We routinely reevaluate stocks on our watchlist as metrics change constantly. Whether it is volatility, fundamentals, technical analysis, or valuation, potential long set-ups change invariably especially after the volatility we have seen recently in US equity markets. The VIX spiked to almost 27 last week as equity markets in the US took us for wild swings in both directions.
When we get a spike in volatility, traders often move to "premium selling" strategies as one can get much further away from where the stock is trading with neutral strategies such as iron condors and strangles. As we are also fundamental and technical traders, we like to use the increased volatility to express a directional stance. For example, implied volatility spiked to over 36% in Sanderson Farms (SAFM) last week. This number is definitely above the average of its range. Now, where price may not be mean reverting, volatility surely is, which brings potential opportunity. The problem, however, is that we would not be interested in putting a delta neutral type trade on SAFM at present for a number of reasons. What we would prefer would be to take advantage of the spike in volatility but by remaining directional from our fundamental and technical research. Let's dig in.
Technical Analysis
If we look at the chart above, we can see that SAFM has been basically trading in a range for the best part of 4+ months now. It is still impossible to tell what pattern is playing out. From a bullish perspective, we could have a triple bottom or an inverse head and shoulders pattern. From a bearish perspective, we could have a normal head and shoulders in play if price cannot make it above its October highs.
We are favoring a reversal triple bottom pattern. We have some support underneath price and we believe the higher high in August is significant. In saying this, sideways pattern can last up to 6 months, so we may have a fair bit of toing and froing before we get a clear signal where SAFM shares are headed.
Fundamental Analysis
Bears will state that Sanderson Farms has no real competitive advantage as its products cannot be easily differentiated from the competition. There is some truth in this as pricing power can easily be adversely affected by something like a bird flu outbreak, a hurricane, or a steep rise in feed costs. Irrespective of how Sanderson Farms is run internally, profits are always going to be at the mercy of external factors - factors that management has no control over.
However, we are confident that the company can come through each down-cycle unscathed. Another factor, for example, which is skewing the numbers at present is the popularity of pork and beef which seems to be taking market share away from chicken. These three protein providers never have seemed to compete in past times, but CEO Joe Sanderson admitted that tariff issues have distorted the market somewhat in that both beef and pork have been promoted more aggressively recently due to their increased availability.
We noted in a previous article that Sanderson's earnings multiple of around 12.5 at present is well below the company's long-term historic valuation of just under 20. Could we see a cheaper valuation going forward? Of course, but the risk/reward play you feel has to be to the upside here. Management admitted recently that it intends to fully invest through the cycle and not let short-term headwinds affect its long-term view.
Trade Analysis
The regular November $90 puts are selling for about $1.50 per contract. If one was assigned, for example, on this sold put option, the new cost basis would be $88.50 per share. This cost basis would give an earnings multiple of under 11.4 which is heavily discounted compared to historic averages.
Source: Interactive Brokers
Furthermore, depending on volatility, one could take possession of shares or continue to roll the put option out in time (buy back the sold put and sell another in the following month) in order to gain duration and extra credit. We are advocates for reducing our cost basis as much as possible on any position over the long run. This can be done through covered calls, rolling naked puts, or simply by reinvesting dividends, etc. Reducing cost-basis over the long run in underlyings that are trading well below their intrinsic value usually bears fruit as long as the trader is patient.
Conclusion
Being a contrarian is not for everyone. Lower poultry prices could persist for a sustained period of time yet. However, we like that Sanderson intends to invest right through the cycle. We may take advantage of the high implied volatility number this week through an options trade which expresses a bullish view.
