29% on a Sideways Stock?

I was a bit off in my estimates. I'll get to details in a minute. But first, this is one of the best, most conservative trades you could have made in the past 15 months. McDonalds. What? Haven't they had trouble posting good stores-open-a-year-or-more returns? Hasn't competition from Chipotle Mexican Grill, Panera Bread,  and  others been pecking away at their market?

Wait, look at this 15-month chart. Haven't they pretty much gone sideways!

Why yes. So?

Read this article that I posted in the Seasonal Forecaster newsletter of February 18th, 2013, and following it I will post an update that you should find interesting.

************************** February 18, 2013 ******************************

In the February 11^th, 2013 Seasonal Forecaster newsletter I proposed a covered call trade in McDonalds that would return $1.04 in income, a 1.25% return over 34 days. That’s ‘only’ 13.2% annualized.

So many people stepping into the world of short-term trading (and even some serious long-term investors) think (dream?) in terms of making 20% per trade and a 100% return per year on their portfolios. A $1.04 return on a $95 stock doesn’t sound like much, does it? It can’t be worth it.

Seasoned traders know the real riches come from the ‘income’ trades, the trade and money-management strategies that produce consistent, regular income over long periods of time. MarketTamer’s Stock and Option Training for instance has whole modules and coaching sessions/webinars devoted to ‘Rock Solid Income Trades’ and similar topics.

Around mid-March of 2009, a good friend, Jim, asked me for suggestions on what to invest some spare funds into. He's conservative, so I suggested he consider buying a major company with a good dividend history, one that supplies a basic product or service used by everyone. I used McDonald's as an example. I went home and created a spreadsheet to show him how a good company like McDonald's could end up being one of his best investments.

Here's the email I sent him:

This is a weekly chart… Notice how MCD's been trading in a range (50 to 65) for a year and a half. It's twice fallen to the 50 level and bounced upwards. It's now back down to 50. Notice the high volume (the red/green bars at the bottom of the screen are the weekly volume levels – colored green if the stock closed up for the week, or red if it closed down for the week). The rightmost price, representing the most recent 5 days, shows it's again bouncing off the 50 level, on higher volume. This 50 level is now what's called ‘support'. The stock price will most likely stay above it. Good place to buy.

MCD currently has a Return on Equity (ROE) of 30, which is very good. This says the company is returning good value to the investor. Dividend Yield is 3.8%. Let’s look at the dividends:

(Note: I went to DividendInvestor.com for this information)

It's paid quarterly dividends since 1976, and has raised dividends every single year. It's 5-yr dividend growth rate is 35%. Let's plug this into a spreadsheet to see how dividend growth could play out:

This worksheet calculates the effect of buying 100 shares of MCD, and having the dividends automatically reinvest. I plugged in a ‘Div increase per qtr' of 7.5%, because from above I see that MCD's 5-yr average dividend increase is 35% per year. A 7.5% increase per quarter comes out to about 35% per year. I also assumed in the worksheet the MCD's stock price would increase 2 percent per quarter. That's probably rather conservative, especially if the economy starts picking up a little.

But you can still see that this stock, with no further investment than the original 100 shares (and dividend reinvestment), could double within 22 quarters (little over 5 years). Most likely it'll be sooner. And at the 5-yr point, you’ll be getting around 4 new shares of MCD every quarter.

So how did MCD turn out?

I created a spreadsheet with the actual dividends paid since my email to Jim, and the closing stock prices on the days the dividends were paid, to calculate reinvestment of dividends. The results from the 15 quarters since then come out to a 76% gain:

 

Jim cuts my hair, and just about every time I go to him, he says he should have listened to me. None of his IRAs or mutual funds have done that well.

I figured I’d just extend the spreadsheet to cover the next 4 years. DividendInvestor.com tells me that MCD’s current Dividend Growth Rate 3yr Avg is 11.88%, and the 5yr Avg is 14.02%. I’ll use the lower value, the 11.88% increase each year. I’ll also assume MCD will increase on average 2% a quarter for the next several quarters. That’s at the low end of its normal growth rate.

Plugging this into the second half of the spreadsheet shows that Jim, if he had followed this approach, in 4 more years could be up 150%, own 18% more MCD shares than he started with, and would be getting 1 to 2 new shares of MCD each quarter:

That is just from buying the stock and reinvesting dividends. Now I know Jim wouldn’t be interested in this, but a lot of Seasonal Forecaster readers are (I read all your emails). Let’s look at adding covered calls into the mix.

The Bid on the slightly OTM call expiring the next month, on the Monday right after an expiration, averages around .40 to .50. For example, say you had shorted January calls against your MCD stock, and they expired worthless on Friday, January 18^th. You would be free to write new calls. The February 95’s, being slightly OTM, could have been sold for around .70-.75 on Tuesday morning, January 22^nd (Monday was a holiday). That is a little on the high side. My experience is you can typically get at least .40 to .50 on new short calls, right after a previous expiration.

Starting with 100 shares of MCD at the current price, doing the dividend reinvestment scheme covered above, but this time adding in $120 per quarter from shorting calls against the stock, gives theoretical results of:

It may be prudent, on the months that MCD will go ex-dividend, to wait until after the dividend payment – same thing with earnings releases. So on the months there isn’t an earnings announcement or dividend payment, you may be able to sell calls at .75 to 1.50. You’ll likely get less on the months you wait. Considering that, I picked an arbitrary $120 per quarter in the spreadsheet above to approximate likely average income.

Considering that after 6 years, you could have almost 50% more shares of MCD stock than you started with, having not spent a dollar more, and you would have maybe $317 per quarter of income (dividends and covered call income), as well as any stock gains, does a covered call returning ‘only’ $1.04 sound that bad?

************************ Update:  May 12th, 2014 ******************************

This weekend I noticed that MCD, after spending over a year moving within a sideways trading range, had returned to the top of the range and may be ready to break out. Remembering the article about doing covered calls and dividend reinvestment on MCD stock, I went back to that spreadsheet.

Let's again look at my 2/18/13 spreadsheet prediction for 15 months in the future. Using my assumptions (above), I showed how MCD could have a total 21.5% return over the next 15 months by starting with an initial 100 shares (at 94.87) and reinvesting all dividends and writing slightly out of the money covered calls on the stock.

Now in the above article I suggested a prudent investor might want to delay covered calls when the stock is about to go ex-dividend or earnings are to be released. Making an assumption that writing covered calls would bring in about $120 per quarter, my 15- month projection looked like:

I was curious how the MCD reinvestment strategy worked out. I retrieved actual slightly out-of-the-money call premiums from every Monday following option expirations, and assumed the full premium would have been captured.

There was some months where a slightly out-of-the-money call would have been in danger of being exercised, thereby calling away the stock at the strike price. An experienced covered call writer would have ‘rolled-up-and-out' to keep the stock. Over a 15 month period, the results would likely have averaged out, so the values shouldn't be off by much.

But here is that chart with actual dividends and likely income from writing covered calls on that initial 100 shares of MCD stock (the Feb 14 quarter is actually a week short – February 2012 option expiration isn't until the end of this week, but MCD's chart encouraged me to revisit this analysis now).

Over the past 15 months, the trade/investment strategy could have returned 29%, and you would now be holding 118 shares of MCD at 102.93 a share and have $89.30 in spare cash balance, ready to be reinvested in more MCD stock next quarter.

We all love the short-term trades, however we can't put all of our trading account balances into Facebook or Apple stock. But neither do we have to settle for 1% annual returns on the larger balances we don't want to play risky games with. A stock that went almost nowhere over 15 months, but still could have returned 29% with less risk than simply owning the stock. Sweet.

Of course, there's much more you need to know and many more stocks you can capitalize upon each and every day.  To find out more, please click on the following link: www.markettamer.com/seasonal

By Gregg Harris, MarketTamer Chief Technical Strategist

Copyright (C) 2014 Stock & Options Training LLC

Unless indicated otherwise, at the time of this writing, the author has no positions in any of the above-mentioned securities.

Gregg Harris is the Chief Technical Strategist at MarketTamer.com with extensive experience in the financial sector.

Gregg started out as an Engineer and brings a rigorous thinking to his financial research. Gregg's passion for finance resulted in the creation of a real-time quote system and his work has been featured nationally in publications, such as the Investment Guide magazine.

As an avid researcher, Gregg concentrates on leveraging what institutional and big money players are doing to move the market and create seasonal trend patterns. Using custom research tools, Gregg identifies stocks that are optimal for stock and options traders to exploit these trends and find the tailwinds that can propel stocks to levels that are hidden to the average trader.

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