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"MO" Dividends

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Excuse me waiter, could I get some more dividend yield, please? "Coming right up!" replies the waiter. Maybe a better title would be the friendly reminder to be careful what we wish for because we just might get it.

Here I was engaged in composition of a completely different topic and along comes news out of Philip Morris that they will miss earnings. Keenly interested in the business end of the news, Fundamentals Guy was busy with his nose buried in the computer screen looking for the details. Was this really bad news or a buying opportunity? Option trading had yet to enter my mind.

I was still engaged in the numbers when I got a call from technical trading guru, LEAPS Editor, and resident rocket scientist, Mark Phillips. The upshot of the conversation was a potentially great way to make a trade on this stock and capture that tasty dividend (currently $2.56 annually) while protecting ourselves from further price erosion.

But before I get into the trade, let me explain why I'm hooked on dividends right now. It all stems from a belief based on evidence that the world is headed for a period of deflation - that is, where prices fall but the value of debt remains the same. In order to service all that debt, people are going to need income.

Stock appreciation is no longer a foregone conclusion - nobody earns income from the selling of declining stocks, except the broker. With bond yields declining, nobody is going to make the house payment, buy groceries or take vacations on a 1.0-3.5% yield. CD's are lucky to pay 2%. So where are we going to get income? Either from a job or from a dividend paying stock. The trick is to make sure the dividend is safe from reduction.

Don't get me wrong. In the severest case where prices of EVERYTHING fall - soda pop, steak, cigarettes, clothing, cars, houses (yes, houses), - companies will have no pricing power, thus no ability to generate greater sales except by taking them from other companies. In that scenario, dividends will fall as earnings fall. That's why we want to buy dividends that are as close to "unsinkable" as possible. With one of the most historically stable dividend histories I've seen, I believe MO fits that description and provides a margin of safety in the process.

OK, I like them, but they just announced an earnings shortfall. Now what? For the answer, follow this hypothetical example. Suppose they earned $4 in FY2001. "The Street" expects $5 in FY2002. Half way through the year, the company says it will hit Q3 earnings, but warns that growth will keep earnings to $4.50. With only 1 quarter left, that means the company will lose $0.50 in a hurry. OUCH! Yet they called for 8-10% growth in FY2003 over their new $4.50 number.

What's that mean? With analysts and the news media tripping over themselves during the past couple of weeks noting that marketing expenses have risen drastically in order to protect market share in the tobacco division, they won't hit the numbers. That's a marketing expense in my opinion and a temporary setback.

Effectively, MO has reduced the baseline from which they will grow. Do I care? Not much. Net earnings after all additional, optional, extra charges will be somewhere around $4.50 in real numbers as they announced today, yet the dividend remains at $2.56. That's still nearly $2 of earnings in excess of dividends. They are not paying out every dime they make, leaving plenty of cushion for that tasty dividend. If you are a widow, nun, or orphan, you are feeling pretty safe right now.

Back to the immediate view in the windshield. . .MO was clocked for $4 under today's close, trading down around $38 +/- after hours. Let's see, a little math says that a $2.56 dividend divided by a $38 stock price is a 6.7% yield. Anybody know where else they can get that kind of income with relative safety? Me either.

Yet we have a fly in the ointment. As Jeff Bailey has pointed out, MO's chart is looking a bit bearish. Let's take a look at the point and figure chart, which give us a simple and effective measure of the market's view of risk and reward.

MO point and figure chart:

Why, looky there! A double bottom breakdown with anew price target of $31. Looks like plenty of downside.

Let's look at another chart - a candle chart this time.

Mo weekly candle chart:

If MO opens tomorrow under $40, the PnF shows a definite down signal. But even the candle chart above shows a possible target of $35 (former support). I neglected the middle dip under $20 on purpose. Those were the days that judgments and settlements might have put them out of business. At least that was the consensus then.

Great, maybe I can buy MO cheaper in coming days or weeks! At $35, the yield reaches 7.3%. At $31, the yield is 8.3%. I like that all day long! The risk is that the price continues to fall, which erodes capital. We don't want to buy a tasty dividend and still lose money.

What to do? A collar, of course! That's where we sell calls and use the proceeds to buy puts. We protect our downside AND our dividend in the process. If you are wondering what in the heck a collar is, be sure to check out Mark Phillip's excellent article on the subject here:

http://members.OptionInvestor.com/options101/082102_1.asp

We'll have to see where prices open tomorrow, but there's no reason we can't pretend with the closing prices today. This is always a good strategy that doesn't cost a dime (or very little) to protect the downside. Today, Mo closed at $42.73. Say we'd like to protect our downside for the next 60 days just in case the "ugly" happens. Looking out to November, we see that a NOV42.5 put costs $2.55 if we split the bid/ask. Kind of expensive, as it puts our total cost at over $45. The good news is that we can sell the JAN45 call for $2.55 splitting the bid/ask. The net cost of protection is zero!

Let's recap. Net cost is zero to protect every dollar of downside through November expiration and offer some upside to $45 by January expiration. In the meantime, we collect December's dividend. It doesn't matter where the price goes. We still make money.

I love the protection of a collar if I'm trying to pick an entry for longer-term hold. For me, it's all about safety, dividends, and capital preservation. Who says options are dangerous when they can hedge risks for zero cost?

That's it for tonight. Best wishes for a great weekend!

Buzz

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