Wednesday, December 2, 2015

Recent Purchase

Last week I purchased shares of Hershey (HSY). The Hershey Company (HSY), together with its subsidiaries, engages in manufacturing, marketing, selling, and distributing various chocolate and confectionery products, pantry items, and gum and mint refreshment products worldwide.

Compared to the situation from earlier in 2015 when I warned of high prices on Hershey, I believe that the shares are attractively valued around $85 - $86/share. This translates to a little under 20 times expected earnings of $4.42/share for 2016 for the company. The stock yields 2.70%, which is a very good starter yield for the chocolate maker. The company has managed to boost dividends for five years in a row. In 2009, Hershey (HSY) froze dividends, thus ending a 30 year streak of dividend increases. I find Hershey to be a company of high quality, which has a unique product, loyal customer base, low chances of product obsolescence and some pricing power due to branded nature of its products. In other words, this is the type of company that I don't believe will change much to the worse in the next 20 years. This is also a company I think I understand. Check my analysis of Hershey on Seeking Alpha for more information about the company.

A few weeks before that, I also sold some puts on Hershey with a strike price of 85 that expire in May 2016. There are three possible outcomes that could occur by May 2016.

1) Those puts will provide me with the obligation to purchase shares of Hershey in May 2016, if it sells below the price of $85/share. However, because I have received an option premium, my effective cost basis will be below $82/share. The upside is that I will get a better price than buying outright today when I sell puts. However, the downside is that the “low price below $82/share” might seem high if Hershey stock is selling at say $70 - $75/share.

2) Those puts will expire worthless if the share price is above $85/share by May 2016. This means that I would not get to participate in any of the upside for Hershey stock and I also won’t be able to receive any dividends either since I have a derivative position. For example, if Hershey sells at $100/share in May 2016, I would have missed out on $15 in share price gains in addition to two dividend payments in the amount of $1.16/share. In order to mitigate this risk however, I used the option premiums I received to acquire shares of Hershey's today.

3) I could decide to cover this position by buying back those puts at some point between December 2015 and May 2016. For example, let’s assume that those options are selling at a low price of say 50 cents/contract (down from $3.50 - $4.00/contract) because Hershey stock is selling above $85/share. I may decide to close the position because having a potential liability of $8,500 may not be worth it for a mere $50 in potential gain. On the other hand, I may decide to close those options because I may change my mind about Hershey or because I may decide that it is not worth it to allocate so much capital all at once.

So why did I sell this put, rather than buy the shares outright?

1) While I believe that the stock is attractive at $86/share, I would find it even more attractive at $81-$82/share. Using expected earnings of $4.10 for 2015, a P/E of 20 translates into a share price of $82/share. While I do not mind buying a few shares around $85 - $86/share, I would prefer that my position have a lower cost basis per share. This lower price translates into higher current yield and higher potential for returns.

2) I may not have $8,500 lying around to purchase 100 shares of Hershey. However, I can reasonably expect that I can save that much by May 2016.

3) I like to put myself in a win-win-win position where I increase my odds of success by lowering my entry price as much as possible, and getting paid with a premium no matter what happens.

What is your opinion on Hershey?

Thank you for reading

Full Disclosure: Long HSY and short HSY puts

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