Adding covered calls and index puts to a dividend-paying strategy focusing on large-cap value stocks is fund manager Ron Altman’s mandate. He tells MoneyShow.com why this combination has been successful, and why he prefers the market’s valuation over analyst estimates.

Kate Stalter: Today, our guest is Ron Altman, manager of the Aston/M.D. Sass Enhanced Equity Fund (AMBEX).

Ron, you have a four-star rating from Morningstar, and I see that they categorize your fund as straddling that Large Cap Value and Blend in their style box. Tell us what the fund’s objectives are, and how you invest when it comes to these styles.

Ron Altman: Sure, well, let me describe the fund from 50,000 feet. We are a liquid alternative. We’re income-oriented, and we’re all about risk mitigation.

Because of that, our investment style is to buy companies that pay high dividends, have low P/Es, high free-cash-flow yields, and are selling at some sort of a discount to the market as a whole. So that’s the underlying portfolio. It usually comes out in the Large-Cap value box.

Kate Stalter: Let’s talk a little bit about some of the sectors. I’m noticing that, at least in the latest quarter that was reported, technology was an area you were overweight, as well as utilities and industrials. Maybe you could talk about some of the sectors and we can touch upon some of the holdings.

Ron Altman: Well, utilities fit right in with how I describe the investment style. We like these companies because their dividend yields are higher than the ten-year cost of debt.

Usually, when you have that sort of a divergence or a disparity, you pay a lot of attention to what the credit markets are saying. They usually get it more right than the equity market. So from a value point of view, the utilities are an extremely compelling story.

But we don’t want to buy stocks just because they’re cheap. We want to buy companies that we think have some sort of a secular tailwind. In the case of the electric utilities, it’s a high-fixed-cost business with a very low variable cost.

The capacity utilization of the base load power for a typical electric utility from 12 to 6 a.m. is somewhere in the vicinity of 40%. On the surface, that doesn’t make it a very attractive business, but because it’s a regulated monopoly, they kind of get a guaranteed profit.

Now, what makes this extremely interesting is the move in the automobile industry to bring to market electric cars. And as that happens over the next five to 20 years, capacity utilization of the industry in the off-peak hours are going to go up dramatically. Their marginal cost approaches zero; therefore, their incremental profit approaches 100%.

I think the market is beginning to understand this much more so than the analysts, who typically look at the next one or two quarters, and don’t really look at the long-term trends. So, we think we have an enormous opportunity to own a group of stocks that we think will be a long-duration play and give us a high yield.

At the same time, one of the aspects of the fund is to sell calls against every stock in the portfolio. Therefore, if I can sell calls and add to the dividend income to create a 10% yield, then I’m going to get paid while I wait.

Kate Stalter: Are there any particular utilities that you can mention today that have been holding to the portfolio that have done particularly well?

Ron Altman: Well, one that has worked very nicely for us is FirstEnergy (FE), which was a merger recently with another utility. In the process, there are some synergies that were created that will cause earnings to improve even before they get the benefit of selling the off-peak power.

So, the stock’s moved up, and at the same time, the dividend yield is fairly attractive. The company’s current dividend yield is 4.7%. So we think this is a fairly compelling story.

Kate Stalter: Let’s move on to some of the other sectors. I was intrigued that tech seemed to be such a big component in the portfolio. Say something about that.

Ron Altman: I own Chicken Tech.

Kate Stalter: Chicken Tech? What’s that?

Ron Altman: That’s tech with a big yellow stripe down my back. What I own are mature technology companies that are growing at more like a 7% to 15% rate of increase, not a 20% or 30% rate of increase.

And they are well beyond the point where they are consumers of capital—they are now generators of capital. Almost every company that I own in that sector has an above-S&P dividend yield. More importantly, they raise the dividend yields regularly.

A perfect example would be Intel (INTC). If you look at Intel over the last few years, the earnings have been improving, the margins have been holding up, free cash flow’s been very strong. And, if you look at the annualized dividend oh for about the last six or seven years, it’s gone up about tenfold.

I like that. I want to get paid now. I much prefer to get a dividend than for the company to tell me they’re returning cash by buying back stock.

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Kate Stalter: And certainly, as you point out, when people tend to think of tech, they often do think of some younger, smaller names that wouldn’t fit into the style box for your fund, anyway. So Intel does seem like a perfect fit, from the way you’ve described it.

Ron Altman: 3.3% yield, raising the dividend constantly. They said they’re going to raise the dividend again this summer, bring it up to about 3.6%. And they’re the dominant company in the business with a very high barrier to entry.

Kate Stalter: We’ve only got a couple minutes left here. I also wanted to talk about some of the industrials, because that looks like another area where the portfolio is pretty heavily weighted. Can you say something about that, Ron?

Ron Altman: There two companies in the industrial sector that are considered defense: Raytheon (RTN) and Lockheed (LMT). Dividend yields of appropriate 4%; huge free cash flow generators.

But the most intriguing is: Everybody who talks about defense companies, thinks in terms of the United States Department of Defense, and how much they may or may not buy, especially with the budget crunch and the financial cliff coming up the end of this year, beginning of next year.

Their market doesn’t end at the Atlantic or the Pacific. Their market is global. Every country in the world wants military hardware. They want missile defense. They want to be able to protect themselves. These companies are merchants to the world, not just merchants to the domestic Department of Defense.

So, again, I like to look at things on a longer-term basis, and I love to find opportunities where I disagree with the consensus of the analysis community, because I think they’re being overly myopic.

Now, you missed one other important aspect of my mutual fund: I also periodically buy index puts. That is how I protect against the downside. If you go back and look at last summer, our performance was the best in the country in any large-cap category because we owned index puts as a way to guard against tail risk. But we don’t buy them all the time. We only buy them when the cost is low.

Easy way to understand that: Look at the option volatility index. When that index is 20 or less, then the cost of the insurance premium is low. That’s when I start buying puts. When the VIX gets to 40—between 40 and 50—then I have the opportunity to sell off those puts and, in effect, book a profit from the downside protection.

And then, that way I deal with the third piece of the stool, the third leg of the stool, which is risk mitigation. So, it’s large-cap value companies that pay big dividends. It’s a liquid alternative in that the portfolio is hedged, and the way we hedge the portfolio is with a combination of selling calls and buying puts. It makes us kind of unique in the industry.

Kate Stalter: Yeah, it is interesting. I’m looking at the Web site with the list of holdings and, as of April 30, equities were the bulk of the portfolio, and then some of the index puts and the calls made up a smaller percentage. Is that generally the case, in any market condition?

Ron Altman: Oh sure. The calls are simply a way to enhance the income. So, if I strive for a 10% income and I get a 4% dividend, then I need, on an annual basis, 6% more by selling calls.

If I want to guard against tail risk, then I’m willing to commit up to 3% of the portfolio on an annual basis, for my insurance policy. So, that’s, you know, a small fraction of the total assets, but it has a magnifying impact if things go wrong.

Kate Stalter: That makes a lot of sense, especially with the market volatility we’ve seen in the past few years.

Ron Altman: I sell volatility. Most people buy volatility.