to a very small number of companies, perhaps under 10.
The methods for picking options range from high-risk to extremely conservative. When it comes to dividends, widespread misconceptions cloud the decision. Many analysts continue to rely on the current yield as the primary test of how a company controls working capital. But combining dividend yield and long-term debt trends tells the real story.
Dividend trends tell a much larger story for options selection than most fundamental indicators. Picking the best option is a function of picking the best stock; and the combination of dividends and long-term debt reveals the long-term strength or weakness of the company’s policies.
Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his websiteat Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.