Renting Out Your Stocks for Cash Flow

The below chart is the Covered Call Process Flowchart as presented by Joseph Hooper and Aaron Zalewski in their book Covered Calls and Leaps - A Wealth Option.

I will go into detail on the individual decision points at a later point but for now, here is the overview.

You enter into a new position following a certain set of rules. (to be covered.) Ensure that the stock is in the bottom 25% of its current price cycle. If the stock increases in price, you either get called out (sell the stock and keep the premium) or you close on the delta effect. (the stock price increases greater than the option buyback cost and you can now buy the call back and sell the stock for a profit.) At this point, you can now follow the rules to enter a new position.

If the stock price drops, you potentially enter territory where you can not sell a call at a profitable called return. (your cost basis is higher than a profitable strike price call.) If you can sell a call for a called and uncalled return of 4%, then go ahead and do so following the rules of a secondary call sell. (covered later) If you cannot, then you need to enter a defensive technique called the Tethered Slingshot or TSS.

In the TSS technique, if you are in danger of being called away for a loss, you buy back the call and then immediately turnaround and sell a call at the second to last expiration date at the same strike price for a minimum 10% uncalled return with the intention of buying the call back once the stock cycles down. The idea is, you sell the TSS when the stock is at 75% of its current cycle and then wait for it to drop down and buy it back for a positive return. The initial buyback creates a temporary loss but the sell of the second to last expiration will cover this loss and the buyback will help to generate a profit.

If your stock does not have a call on it and you cannot profitably sell a call for a 4% called and uncalled return, then you simply enter the TSS technique while adhering to the 75% rule - sell the second to last expiration for a minimum 10% uncalled return (using the higher of the market value or your cost in the stock), wait for the call to cycle down and buy it back for a profit.

If the stock does not cycle down, if instead it shoots up, then you should look to close on the delta effect (the sell of the stock will reap a greater reward than the cost of the buy back of the option) or look to the Surrogate Stock Replacement technique which I will cover in a subsequent post along with the CPR technique.

All of the preceding information can be found in Joseph Hooper and Aaron Zalewski's book Covered Calls and Leaps - A Wealth Option.

The Engine for a Better Business Model

The Business Plan - Well Yeah There is an Outline But This is Not War and Peace

If you perform a web search on the term “business plan outline” or peruse your local book warehouse, you will inevitably come across a half a dozen, varying outlines. My motto is – find one that you are comfortable with and then get very comfortable with that outline - quite similar to Warren Buffet’s “put all of your eggs in one basket and then watch that basket closely,” except he has a billion dollars. If you are dusting off the old business plan or starting from scratch then you need to familiarize yourself with a good outline. And remember, this is not an Ayn Rand novel.

Here’s the one I use:

Executive Summary

The Business

Vision and Mission

Strengths and Weaknesses

Legal Structure

Business Description

Product or Service Description

IP Property Description

Location

Management Personnel

Records

Insurance

Security

Litigation

Risk Factors

Major Forecasted Achievements – Milestones and Goals

The Marketing

Markets

Competition

Distribution and Sales

Marketing

Industry and Market Trends

Strategy

The Operational Plan

Organizational Structure

Management and Personnel

Legal Structure

Equipment and supplies

Accounting and Legal

Daily Operations and Processes

The Financials

Uses of Funds

Income Statement

Cash Flow Statement

Balance Sheet

Income Projections

Breakeven Analysis

The Supporting Documents

A Living, Breathing, Implementable Document

In a perfect world, your business plan would sprout arms and operate the cash register but the truth is it is probably dead in a drawer somewhere next to an old Kenny Roger’s CD you keep around for “me” time. Your mission now is to find that drawer, open drawer, grab feather duster and get to work. Your business plan in part contains your hopes and dreams for your business as well as how to operate the whole thing. It sure as heck deserves a better fate than Kenny.

As far as the living, breathing and implementing part, your business plan should be wired into your business. At a minimum, you should do this by reviewing the key elements of the plan in bi-weekly team meetings and quarterly strategic meetings and tracking progress. According to Dr. Matt Marvel, Professor of Entrepreneurship at Western Kentucky University, “the bane of most entrepreneurs is the lack of business plan implementation. For the most part, business owners find it difficult to integrate the plan into the business. This is a critical failure point for most small businesses.”

Let’s examine specific sections and see how you are stacking up:

The Vision and Mission – sometimes viewed as the enlightening, blue sky statement that hangs on the manager’s wood paneling – it sounds idealistic and cute but the real world says otherwise. The real world says to hell with your idyllic view of how you think your business should run, I’m in charge. But isn’t the Mission why you went into business in the first place? The Vision and Mission at a minimum is the driving force of the business, the fountainhead the business is chasing after. The whole point of having one is to use it to drive through the daily onslaught of reality. It should be kept at the forefront and reviewed daily. If you haven’t developed an overall mission or vision stop now, do not pass go, do not collect $200. Get to work putting one together by asking who do we serve, why do we serve them and how do we serve them? What is our overall purpose for being in business? What should our business look like now and in the future? Write it down and read it at every meeting.

Business Description and Product or Service Description – this is the section that says “we will deliver quality service and products in a unique and outstanding environment. Our customers will be wowed by us until they explode.” Great! Now the question is, how is this glorious statement tied into the business? What is your standard for checking up on customer satisfaction and product quality? Do you survey the customer on a regular basis, bring up the results in team meetings and pow-wow on solutions to the situation? You should be.

Which brings us to our next area of planning and integration …

Management and Personnel

If you really brought your “A” game to this section then you developed an organizational chart. If you brought your “A” game, a cup of coffee and a knack for delegating, then you fleshed out roles, responsibilities and accountability for each position listed in your org chart. In keeping with the previous product and service example, if you show up at a meeting and don’t know who is responsible for improving customer service, then chances are you have some unhappy customers. If the org chart indicates that Joe is responsible for customer satisfaction then the meeting script would go something like this … “Joe, we are receiving a fair amount of customer complaints. Any insight into this?” or “Joe, our customers are raving happy, how’d you do this?” Joe would ideally wake up from his nap and respond “are you talking to me?”

If everyone knows their roles and responsibilities and accountability, then there should be no big surprises.

Marketing

In the marketing section you literally listed out the varying channels that you would employ to market the business – web, print, radio, blimps, wacky waving inflatable arm flailing tube men, etc. Hopefully you also included a measure on how to grade the effectiveness of each channel. How are you doing? If the newspaper ads are providing a rate of return of 150% but the radio spots are barely breaking even, perhaps it is time to kick the radio channel and beef up the print ads … or invest in half a dozen more wacky waving inflatable arm flailing tube men.

Finally, Financials

No matter how you slice it, it typically boils down to the money. You should be preparing a monthly budget and reconciling actuals back to the budget. If not, then again, do not pass go, do not collect $200, go directly to your local book warehouse or search on “budgeting”. This is all important – in your business plan you prepared forecasts. Those forecasts need to be revisited – there may be opportunities for improvement.

You also need to be fairly familiar with the balance sheet and cash flow statement. Ideally, the business is building an asset and increasing equity over time, not metastasizing into a raging spiral of death. If you are continually throwing good money after bad into a black hole of debt, it is time for radical improvement or time to cut your losses.

Goals and Milestones – You Said You Were Going to Live up to Them, How’d you do?

Although by all appearances the “Secret” was a profitable attempt to repackage motivational material from the 80s and market it into an international bestselling book and DVD, the real secret is to set meaningful goals and milestones for your business and keep them in front of you at all times. They will serve as the engine that will drive your entrepreneurial spirit even when you don’t want to go into work for the day. They should answer the question where is the business headed and prompt you to take the steps to get there.

In the existing business plan you want to review the goals that were created and check to see if in fact you hit those goals. If not, why not? Keep the business goals in front of you and the staff at all times and remember, be specific: It is much better to say “I want to weigh 171 by December, 25^th2011 at 7pm” than “I want to lose weight.” In the second example you can take off a sock and then cheer “mission accomplished.”

Some goals and milestones you may want to think about:

1) An exit strategy is not a planned fire escape route. It is the ultimate goal for your business. Are you going to work until you hit the ripe old age of 110, hand it off to the kids, or sell it for a nice sum of cash? Michael Gerber, author of eMyth Revisited, asserts that the goal of every business owner is to eventually sell the business. How much will you sell it for?

2) When will you be financially independent? You didn’t start the business to have a hobby. At what point will your passive income be equal to or greater than your expenses?

3) What will sales levels look like in the next 3 and 5 years?

4) Do you wish to expand and open additional stores this year, create a new strategic alliance, or perhaps diversify your product offerings? Sometimes though it is best to remember that many business opportunities will come your way and it is best at times to be selective and focus.

The Times They are A’Changin

According to Matt Whitaker, Business Consultant with the Small Business Development Center, “most business owners do not accommodate for change in their business plans. They remain rigid and hope that everything will roll out exactly as planned. If it doesn’t, they are typically at a loss and cannot adjust.”

The point is, plan for change. Your budget should have a miscellaneous category for unforeseen expenses and you should project a best, worst case and most likely scenario in your sales projection.

Implementation – It’s a Pretty Document … So What?

Again, as I previously indicated, if you have a great plan chock full of financially literate terms such as “nominal rate of return” and “net present value” then good for you … you have a great vocabulary. If you actually use the plan in the business then you have great follow-through and a solid business model in addition to a fancy vocabulary. I can’t emphasis this enough: the plan needs to be integrated into the business on a strategic and tactical level via company meetings and day to day operations. The individuals responsible for facilitating the key functions of the business need roles and responsibilities spelled out and a standard they are held accountable to. The mission, vision and goals should be at the forefront of the business. The cash flow projection should be reconciled monthly.

In summary, the business plan is typically gathering dust in a drawer next to a fork stashed away for lunch. More than likely the initial development process was haphazard, painstaking and a relief to finish. In reality the plan, if done correctly and implemented, provides a great vision and map for your business to succeed as well as a consistent experience for both the customer and employees. It provides a standard of operation in your business and delivers a consistent value proposition to your customers. It creates the future by laying out goals and milestones, and builds rail-road tracks to take you there. It is a cliché to say it is a “living document” but the fact is the business plan can be a multi-cylindered engine that drives you to a better business model.

REITS - Real Estate Investment Trusts

An equity REIT owns physical property – skyscrapers, malls, hospitals, hotels, shopping centers, nursing homes and the like.

It also manages them – leases space, screens tenants, collects the rent, renovates, paints, patches carpets and fixes the water heater and air conditioning – does whatever it takes to keep the properties operational.

Manages a portfolio of real estate, selling existing properties and buying new ones as it deems advantageous.

Pros: Diversification in Real Estate

Since a REIT is a collection of properties that are often located in diverse geographic regions, by buying several REITs you can cover the entire states thus, you can own a stake in a nationally diversified portfolio of commercial real estate properties with as little as $100.

Since they trade on stock exchanges, shares can be bought and sold within ten seconds any time the market is open, whereas an individual rental property might take months to unload.

Commission to sell = $10 versus a single million dollar rental at $60k.

REITs are leveraged at 50% and you can equalize with rental leverage at 80% by buying REITs on margin or in a leveraged closed-end mutual fund.

The yields on REITs can be somewhat comparable to those from owning an apartment house.

They have a transparency and accountability previously unknown in real estate.

By law, a REIT must distribute 90% of its annual taxable income as dividends to its shareholders.

Depreciation used for tax purposes is returned through dividends – usually about 25 – 30% of the dividend yield from equity REITs constitutes such a return of capital and is ultimately taxed at the lower long-term capital gains rate. This makes for a better after-tax yield on REITs.

Just to play devil‟s advocate, below is a list of advantages in traditional, real property real estate that we would potentially miss out on if we only invested in REITS.

• Leverage
• Tax Advantages Through Depreciation
• Control to Improve Value of Property
• Not correlated to the Stock Market

I wish to make a big, important point here: Although a REIT can give you national or global real estate diversification, and let you avoid tenant and property headaches with an investment that can be leveraged with a tax advantage, you are still correlated to the stock market. It is not a strong correlation to small stocks, but a correlation nonetheless. Thus, with a stock market crash during a period when real estate holds, you would still lose value in a REIT versus if you were in real estate. In my opinion, this defeats the purpose of true asset diversification – investing across asset classes such as paper, real estate and business. So again, although I wish to present a plan that allows you generate passive income through other sources besides real estate, rental property is still a part of the plan.

So, during a market crash, the question becomes, is it still delivering yield? Perhaps you are not as concerned with underlying value if the checks are still arriving in the mail. Still, even if the checks are showing up, you would not have true asset diversification.

Is This Album Better Than the Beatles Sgt. Pepper?

In 1966 the Beach Boys released Pet Sounds, considered to be an all-time classic rock album. Brian Wilson went back into the studio, completed Good Vibrations over the course of a few months and $50,000 (reportedly) and then, as the Beach Boys went back out on the road, Brian stayed home to work on the next album, Smile. As on Pet Sounds, he took a modular approach and recorded symphonic, elaborate pieces of music to be joined together. Brian also began delving heavily in drugs and signs of an undiagnosed schizoaffective disorder began to surface.

Brian previewed the tracks to the "touring" Beach Boys upon their return and Mike Love objected to the recordings stating the lyrics would not be acceptable to fans. In addition, Wilson claims he lost interest and faith in the project. He subsequently shelved it and the Beach Boys went on to record Smiley Smile which included a handful of less ambitious, scaled down versions of Brian's tracks. The Beatles meanwhile released Sgt. Pepper's Lonely Hearts Club Band, their effort to top Pet Sounds.

Thirty-seven years later, after many "leaked," bootleg compilations of the "what could have been" Smile album, with the help of Darian Sahanaja, Wilson completed the tracks for Smile, performed a number of concerts and released a CD.

The question now is ... if Smile had been released in 1967, would it have been superior to Sgt. Pepper's? I encourage you to listen to both the reconstructed Smile and the 2004 release before weighing in.

You can vote in the poll to the right and comments are greatly appreciated.

The cover to the unreleased Beach Boys Smile. Over 400,000 stored warehouse copies existed until the late 80s when they were destroyed. Reportedly, fewer than a dozen exist today.

Influence Charts

For those unfamiliar, an influence chart is "a simple diagram that shows what outcome variables the model will generate and how these outputs are calculated from the necessary inputs." - Powell, p27.

An influence chart is not meant to be a flow chart, rather they assist in bringing initial clarity to a problem model. A simple example that the text uses is a simple profit and loss chart. The motive is profit, the influence chart decomposes profit into total revenues and total costs. Total Costs are decomposed into variable costs and fixed costs.

Hexagons represent outputs, boxes represent decisions and circles represent other variables. In the chart an arrow from a variable to an output indicates a determinant.

To me this process is also similar to a mind-mapping, goal setting technique in which one identifies a specific goal in a center circle and then radiates out from the center spokes which are attached to the specific tasks or actions that must be accomplished in order to complete the goal. These actions can be composed of sub-tasks as well. This method is detailed in my first book My Happy Assetsas well as my second, Small Business Coffee Hour.

Scaling Down the Risk

Opening the Business as Part of Marketing Research

It is vital to conduct marketing research for a start-up business in order to determine, at the very least, revenue projections. Typically this research consists of surveying your target audience and asking how much will you spend and how often. You can also use focus groups in your primary research and determine, hopefully, an accurate demand forecast. In secondary research you use industry data and public company information to fill in the underlying business climate. Additionally, I recommend the following:

1. Asking a non-competitor in a similar market about his customer traffic.
2. Researching public company information and applying it to your business model and market.
3. Reverse engineering your expenses and asking, "how much do I have to make?"
4. Using consumer spend data for your market and applying it to your business.
5. Conducting a test, trial run or opening small.

The bottom line is that opening a small business is risky: 8 out of 10 fail within the first 5 years. Thus, it is always prudent to look for ways to scale down the risk. One of the ways to do this is to open small. Even thorough marketing research with target market input cannot 100% predict what will happen in reality when you open the doors. The best way to find out is by opening the doors ... on a small scale at first.

Instead of borrowing $500,000 to buy a building for a restaurant and make improvements, how about leasing a small place at first in order to determine if it will work. Or if you make handmade furniture, perhaps intially sell it through local flea markets and gather customer feedback on how to improve your product or sales process. Additonally, the web provides numerous opportunities to start small and test the market: You can easily set up an eCommerce site at low or no cost, you can list on eBay and you can use Google's keyword tool in order to determine if there is demand for certain keywords that relate to your business.

In summary, many people jump two feet first into a small business only to find they have landed in the deep end of the pool. You can mitigate this risk by conducting marketing research: Primary Research involves talking to your target market and Secondary Research involves researching your industry. In addition to these methods you can open up as the final proof in the pudding. Just open small and then when you prove the model works, scale it.