Dividends? Forget DRIP and Go PRIP

For all I know, the proponents of the Dividend Re-investment Plan (DRIP) concept, who used to sell a simple booklet of all of the publicly traded companies offering such an investor option, are still raking in the big bucks from giving you that readily available information at a price.

If memory serves me right, the sales pitch was actually the basis for one of the early generation infomercials, but there was none of the yelling that became popular as the genre evolved.

When I first started investing I thought that was a great idea. Just have the company plow those dividends into say 0.29156 shares every four months, without incurring any fees.

I thought it was great until I got to the point that I wanted to close out positions that held such fractional shares.

Certainly, the pure math of re-investing dividends has to be favorable, if you are a believer in the upward march of stock prices, more specifically the price of the shares that underlie the dividend paid in share form. You may also need to have a very, very long perspective or at least be investing for the benefit of your yet unborn great-great-grandchildren.

Maybe my portfolio wasn’t large enough, or maybe getting a little prize every 3 months just wasn’t enough to make me feel as if I was getting any more wealthy, especially when at best, the quarterly dividend was no more than 1-1.25%, if you limited yourself to stocks with relatively secure dividends.

Of course there is a certain amount of wisdom that suggests dividend paying stocks are the cornerstone of many portfolios, especially for individual investors. The idea is just sit back, let the dividends accumulate and when you’re old and wizened, sell your shares and move to a more age appropriate portfolio mix, designed for income.

Maybe it’s related to the fact that I never really understood bonds and get easily confused by the inverse relationship between price and yield, but that strategy never really had much appeal for me.

I also never really understood the allure of dividends, yet, even I have a strategy that is specifically focused on dividends. Of course there are “dividend capture” strategies and the “Dogs of the Dow” strategy, which is based upon dividends as a guiding tool. You can decide for yourself which of the conflicting studies you would like to believe with regard to those strategies.

Part of my lack of understanding is related to the fact that it’s still your money that’s being returned to you, entitling you to the right to pay taxes. I know that there are studies that look at the eventual price rebound following the payment of a dividend, but I just don’t find that comforting enough to simply buy a stock because of its dividend, secure as it may be.

Instead, I look for other ways to create income that can more meaningfully grow my assets and perhaps even my number of shares.

In fact, even non-dividend paying shares can generate income. Even pieces of paper that have no inherent value, like Barclays Volatility Index ETN (VXX) can create income.

It’s all through the modern miracle of options. Specifically, the miracle of selling a promise and a dream to someone willing to pay you for that opportunity, that so often fails to materialize.

Selling options, even on boring, relatively not volatile stocks, such as Microsoft (MSFT) can return a nice weekly or monthly premium and can form the basis for anyone to design their own “Premium Reinvestment Plan (PRIP).”

I know that “PRIP” doesn’t really sound appealing, but the concept is very appealing even if minimizing the size of premiums by selecting strike prices that are safely outside the probability of having shares assigned.

Take Mosaic (MOS) for example. Mosaic isn’t exactly a boring and non-volatile stock, but it serves as one of many possible examples.

With its shares trading at $47.50 (May 31, 2012, 2:13 PM), it offers a premium of $0.47 (bid price) for the $47.50 strike contract expiring tomorrow. That happens to be a 1.0% return for a bit more than a day, whether shares are assigned or not.

Don’t want to lose shares at $47.50? In that case, next week’s $50 strike price offers a $0.29 premium. That return, for 6 business days is 0.6% and offers the opportunity for capital gains on the shares as well.

Still not happy? Your cost basis is $60, because you bought your shares 7 months ago? Well, if you waited 7 months trying to turn a profit, why not wait another 7 months and sell the December 2012 $60 call contract for a $1.42 premium (3.0% ROI based on current price and 2.4% ROI based on purchase price). To that, you can also add a year’s worth of dividends, albeit small to your bottom line to the tune of an additional 0.8% on the original purchase price.

Dow Chemical (DOW), one of my favorites is even more appealing, especially if your a little averse to the volatility of a company like Mosaic and aren’t enticed by its paltry dividend payment.

Trading at $30.90, DOW offers an options premium of $0.82 for the $31 June 2012 contract which expires in 11 business days. That’s 2.6% ROI.

Jump ahead to December 2012 and get the same $0.81 premium, but this time for the $37 strike price. And again, don’t forget to add in the 4.1% annual dividend, which is far more generous than for Mosaic.

Obviously, there’s no shortage of examples, including the more volatile and non-dividend paying issues such as ProShares Ultra SIlver ETF (AGQ) and Barclays Volatility if you’re the speculative kind.

But what do you do with the income that comes your way after selling the call contract of your choice? It’s called PRIP.

When I first started the strategy of selling covered calls on as many of my holdings as I could derive satisfactory premiums, I routinely took the accumulating premiums and used them to purchase more shares of stock. As opposed to dividends, the share price didn’t fall just because someone pays you a premium, although granted, the premium is taxed as a short term capital gain.

Sometimes, I used the cash and bought additional shares in those already owned and sometimes I used the money top add a new holding. Of course once those additional shares were purchased, they too were used for the ability to sell covered calls and generate even more premiums. Instead of feeding on itself, this is an example of growing on itself.

I don’t think Albert Einstein was referring to this kind of compounding when he referred to the “true miracle.” but if he could, he might consider expanding his definition.

As time went on, I came to the realization that the income could be used for something entirely different. In my case, I partially abandoned my PRIP plan and instead diverted a portion of the income to replace the need to rely on a regular paycheck. The remainder would go right back into purchasing more shares.

In a way, using the PRIP approach is akin to converting the leverage than an option buyer so craves into a no-risk form of leverage for your own portfolio. Instead of relying on margin to accumulate more shares, your additional buying power is tied to the hidden value of your holdings.

Once I come up with a better name and acronym, be certain to look for me in the 3 AM hour on the basic cable network of your choice.