The Money Tree

Safely Generating Income in Retirement

New Strategy – New Selection

Posted by mounddweller on December 18, 2011

Fellow Traders,

As I mentioned in an earlier post, I am in the process of developing a new strategy for trading covered calls (CC)and naked puts (NP).  Options will be selected from a limited universe of companies which have increased their dividends annually for a minimum of 10 consectutive years.  The strategy will hinge on identifying companies in this list which have fallen out of favor on Wall Street and consequently are trading near 52-wk lows, or better yet, multi-year lows.  I will establish a position in these ‘out of favor’ companies via the sale of NPs.  After having the stock put to me I will begin collecting dividends, and will sell OTM covered calls.  The objective will be to eventually sell the stock after substantial capital gains have been achieved.

You may have gathered from my lack of specific criteria that I don’t have this strategy fully developed yet.  You would be correct.  However, I’m willing to ‘go out on a limb like this’ because of the stocks I’ll be trading in.  All have been around for many, many years and thus have survived all manner of economic downturns and adverse business conditions.  I have no fear that any of these companies will go out of business.  Also, because I’m buying at an already discounted price the risk/reward ratio is in my favor.  Now, does that mean that I don’t think any of these selections will not drop any further after I acquire them?  No, certainly not!  Anything is possible, especially in these volatile times.  However, I am confident that I’m buying closer to the bottom than the top.  And, I’m confident that if the stock does continue to head south after I buy it, it will eventually recover.

So, without further ado, let me give you my first selection from this new strategy.  The company is Avon Products, Inc. (AVP).   AVP engages in manufacturing and marketing beauty and related products in worldwide. Its beauty products consist of color cosmetics, fragrances, skin care, and personal care; fashion products include fashion jewelry, watches, apparel, footwear, accessories; and children’s products; and home products consists of gift and decorative products, housewares, entertainment and leisure products, and nutritional products. Avon Products Inc. markets its products through direct selling and independent representatives, as well as through distributorships. The company was founded in 1886 and is based in New York, New York.

So, let’s begin our due-diligence by looking at the price history of AVP.  As I mentioned above one of my key criteria is to begin selling puts when the stock is at or near yearly or multi-year lows.  AVP fits that criteria to a ‘T’.  First, let’s look at a 1-yr price chart.

Friday, AVP closed at $16.72.  It’s 52-wk low is $16.09 which was hit on November 25.  Now, let’s look longer term.  Here’s a chart going all the way back to 2000.

As you can see AVP is rapidly approaching its March 2009 lows.  On March 9, 2009 it hit an intra-day low of $14.40 before closing at $15.20.   Prior to March 2009 AVP hadn’t been in the $15 range since 1999.

Now, as I also mentioned, each stock in my investing universe must have paid steadily increasing dividends for a minimum of 10-years.  AVP fits the bill in this regard as well.   AVP has increased its quarterly dividend from $0.09 in 2000 to $0.23 in 2011.  As a matter of fact AVP has been steadily increasing its dividend since 1989 when it was $0.0234.  That’s 22 straight years of dividend increases through all kinds of market conditions.  That, coupled with the fact that the company has been in existence since 1886, gives me a lot of confidence that even if I don’t perfectly time the bottom I’ll be fine at the end of the trade.

Now let’s look at a few other fundamentals before moving on to the specifics of the trade.

First, let’s discuss some of the more positive metrics.

(1) P/E Ratio – the trailing P/E ratio is 9.83.  This compares favorably with P/E ratios encountered over the past 10 years.

(2) Income – AVP is consistently profitable.  I’m not saying its profit is consistently increasing.  I’m saying they find a way to make a profit every year in all market conditions.  They have been profitable every year for the past 10 years.

(3) Dividend Payout Ratio – is currently 53%.  This means there is plenty of room for further dividend growth.

Now, let’s consider the negatives.

(1) Debt/Equity Ratio – is 178%.  This is higher than I generally like to see in a stock.  However, the company generates strong cash flow so the debt load can be supported.

Now before looking at specific trades let’s consider why AVP is currently out of favor on Wall Street.   It primarily is because of a lack of execution.  SG&A costs have far outpaced sales growth.  Evidently, the board of directors finally had enough of this under-performance because they recently announced that Andrea Jung would be replaced as Chief Executive.  Finding someone who can rein in costs and run a tight ship is key to AVP’s recovery.  I am confident AVP can regain Wall Street’s confidence.

Now, finally let’s consider some possible trades to establish a position in AVP.  With a dividend rate of 5.5%, and a dividend increase announcement likely before the next ex-date on or around February 15 I am leaning towards structuring my trade such that I acquire shares at January expiration.  However, given the recent market weakness I’m also concerned that AVP might have further to fall so acquiring shares now may be premature.

Here are two possible trades with January expirations.

(1) STO JAN $16 puts at $0.40.  If the put finished ITM I would own AVP at a cost basis of $15.60 and be in position to earn the next dividend.  This trade has a ROIC of 2.5% with 5.2% DSP.

(2) STO JAN $15 puts at $0.15.  If the put finished ITM I would own AVP at a cost basis of $14.85 and again be in position to earn the next dividend.  However, this trade only has a ROIC of 1%.  DSP is 9.8%.

As I mentioned above, given the overall market conditions, I’m not totally convinced AVP has found a bottom and is trying to carve out a base.  Thus, I am going to work my way into this position over time.  I eventually would like to own 1,000 shares of AVP.  So, I am going to start by entering this trade by only selling 3 option contracts.  This lets me ‘have my cake and eat it too’ so to speak.  I can possibly acquire some shares now at what I think is a fair price and begin collecting the ample dividend.  Then, if the market continues to fall I can dollar cost average down by selling another round of puts at a lower strike price.  However, if AVP does find a bottom and begins to rise I will at least have been able to acquire some shares at a great price.

Well, that’s it for this post.  I hope to have another one or two trades to consider in the very near future.  WAG and SYK are on my radar screen.

Regards,

Troy

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3 Responses to “New Strategy – New Selection”

  1. dave said

    troy I am very interested in your new strategy for 2012. am I able to sign up for email alerts?

  2. mounddweller said

    Dave,

    My site doesn’t support automatic email notification of updates. However, it does support RSS feeds. You can sign up for an RSS feed by clicking on the icon in the top, left corner of my home page. Below are detailed instructions on how to complete this process and how it works.

    How to use RSS feeds in Internet Explorer 9

    Feeds, also known as RSS feeds, are content listings published by a website. They’re used for news and blog websites, but are also used for distributing other types of digital content, including pictures, audio, or video.

    Subscribing to feeds
    When you subscribe to a feed, new content is automatically downloaded from the website, so the feed is always up to date. There are many ways to subscribe to feeds. Here are a few:

    Subscribe to feeds directly from Internet Explorer. This is what’s described below.

    Use RSS reader software.

    Click a link on personal webpages.

    To subscribe to a feed using Internet Explorer
    Click to open Internet Explorer.

    If the Command bar isn’t visible, right-click the Favorites button , and then select Command bar.

    Go to the website that offers a feed.

    Click the Feeds button to view feeds on the webpage.

    Note
    If a Web Slice is available for the webpage, the Web Slice button will appear instead of the Feeds button. Click the arrow next to the button to view available feeds.

    For more information on Web Slices, see Using Web Slices in Internet Explorer 9.

    Click a feed (if more than one is available). If only one feed is available, you will go directly to that page.

    Click Subscribe to this feed.

    Type a name for the feed and select the folder to create the feed in.

    Click Subscribe.

    Viewing feeds
    All of the feeds that you subscribe to are available in the Favorites Center. You can also add feeds to your Favorites bar.

    To view feeds in Favorites Center
    Click to open Internet Explorer.

    Click the Favorites button , and then click the Feeds tab.

    Click a feed to view it in the browser.

    To add a feed to the Favorites bar
    Click to open Internet Explorer.

    Click the Favorites button , and then click the Feeds tab.

    Right-click a feed, and then click Add to Favorites bar.

    If the Favorites bar isn’t visible, right-click the Favorites button , and then select Favorites bar.

    Click the feed, and then click an individual entry to view it in the browser.

    Note
    You can delete a feed from Favorites Center or the Favorites bar by right-clicking it, clicking Delete, and then clicking Yes.

    Regards,
    Troy

  3. mounddweller said

    Fellow Traders,

    A quick update on AVP. Thus far I have not executed the trades referenced in my post earlier this week. AVP has moved back up above $17 in the past couple of days and option premiums have declined. I am still interested in the JAN ’12 $16 put. However, not at $0.20 bid. This is half of what it was at the close on last Friday. Consequently, I am trying to be patient and let AVP come back down and/or have volatility increase such that the option premiums go up.

    I am also considering selling either JUL ’12 or JAN ’13 puts at the $15 strike. I would pull the trigger on either one of these if I could get a 15% annualized ROIC. For the JAN ’13 $15 put this would require a bid price of around $2.40. That might be asking too much so I might have to set my sights a little lower and settle for 12% annualized.

    Regards,
    Troy

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