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Don’t miss the end of today’s post; INTC is an existing position I hold shares in, and that has picked up enough bullish momentum to offer some interesting new opportunities to generate additional income with covered calls. I’ve highlighted that trade at the end of today’s post.

If you’re a student of the stock market, you look for as much information as you can find about different investing methods and systems. Books, newsletters, videos, seminars, classes – you may not use them all, but even if you learn something you don’t end up using, it’s all useful, because it expands the scope of your knowledge, your perspective about the market’s many different possibilities, and your understanding of what fits you best.

One of the things I’ve found interesting over more than two decades of studying and investing in the stock market is the role dividends can – and in my opinion, should – play in a successful investing system. Directional trading strategies, which usually emphasize relatively short-term trades based on price swings from low to high points that might last anywhere from a few weeks to a few months, tend to ignore dividends altogether, since in many cases you might not actually hold a stock long enough to be counted for a dividend distribution. The same is true of directional investing strategies that focus on equity options, since buying and selling call or put options on a stock will rarely translate to actual ownership of that stock.

The subject of stock dividends comes back into discussion among talking heads on news media and other source every so often – often when people start differentiating between quality versus growth. I’ve come to rely very heavily on dividends because companies that pay a regular dividend tend to have a different focus and discipline about their management of assets and their relationship with shareholders. I like to think of them as the “low-hanging fruit” of the stock market, that I don’t have to do anything to get, except to own the stock. As investors start to look for “safe haven” assets that can help them keep their money working for them, dividend-paying stocks are likely to become even more attractive to a much larger audience.

Kinds of Stocks that Pay Dividends

Long-term investing concepts usually differentiate between stocks based on the underlying company’s size and scope of business, how much their business has grown in the past and what analyst’s forecast of future growth is likely to be. Large, established and easily recognized companies, like General Electric Co. (GE), Caterpillar Inc. (CAT), and Microsoft Corp (MSFT) among others are referred to as blue-chip stocks; these stocks are usually included in the major market indices including the Dow Jones Industrial Average and the S&P 500. Medium-sized businesses who have been successful at building their businesses but have not yet reached the status or size of a blue-chip stocks are usually called mid-caps, and smaller, up-and-coming companies are called small caps. Depending on how aggressive or conservative you want to be as a stock investor, these different categories present various levels of opportunity as well as risk. Small-cap stocks, who usually have the largest scope of opportunity to grow, generally provide the largest overall growth potential, with mid-caps coming in next, and blue-chips last, since these stocks already have become the 600-lb. gorillas in their respective industries and sectors. In the same way, blue-chips are usually considered to be the safest overall long-term investments, while small-cap stocks are far more speculative since a minority of these up-and-comers ever actually fulfill their potential.

One of the other reasons that blue-chip stocks are considered to carry a higher level of safety comes from the fact that most of them pay a regular dividend to their shareholders. Why do some stocks pay dividends while others don’t? Because companies are naturally allowed to decide what they want to do with their profits. What they actually do with those profits can tell you a lot about the strength of the business and what management thinks about the future. Dividends are one of the simplest and most transparent means companies have to return a portion of their profits back to their shareholders. Smaller, less-established stocks often don’t pay a dividend simply because their profitability can be widely variable from one year to the next (though notable exceptions do exist). Dividends have to be approved by the company’s board of directors, and they won’t be likely to commit to pay out a portion of their profits if they don’t believe they will be able to maintain a level of profitability that is higher than the dividend.

The most common line of thought suggests that a stock shouldn’t begin to pay a dividend until the business has reached a size and scope of operations that makes a dividend easier to maintain. Microsoft Corp, for example, didn’t pay a dividend to its shareholders for almost 20 years after their initial public offering in 1986 despite their domination of the software industry and the mountains of dollars they held in cash. When they finally declared their first dividend in January 2003, MSFT held more than $43 billion in cash; their initial dividend payout was only $864 million of that amount, or about 1.8% of their total cash. To me, this is a good example of why identifying stocks that pay a dividend – even a small one – is so important; it says a lot about management’s confidence in their business as well as recognizing the important role shareholders play in their overall success. 

Another interesting aspect of dividends is that while blue-chip stocks are the most likely places you’ll find attractive dividends, it also isn’t unusual to find mid-cap and in some cases, even small-cap stocks that have committed to a consistent dividend payout. I think there is a lot of power in finding these types of stocks, which are even more in the minority than their larger brethren; most of these companies prefer instead to reinvest their profits in their business to keep driving growth. Those that do decide to pay a dividend, in my opinion, are communicating a different level of confidence in themselves and future of their business than those that don’t. They are using the dividend payout to attract shareholders that can buy in to their long-term plan and prospects, which I think is a smart thing. That’s why you’ll see me write about stocks that fit this description as I find them and they meet my other fundamental criteria.

The Real Impact of Dividends over Time

The fact of the matter is that on a historical basis, dividends have always made up a significant piece of the overall returns the stock market has achieved for decades. As of now, the average dividend yield for all stocks that make up the S&P 500 is bout 1.38%; the average yield for the past 25 years is around 1.87%. Over the same period, the index itself has returned an average 7.45% return. If you take dividends out of the equation, that annual return lowers to about 6.07%. The difference might not sound like much; but remember that dividends are paid no matter what direction a stock’s price moves, and that they can usually be taken either as cash distributions or reinvested back into the stock to purchase more shares. You get that flexibility for doing nothing more than holding shares.

The benefit from dividend payments is a primary reason that as long as I see the stock’s fundamentals holding, I will continue to wait for the stock’s price to recover back to my assignment price; my analysis of the company’s business strength still confirms my belief that the value of the stock should be higher than my assignment price. I also want to continue to hold the stock because when it does recover, I should be able to find opportunities to generate even more income with covered calls. Both of these statements are true; but another reason I don’t mind holding these stocks even for an extended period of time is because of the fact I can draw dividend payments from them. Those dividends are extra income I don’t have to do anything to get except to hold the stock before and through the announced ex-dividend date.

It’s true that in general, I don’t expect to hold a stock long enough to see an entire year’s worth of dividend payments on it; even so, the fact that I can enhance my ability to generate income – even if by just a few cents per share – by doing nothing more than emphasizing dividend-paying stocks in my screening process is more than worth the trouble. It is also one more layer of protection I can add to my system, since I can also lower my net cost basis in a stock by the per share amount of the dividend.

Dividends vs. Stock Buybacks

Tech stocks, in particular have historically chosen a slightly different tack over paying dividends, which is to implement a large-scale stock buyback program. The result is that shareholders hold fewer shares than before, but also see an increase in the stock price; the increase in buying activity over time will also often create an extra wave of bullish enthusiasm for the stock that inflates the price even higher than the buyback alone would yield. I prefer to look for stocks that pay a regular dividend because it signifies a greater commitment to return value to shareholders on a consistent basis; stock buybacks are really about letting the company maintain flexibility and control over your shares, since the timing of buybacks, how large they are, and what they mean to you is at their complete discretion. With a dividend, you get to decide what to do with the money; you can spend it at your discretion, or you can invest in back in the stock or the market at large.

Another element that can also make a company more attractive from a fundamental standpoint is whether their dividend payout has grown over time, remained static, or decreased. Ideally, dividends should grow as profitability does, and more proactive companies do this either by increasing their regular dividend or by issuing a special dividend on an annual basis. If I’m trying to decide between two different fundamental strong stocks, this can be a way to delineate between them. Be aware, though that the dividend itself is the main criteria for my income trading system, even if the company has not increased its payout. I also don’t place a lot of emphasis on the size of the dividend, again unless I’m trying to differentiate from multiple candidates.

Dividends provide a strong reason to hold stocks even when they might be in a downward trend. If the company’s fundamentals remain strong, the dividend adds an element of income above and beyond my ability to write covered calls. While there certainly are undervalued, fundamentally strong stocks out there that don’t pay dividends, the presence of a dividend says a lot about that company’s management, their management style, and the relationship they maintain with their shareholders. That’s why dividends are a big part of my system.

Covered Call: XRX

I was originally assigned shares of INTC in August of last year at $55.50. The stock struggled after that assignment, hovering a little below my purchase price until late October when broad momentum in the Tech turned strongly bearish and pushed INTC to a low at around $48. The stock has been picking up bullish momentum since the beginning of December, however and is now a little over $1.50 below my assignment price. That is close enough to open up the opportunity for the trade below.

If you don’t currently have an open position in INTC, you can consider using the trade outlined below to initiate a new position; keep in mind however that all return numbers listed below are based on my $55.50 assignment price. Make sure to run through the company’s fundamental strength and value proposition on your own to ensure they meet you requirements, and check the premiums offered against the price you would have to pay to own shares in INTC to place this trade. Remember that your return numbers will be different than what is shown below.

Also, keep in mind that all pricing information shown here is current only as of this writing; you should expect to see different pricing from your broker.

  • INTC Current Price: $23.47
  • Covered Call: then sell the January Week 4 (expires 1/28) 56 Call
    • Current Bid: +$1.13
  • Return, not called out: 2.03% (based on $55.50 assignment)
  • Called out return: 2.93% (based on $55.50 assignment)
  • This trade expires in 22 days.

If you are a new subscriber, please take some time to review the videos in the Getting Started area of the website. These will give you a pretty comprehensive view of the value-oriented approach I use to generate income with put selling and covered calls. You will also find it useful to read my Frequently Asked Questions article. Also feel free to review my previous posts as you’ll find additional answers to many of the questions you may have.