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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Big fan of HSY and hope to add more shares to my portfolio. Disappointed I missed the dip down into the $83's in mid November. Hopefully some market turmoil will push it back down to those levels. I like the route you're going with making a small purchase of shares with the option premium and selling the puts. I hope to build up a decent sized cash position so I can start using options more again. Even though I don't have a problem with selling naked puts I don't like being too exposed to an early execution and me being without capital.
ReplyDeleteDo you target any specific return amount when selling puts or just aim for what gives you your desired entry price? I typically look for opportunities to generate 10% annualized returns if the option expires without execution but sometimes the pricing doesn't quite work out as I'd like.
Thanks for the update!
I don't target annualized returns. Sure, I could sell a put that expires in 1 month and get 85 cents in return for an annualized 12%/year. However, the issue is that this "annualization" assumes I will be able to sell one put every month at 1% profit, which of course is not realistic.
DeleteI have found it easier to target specific entry prices for companies when I sell options. Selling options gets me there sometimes.
I have been bad with Interactive Brokers because margin rates are ridiculously low, which provides an incentive to lever up ( though for whatever reason I have been levering down this year).
I hear you on the annualized returns. When I was selling puts more often I would typically sell ones that were 3-6 months out so the annualized returns aren't skewed as much by such a short time period. I still give preference to my target entry price over the premium return; however, I also want to make sure that capital earns a decent return over the time period. Otherwise it might be better to just straight up purchase shares at higher prices in order to get the dividends or look for other investment opportunities while you wait for the price to come down.
DeleteOff topic - what is your opinion about the collapse in KMI? Perhaps you've done a recent stock analysis? Thanks.
ReplyDeleteI am holding tight. I should probably post something in the next few days
DeleteI look forward to your take on KMI. It is (was?) one of my largest holdings. I'm torn between adding a bit here or selling a bit to mitigate further losses. It appears they intend to raise the dividend next year so hopefully, the dividend is safe.
DeleteThanks,
SAK
I also hold KMI and find the price collapse after making such a great acquisition puzzling. Would be interested in your thoughts.
DeleteAlso: options! Now you are talking. :-)
Hi, I love your blog and a loyal subscriber. I am new to this but am very curious why you seem not very interested in utility stocks, such as ED and DUK? anything I might be missing here?
ReplyDeleteThanks.
You may like this article:
Deletehttp://www.dividendgrowthinvestor.com/2013/07/high-dividend-utility-stocks-are-they.html
I know you don't use PE as an over riding factor for purchases, but isn't it a bit rich for purchase right now?
ReplyDeletePlease read the article again
DeleteSweet! I purchased HSY a little bit early, but am not concerned because it is as close to a forever hold as I can imagine. I would purchase more shares if the price dropped enough to have a significant impact on our cost per share, but that would be in the $80 per share range.
ReplyDeleteSweet dividends coming your way every 90 days ;-)
DeleteGreat buy DGI! Just looking at the P/E Hershey might seem expensive. But it actually is a good value when you compare HSY to its historic P/E and dividend yield.
ReplyDeleteI would love to add more in the low 80s. Even the current price will seem very attractive a few years down the road.
Thanks for the article.
Please read the article again, particularly on the valuation part
DeleteAnd I just added shares of CMI Cummins, and bought GPS The Gap. CMI is most certainly a longer term play but even if I only brake even for 18-24 months, I feel from the M* report that it will turn around as demand picks up. As for GPS, after reading an article on M* with a FV of $45 I got in at $26.50 with a yield of 3.41%, a P/E of 10.0, a high P/B of 4.0 though in that industry the average is better than 5.0, a P/O ratio of 34% and an attractive ROE of 40%. They are rated 5* and a BBB- corporate credit rating and an B in growth and an A in profitability. Retails is not a sector I wanted to be in but I'll take this one and ride it as long as possible. Could I have made a mistake? Quite possibly, as retail customers are fickle. I'll also be looking at IBM and Disney over the next few weeks.
ReplyDeleteDoubled my CMI position myself today at 93.50. Unfortunately first buy in was 109 just a few weeks ago. Considering IBM at 125 but it rebound strong off recent lows so I'll wait and hopefully catch the falling knife at a later date :)
DeleteCurious as to why you place the emphasis on Forward P/E which is fairly valued vs. P/E ttm (~37), which seems highly overvalued. I've noticed other dividend bloggers do the same thing and I don't understand why. I have re-read the article by the way and still do not understand. Thanks
ReplyDeleteYou may enjoy this article here: http://www.dividendgrowthinvestor.com/2015/06/how-to-value-dividend-stocks.html
Delete