Since I wrote my bullish piece on Sonoco Products Inc. (SON), the shares are up about 13.5%, against a gain of 30% for the S&P 500. Since then, much has happened that deserves commentary, so that’s what I’ll endeavour to do for you, dear readers. In addition to changes at the company, the options that I recommended in my previous article have expired worthless and that requires commentary too. Specifically, I want to try to determine whether or not I should hold my shares, sell them, sell more put options or some combination of these.
I’ll leap right to the point, as I’m not cruel enough to subject you to an entire article. I still like the business a great deal, and I expect 2021 will be much better for it. The company is also shareholder-friendly, quite obviously. The problem is the valuation. The more an investor pays for any stream of future cash flows, the lower will be their return. That said, my short puts on this name were a success before, and I think they can be again. I offer a specific trade below.
In case you forgot, in my previous discussion of this business, I made much of the fact that revenue and net income have grown nicely over the years, and that net income growth has outstripped revenue growth, suggesting an improvement in efficiency. I also noted that management has treated shareholders fairly well by returning ever greater sums to them in the form of dividends. For my part, I prefer it when management returns wealth to shareholders in the form of dividends, because unlike buybacks, the return can’t be wiped out by a capricious market.
Turning to the most recent period, we see that this company, like most, has suffered in 2020 relative to the same period a year ago. I was actually impressed that performance in the consumer package segment was not as bad as I was modeling. Specifically, if we strip out industrial plastics, consumer package actually grew ~1% in the third quarter of this year relative to the last. Revenue is off by about 6%, while net income is down over twice that as a result of increased restructuring charges. On the bright side, Sonoco Products managed to reduce cost of sales along with a decline in revenue. This suggests to me that there is some dynamism built into the system, which is a positive, in my view. In the face of this slowdown, Sonoco increased dividend payments by just over 2.5%, which is a positive, in my view, as it shows that management remains shareholder-focused. Finally, in spite of the timing of the debt repayments, I’m not worried about the capital structure here because the company has a cash hoard that represents 38% of long-term debt.
In sum, I’d say I’m still comfortable with the financial performance here and would recommend that investors buy this stock at the right price.
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(Source: Company filings)
The problem with the combination of decreased earnings and a run-up in stock price is that the shares are going to be more expensive. So, I was willing to buy the shares when they were unreasonably cheap in the past, but we all know that the more an investor pays for any business – even a great, shareholder-friendly one – the lower will be their subsequent returns. So, the shares will not be as cheap as they were in the past. The question is, by how much.
I measure cheapness in a few different ways, ranging from the simple to the complex. On the simple side, I look at the ratio of price to some measure of economic value, like earnings, free cash flow and the like. To remind readers, I like cheap because they represent a combination of lower risk and higher return potential. They are lower-risk because much of the bad news is already “priced in”, so the market is less likely to be shocked by a disappointing report. I think they offer higher return potential because of what I call the “prodigal son” effect. If a so-called “dog” offers a positive surprise, the returns can be quite good.
On this basis, I’ll note that the stock is about 35% more expensive when I last looked in on the name, per the following:
In addition to looking at the ratio of price to some measure of economic value, I want to try to understand what the market is currently assuming about a given company’s future. In order to do this, I turn to the methodology described by Professor Stephen Penman in his book “Accounting for Value.” In this book, Penman walks investors through how they can use a fairly standard finance formula and the magic of high school algebra to work out what the market must be thinking about a given company’s future. We do this by isolating the “g” (growth) variable. Holding all else constant, this model suggests that the market is currently assuming a long-term (i.e., perpetual) growth rate of ~5.7%. I consider this to be a fairly optimistic forecast. Given the valuation, I must continue to recommend avoiding the name.
Options As Alternative
In my previous article on this name, I recommended selling the October 2020 puts with a strike of $35. These were bid at $2 and they have recently expired worthless, which was a great enhancement to my returns on the stock itself. While I can’t recommend buying the stock at this point, I like short puts. They offer a way to either earn some return and/or (potentially) buy this stock at a much more advantageous price. In particular, I recommend selling the April 2021 put with a strike of $40. These are currently bid-asked at $.95-$1.30. If the investor simply takes the bid on these, and is subsequently exercised, they’ll buy this stock at a P/E of ~15. Note that I was quite bullish, and the returns were quite good, when the stock was trading at a P/E of 14.75. Obviously, if the shares remain above $40 over the next six months, the investor will simply pocket the premia and move on. That’s also a fairly decent position to be in, and thus, I call short put trades like this “win-win.”
It’s at this point in the article when I get to indulge a little bit of my sadistic streak by spoiling the mood after getting you excited about a win-win trade, dear reader. Although I’m not cruel enough to subject you to an entire article, I’m not necessarily “nice.” The nature of the world is such that we must choose between a host of imperfect trade-offs, as there’s no “risk-free” option. Short puts are no different in this way. We do our best to navigate the world by exchanging one pair of risk-reward trade-offs for another. For example, holding cash presents the risk of erosion of purchasing power via inflation and the reward of preserving capital at times of extreme volatility. The risks of share ownership should be obvious to readers on this forum.
I think the risks of put options are very similar to those associated with a long stock position. If the shares drop in price, the stockholder loses money, and the short put writer may be obliged to buy the stock. Thus, both long stock and short put investors typically want to see higher stock prices.
Puts are distinct from stocks in that some put writers don’t want to actually buy the stock – they simply want to collect premia. Such investors care more about maximizing their income and will, therefore, be less discriminating about which stock they sell puts on. These people don’t want to own the underlying security. I like my sleep far too much to play short puts in this way. I’m only willing to sell puts on companies I’m willing to buy at prices I’m willing to pay. For that reason, being exercised isn’t the hardship for me that it might be for many other put writers. My advice is that if you are considering this strategy yourself, you would be wise to only ever write puts on companies you’d be happy to own.
In my view, put writers take on risk, but they take on less risk (sometimes significantly less risk) than stock buyers in a critical 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 circumstance is objectively better than simply taking the prevailing market price. 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.
I’ll conclude this rather long discussion of risks by indulging my tendency toward tedious repetition, and I’ll use the trade I’m currently recommending as an example. An investor can choose to buy Sonoco Products today at a price of ~$52.00. Alternatively, they can generate a credit for their accounts immediately by selling put options that oblige them, under the worst possible circumstance, to buy at a net price about 25% below the current price. Buying the same asset at a 25% discount is the definition of lower risk, in my estimation.
I like this company a great deal. It’s obviously a dividend superstar, and management shows no signs of ending that streak. Sonoco Products is hardly unique, having a relatively soft 2020 so far, and I think performance will improve as the world comes out of the COVID-19 induced recession. The problem here is, as is frequently the case, the stock. There is a strong link between acquisition valuation and future returns, and Sonoco stock is no longer attractive, in my view. The market anticipates the good news coming in future and has already priced that in. Thus, I must recommend avoiding the shares at these levels.
That said, I think put options offer investors the opportunity to either make some return and/or to buy a great business like this at a reasonable price. Short puts worked out very well for me in the recent past, and I suspect they will again. For those not interested in options, there’s nothing else to do but wait, I’m afraid.
Disclosure: I am/we are long SON. 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’m currently long, but I’ll be selling this week. I’ll also be selling 10 of the puts described in this article.