This article represents the final installment in our “There Is A Lot of Value In This Market” series. Links to parts one through four can be found here.
In some ways, this article represents prima fascia evidence supporting
some of our main hypotheses. First of all, this article will clearly
support the notion that not all common stock are the same, and
therefore, they should all not be painted with the same broad brush
stroke (generalities or opinions). The examples in this article will
clearly illustrate just how different individual companies are.
Therefore, this further validates the notion that each company should be
evaluated on its own individual merit, thereby validating the concept
that it is a market of stocks and not a stock market.
Furthermore,
this article will present a significant challenge regarding how to
properly calculate fair valuation on cyclical or semi-cyclical
companies. The real issue with cyclical companies is having the
confidence regarding what future earnings might be. In other words,
even when consensus estimates are positive, the prudent investor must
ask themselves - how long can it last? Moreover, the answer can vary
dramatically from one company to the next. In other words, depending on
exactly how cyclical the company is and how cyclical its industry is,
will ultimately determine whether earnings are to continue rising for a
while or suddenly fall out of bed. This is the treachery with investing
in cyclical stocks. Sometimes they can be very rewarding, and sometimes
they can cut the legs right out of your portfolio’s performance.
Turnaround Stocks: High Risk or High Reward?
The
first equity classification we are going to look at we will define as
turnaround situations. This implies a company that, after struggling
with significant operating issues, is set to turn its business around.
It’s important to state, that these are typically not your everyday
buy-and-hold kind of stocks. Instead, these tend to be higher risk
opportunities that will often only warrant a short-term holding. To put
this into perspective, these are the situations that offer a high
degree of profit potential, but simultaneously at a high degree of
risk. Consequently, they would not be for consideration as a core
holding, that might represent opportunities for what some investors like
to call their play money.
Is Goodyear Tire & Rubber (GT) A Turnaround Opportunity?
Our first example will be Goodyear Tire & Rubber. A quick glance at the 20-year F.A.S.T. Graphs™ on
this company tells us a great deal about its business instantaneously.
For example, we can see that it has been very challenging for this
company to maintain any type of profitability. We see that profits
began collapsing in the late 1990s, and we also see that price
followed. This validates the idea that earnings determine market price
in the long run. Another important perspective that this graphic
illustrates is how the company quit paying its dividend in 2003. The
light blue shaded area indicates dividends, and visually we see that
they disappear.
Since
2003 we see a very cyclical and spotty record of earnings volatility.
This begs an important question that a prudent investor should ask. How
much can I trust this company’s future earnings potential? In other
words, forecasting future earnings for this company would be very
difficult, to say the least.
A
quick look at the long-term track record of this company with
deteriorating long-term earnings results validates our notion that this
is not a buy-and-hold candidate. If you are an investor that believes
that the strategy buy-and-hold is dead, then this company could be your
poster child. As the performance report reveals, this company has
destroyed shareholder value since 1994.
Yet,
and on the other hand, after a company has generated very weak results,
it can often be very easy to generate very high future growth if the
business has any earnings power at all. Therefore, our next graph on
Goodyear shows an extremely high rate of earnings growth simply because
earnings are coming off of such a low base. But, and this is a very
important but, we believe this also represents a classic example of how
statistics, or put another way, a representation based on just numbers,
can be very misleading. Because, it is a fact that since 2010, Goodyear
has generated an extraordinary earnings growth rate in excess of 45%
per annum.
Furthermore,an
observation that we have noticed after reviewing thousands of examples,
is that future earnings estimates will tend to have a built-in bias
based on recent results. In the case of Goodyear, the consensus
earnings estimates of nine analysts reporting to Capital IQ estimate
five-year earnings growth of 46.3% per annum, a number that is very
close to what it has achieved over the past four years or so.
Microsoft MSN Goodyear Tire Forecast From Zacks
A
cross-check look from another source corroborates what Capital IQ
analysts are forecasting. Below is a screenshot from Microsoft MSN
illustrating the consensus five-year estimated earnings growth rate on
Goodyear by seven analysts reporting to Zacks. Interestingly, the
estimate is identical to Capital IQ. However, it seems too much of a
coincidence that this number mirrors recent history so closely to not
consider it biased.
General Electric (GE): A Turnaround That Is Succeeding
When
we look at the long-term operating history of General Electric we see a
company that was once a classic example, or even the epitome, of a
blue-chip dividend growth stock. However, since the company had built in
a very large financial division, everything changed as the financial
industry instigated the great recession of 2008. As we can clearly see,
General Electric’s earnings collapsed during 2008 and 2009. However,
earnings growth has been recovering since, as we will see with our next
graphic.
Since
calendar year 2010, General Electric’s earnings have staged a very
respectable rebound averaging growth of 12.3% per annum. It’s also very
important and useful to note that stock price has followed suit and has
closely tracked the resurgence in earnings growth. Also, notice that the
great recession that actually brought General Electric’s stock price in
line with fair value based on these resurging earnings.
As
a result of the turnaround in General Electric’s business, investors
who had the foresight to buy the company expecting a turnaround were
well rewarded. After the dividend was literally cut in half in 2009, it
has once again begun growing again. Moreover, since share price has
closely tracked General Electric’s recovery earnings, capital
appreciation of 16% per annum has been exceptional. Add in the once
again rising dividend and shareholders have enjoyed an 18.8% rate of
return since the beginning of calendar year 2010. This validates the
notion that turnarounds can represent exciting and profitable
opportunities.
Cyclical Stocks: A Roller Coaster Ride To Riches Or The Poor House?
Cyclical
stocks are different than turnarounds. A cyclical stock is a company
that has a legacy of its business routinely going through cycles of boom
or bust. A true cyclical company can provide investors great profits
during the good times, and conversely destroy a portfolio’s performance
during the bad.
Textron Inc. (TXT)- When It’s Good It Is Very Good, When It’s Bad It Is Very Bad
Let’s
examine the long-term historical record of Textron Inc. (TXT) since
1994 to see a quintessential example of a cyclical stock in action. You
will see that when Textron’s earnings are strong and growing, stock
price follows suit. Conversely, during the times when earnings are
falling off a cliff, so do stock prices. The point being that if you
can pick a stock when earnings are poised for an intermediate term
advance, there are great profits to be had. However, the hat trick is
finding when to get out before the music stops. Although that is easier
said than done, timing does not have to be perfect, but it does need to
be reasonably responsive. In other words, waiting around too long
validates the old adage “he who hesitates is lost.”
In
order to get a perspective of how profitable a cyclical stock can be
when things are going right, our next graph looks at Textron from
calendar year 2002 through calendar year 2007. This was a six-year time
frame when earnings growth was averaging 28.5% per annum, and when the
company’s beginning valuation was in alignment.
Therefore,
shareholders in Textron during these profitable years were highly
rewarded. Capital appreciation generated 22.9% per annum compounded
return, and the addition of its dividend, paid but not reinvested,
increase the annual rate of return to over 24% per annum.
On
the other hand, if you own a cyclical stock during the bad side of a
cycle, like the last six years have been for Textron, it can be a
devestating investment. The following graphic looks at Textron since
the great recession of 2008 where we see the company’s earnngs
collapsing and stock price following it down. However, since calendar
year 2010, Textron’s business and stock price have been on a recovery
trajectretory.
It’s
amazing what a difference owning a cyclical stock during the bad times
can make. The following performance since calendar year 2008 (the great
recession) shows that shareholder returns were abysmal. Both capital
appreciation and dividend income were negative during this period.
Currently,
the consensus of 14 analysts reporting to Capital IQ, expect Textron to
once again grow earnings in excess of 28% per annum. If this truly is,
as Yogi Berra would say, déjà vu all over again, then this may be a good
opportunity to invest in Textron.
A
cross-check with Microsoft MSN corroborates that the consensus of
analysts reporting to Zacks also expects similar five-year earnings
growth at 26% per annum. Although this instills some confidence that
there is at least a reasonable consensus, let us remind you of the
warning we expressed with our Goodyear Tire example above. In other
words, at the end of the day it’s always up to us to determine whether
or not we think the estimates are reasonable and achievable or not. Our
future returns will be a function of what the future investment results
turn out to be adjusted for valuation.
Microsoft MSN Textron Inc. Forecast From Zacks
Manitowoc Co. (MTW) and Caterpillar (CAT)
Our
final two examples review the historical records of Manitowoc Co., a
leading manufacturer of building cranes and a major player in food
service equipment, and Caterpillar, who needs no introduction. Although
both of these companies would clearly meet our definition of cyclical,
the earnings and price correlated graphs on each show that they are
different, yet in some ways the same. Both graphics illustrate that
these companies are sensitive to economic cycles, you can clearly see
how profits rise and fall with the economy. But even more importantly,
you can clearly see how stock prices logically react to those same
cycles.
Summary & Conclusions
As
we conclude this series of articles, we hope that readers have at least
been given the perspective that not all common stocks are the same.
More importantly, we also tried to illustrate that it is not the stock
market that ultimately drives the returns of individual companies.
Instead, it is the individual operating results of each respective
company that will reward shareholders in accordance with the business
results that individual companies have achieved on their behalf.
Therefore,
the final message is to encourage investors to quit worrying about what
the market might do or what the economy is going to do. Instead, try
to identify really great businesses where you like the management and
the price. Long-term investment performance will follow long-term
operating performance. Try to keep your emotions in check, try to
filter out all the noise that you are bombarded with every day, and try
to make intelligent investing decisions on facts. Because, as we have
often stated, the problem with following the herd is that your ultimate
destination is the slaughterhouse.
Disclosure: No positions at the time of writing.
Disclaimer:
The opinions in this document are for informational and educational
purposes only and should not be construed as a recommendation to buy or
sell the stocks mentioned or to solicit transactions or clients. Past
performance of the companies discussed may not continue and the
companies may not achieve the earnings growth as predicted. The
information in this document is believed to be accurate, but under no
circumstances should a person act upon the information contained within.
We do not recommend that anyone act upon any investment information
without first consulting an investment advisor as to the suitability of
such investments for his specific situation.This article was written by Chuck Carnevale. If you enjoyed this article, you can read more of his articles here.
