A Bet on Dividends

An old saw in the investment industry is that bull markets climb a wall of worry. If I may be allowed a variant on that theme, global stock markets are about to embark on the Fall of worry. What with third quarter earnings season around the corner, the continuing countdown to a Greek default, the funding of Euro banks and the US Fed’s version of the twist, there is much to worry about.

Last week, we saw the market’s potential as US stocks were bolstered by assurances from Treasury Secretary Timothy Geithner that Europe has the wherewithal to manage their crisis and there is no possibility of a Euro-Lehman event.

If Europe can orchestrate an orderly default in Greece, demonstrate that its banking system is well funded, if earnings come in better than the lowered expectations, and if you believe that stocks are oversold, we have the cornerstones that could support a sustainable rally. Mind you, that’s a lot of “ifs” for investors looking to take bullish positions.

Among those cornerstones, one could argue that earnings will likely top expectations. Mainly because expectations have been substantially reduced in recent weeks. One could also make the case that stocks are oversold, with the dividend yield on the S&P/TSX Composite at 2.7%, compared with 2.21% for Canadian bonds.

If you focus specifically on dividend paying stocks, the risk premium looks even more enticing. The iShares Dow Jones Canada Select Dividend Index Fund (TSX: XDV, recent price $20.24), which includes 30 of the higher dividend paying stocks in the S&P TSX composite index yields about 4% annually.

Given the uncertainty that is the Fall of worry, traders would be well served to keep a portion of their portfolio allocated to high dividend paying stocks. Stocks that pay higher than average dividends should do well in a low interest rate environment which is the one factor that is certain to continue for the next 12 to 18 months.

Some dividend paying stocks do not have any real prospect for growth. BCE Inc. (TSX: BCE, recent price $38.32) would be a case in point. Companies like this make interesting longer term covered call writing candidates, where the total return is made up of dividends plus the premium from the sale of the call option. Think of the cash flow metrics rather than the growth metrics.

With BCE Inc., buy the shares and write the BCE February 39 calls at $1.22. The return if exercised is 8.03% (including two dividend payments) over five months. If the stock remains where it is, the return is 6.1%. And you have downside protection to $36.10 when you account for the dividend stream.

Another possibility is a covered call strategy on Canadian banks. CIBC (TSX: CM, recent price $76.02), for example, has a dividend yield of 4.73% (that equals a $3.60 annual dividend). Of course it is also considered the highest risk among Canadian banks. Although I would take a high risk Canadian bank over anything in Europe or the US.

If you were to examine a longer term covered call strategy, look at buying CM and writing the CM April 78 calls at $3.50. The seven month return if exercised is 10.3% and the return if unchanged is 7.5%.

A dividend / covered call strategy may be just the right medicine when faced with a Fall of worry.