This is the last installment of our five-part series: "There
Is a Lot of Value in This Market." In some ways, this article
represents prima facie evidence supporting some of our main
hypotheses. First of all, this article will clearly support the
notion that not all common stocks 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 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. 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 is 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 devastating investment. The following graphic looks
at Textron since the great recession of 2008 where we see the
company's earnings collapsing and stock price following it down.
However, since calendar year 2010, Textron's business and stock
price have been on a recovery trajectory.
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,
d�j� 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 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.
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