You are here

The Safest Way I Know to Boost Your Yield on Value Stocks

I ran a simple value screen, looking for large-cap stocks that pay a dividend and have a low price-to-earnings (P/E) ratio. These are the kind of stocks that have traditionally been favored by value investors. Large-cap stocks with market caps greater than $10 billion are usually stable companies with solid earnings and little risk of bankruptcy.

Dividends that are above the rate of inflation are necessary for income investors, so I looked for stocks with dividend yields above 2%. And I used low P/E ratios as an indicator that the stock is not overpriced.

Out of the more than 6,400 stocks that my screening software has data on, 105 stocks passed this test.

To narrow the list further, I required the PEG ratio to be under 1, which is generally considered to be fair value for a stock. The PEG ratio compares the P/E ratio to the earnings growth rate and helps eliminate stocks that have low P/E ratios because they are expected to grow at a slow pace.

For example, if the P/E ratio is 10, but the earnings growth rate is only 5%, the stock could be overvalued -- indicated by a PEG ratio of 2. Isolating the low PEG ratio stocks left me with only 18 value stocks.

Value stocks are often thought of as consumer giants like Coca-Cola (NYSE: KO) or Campbell Soup (NYSE: CPB). The current list includes a gold miner, a bank in Chile, a bank that recently paid a $1.9 billion fine for money laundering, and other companies that are not what most investors would typically consider safe.

Of the companies that passed what I call a "typical value screen," my two favorites are Intel (NASDAQ: INTC) and WellPoint (NYSE: WLP).

Intel is priced at about 12 times 2013's expected earnings. This tech giant is projected to grow earnings at a about 11% a year on average for the next five years and seems to be fairly priced with a PEG ratio of 1. The dividend yield is significantly higher than average at about 4.0%.

WellPoint is riskier. This company is one of the nation's largest health insurers -- and that is an industry that is about to undergo significant change. The fact that the industry will change over the next few years is really all we know with certainty. Uncertainty about the impact of reform could be the reason this stock is cheaply priced.

WLP is trading at about 8.3 times this year's estimated earnings and is expected to grow earnings at about 12% a year on average for the next five years. The dividend yield of about 2.2% is well above the yield of the 10-year Treasury bond and is beating inflation, for now.

While both of these stocks offer some income, shareholders can use covered calls to increase their income. A covered call trade is entered when you sell an options contract on a stock you own (the shares you own "cover" the position). Each options contract is for 100 shares, so you could sell one call for each 100 shares you own.

Buy-and-hold investors might be most comfortable selling calls that have several months to expiration. This will decrease the amount of trades they have to make. Assuming we want to sell calls only two to four times a year, we will want expiration dates three to six months in the future.

Intel is currently trading at about $22.88, and options expiring in October with an exercise price of $25 could be sold for about $0.50 per share, generating total income of $50. If INTC is trading above $25 when the options expire, you will have to sell for @25 and accept the profit based on the price appreciation (9.3%), the options premium (2.2%), and the two dividends paid (2%) -- a potential gain of 13.5%. If the stock falls or prices just stay the same, your income should be about 4.2% in six months.

For WellPoint, which is trading at about $68.25, options expiring in September with an exercise price of $80 could be sold for around $0.62 per share, generating total income of $62. If WLP is trading above $80 when the options expire, you will have to accept the profit based on the price appreciation (17.2%), the options premium (0.9%), and the dividends paid between now and expiration (1.1%) -- a potential gain of 19.2%. If the stock falls or prices stay the same, your income should be about 2% in five months.

If this strategy is repeated two or more times a year, you could add 4%-8% a year to the income you earn from your stocks. That might seem small, but it is more than you could obtain from an investment in 10-year Treasuries. The returns from selling calls could be similar to owning both the stock and the Treasury, leveraging your returns with little risk.

Actions to take: Consider selling covered calls on stocks being held for income. If you are considering new income investments, apply this strategy with INTC and WLP.