In my ongoing effort to find pandemic resistant stocks, I thought I’d look in on Lancaster Colony (LANC). The shares are down about 18% so far this year, and that move has me intrigued. I want to try to understand whether it makes sense to buy this dividend superstar at current prices on the basis of its relative resistance to the recession we’re witnessing. For those who are too bored by my writing to want to wade through to the end, I’ll come right to the point. This is a great business, but the stock is too expensive in my estimation. Thankfully, the options market presents a viable alternative to simply buying the shares, and you’ll have to read through to the end to get the specifics of the trade. I think the market is too optimistic about the prospects for the company, especially in light of its exposure to the restaurant sector. I’ll go through my reasons for avoiding the shares at current levels and the options trade that I recommend instead below.
The financial history here is impressive in many ways in my estimation. First, and most significantly, the company has no debt to speak of. This is enormously important in my estimation, as it represents significantly reduced risk. Also, this is, for all intents and purposes, a growth company. Specifically, over the past five years, revenue and net income are up at CAGRs of 3.45%, and 8.2% respectively. The fact that net income has grown at a faster pace suggests to me that the company has gotten more efficient over time. Also, management has been very shareholder friendly in that they’ve returned just over $482 million to shareholders over the past 5 ½ years. I also like the fact that the vast majority of this return of capital (97.6%) came in the form of dividends. The result of buybacks and dividends has resulted in dividends per share growing at a CAGR of ~7% over the past five years.
The themes described above seem to be intact when we look more granularly at the comparison between the first six months of the most recent period relative to the same period a year ago. Sales grew by just under 4%, and gross profit was up fully 11.24% against the prior period. Net income fell as a result of a change in the value of the contingent consideration. This was a $9.6 million benefit during the first six months of the prior year and switched to a $127 thousand liability in the first six months of the most recent period.
Source: Company filings
In spite of the fact that this company may not be the sweet spot investment in these unique times, it is a very well run, shareholder friendly enterprise. I’d be happy to own these shares at the right price.
The final sentence of the previous section is what we in the writing business call a “segue.” In this section, I’m going to write about what constitutes the “right” price. In my opinion, “right” in this context refers to shares that are priced pessimistically. There are two related benefits to finding shares that are pessimistically priced. On the one hand, these are by definition less risky than high flyer stocks. There’s only so cheap that the stock of a profitable business can get, and it will not trade below that level. Stocks that are priced cheaply don’t have far to fall, and thus are less risky. On the other hand, pessimistically priced shares are potentially more profitable in my view. The reason for this is that all of the bad news is already priced in, but good news isn’t. So, when a particular “dog” has its day, the shares should rise in price. I judge whether shares are pessimistically priced or not in a number of ways, ranging from the more simple to the more complex.
On the simple side, I look at a ratio of price to some measure of economic value, like earnings, free cash flow and the like. The less the investor needs to spend to buy $1 of future earnings, for instance, the better in my view. As I suggested above, I think such shares are less risky, and have the potential for greater profit potential over time. In particular, when I look at PE, I want to find a company that’s trading at a discount to both the overall market and to its own history. At the moment, Lancaster is trading at a PE of about 24, which is obviously more expensive than the overall market.
In addition to looking at a simple ratio, I want to understand the market’s current assumptions about a given company embedded in price. I do this by using the methodology employed by Professor Stephen Penman in his excellent book “Accounting for Value.” In this book, Penman walks an investor through how they can use a standard finance formula, and the magic of high school algebra, to work out what the market must currently be thinking about the long term. Applying this methodology to Lancaster suggests that the market thinks this business will grow perpetually at 10%. Although this is an excellent business in my estimation, this is an enormously optimistic forecast in my view. For that reason, I can’t recommend buying the shares at current levels.
Options As Alternative
The fact that I think these shares are too expensive but the underlying business is quite sound presents me with a choice. I can either wait for the shares to drop in price, or I can sell someone the right to sell me this great company at a price that I’d be happy to pay. I think the shares are worth about 18 times earnings.
My preferred options at this point are the September puts with a strike of $105. These are currently bid-asked at $4.90-$6.30. If the investor simply takes the bid on these puts, and is subsequently exercised, they will be buying at a price about 21% below the current level. Holding all else constant, that would represent a PE of about 18 and a dividend yield of about 2.8%. I’d be comfortable owning the shares at that price. In addition, if the shares remain above $105, the investor simply pockets the premium, and that’s never a hardship. Note that the shares haven’t traded at that valuation since late 2014. Given the current mood of the market, there’s a chance that these puts will be exercised, but it’s not exceptionally high in my estimation.
I feel duty bound to point out that this investment strategy, like every investment strategy, comes with risks. I think the risks of put options are very similar to the risks associated with a long stock position. If the shares drop in price, the stockholder loses money, and the short put writer will be obliged to buy the stock. For that reason, both long stock and short put investors are “on the same side of the table” and want to see higher stock prices. Also, some (though certainly not all) short put writers don’t want to actually buy the stock. Their interest is simply to collect premia. Given that these investors don’t actually want to own the stock, being exercised would be troublesome for them. For my part, I’m happy owning stocks, but at a price that I deem acceptable.
In my view, put writers take on risk, but they take on less risk (sometimes significantly less risk) than stock buyers in the following way. Short put writers generate income simply for taking on the obligation to buy a business that they like at a price that they find attractive. This is an objectively better circumstance than the person who takes the prevailing market price for the shares. This is why I consider the risks of selling puts on a given day to be far lower than the risks associated with simply buying the stock on that day. Selling puts is analogous to receiving money for taking on the obligation to buy the stuff you were going to buy anyway, at a lower price than is currently on offer. There’s risk there, but it’s far less than simply buying in my estimation. To continue to violently beat the proverbial dead horse, the risk of being obliged to buy these shares at a net price of ~$100 is by definition less risky than simply buying the shares at their current price of ~$128. This is why I call this a “win-win” trade. One potential involves free premia. The other potential involves owning these shares at valuations not seen for 5 ½ years.
I think this is a fine company, and I particularly like the fact that they are debt free. I think this will be of critical importance for this business over the next year or so. In addition, the company is consistently profitable, and I think management treats shareholders very well. That said, investors access the future cash flows of a company through the stock, and stocks are risky when the market is too sanguine about the company’s prospects. For that reason, I can’t recommend buying the shares at these levels. In my estimation, a much more profitable, less risky alternative involves selling the puts described in this article. If the shares remain optimistically priced, the investor simply pockets the premium. If the shares fall, the investor may be obliged to buy at much more favourable levels in my estimation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I will be selling 5 of the puts mentioned in this article.