Short Puts is The Way To Play Norfolk Southern (NYSE: NSC)

Stock Market


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Since I wrote my cautious note about Norfolk Southern Corporation (NYSE: NSC) a couple of months ago, the shares have returned about 0.3%, against a gain of ~ 0.9% for the S&P 500. The company has released financial results since then, and I think these are worthy of commentary. I also want to see if the shares are more compelling, given the admittedly great results we saw for the year. In addition, you gotta know I’m going to be writing about the short puts in general and the specific trade I recommended previously because I never pass up an opportunity to brag. I know that this has a negative impact on my social life, but, like the song says “I gotta be me.”

You may have missed the title of this article. You may have skipped the bullet points, above. If that describes you, here’s your last chance to get the “gist” of my argument before you wade into the weeds of the article proper. I continue to think Norfolk Southern is overpriced, in spite of the fact that they just posted an excellent year. I do not like the fact that investors are paying more in terms of valuations, and getting less in terms of a dividend yield. Just because I do not like the shares at current levels does not mean I think there’s nothing to be done here, though. I’ve made about $ 50 per share by selling puts on this stock over time, and I want to continue that tradition today. Although I’m still short the January 2023 puts with a strike of $ 200, I’ll be selling the September puts with an identical strike, as I think the premium is reasonable. As my regulars know, I consider these lower risk investments to be “win-win.” There it is. That’s the argument in a nutshell. If you need more detail, feel free to read on. If you’re new here, I’ll warn you that my writing style is, uh, “atypical” for this site.

Financial Snapshot

There’s no other way to say it. The company had a very good 2021 relative to 2020. For instance, revenue and net income were up 13.8% and 49.3%, respectively. Further, management rewarded shareholders with this improvement by upping the dividend fairly substantially from $ 3.76 to $ 4.16. The only significant dark spot in my estimation is that the capital structure deteriorated substantially from 2020. In particular, long term debt was up by about $ 1.159 billion, and cash was off by about $ 276 million, or 24.75%. This is troubling, but does not disqualify the company from consideration in my estimation.

I think it’s also worth pointing out that 2020 was actually a bit of an outlier for some reason. In fact, someone could be forgiven for thinking that 2020 was “just so 2016”, because it had been that long since revenue was that low. When we compare revenue in 2021 to 2019, for instance, we see that the former was ~ $ 154 million lower. Net income was up nicely, though, relative to 2019, though. In fact, with the exception of 2017, 2021 saw the highest net income in the company’s history.

Stock Buyback

I feel like writing about the stock buyback activity, so I’m going to write about the stock buyback activity. When we compare the full-year results to the 9-month results, we see that the company spent about $ 913 million retiring exactly 3,567,065 shares in the final three months of the year. This represented about 1.46% of shares outstanding as of the end of Q3. Applying our basic math skills, we see that the company spent about $ 255.95 per retired share during the period November 1, 2021, to January 31, 2022. Given that shares are trading hands about 9% over that price at the moment, suggests that this was a reasonably good use of owner wealth. One thing concerns me, though, because I’m just that kind of guy. In spite of the company throwing this $ 913 million at the market, the stock price was ~ $ 16.70 lower at the end of January than it was at the beginning of November. It’s an impossible counterfactual to argue, but I can not help but wonder what would have happened to the share price absent this $ 913 million buy.

In spite of that, and the deterioration in the capital structure, I’m impressed by the results, and would be happy to buy the shares aggressively at the right price.

A financial history of Norfolk Southern from 2012 to the present.

Norfolk Southern Financials (Norfolk Southern investor relations)

The Stock

Welcome to the “downer” portion of the article, where I remind investors that a great company, with an excellent “moat” can be a terrible investment at the wrong price. This is because the stock (ie the thing we buy) is governed more by the mood of the crowd than anything that happens at the firm. If the crowd gets too optimistic about a given company’s future, they’ll bid the shares higher, and will then punish the shares when the company does not ‘execute perfectly. Netflix and Meta Platform shareholders, I’m looking in your direction. The fact is that even an excellent business will hit a soft patch, so buying shares that are priced for perfection will eventually destroy value. Rather than try to continue to bore you more than absolutely necessary with theoretical arguments, I’ll use Norfolk Southern itself to demonstrate.

The company announced earnings on February 4th. Had an investor bought the next day, they would be up about 5.7% since then. Had they waited exactly one month before buying, they’d be down about 2% since then, eh. In my view, not enough happened over this one month to warrant a 7.7% swing in returns for virtually identical shares. The person who bought the shares most cheaply did best. This is why I write, yet again, that it’s better to buy shares when they’s cheaper.

The few thousand people who read my stuff regularly for some reason know that I measure the cheapness, or not, of a stock in various ways, ranging from the more simple to the more complex. On the simple side, I look at the price ratio to some measure of economic value like sales, earnings, free cash flow, and the like. In case you do not have it printed out in front of you, I’ll remind you that in my previous missive on this name, I was vexed by the fact that the shares were trading at a price to sales ratio of about 6.4 times , and a price to book ratio of about 4.8. This was troubling to me because I noted that the valuations were very near multi year highs.

In spite of the great financial results, the shares remain expensive, per the following:

Norfolk Southern price, PS ratio, and price to book value
Data by YCharts

Source: YCharts

While investors are paying more, they’re getting less, per the following:

NSC dividend yield
Data by YCharts

Source: YCharts

In addition to looking at simple ratios, I also turn to the work of Professor Stephen Penman, particularly his work in the book “Accounting for Value.” In this excellent, very in depth book, Penman walks investors through how they can work out what the market price of a stock implies about future growth prospects. This is done by isolating the “g” (growth) variable in a pretty standard finance formula. When we isolate the “g” variable in this way at Norfolk Southern, we see that the market is forecasting a growth rate of ~ 5.8% for this company going forward. While this is lower than it was when last I reviewed this business, it’s still objectively cheap, and so I can not recommend buying the shares at current prices.

Options Update

In my previous missive on Norfolk Southern, I pointed out / bragged about the fact that I’ve earned about $ 50 per share selling out of the money or deep out of the money puts on this name over the years. Unlike price gains in the stock market, these returns will only be “taken” from me by the rather rapacious Canadian government or by one of my many unhealthy habits. This is opposed to capital gains which, as we all know, can disappear in an afternoon. I think we need to constantly remind ourselves that what the market giveth, the market can taketh awayeth. I attempted to add to this $ 50 in my previous missive by selling the January 2023 puts with a strike of $ 200 for $ 4.10 each. These have not budged in price much, but I’m confident that as time drags on, I’ll be able to add this $ 4.10 per contract to the whiskey acquisition fund. I want to take this opportunity to point out, yet again, that there are other ways to earn a return on stocks. In my view, selling puts is a safer approach relative to buying stock near what may very well be a market top.

I am a creature of habit, so I want to try to repeat success, so I’m going to sell some more puts here. In particular, I’m selling the September puts with a strike of $ 200 which are currently bid at $ 2.10. Although the yield of just a shade over 1% isn’t much for six months of, uh, “work”, the risk of exercise is incredibly low in my estimation. The shares would need to fall about 28% over the next half year to be exercised, and I think the probability of that happening is remote. Thus, in some sense I consider this to be “free” money.

It’s now time for me to pour some cold water on the idea of ​​selling short puts by writing about the risks inherent in this type of trade. Everything comes with risk attached, so all my talk about “win-win” trades is a bit of hyperbole. Recently I’ve started categorizing the risks here as both economic and emotional. The economic risks are obviously much simpler to write about, and the emotional risks vary from person to person. I think you would be wise to think about these before embarking on this type of trading strategy, though.

The short puts I suggest people sell are actually a small subset of the total number of put options out there. I’m only ever willing to sell puts on companies I’d be willing to buy, and at prices I’d be willing to pay. So my first recommendation to people interested in short puts is to follow this lead. Do not take on the obligation to buy a stock at a terrible price for some put premia. Things will eventually blow up on you if you do that. To indulge in my tendency to be repetitive: Only ever sell puts on companies you want to own at (strike) prices you’d be willing to pay.

Another thing that might be painful for some people, though not all of us, is that the returns from short puts are capped by the premium received. This is well known in theory, obviously, but it stings some people when they see a stock that they wrote some puts on rise dramatically in price. I handle the emotional pain of this by taking a portfolio approach to the enterprise. I acknowledge that I will not maximize profits, but if I hit my return target for a period, I’m fine. You may be “wired” differently than me, though. If the emotional pain associated with this is too much for you, you may want to avoid this type of trade.

Also, it can be emotionally painful when the shares crash below your strike price. I’d say this is less painful for the put writer than the stock buyer, but it should be acknowledged. For instance, if Norfolk Southern drops below $ 200, that will be emotionally painful for some of the people who follow me on this trade. I’d say it’d be less emotionally painful than it is for the people who bought the stock at $ 278, but “someone else is worse off” isn’t much of a consolation for the people who are freaked out by a 28% price drop. The way I handle this is to remind myself that I’m buying a great business at a great price, and that, over time, this always seems to work out well. I think people who sell puts should be aware of these emotional risks before selling.

All that said, I am still of the view that this is a win-win trade. If the shares remain above $ 200 for the next several months, I’ll simply pocket the premium. If the shares fall in price, I’ll be obliged to buy, but will do so at a price that lines up with a dividend yield of ~ 2.5%. The fact that I consider this to be a “win-win” trade is why I’m willing to bear the risks here.

Conclusion

I think Norfolk Southern is a great business in many ways, and they had an excellent 2021 in my view. The problem is the valuation. I can not recommend buying at current levels. Just because I do not want to buy at a time when shares are trading near multi year highs, and multi year low dividend yields does not mean there’s nothing to be done here in my view. I’ve earned a very decent return on short puts over time, and I want to continue that tradition. I would recommend others follow me on this or a similar trade. If you’re a traditional stock investor and are not comfortable selling put options, I would recommend waiting for shares to fall in price. I think “price” and “value” are very different things, and can vary over time, but will eventually meet. I think investors would be wise to wait for price to fall closer to value before buying.



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