I was impressed by the way that shares of Colgate-Palmolive Company (CL) managed to hold up well throughout 2020, and this has caused me to do a deeper dive into this dividend superstar. I am curious to know if the shares are a reasonable buy at the moment or not. I’ll try to answer that question by looking first at the financial history here, and in particular addressing whether the dividend is sustainable or not. In addition, I’ll look at the stock itself as a thing distinct from the underlying company. I’ll also recommend an options trade for those investors who might be hesitant about buying anything at the moment. For those who can stand neither the suspense, nor my writing, I’ll come right to the point. I think the shares are reasonably priced, and for that reason I’ll be taking a small position at this point. In addition, I’ll be selling the puts described below because I think these represent a win-win for investors.
Financial Snapshot: Elephants Can Dance
In spite of the fact that revenue is down slightly over the past five years, net income has grown at a CAGR of about 11.3% since 2015. This has allowed the company to increase earnings per share and dividends per share at CAGRs of 12.5% and 2.6% respectively. When comparing the first quarter of 2020 to the same period a year ago, the growth theme seems to be intact, at least for now. For the first quarter of 2020, revenue was about 5.5% higher and net income was fully 27% higher than the same period in 2019. After looking at the financials here, I’d characterize Colgate Palmolive as a company that can generate higher profits on the back of relatively low revenue growth.
Not everything is sunshine and lollipops at Colgate Palmolive, though. The company has grown its debt level at a CAGR of about 3.5% over the past several years, and this is prompting me to worry about the sustainability of the dividend.
I think a reason why a significant number of investors buy this stock for the dividend, and for that reason, I need to spill some virtual ink to answer whether I think the dividend is sustainable at the moment. In order to do that, I’ll compare the size and timing of the company’s upcoming financial obligations with the resources it has available to meet those obligations. I’ll say up front that I’m a fan (or as much of a fan as someone can be) of accrual accounting for a host of reasons that I won’t bore you with, dear reader. That said, when it comes to dividend sustainability, I look at cash, specifically cash from operations, and cash on the balance sheet.
To try to make your life somewhat easier, dear reader, I’ve compiled a list of the size and timing of the company’s upcoming obligations in the table below.
Source: Latest 10-K
Against this year’s obligation of $1.14 billion, the company has about $854 million in cash per the latest 10-Q. In addition, over the past three years, the company has generated an average cash from operations of $3.08 billion. In my view, this provides sufficient buffer. If cash from operations is slashed by up to 40% this year, I think the firm would still have sufficient resources to both meet obligations and continue to pay the dividend.
Source: Company filings
In sum, I think Colgate Palmolive is a relatively recession proof business that has a sustainable dividend at the moment. I would be quite happy to buy these future cash flows if, to paraphrase the great Bob Barker, “the price is right.”
The Stock: Is The Price Right?
We’re now at the relatively more repetitive part of my article, where I try to remind investors yet again that a great business can be a terrible investment at the wrong price, and a troubled company can be a great investment at the right price. The reason for this is that if a stock is “priced for perfection”, sooner or later the company will deliver less than perfect results and the stock will be devastated. Alternatively, if the stock is priced as though the future is very gloomy, the next marginal bit of bad news won’t have much of an impact because the company in question is a “dog.” This is why I’m a dog person. The other advantage of dogs is that they have a great risk-reward profile in my estimation. As I wrote earlier, bad news has little impact, but surprisingly good news can send the stock soaring.
I judge whether a stock is priced “right” or not in a few ways, ranging from the simple to the more 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. In particular, I am looking for a low PE on a relative and absolute basis. I want to see the company trading at a cheap valuation relative to the overall market and to its own history. On that basis, I think it’s safe to suggest that Colgate-Palmolive is trading on the cheap side of its valuation range per the following:
In addition, I want to try to work out what the market is forecasting about the long term future of a given firm. In order to do this, I turn to the work presented by Professor Stephen Penman in his book “Accounting for Value.” In this book, Penman walks investors through how they might isolate the “g” (growth) variable in a standard finance formula to work out what the market must be assuming about a given company’s future. Applying this methodology in this case suggests that the market is assuming a perpetual growth rate of ~4%. I consider this to be a reasonable valuation, given the past earnings growth here.
Options as Alternative
I can certainly understand why an investor would be a bit gunshy in the middle of 2020, as this has been a relatively bad year for stocks. That said, in my experience, investors who worry about buying at a particular time, and want to wait for “prices to return to normal” will not execute their trades when shares drop in price. The reason for this is that drop in price will have been caused by some other variable that convinces such people to stay on the sidelines. Thus, I think there’ll always be very sound reasons to avoid a given stock.
I try to overcome this bias, and the boredom inherent in the interminable waiting for stocks to drop by selling put options at strike prices that represent prices that I’d be willing to buy at. I consider these trades to be “win-win” because the outcome is positive no matter what happens. If the shares remain above the strike price, the investor simply pockets the premium, which is never a bad thing. If the shares drop in price, the investor will be obliged to buy, but they’ll do so at a net price much lower than the current market price. I consider that to be a win also.
Keeping all of this in mind, my preferred trade here at the moment is to sell the January 2021 put with a strike of $60. These are currently bid-asked at $2.02-$2.35. If the investor simply takes the bid here, and is subsequently exercised, they’ll be obliged to buy the shares at a price about 19.5% below the current price. Although I’m not a technician, I would note that the shares seem to have relatively long term support at this price per the following:
It seems that the market isn’t willing to let these shares go for less than $60, so I consider that strike price to be quite safe.
Now that you’re hopefully somewhat intrigued by the idea of short puts, dear reader, because I’m about to absolutely destroy the mood. Investing, like life, involves making choices among a host of imperfect trade-offs. There is no ‘risk-free’ option, and short puts are no different in this regard. 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 risk-reward trade-off of buying shares should be self-evident in early 2020.
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. For my part, I’m too risk averse to sell puts on anything other than 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 short discussion of risks by indulging my tendency to be repetitive. What I mean is that I repeat myself often in order to make the same point. I’ll frequently say the same thing over and over in order to either drive home a point I fear isn’t being understood or to hear my own voice. This tendency has impacted my social life in predictable ways. Anyway, I’ll use the trade I’m currently recommending as an example. An investor can choose to buy the shares of Colgate-Palmolive today at a price of ~$72. Alternatively, they can generate a credit for their accounts immediately by selling put options that oblige them – under the worst possible circumstance – to buy the shares at a net price 20% below today’s level. Buying the same asset for a near ⅕ discount is the definition of lower risk in my view.
I think the shares of Colgate-Palmolive are reasonably inexpensive at the moment. The dividend is sustainable and the shares are trading on the low end of their multi year valuation range. That said, the immediate future will definitely not resemble the immediate past, given the world we’re living through at the moment. For that reason, I think selling put options might make the most sense here. By selling puts, the investor can generate premia today, and will take on the obligation to buy at the long term support level for the stock. In my view, that’s the definition of a win-win trade. I’ll be buying a few shares immediately, and will be selling many more of the put options mentioned above. I think investors would be wise to follow suit.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CL over 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: In addition to buying a few shares, I’ll be selling 10 of the puts mentioned in this article.