Every Daily Profit reader knows that I’m a huge fan of dividend growth. I think it’s the best strategy for building wealth and collecting income along the way.
I like dividend growth for its simplicity. All that’s required is finding high quality stocks led my executives that are committed to the shareholders. Just buy and hold a portfolio of dividend growers for the long term, and watch your portfolio grow.
As the years roll by, rising streams of cash roll in. Because investors are willing to pay a higher price for more income, the share price rises with rising dividend payouts.
Over time, you find yourself owning an investment with a high yield on your cost basis. You also find yourself owning an investment worth significantly more than your cost basis. And this is the very essence of wealth creation!
But dividend growth isn’t perfect. The best dividend growers frequently fail to provide high yields. That’s because companies that are growing their dividends are doing so because they are growing their business. And that means reinvesting some cash in the business, and distributing some to the shareholders.
As a result, many of the best dividend growers have yields of just 2 – 4%. This is an obvious shortcoming for investors demanding immediate high yield.
Consider one of my favorite dividend growers McDonald’s Corp. (NYSE: MCD). The company has raised its dividend every year since 1976 – a trend that’s likely to continue.
I first recommended McDonald’s to my High Yield Wealth readers in January 2011. Over the past 32 months, the quarterly dividend has increased 26% to $0.77 a share. On our cost basis, McDonald’s dividend yields just over 4.1%.
McDonald’s share price is also up roughly 28% during our holding period. At the current market price, it yields 3.2%. That’s better than the average company in the S&P 500. But it isn’t exactly high yield.
For some income investors, McDonald’s lower current yield is a turn off. But you can have the best of both worlds – dividend growth and high yield from the outset.
By overlaying a covered call strategy on McDonald’s, you can immediately double your current income. At the same time, you retain your exposure to the wealth-building characteristics of dividend growth.
With a covered-call strategy, you buy (or already own) shares of a quality company like McDonald’s and then sell an out-of-the-market call option.
By selling a covered call, you agree to sell your McDonald’s shares at a future date and at a specific price (the strike price) to another investor. In exchange for selling this right, you earn a premium in the form of a one-time upfront payment – the extra income.
Let’s assume you own 100 shares of McDonald’s. Shares trade at $96 today. An October 100 call option sells for $0.49 a share. By selling one covered-call contract on 100 shares, you earn an extra $49.00 (100 times $0.49).
McDonald’s is a low volatility stock that’s in mild downtrend. The probability is low it will be called over the next two months. And two months from now – and every two months thereafter – you repeat a similar transaction.
This means you can collect roughly $49 of extra income every two months. Over the next 12 months, you’d collect an additional $294 ($49 times six). Add $294 to the $308 you’d receive in dividends, and your annual McDonald’s income soars to $602.
In short, you’ve just taken a blue-chip dividend grower with a 3.2% yield and pumped up the cash flow. And that’s how you can collect a 6.3% income stream from McDonalds.
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