07/23/12 Covered Call Pick: Southern Co. (SO)

Southern Co. is an American utilities company that engages in the generation, transmission, and distribution throughout most of the Southern United States. With 120,000 square mile territory, and 27,000 miles of distribution lines, Southern Co. is the fourth largest utilities company in the country.

Southern Co. has a market capitalization of $41.5 billion with 868.7 million outstanding shares.

SO currently pays a $0.49 quarterly dividend for a current yield of 4.1%

Southern Co. has a beta of 0.30, trading with 70% less volatility than the current market.

Southern Co. is a great safe play for an income-oriented investor that is concerned about risk in the current market. With a beta 0.30, SO has extremely little price volatility, and is effected much less by changes in the market as compared to many of other equities out there. In addition, they have that wonderfully attractive yield that everyone is looking for. These are two things that are important to look for when employing the Covered Call Strategy in a volatile and declining economy.

Because SO is a utility company it doesn't need to worry about growth as much as companies in other sectors. Once the initial equipment is in place (generators, transformers, power lines, etc.) maintenance and labor become the major costs of doing business. Utility companies can grow, but it is usually at a much slower rate than lets say a tech company. This is because they don't need to necessarily keep innovating to make a profit, and to expand their current network they need urban areas to expand first, which takes time. Because SO doesn't need to focus on growth, they can send those profits out in the form of dividends. SO has raised their dividends every year for the past TWELVE years, including through the 2001 and 2008 recessions. If you are concerned about the way the economy is headed, like we here at OakTree are, then this makes SO an attractive investment.

We at OakTree believe that the market is currently headed downward. This is reinforced by how stocks tumbled on this morning's opening based upon renewed worries coming from Europe. In an average bear market (a business cycle contraction), the market as a whole drops around 40%. But because SO has a beta of 0.30, it means that it will only drop, on average, about 12% in a bear market - 70% less than the market. Because SO is 1.84% off its high, we can expect that if the market continues to decline, similar to how it did in 2008, it will drop on average of 10.17%.  By selling a $47 in-the-money Call Option, we can remove an additional 3.06% from our cost basis by receiving the premium, leaving us with only a risk of a 7.11% drop on average. While a drop of this magnitude isn't without precedence, such as the Great Recession in 2008, it is currently not an inevitability, which is why we are not selling an extremely deep in-the-money Call. Yet we do believe a continuous decline of the economy will force stocks lower over the next few months, which is why we are deciding on an in-the-money Option, specifically the $47 Call because we believe it provides the best premium for the expected price movement. While these are all just estimations based upon average behavior of both the stock and the market, Southern Co.'s fairly stable and predictable stock movement allows us to make certain assumptions with a fair amount of accuracy. This is why we are recommending buying SO and selling the $47 in-the-money Call Option.


Scenario:

  • Buy 100 shares of SO @ $47.56 = $4,756 + Commission ($12.95) = $4,768.95
  • Write 1 SO January 2013 $47 Call @ $155 - Commission ($8.70) = $146.30

Note: Prices may vary from the time of post. Actual commissions paid will vary returns. 


Static Return (Not Called):

(Call + Dividend)/Stock Price   X    (Days/Year)/Days to Expiration

(1.46 + (2*0.49))/47.69      X    (365)/179

10.43% Static Return


If-Called Return:

(Call + Dividend + Strike Price - Stock Price)/Stock Price       X        (Days/Year)/Days to Expiration

(1.46 + (2*0.49) + 47 - 47.69)/47.69       X      (365)/179

7.48% If-Called Return



Disclosure: Clients and/or principles of OakTree Investment Advisors may or will have an investment in the above positions, but only on the the same sides of the trades. The above numbers are analytic estimations based on information known at the time of this post. OakTree Investment Advisors does not guarentee the above, or any, result. All investment decisions should be made based upon individual’s personal investment goals and risk tolerance.

 

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