Saturday, January 12, 2013

The 2013 Low P/E with Moderate Dividend Portfolio

This portfolio is constructed following guidelines set in James O’Shaughnessy ’s book “What Works on Wall Street”. O’Shaughnessy concluded that based on historically data the decile (1/10th) portion of the stocks with the lowest Price-Earnings Ratio and with good, but NOT the highest (and often riskiest) dividend yields outperform the average market (in our case the Canadian Stock Market) by 4% annually.
Last year’s portfolio returned 6.3% just slightly less than the S&P/TSX60 did as represented by the corresponding iShares ETF (symbol: XIU). So, somewhat disappointing – but then this is a long term (10 to 30 year) game. So let’s create our 2013 portfolio of 10 stocks that meet the criteria.  To find our possible candidates, we used Globe Investor’s GOLD database and found that 10% of TSX stocks with a market capital of $200 million or more trade at a maximum P/E of 10. Of these stocks I selected those with a dividend yield between 3 and 5%.
Thus I identified eighteen stocks. It turned out that several  of these stocks traded in the same market segment. For example there were several banks. In the Oil Service sector we found 2 companies that performed hydraulic fracturing including multi-stage fracturing. Also we found three stocks from last year’s portfolio still meeting the criteria.  Weeding out duplications and/or clearly unattractive stocks due to high debt or poor performance resulted in common shares of 10 excellent companies.
Drum roll! Ladies and Gentlemen, I hereby present to you the 2013 Low P/E and Moderate Dividend portfolio! 
Click on table to magnify
I must confess that I was shocked by the high quality of the stocks in the portfolio. I do want to note that I bought these stocks in the early part of this year before publishing this post and in amounts that I will not disclose. The theoretical initial investment in 2012 was $100,000 so this year we invested all the cash from dividends received last year plus the proceeds from the companies that we sold. We did not add to last year’s stocks that remained in the portfolio.

This blog does not make stock recommendations – it is only a ‘how-to’ blog and I don’t make any warranties or take responsibility for how you, the reader, use this information. Most stocks that I mention, favorably or unfavorably I do own or have owned in the past and may own in the future.
Oh! The 2013 TWIST! I promised a twist… Yeah right. I did not buy the stocks of the National Bank and BMO yet.  Instead I sold PUT options with a strike price that equaled the price at which I would LIKE to buy either bank.  You may want to review the discussion on buying and selling options posted last year on this blog.
Basically an option is the right to buy or sell a share of a company, e.g. Bank of Montreal (symbol BMO) for a certain price (the strike price) over a certain period of time. The time period maybe a couple of days, two months, three months or an entire year!  The longer the option is valid, i.e. not expired, the higher its value, also referred to as its ‘premium’, will be (just like in insurance).
I don’t buy options, i.e. buy insurance which is a form of gambling but rather I SELL ‘insurance’. For example, the BMO put option with strike price $60 expiring this April 21, 2013: I have sold to someone this option, i.e. I  collected the premium for the right to sell to me (my obligation) a BMO share for $60 between now and April 21, 2013.  To take on the obligation to buy this stock, the PUT option buyer paid me a premium set by the market and which in this case was $1.90 per share.
Rather than buy the BMO for $60 per share as we were more than happy to do, we collected $1.90 and we must buy the stock for our dream price if BMO falls below $60. If BMO shares don’t  fall below $60 between now and April 21 then we put the $1.90 in our pocket without having invested a penny i.e. we have an infinite high ROI. Of course, you need a line of credit or cash to be able to buy the stock if the option is exercised. 
If the PUT option is exercised then, in fact we have not bought BMO for $60 but for $60 minus $1.90 or $58.10 per share. Shares we’re willing to hold for at least a year in our Low P/E and Moderate Dividend Portfolio. However, even if by the end of 2013, either BMO or NA (National Bank) do not longer meet the criteria of the LOW P/E moderate dividend strategy; they would easily fit in one of our other portfolio strategies, in particular “buy quality companies that pay good dividends to be reinvested and hold ‘forever’. Long term returns for this second strategy are typically around 15% per year.
Thus buying BMO and NA for the long term for $1.90 less than our ‘dream price’ is perfect and has reduced the investment risk to less than when buying it outright. Bank stocks, typically fluctuate enough during the year, that we should fill our portfolio sometime during 2013 and in the meantime we can write every three months another put option until it gets exercised. The result is a final ROI that increases our originally projected return each time we write another put.
Say that we can sell a put option with a strike price of $60 twice between now and May, after which stock markets tend to fall (markets often peak between January and May). Remember: "In May... ", according to the expression "we go away" and in the fall (September and October) markets often fall. So, say in July BMO falls temporarily below $60, the option gets exercised and we buy BMO for $60 per share. The result is that we collected $1.90 between now and April and say another $1.60 between April and July;  we bought the stock for $60 and (with some luck) by year end the price has recovered and increased to $65.00. Then our annual profit is not $65-$60 or 8.3% as when the stock was bought right away in January 2013; rather the profit is $65 - $60 + $1.90 + $1.60 or $8.50 or a return of 14.2%. Hmmmm!
In fact profits are a bit lower because if you ended up buying in July, you missed 2 dividend payments of $0.77 per share. However, I am sure you’re getting my drift. Next post I will add even more profits!

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