Although the S&P 500 rallied sharply into the close today (Friday 13th of March), we cannot say with any form of real certainty that the lows are in at this time. Our portfolio remains mainly in cash at this time. However, we still maintain that investors (who are holding multiple blue-chip positions) should be definitely taking advantage of the high level of the Volatility Index (VIX) that we have at this time (57.83)
One such stock which is a prime candidate for covered call writing is Estee Lauder Companies (EL). The reasons being that shares are liquid and there remains a high level of uncertainty (due to the coronavirus) as to how earnings will play over the next four quarters.
Estee Lauder rallied hard along with the S&P into the close today and finished at $172.22 per share. This means shares are down around $34 per share since the start of the year which equates to about 17% of a drop in total.
On the recent second quarter earnings call, CFO Tracy Travis was slow to give any type of guidance for the third quarter and beyond for good reason. The business looked very solid, though, up to the midpoint of the fiscal year. Net sales over the first six months was reported up 14% whereas adjusted EPS growth came in at over 20%.
These numbers were buoyed by strong growth in international markets in the second quarter, especially in the Asia Pacific region. In terms of categories, the skin care range of products led the way again, reporting 28% growth, with fragrances and make-up reporting high single-digit percentage growth rates, respectively, in the quarter.
Second-quarter numbers once more exemplified that we are dealing with a solid firm here with a clear economic moat. Gross margins actually rose by 20 basis points in Q2 and rest at just under 78% over a trailing twelve-month average.
However, what sticks out to us is the present book multiple of 12.4. It rarely has been higher which leads us to believe we may see some downside over the next while or consolidation at best.
Estee Lauder pays out a dividend yield of $1.92 which equates to a dividend yield of about 1.11% at present. It must be said the yield is low for this sector (2.98% average), although management has been aggressive in also returning capital to shareholders in the form of share buybacks.
Estee’s commitment to shareholders was plain to see once more over the first six months of this fiscal year. Operating cash flow of $1.26 billion was not enough to cover investing and financing costs (due to the Have & Be equity interest), so the firm issued some debt to pay the bills. In saying this, in the quarter gone by, management still bought back $500 million worth of stock which was encouraging to see.
However, to increase that 1.1% yield, we believe Estee Lauder at this juncture is a prime candidate to start selling call options against long stock positions. For example, look at how high implied volatility has gotten to over the past while. We have not seen implied volatility (65%+) levels in this stock for quite some time. Suffice it to say, options prices are very rich at present which suits covered call writing.
Source: Interactive Brokers
For example, the regular January 2021 (307 days to expiration) $180 calls are trading for around $21 per contract at present. Remember the dividend is $1.92. If we were to add both of these incomes together (option premium and dividend), we would get $22.92. This number, based off the present share price of approximately $172, would yield the investor 13.3%. A lot better than the 1.1% which is being paid out at present. Furthermore, that January call is only 10 months away. If one wanted to wait for other LEAP options to become available, the premium would most likely be larger.
Therefore, to sum up, let’s talk about the drawback(s). The only downside as we see it is that when one sells an out of a money call as described above, one is essentially receiving money upfront for the future risk that his or her basket of shares will be called away. If the share price is above $180 a share at expiration, shares are called away. If the share price is not, shares are kept. In both cases, however, all of the premium is kept. We like covered calls because (for income purposes) it demands that we never fall in love with our stocks. We continue to believe now is a good time to start writing calls in Estee Lauder considering shares are trading near the lows of their range.
Elevation Code’s blueprint is simple. To relentlessly be on the hunt for attractive setups through value plays, swing plays or volatility plays. Trading a wide range of strategies gives us massive diversification, which is key. We started with $100k. The portfolio will not not stop until it reaches $1 million.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any 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.