Continue To Avoid Lancaster Colony

Summary

• While the shares are cheaper than last time I checked them out, "cheaper" is not the same as "cheap."
• I do a back of the envelope comparison between cash received from dividends and a 10-year Treasury. It doesn't look good for shareholders.
• While I normally like to sell deep out of the money puts, the premia on offer for reasonable strike prices are too thin, so the exercise is pointless.

da-kuk/E+ via Getty Images

It’s been a little over two months since I put out my cautious piece on Lancaster Colony Corporation (NASDAQ:LANC), and in that time, the shares have returned a loss of ~10.4% against a loss of just under 5% for the S&P 500. An investment in a stock priced at $150 is, by definition, less risky than one in which that same stock is priced at $168, so I thought I’d check back on this name to see if it makes sense to buy now. I want to compare the current stock to the previous stock. In addition, I want to compare this stock’s dividends to the cash flows an investor knows they will collect from a 10-year Treasury Note. After all, if we believed the “TINA” (there is no alternative) narrative that stocks were compelling because treasuries were yielding very little, the opposite may be true now that treasuries are yielding close to 3%. I think it would be wise for us to grapple with this idea at the moment. Finally, while I’ve written puts on this name in the past successfully, I didn’t do so last time as the premia on offer weren’t sufficiently high to justify the risk. Now that shares are 10% cheaper, it might be worth doing so now.

I understand that you’re a busy crowd, dear readers. You’ve got rockets to design, supermodels to date, and ancient ruins to explore. I’m the same. I’ve got hours of baby elephant videos that aren’t going to just watch themselves. Given that you’re a busy crowd, I’ll give you the highlights of my thinking here, so you won’t have to wade through the entire article. I’m of the view that in the realm of investing, everything’s relative. When we buy “X”, we are eschewing countless “Y”s. For this reason, we need to always be open to changing our minds about the relative merits of what we happen to own. At the moment, I think these shares are far less compelling than 10-year Treasury Notes, and for that reason I recommend people continue to avoid this stock. While the shares are cheaper, “cheaper” is not the same thing as “cheap.” Finally, I would normally sell deep out of the money put options at this point, but the premia on offer for a reasonable (i.e. $120) strike price is too low in my estimation. I would recommend continuing to avoid these shares until the price falls to more closely line up with value.

Everything’s Relative

In the domain of investing, everything is relative. If we buy "X", by definition we're eschewing countless "Y"s. This dynamic applies, whether you're talking about different stocks or different asset classes. If you buy stocks, for instance, you're not buying crypto. I think it's helpful to sometimes review the relative merits of our favourite asset classes and to check our assumptions to see if they are still valid.

For instance, for years I've heard the argument that investors must buy stocks because the returns from government bonds are paltry. When the 10-year Treasury note was yielding 1.1% only one year ago, why would you lock in for such a pittance? Now that the 10-year note is yielding alarmingly close to 3%, it’s time to revisit this narrative.

In the following analysis, I'm going to compare the cash flows from the dividend to the cash flows from the treasury note. While this analysis won't answer whether it's preferable to buy this stock or a 10-year note, I think it'll go some way toward defining for us what growth we need from the stock to be indifferent between owning that stock or treasury.

In the following spreadsheet, I'm going to compare the cash flows an investor would receive from a $20,000 treasury note investment relative to the stock. I'm going to compare the treasury to two future states: one in which the dividend remains constant, and one in which the dividend grows at the same rate as it did between 2015-2020.

Here's what I found:

1. If the dividend continues to grow over the next decade at the same 7.5% rate it grew between 2015 and 2020, the investor will receive slightly less from dividend cash flows relative to the income received from the treasury note.

2. If the dividend does not grow, the treasury investor will finish the decade with an extra $1,740 on their $20,000 investment, which is about 8.7% of the original investment.

So, if the dividend does not grow over the next decade, the stock investor will need to see shares rise just under 9% from current levels for the capital gains to make up for the relatively lower income. If the dividend manages to grow at the same immense rate over the next decade as it did between 2015 and 2020, the cash flows will be about equal. I'm not afraid to tell you that I doubt the dividend can continue to grow at this rate for another 10 years, so investors are betting on some further capital gains. I hope the stock is cheap enough to justify this assumption.

There are obviously many other variables at play when we review the relative merits of bonds and stocks. For instance, investors sometimes forget for some reason that bonds, too, can make capital gains. For instance, if the yield on the 10-year note drops to its lows of the past year, the treasury bond will appreciate by about 29% from current levels. So, bonds rise in price, too. Additionally, I think there's the "sleep at night" value you get from knowing that in 10 years, your bond investment will be repaid exactly 100 cents on the dollar. Before you scream it at the screen, I know. Bonds are subject to the corrosive effects of inflation. Surprisingly enough, so are dividends. So are future proceeds from stock sales.

A comparison of forecasted dividend payments and 10 year Treasury Note cash flows (Author calculation from public sources)

The Stock

Now that the stock’s trading around $150, it’s time to revisit the valuation. This is especially important in light of the fact that stock investors should be expecting some capital gains from the shares over the next decade if they prefer this stock to a Treasury Note. I want to look at the stock as a thing distinct from the underlying business because, as I point out with tedious regularity, a stock is quite distinct from the underlying company. A company takes a number of inputs, adds value to them, and tries to sell the various products and services it added value to at a profit. At their core, that’s what all companies are. Stocks, on the other hand, are proxies of the business that reflect much more about the crowd’s ever changing moods about a given company’s long term prospects. Given the fact that the stock changes much more rapidly than the company, we can infer that the crowd’s pretty capricious.

The company released its latest results on February 3rd. If you bought the shares that day, you’d be down about 2.3%. If you waited until the end of March, to pick a date completely at random, you’re up about 1.3%. In my view, not enough changed at the firm to warrant a near 4% variance in returns. The difference in returns, and whether this stock was a “good” or “bad” investment came down entirely to the price paid. The person who bought the shares relatively more cheaply did better. This is why I’m obsessed with not overpaying.

My regular readers know that I measure the cheapness of a stock 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. These simple ratios are a handy starting place in my view. In my previous missive, I turned my nose up on the stock because it was trading at a PE multiple of ~36.9. As you’d expect, the shares are now trading at a multiple about 11% lower per the following:

Data by YCharts

Source: YCharts

While the shares remain objectively expensive in my view, I'll admit that the yield investors receive is on the high side relative to this company's history.

Data by YCharts

Source: YCharts

While I'll admit that the shares are certainly cheaper than when I last reviewed this name, "cheaper" is not the same thing as "cheap."

In addition to simple ratios, I want to try to understand what the market is currently "assuming" about the future of this company. In order to do this, I turn to the work of Professor Stephen Penman and his book "Accounting for Value." In this book, Penman walks investors through how they can apply the magic of high school algebra to a standard finance formula in order to work out what the market is "thinking" about a given company's future growth. This involves isolating the "g" (growth) variable in a fairly standard finance formula. Applying this approach to Lancaster at the moment suggests the market is assuming that this company will grow at a rate of about 7% over the long term. While this isn’t as optimistic as the previous forecast, it is still a massively optimistic forecast in my view. Taking all of the above into account, I still recommend avoiding the shares.

To my mind, this highlights the fact that treasuries are even more relatively attractive here. If the shares were cheaply priced at the moment, we might reasonably assume that they could deliver decent capital gains in the future. Given that they’re expensive, and poised to head lower, their relative underperformance will worsen in my view.

Options As An Alternative?

In case you don’t happen to have your “Almanac of Doyle’s Trades” handy, I’ll remind you that way back in April of 2020, I recommended investors sell the September Lancaster Colony puts with a strike of $105 for $4.90, because I considered that premium very generous for that strike price. This highlights the power of short put options in my view. This was a great risk-reward trade in my estimation. Although my short put trade didn’t generate the same returns as investors in the stock on the way up, I’ve certainly managed to avoid the losses shareholders have suffered here. I’d remind investors who seem to care only about “price go up” that we’re not looking for “returns.” We’re looking for “risk adjusted returns.” Short put options have the potential to generate fantastic risk adjusted returns, and this trade was an example of their power in this regard.

While I normally like to repeat success, I can’t in this case, because the premia on offer for reasonable strike prices is way too thin in my estimation. I’d be very willing to buy this stock at $120 because that price lines up with a more “typical” PE for the stock. The problem is that the September 2022 put with a strike of $120 is bid at $0, and the December puts at that strike are bid at $0.50, which I consider to be too thin to make the exercise worthwhile.

This offers yet another lesson in my view. We should only ever sell puts on companies we want to buy at prices we’re willing to pay. Selling puts at unreasonably high strike prices will eventually lead to disaster. Trust me on this lesson. It’s been painfully learned.

Conclusion

I’m of the view that when it comes to investing, everything’s relative. I’m also of the view that Lancaster Colony stock is now relatively less attractive than 10-year Treasury Notes, which is one of the reasons I think the shares will remain under pressure going forward. In spite of the relatively thin cash flows associated with this stock (as compared to Treasuries), the shares remain richly priced relative to their history. This won’t end well in my view, and I would recommend investors continue to avoid the name.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within 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.

Comments

[Gladiator321]

Hey Doyle, it´s starting to look interesting to me here below 120 although dividend payout ratio is quite high.

[Patrick Doyle]

@Gladiator321 I was starting to think the same thing...

[Announcer]

@Gladiator321 When thinking about the payout ratio, consider that LANC took a restructuring charge in Q3 2022. Also, other than a relatively small amount of capital leases, they have no debt, a large cash balance and very healthy balance sheet.

Their last 4 quarters have seen YOY revenue increases in revenue exceeding 10%. Part of this is likely inflation, part is likely unit volume increases from their several growth initiatives.

LANC is a very well run company with a decades long track record of conservative financial structure and moderate but steady growth in revenue, earnings and dividend. If that is what you are looking for, why wait? Better to buy a good company at a fair price than a fair company at a good price. Someone with a better investment track record than you or I famously said those words.

LANC is not high yield nor is it rapid growth. If looking for either of those, you should look elsewhere.

[Announcer]

One of the flaws in the CPI is who it calculates the housing components of inflation. 22% of the CPI is their measure of the cost of owned housing, which they estimate using a process called "Imputed rent". As such a bid part of the CPI, it should be important to get it spot on, right? It is anything but, and it tends to lag the housing market significantly. This interesting but obscure element figures large in the CPI calculation.

Bonds also perform badly during the ramp up of inflation. Inflation is incredibly harmful, but it hurts those who hold fixed dollar savings the most. Interest rates tend to lag inflation, so after tax real returns are negative during this part of the cycle.

Investors can do very well if they buy longer term bonds at the peak of an interest cycle, which tends to lag the peak of inflation. A long term bull market in bonds that started around 1980 just ended.

My sign that the money supply has been increasing rapidly is that the money supply has been increasing rapidly. The Fed said they would do it, and they did it. There is no mystery here. They called it "Quantitative Easing". They purchased bonds, both government and corporate, with newly created money, flooding the market with tremendous amounts off liquidity. My reference to the growth in the money supply since 2020 was from the Federal Reserve. They should have a good idea of the numbers.

Inflation (not sporadic price increases) is everywhere and always a monetary phenomenon.

The 20 year comparison was not from some "stock advisor who gets paid commission". I do not use one of those, never have. It might have been from Roger Ibbotson data, he has done a lot of historical analysis of returns from various asset classes. In any case, it is not hard to find historic comparisons of stock and bond returns. Per Ibbotson as posted at Morningstar, the value of $1 invested and continuously compounded from 1926 to 2015 was:

T Bills - $26
Government Bonds - $132
Large Stocks - $5,390
Small Co Stocks - $26,433

Some people equate volatility with risk, but there are other forms of risk - default/bankruptcy and inflation are also risks. The latter two are wealth destroyers. To me, volatility is a welcome phenomenon. Market fluctuations cause many investors to avoid stocks and select fixed income under the mistaken belief that those are "risk free". The aversion to volatility drives higher expected long term returns in stocks, so I am thankful for volatility. My time horizon is many decades, not next week or next month or even next year. I invest to increase my real after tax wealth over decades. Started in the 1970s, it has worked well so far.

I hope buying T-BiIls works out for you. I actually purchased I-Series bonds just a couple of weeks ago. These will provide a pre-tax return equal to inflation. They seemed like the least bad fixed income alternative out there right now, and I had some cash that needed to be parked and available in case of emergency.

[Patrick Doyle]

@Announcer Hi thanks for all this.
I don't know why in a world apparently dictated by free market principles we pay so much attention to aparatchiks like The Fed. This is especially mysterious to me in light of the fact that they seem to do more jaw boning than anything real. If I were you, I would recommend not listening to what they say, because their explicit role is to try to move people up the risk curve, and watch what they do.
Start asking yourself questions like:
How exactly is 97% of money created? This is from Richard Werner. He published an article at Oxford University on the subject. He's credible.

www.youtube.com/...

How does the compound math of the "inflation's massively understated" crowd actually work? I mean, if inflation's really growing at 5% how does that work? At 5% inflation, the basket that cost me $10,000 in 2012 now costs me $16,300? At 6% that same 10k basket costs me $17,900? At 7% it's nearly double at $19,670? I mean...whenever I hear this argument (usually from gold bugs who seem to be perpetually waiting for Godot) It just drives me crazy. This argument of "inflation's running hot for years now and 'the man' is keeping a lid on it"...Just...Do the (expletive deleted) math!

I'm not buying T-Bills. I'm buying treasury notes and longer duration, because the economy's weak, there are weird, uninformed prejudices against bonds perpetrated by the people who don't make margin on them, and I'm aware of the fact that the stuff you read/see on CNBS and from the Fed. is not trustworthy.

Finally, I hope people took my earlier advice and got out of this dumpster fire before it dropped another 7%.

Thanks for the comment and take care.
PD

[Announcer]

I love to read an in depth analysis of a companies future prospects, coupled with a diversity of valuations compared to the present price.

I am quite interested in the revenue performance of the various restaurant branded salad dressings and sauces that LANC is selling to retail; Olive Garden, BW3, Arby's, perhaps others?

None of that in this article. This article does not bother with any of that superfluous stuff.

He could have made a case that today's price is not a good entry point backed up by some real data and analysis. That would be worthwhile to some readers.

Instead, he seems to think that the comparable alternative investment to LANC is the 10 yr T-Bill. Really? Not other branded food product companies? How many of you out there are right now debating between buying 10 yr T-Bills and LANC? Anyone?

We are many decades long in this stock. We have confidence that their management team will to continue to grow and succeed, knowing that the market price will ebb and flow with interest rates and shifting market sentiments. I will continue to hold long term and enjoy the consistent growth. Maybe that's why they have a premium P/E ratio, whadduya think?

My other disclosure, I do not own any 10 yr T-Bills. I avoid long term fully taxable holdings that come with a guaranteed negative real return.

Also, LANC has no long term debt. Same cannot be said for the US Government.

[Patrick Doyle]

@Announcer Hi and thanks for the comment.
Sorry to be unclear, but my point was that in a world of a 3% risk free rate, stock prices in general have to come down. I went for the "everything's relative" angle here, but I could have also mentioned that a 3% risk free rate reduces the present value of future cash flows pretty substantially, relative to this time last year.
So...I'd suggest if you're not debating between this stock and a 10 year, you should open your mind to the possibility, rather than comparing a red dumpster fire to a blue dumpster fire.
"Guaranteed negative real return?" "Guaranteed" is a big word. Are you sure you fully understand bonds? If rates drop to 2%, for instance, the bond gives you ~50% capital gain. It's weird to me that retail doesn't often recognise that fact. Also, are you of the view that this pernicious inflation that some people on CNBC are speaking about doesn't affect future cash flows of a company? Or is it just bond payments?
Also, I'm not as familiar, but I thought Americans had tax sheltered savings plans, too.
Finally, last I checked LANC doesn't produce the world's reserve currency. Same can not be said for the U.S. government.
Anyway, many thanks again for the comment, sharing your tastes, and take care.
PD

[Announcer]

@Patrick Doyle Stated inflation is running over 8%. However, the CPI as constructed understates the actual impact on consumers. Also, inflation lags increases in the money supply, and once in place, has a momentum that takes time to reverse. The Fed went berzerk creating new money, and the impact of that orgy of excess is far from over. The Fed just stopped buying private bonds on the open market. They will still be funding new gov't debt, and creating more new money in the process. The Fed used to target 2.5% inflation, that seems like a long time ago, and it will be at least several years until we see that level again, and probably longer. Turns out inflation was not transitory. There is nothing "risk free" about fixed income, as both principal and interest are subject to the scourge of inflation.

A two second Google Search revealed this quote - I had heard 60%. Either way, there is remains plenty of price inflation ahead as the full impact of this monetary expansion has is far from over:

"By November of last year, that number climbed to $20.354 trillion dollars in circulation — meaning that since January 2020, the United States has printed nearly 80% of all US dollars in existence. This is according to the Board of Governors of the Federal Reserve System and not some conspiracy theory either."

I hold LANC in a taxable account, so that is my point of comparison. My ordinary tax rate is not the top rate, but getting close to 33%. Using round numbers, that nominal 3% yield on a T-Bill after tax is just 2%. Inflation now at 8% means a real loss of purchasing power of 6% each year that inflation stays at this level.

The calculus is only 1% different in a tax deferred account. Same conclusion.

The impact of inflation on companies is less consistent then on consumers, but companies with pricing power tend to cope with inflation to a large extent. I will take may chances with quality dividend growth companies over highly likely annual losses of 5% or more in real value. I expect these companies will have higher share prices in 10 years than today, and it is not hard to construct a portfolio of same with after tax yields at least as high as the 2% from a 10 year T-Bills.

The US government is no longer a AAA credit, that derating happened years ago. Next one should come soon. Most of the federal governments' unfunded obligations are not on its balance sheet, and the government has only made things worse since the early 2000's. China is angling to displace the USD as the world's reserve currency. Only a matter of time with the current trajectory.

BTW, I am not suggesting people go out and purchase LANC at the current price. I think it is a solid hold, especially for someone like me with a large unrealized gain.

Finally, the history of stock vs bond yields is:

- Since 1926 there has never been a 20 year period where stocks did not outperform bonds. That includes buying on the worst possible dates for stocks during the last 100 years.
- The stock index used in this comparison is the S&P500, not a less volatile dividend growth portfolio.
- The bonds used in this comparison are corporates, which have returned considerably more than T-Bills for the last 100 years.

As my time horizon is multi-generational wealth building, not short term valuation, I will stick with equities over T-Bills.

[Patrick Doyle]

@Announcer Hi and thanks for the very thorough response. I don't have buckets of time, but I'll do my best to get to the highlights. You reference both Macro and stock specific stuff here. Let's get into the micro.
Inflation:
Generally stocks underperform during periods of high inflation.
Also, on inflation high CPI print does not equal inflation. Becasue prices rise because the aggregate supply curve shifts left because of a global pandemic isn't a sign that monetary authorities are getting too loose.
Also, I've heard this argument that CPI understates for years. I've talked to gold bugs on occassion who've suggested that it's been closer to 8% for years. Uh...Ok. So if inflation is at 8%, for years, something that cost $1000 in 2010 should now cost $2158? This one's just so dumb because all people have to do is look at a chart and realise that these "high" oil prices for instance, are bringing us back to 2014 levels. This one's important because fuel's a big component of inflation.
Also, can someone walk me through how the creation of bank reserves is "money printing?"
Also, no one on Earth has a clue about the number of U.S. dollars in circulation given the immensity of the EuroDollar system. There's growing evidence that there's actually a shortage of money globally.
China reserve currency... Uh. I don't know if you're into current events but the Yuan/Renmimbi has just cratered about 4% over the past 3 weeks. I mean no offence, but only Americans make this "U.S. dollar is about to lose status" argument. It seems they consistently underestimate the extent to which the rest of us need it to facilitate trade.

20 year period stocks bonds etc. Don't tell me, let me guess....This one's from an investment advisor or similar, who happens to get paid about 4-5x more on stock sales than bond sales? Anyway, I guess it depends on what you mean by "outperform." In 1980 the 30 year treasury bond was yielding 11.27%. By 2000 it had fallen to 5.94%. So, that's pretty good. Another element of "outperformance" relates to knowing the future, because we're not after "returns", we're after "risk adjusted returns." For example, if you buy $1 million worth of lottery tickets and happen to get a payout of $2 million, you can talk all you like about your great return, but it was still a stupid decision.
Ok I've dumped enough on you for the moment. We obviously disagree on most, and that's fair enough. I would recommend you check out Emil Kalinowski/Jeff Snider on YouTube. Maybe start reading Lacy Hunt to offer a different (more well informed) perspective on inflation/macro issues.
Take care.
PD