- Walmart is an excellent candidate for an income strategy. It's undervalued, a dividend aristocrat and performs exceptionally well in recessions.
- The strategy involves the sale of a covered call right before earnings are announced.
- This enables the investor to take advantage of inflated implied volatility which makes call prices more expensive than normal levels.
Why Walmart (NYSE:WMT)? We live in a world where yield is king. Central banks around the world have kept interest rates artificially low which have crippled retirees and savers alike. Japan has become the latest victim in the world-wide interest rate debacle announcing the move to negative interest rates last week. Switzerland also has prevailing negative rates and I believe before long, this may be the Fed's course of action also. Why? Well, volatility has spiked meaningfully this year and the Fed won't be able to keep its tightening cycle going if the likes of China and Japan are contracting. This is why we have to take the U.S. jobs number announcement on Friday with a pinch of salt. It will probably come in big again but jobs alone won't dictate the Fed's policy. In fact, most of the jobs being created in the U.S. are low paying service jobs and not high paying manufacturing jobs.
Moreover, results this week showed that the service sector's growth is slowing down and equity markets suffered as a result. Therefore, with Europe, Japan and China itching to increasing their easing measures in the near term, the U.S. may be the next country forced to act. So where can investors find yield in a world where bond yield are at all time lows and U.S. equities look overbought after a 7-year bull run? Well firstly, protecting the downside is key, which is why Walmart is a good candidate at the moment. McDonalds (NYSE:MCD) also thrives in recessions, but its valuation is a bit rich for me at the moment. Let's go through Walmart and discuss how it could be a high yielding hands-off investment for you in 2016.
Firstly (and this could be the trend for 2016) Walmart has performed exceptionally well since the start of the year. The stock is up 8% already this year with the S&P500 down 6% (see chart below). Walmart's top line dropped to $117 billion last quarter, with the bottom line dropping to $3.3 billion in net income. Furthermore, the Walmart stock got dragged down last year due to poor bottom line guidance for the next few years. Walmart has decided to elevate spends on staff and e-commerce, which will affect earnings in the near term, but revenues should remain buoyant. On the valuation front, Walmart stock's earnings multiple of 14 is still below its 5-year average despite the recent rally this year.
The company currently offers a yield of just under 3% and because of the robust cash flows (trailing twelve months FCF is $15.94 billion) this company spins off every year, the dividend pay-out ratio is just over 40% which is attractive. Moreover, when you combine its solid financials and valuation with its great recession performance (EPS rose $0.20 to $3.39 in 2009), I think we have a solid performer here, which should provide a nice yield for 2016.
So here is how you could play Walmart over the next 12 months. The company is announcing earnings on the 17th of February for its fiscal fourth quarter earnings. The time to put on this trade will be very close to earnings to ensure we sell premium for the maximum possible price. Here is a current option chain for Walmart. Since Walmart is presently trading in the mid-sixties, we will be looking at the 70 strike in January of 2017.
Source: Options Xpress
By selling the 70 call for around $325, you are agreeing to give up your shares at this price if Walmart is trading over $70 a share next January. Now the $325 option premium plus the dividend of $196 (which will probably be more in 2016 due to an expected increase) equals $521. Irrespective of whether the stock gets called away from you or not, your yield or income for the year will be almost 8% (which doesn't include the potential capital gain of a sale at $70 a share). This strategy carries no more risk than holding the stock. It's a perfect hands-off strategy considering that Walmart has raised its dividend for 40 years.
Just make sure you collect as much as you can when selling the call. The implied volatility for the calls that are 12 months away is currently around 21% (see chart). This should increase going into earnings, meaning the $325 figure quoted above should be more when you put on the trade. If you are comfortable holding the underlying stock for the long term and don't mind potentially giving up your shares at a higher price, then this strategy is for you, if you want a hands-off income strategy.
Source: Interactive Brokers
To sum up, strategies such as selling long-term out of the money covered calls on undervalued dividend aristocrats like Walmart is an excellent strategy for investors seeking yields much higher than what is available at present. The best time to invest in such a strategy (minimum of 100 shares is required) is right before earnings when implied volatility is inflated. Returns of 10% are easily attainable if the trade is put on correctly. Leave a comment below if you have any queries on this strategy