Since I wrote my bullish piece on United Parcel Services, Inc. (NYSE:UPS), the shares are up about 50% against a gain of 6.4% for the S&P 500. Although it’s been a relatively short time since I wrote about this business, the shares have moved quite dramatically higher, and thus this is basically a different investment than the one I looked at three short months ago. The company’s market capitalisation (Yes! That’s how you spell “capitalisation!”) has increased by about $47.6 billion in three months, and it’s worth looking into whether this increase is warranted or not. A stock trading at $166 is, by definition, more risky than the same stock when it was trading at $111, so I need to look again to see whether it’s worth holding or not. I’ll make this determination by looking at the most recent financial history here, and by looking at the stock as a thing distinct from the actual company. I’ll also write about the short put options that I recommended earlier. In particular, I’ll write about a particular problem with short put options that have been highlighted by the UPS case.
For those who can stand neither the suspense nor my writing, I’ll come right to the point. I think this was a great investment at $111, and I think it’s a terrible investment now. I think investors who buy at the current price will experience disappointing returns going forward. As I wrote in my previous piece on this name, I think the dividend is well supported. The problem is that the return investors receive is largely a function of the price paid, and the shares are priced at multi-year highs. For that reason, I will be selling my shares and I recommend others do the same. If you were considering buying the shares, dear reader, I would recommend against it. I’ll expand on my arguments below.
I wrote at length about the sustainability of the dividend in my previous article. Although I normally try to take any opportunity to be repetitive, I won’t go over that well-worn ground here. Suffice to say that I’ve concluded that the dividend is reasonably well covered.
What is interesting (to me at least) is the fact that revenue in the most recent period was up about 9.3% relative to the same period a year ago, but operating profits were down about 7% and net income was down about 2.25% from the same time in 2019. Profits dropped slightly for the first six months of 2020 in spite of a massive reduction in fuel expense. The reason for the drop in profits is that every expense but fuel rose fairly dramatically. Compensation was 12.4% higher, repairs and maintenance were up about 23%, and the dreaded “other expenses” were 18% higher in the first half of 2020 relative to the same period a year ago. Whether this represents a new normal is unclear to me, but at some point, the combination of increased dividends and muted profits will be unsustainable.
I should also write that management continues to treat shareholders reasonably well in light of the fact that it increased dividend payments by about 5.25% since this time last year. At the right price, I’d be willing to buy more shares in order to acquire these elevated dividends.
Source: Company filings
The phrase “at the right price” is of critical importance, obviously. It’s great that the dividends have grown, but the fact is that our returns as investors are largely a function of the price we pay for them. For that reason, I need to write about the stock as a thing distinct from the underlying company, because it is a completely different animal. The stock is supposed to be a proxy for the health of the underlying business, but it’s obvious that the stock is driven by forces that have nothing to do with the underlying. What (apparently) matters much more is some utterance by a central banker, or whether an institutional investor likes a related sector or not. We investors are subjected to a host of risks associated with the business itself, but we’re also subjected to these relatively more non-obvious threats. In my estimation, the only way to insulate ourselves from this is to insist on never overpaying for a stream of future cash flows.
I try to determine whether or not I’m overpaying for a stock in a host of 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. On that basis, UPS is far more expensive than it was three short months ago. Specifically, the shares are 48% more expensive on a price-to-earnings basis. Admittedly, the valuation may have been on the meagre side back then, but it’s presently the case that investors are paying more for $1 of future economic benefit than they have at any time over the past five years, per the following.
While I don’t think history repeats, it may rhyme, and I’d point out that the last time these shares were nearly this expensive, they went on to under-perform.
In addition, I like to try to work out what the market is currently assuming about a given company’s future. In order to do this, I turn to the methodology outlined by Professor Stephen Penman in his book “Accounting for Value.” In this work, Penman describes how an investor can isolate the “g” (growth) variable in a finance formula to work out what the market must be assuming about a given company’s future. The more optimistic the forecast, the more risky the stock. At the moment it seems that the market is forecasting a long-term (i.e. perpetual) growth rate of just under 6% for UPS. I consider this to be a fairly optimistic forecast. This strengthens my view that the shares are too expensive at the moment.
In my previous two articles I recommended selling put options on this name. In the first of these, I recommended selling the April 2020 puts with a strike of $100. I was exercised on these at a price in the high $90s. In my latest article, I recommended selling the January 2021 puts with a strike of $90. I earned $4 per share on this second batch of put options, and these are currently bid-asked at $.22-$.53, so these trades have seemed to workout reasonably well.
Everything’s relative, though, and my short put history here raises a reasonable criticism of put options that I don’t think I ever wrote about on this forum. Had I only sold put options on this name, my returns would have been very muted relative to the people who purchased shares. Short put options reduce risk, obviously, and as a result they can also reduce returns. On a few occasions, I’ve earned a few dollars on short puts and watched the shares skyrocket many tens of dollars per share. This is why when I’m very committed to a particular trade, I like to buy some shares along with selling some puts. Puts are an excellent way to participate and earn a return with great businesses, but their returns can also be muted. That’s something an investor needs to consider, obviously, before trying this strategy.
Normally, I recommend repeating success and selling more puts. The problem is that the current stock price is so far above a reasonable strike price in my view that it’s not worth it. I’d be willing to buy back into these shares at a price of ~$105, but the premia on offer for that strike are too thin in my view. For example, even if we go out to January of 2022 (!), the market is only offering $3.20. Tying up this much capital for 15 months is not reasonable in my view, and I must therefore sit on the sidelines and wait for the price to drop its current level.
I remain interested in markets long after leaving Bay Street because they are the visible manifestation of crowd psychology. I find this interesting because I’m a bit of a nerd. Please contain your shock. One thing that many observers have noted is that markets “overshoot” on the upside and on the downside. I think the market got ahead of itself on the downside earlier this year, and the always capricious market is now excessively optimistic in my view. For that reason, I’ll be selling my shares. In addition, I’m going to remain short on my put options, as I think there’s little chance that I’ll be exercised. If the shares crater from current prices, and I am exercised, I’ll be happy with that entry price.
I think the case of UPS demonstrates that a company can be either a great or mediocre investment, depending on the price paid. It was a great investment before, and it’s a terrible investment now. I think price and value can remain unmoored for some time, and I think investors would be wise to eschew these shares until price drops to more closely match value. For those who took my advice and bought earlier, I recommend selling. For those who didn’t and are considering buying now, I would recommend against it.
Disclosure: I am/we are long UPS. 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: Although I’m currently long the stock, I’ll be selling it this week.
I’m short 5 put options described briefly (and more extensively in my previous article). I suspect that these’ll expire worthless, so I’ll take no action with them.