CL - Colgate-Palmolive: A Great Choice For Income Investors Why I'm Buying The Dip

2023-03-05 11:30:02 ET

Summary

• Colgate-Palmolive (along with most of the Consumer Staples sector) has underperformed the broader U.S. equity market this year.
• The company now trades at an estimated forward P/E of 24x. I think it's slightly undervalued but fits well into my income-focused strategy.
• 2023 Non-GAAP organic sales growth for Colgate-Palmolive is expected to be at the high end of the company's 3-5% target.
• Gross margins and EPS are also expected to be up modestly.
• My strategy includes purchasing common stock, collecting the 2.5% dividend yield, and selling covered calls until I'm assigned.

Summary

Colgate-Palmolive (CL) has gotten off to a slow start in 2023 as shares have fallen -6.6% YTD vs. the S&P 500 Index return of +5.8% YTD (as of March 3rd, 2023). While concerns of high market valuation and slowing growth are valid, I think Colgate-Palmolive is still a great buy at these levels if investors are patient and use a smart approach. Firstly, here's what I'm seeing using a top-down approach and why I like Colgate-Palmolive:

1. Macroeconomic Outlook Is Not Great: A commonly recommended strategy for a potential recession is simple: get defensive. As interest rates keep rising and respected organizations including the World Bank continue to warn of a lingering recession, I'm not taking on unnecessary risks in my portfolio. Consumer Staples, Utilities, and Health Care are best in this environment.
2. Its U.S. Households Products Are Cheaper: Morgan Stanley recently highlighted that Colgate-Palmolive's U.S. products are at a -17% discount to peers. During a recession, consumers will look to save wherever they can.
3. Organic Sales and Gross Margins Are Growing Steadily: Q4 2022 was up +8.5% YoY and saw broad-based growth across its main business units. Both gross and profit margins are also expected to be up in 2023 according to management.
4. The Stock Is Expensive (For Good Reason): 2023 EPS is expected to come in around ~$3.11 based on management's guidance, which implies it's trading at almost 24x forward earnings now. This isn't cheap by any means but investors should understand that the company has been trading at 30x its current year EPS for a few years now. If Colgate-Palmolive can grow into these earnings, I think it's reasonable to pay a 24x premium today. Even at a forward P/E multiple of 25x (which is a conservative multiple based on its +30x P/E over the last year), Colgate-Palmolive would trade close to $77.50/share. It represents a +4.8% upside from its current price at the time of writing.

My main takeaways, for now, are that Colgate-Palmolive is likely to trade rangebound or slightly higher until the company reports future quarterly earnings or updated guidance. I do think management is taking a conservative approach with EPS and margin guidance right now since the company has a decent amount of pricing power for its staple products. This conservative view isn't necessarily a bad thing given all of the uncertainty on the horizon for U.S. markets but I am surprised with Colgate-Palmolive's stock underperformance this year.

The Strategy

I want to first clarify this strategy is not for everyone. This is strictly for a portion of my portfolio focused on generating income. There are many considerations around taxes and limited gains investors should understand.

The approach I'm taking for Colgate-Palmolive is straightforward: I'm purchasing common stock, collecting the modest 2.5% annual dividend yield, and selling covered calls with 30-60 days to expiration at a strike price that earns 1.75-2% premium and is at or below my target price of $77.50/share until I'm assigned . I believe on a risk-adjusted basis, this strategy can outperform the S&P 500 index if the U.S. economy does in fact head into a recession. This is a bearish strategy compared to just buying and holding an equity index fund as it limits upside potential.

Covered Calls + Dividends = Income

My current strategy has resulted in positive gains this year with consistent monthly income through a combination of covered calls and receiving quarterly dividends. Below is an example of how it works:

1. Purchase 100 shares of Colgate-Palmolive on March 3rd at the market price of $73.95/share
2. Immediately sell 1 call option on the 4/21/23 $75.00 strike. The total premium collected: $130 or 1.75% of my notional invested

Now we wait. As time passes, there are 3 possible outcomes here:

1. Shares rally above the $75.00 strike price. I get assigned on 4/21/23 (likely before that depending on the ex-dividend date). I would earn $130 from the call option and $105 from stock appreciation. That's a total return of 3.1% in only 50 days. That's 28% annualized. If shares are still trading below my $77.50 target price, I'd rinse and repeat what I did.
2. Shares trade flat . In this case, I would be eligible to receive the quarterly dividend, and then I could sell another call option after the 4/21/23 option expires out of the money. The next call option I'd sell would be the 5/19/23 expiration, which would hopefully earn another 1.75%-2% depending on how volatile markets are.
3. Shares trade lower. This is the worst outcome of the 3. While I'll be eligible to receive the dividend, my common stock will be at a loss, and I likely won't be able to earn the 1.75-2% premium on my covered call option at a strike price at or above what I paid for.

The strategy isn't perfect, especially when equity markets are falling. While it may outperform the S&P 500 since I'll collect additional premiums from covered calls expiring worthless, it doesn't mean I'm making money. In an ideal scenario and based on the current macroeconomic outlook, I want shares to trade range bound or higher with little change in market volatility. That's why I am currently focusing this strategy on defensive sectors such as Consumer Staples, Utilities, and Health Care. Colgate-Palmolive is a great fit for my strategy based on its historical beta and performance during recessionary periods of the business cycle.

Colgate-Palmolive has a very low historical beta vs. the S&P 500, meaning markets don't expect shares to dramatically move on a day-to-day basis. Just simply buying and holding shares isn't likely going to outperform the S&P 500 since a lot of investors believe the company is fairly valued now and little will change in the future. This can work in your favor if equity markets plunge because lower beta stocks typically don't fall as much (historically speaking). With that in mind, I think the combination of stock appreciation and the use of covered calls on Colgate-Palmolive, a low-beta company, can potentially lead to better risk-adjusted vs. the S&P 500.

As you can see above, Colgate-Palmolive has a historical standard deviation that is lower than the S&P 500, which makes sense after viewing its beta, which is under 1. A popular measure of risk-adjusted returns known as the Sharpe Ratio is a great way to see if a company is better performing when accounting for risk. If Colgate-Palmolive trades flat or is up during 2023, I believe the gains I'd earned from dividends, capital appreciation, and covered call premiums could potentially outperform the S&P 500 on a risk-adjusted basis. Time will tell.

Conclusion

Colgate-Palmolive is off to a rough start in 2023 but I think it could be having its "buy the dip" moment. As long as management can deliver on its promises for margin improvement and organic sales growth at or above 5%, EPS should be up considerably this year. I think the company can meet its $3.11 EPS estimates for 2023. At a 25x multiple, there is a modest upside. At a 30x multiple where it has historically traded over the past year, there's a significant upside.

Regarding the income strategy, it is not for everyone. It's primarily for income investors looking to generate consistent income while minimizing beta in their portfolio vs. the S&P 500. It involves a lot of trading and consistent monitoring to ensure the portfolio is where it needs to be. By focusing on lower beta securities such as Colgate-Palmolive, I can be prepared for a potential market sell-off if the U.S. economy does in fact enter a recession.

For further details see: