Selling Puts for 30% Annualized Returns

Last night in the Investment Intel webinar, we continued with our discussion of selling puts on great companies we want to own, as well as analyzing a globally elite company that has recently dropped in price. You can access the recording below:

As the number one rule for selling puts, we have continued to preach that you should only be selling puts on companies you like at prices you are comfortable paying. That’s because selling a put is agreeing to pay the strike price—in exchange you receive the premium upfront. If you are not comfortable paying the strike price, then you should not be selling that put. This is just like an insurance company. We act as the insurance company, collect our premiums, and only insure the best of the best companies. This way, there is very little risk with a high upside.

In the webinar last night, we showed an account we took (my brothers) with $10,000 toward the beginning of 2012. We wanted to show one a few years back so as not to confuse the situation with current companies we are looking at.

selling puts

In this account, we were only selling puts, then looking to buy them back early, when the remaining annualized rate of return was less than 10% or so. This way, we could capture the majority of the put premium received—then buy the put back, clearing up funds to sell more puts. This allowed us to speed up the process and amplify our returns. By the end of the year, we had collected over $3,000 in net premium (30% annualized return on the entire account value), by focusing on only 4 companies over the year, and dedicating very little time to the process on a weekly basis. In the webinar, we walked through that process—including spreadsheets, analysis, and some of the thoughts that went into those decisions, and how you would go about buying back puts to increase your returns.

This is a pretty typical example of our put selling strategy. Of course, we only sell puts on companies we are comfortable owning, but if we can drain the majority of the premium early, get our risk (or responsibility) off the table, and roll into a new position—then we will always look to do that.

The other alternative is allowing the put to expire, instead of buying it back early. There’s nothing wrong with that, it just leaves you responsible for buying the stock a little bit longer—sometimes when the remaining return is no longer very high. If we have other choices with higher return potential, then buying back puts and allocating that money into higher yielding positions is what we usually choose to do.

The final outcome with selling puts comes about if the stock drops below the strike price of your put. In that case, we would own those stocks at the strike price (minus the premium received). That is a great outcome as well, since even bigger gains should result from owning the stock. Like we say with selling puts—it’s win/win. Last night’s talk was just another way to approach it.

Note that this final outcome (owning the stock) usually does not materialize when selling puts that are below the current stock price (known as out of the money). And as we show in the webinar, it did not happen once on the account shown. More often than not, out of the money puts expire worthless—which means you collect the entire premium as the seller—with no additional responsibility. This is just fine with us, 30% annualized returns collected on put premiums is not a bad result.

We also discussed the globally elite Walt Disney Company (DIS). Disney is a company that has strong roots with our family, and we have always loved what they do. Their competitive advantage is rock-solid and clear to see, their core businesses are relatively easy to understand, and their management team has proven to be wonderful over the years. In addition, their company culture and management style has been idolized and taught all around the world as a model for success. These traits are ideal for companies we would be proud to own.

The problem is—as a value investor, it’s just been too hard to justify buying Disney at any time over the course of this bull market. In order to buy some really great companies, we always look for triggers, or events that might bring the stock price down in the short-term, but not have any material effect on their long-term competitive advantage. Disney’s price has come down a bit for two primary reasons, but has it come down enough to justify buying our first position? We talked about that last night, and dug into placing a value on them as well.

We encourage you to analyze and review the EV/EBITDA ratio. This is a measure we are going to use more and more going forward, and will certainly use to try and nail down a fair value on Disney.

 

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Kevin Tudor is the VP of Investment Training for Margin of Safety Investing, LLC. After a significant amount of time in the financial services industry, Kevin moved on to investment research and analysis to bring his expertise to the individual investor. He now resides in Scottsdale, Arizona where he conducts online newsletters, webinars, and various investment trainings to show others the key strategies to successful investing.

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