(A version of this article appeared in TheStreet.com)
The idea of utilizing a DRIP strategy toward achieving asset growth is an appealing one. Dividend Re-investment Plans offer the opportunity to take an income stream and convert it into more shares without cost. For the inveterate buy and hold investor the appeal may be compounded by the thought of actual compounding.
For most investors, at least those of moderate means, that would mean adding fractional shares and certainly odd lot shares. It might also mean adding shares in a company at a time that you wouldn’t ordinarily want to be adding shares of that particular company. Regardless of those advocating a dollar cost averaging approach, it would take a large portfolio of dividend paying stocks with payment dates broadly distributed to achieve a sufficient sampling of the market’s ups and downs to really cost average. Otherwise one is at the mercy of timing if dividend dates are clustered on a quarterly basis.
Using the 2013 S&P 500 average for dividend yields that also means a quarterly income stream of approximately 0.5% per eligible position. For example, anyone re-investing quarterly dividends on 1000 shares of Microsoft (MSFT), which offers a dividend yield nearly 51.7% higher than the S&P 500 average, would be able to add approximately 7.6 shares.
While there is certainly a body of evidence that suggests the out-performance of dividend paying stocks, I have never fully understood the allure of dividends. The opportunity to pay taxes in exchange for the privilege of being able to reduce your stock’s cost basis may be an apt summary of the transaction. But for many the dividend represents a tangible expression of ownership and sharing of good fortune. What better way to reciprocate that good fortune than by re-investing the dividend for even more shares?
However, quarterly distributions, small distributions, and being held hostage by timing of dividend payments conspire to make the DRIP strategy inefficient for those interested in compounded growth, or for those that don’t have the patience to wait many years.
While Albert Einstein purportedly referred to compounding as the greatest of inventions, he would have added some additional superlatives had he known about the use of premiums derived from option sales to fuel share purchases and asset growth.
Rather than relying on the muted power of dividends, selling options, on core holdings, such as Microsoft can return a nice weekly, monthly or yearly premium and can form the basis for anyone to design their own “Premium Reinvestment Plan (PRIP).”
In general, I prefer the use of weekly options, but that may require more maintenance and attention than many individual investors are willing to dedicate. However, as an example, anyone purchasing 1000 shares of Microsoft at Friday’s close of $36.69 could have sold 10 weekly contracts at a $37 strike price for $490. Compare that to the $280 quarterly dividend. Of course the shares may be assigned or the contract may expire, allowing the holder to look for additional opportunities to sell new contracts, perhaps even holding shares at the time of the ex-dividend date and doubly reaping rewards.
While the option premium income can’t be re-invested in additional shares at no cost, what it can do is serve as a building block for additional share purchases in any position desired, not just the income producing stock. Furthermore, that purchase of new or additional shares can be done at a time that seems most propitious, rather than being on a pre-determined date. The cumulative impact of selling option contracts on portfolio holdings can be to generate enough income to purchase entirely new positions and in sufficient quantity to have their own income producing option contracts sold.
Income producing income.
If you’re a buy and hold kind of an investor and don’t really like the idea of being subject to assignment on a short term basis then look at the longer term option contracts. The beauty of the derivatives market is that there is no shortage of time frames nor of strike levels available for the investor that wants to customize risk and reward, as well as the time frame in which to invite exposure..
An option contract expiring January 18, 2014, also with a $37 strike price affords a premium of $1120, in addition to possible gains on shares if assigned. To put that into perspective, the premium yield of 3.0% for a 5 week period would be sufficient to re-purchase 30.5 shares of Microsoft. As with the weekly contract, if not assigned the opportunity to do the same is explored in an effort to generate even more income.
For those that can’t be bothered by even monthly contracts or that may want to emphasize share gains over income, consider the sale of a longer term contract, or LEAP, such as one expiring in January 2015. Not only will your $40 strike option contract sales generate an immediate receipt of $2150 in option premiums, but as the holder of shares, unless Microsoft rallies well past $40 prior to expiration you will also receive deferred income in the form of $1120 in dividends. In this instance if shares are assigned the ROI is 19.8%. If not assigned, the total income yield would be 8.9%., regardless of disposition of shares.
I know that “PRIP” doesn’t really sound appealing when said aloud, but investors can get over the unfortunate acronym once the fun starts and the Einstein inside begins to show.