If it were not for the 2.65% dividend in 3M Company (NYSE:MMM), investors would have many reasons to be disappointed over the past 8 years. For almost the entire past decade, MMM has experienced much volatility and very little share price appreciation. Through this article, I will present a fundamental analysis and a realistic risk management framework for investors participating in MMM.
A History of Consistent Returns
In order to analyze MMM, I have relied heavily on return on assets and return on equity. Return on assets is the net income of the firm divided by average total assets. This ratio is very beneficial for analysis in that it allows an investor to understand how efficiently an organization uses its assets to generate profits. Return on equity is the net income of the firm divided by directly-invested shareholder equity and this key ratio tells investors how successfully management uses investments to bring income into the firm. The chart below shows a decade of return on assets and return on equity for the 3M Company.
Good news and bad news can be perceived from the chart of returns. Let's start with the bad news. The bad news about MMM's organizational returns is that they have been very consistent over the past few years. The reason that this is bad news is that share price tends to be driven by sudden changes in organization returns or new trends in firm performance. For example, as seen in the recession (gray area on chart), returns for MMM were cut nearly in half. This decrease in firm performance corresponded to a decrease in share price by around 52%. For an investor seeking capital appreciation through share price change, MMM's consistent returns will simply not deliver.
The good news is that MMM's returns are consistent. MMM delivers around $25 in profit for every $100 of shareholder equity. This is excellent - they are generating a return ... for internal investors. The modest 2.65% divided that is delivered to shareholders every quarter is essentially the only gain that MMM's shareholders are receiving at the moment. Make no mistake, MMM is a fundamentally strong organization, the key problem is that the share price simply isn't going anywhere. For a tactical investor, this is not the place to be parking capital at the moment.
My greatest concern comes from the recent 3 quarters of fundamental performance. During this time period we have seen a decoupling in which return on assets has slightly decreased and return on equity has slightly increased. This really wouldn't be too much cause for alarm except for one thing. Remember the calculation of return on assets? It's net income divided by average total assets across a time period. For return on assets to increase, a company must increase net income with a less increase or decrease in assets. In light of this definition, please examine the following two charts.
Did you see it? MMM is increasing its assets at a consistent pace while its net income is pretty much staying flat. The timing of gains in assets and the volatility of net income has not mathematically shown it, but return on assets should realistically be falling. If an organization increases its assets and its net income does not increase in proportion, its return on assets will mathematically decline. Why is this important? The first chart we looked at demonstrated that decreases in returns tend to drive a decrease in shareholder wealth. MMM is currently in a situation in which return on assets is actually degrading from a realistic standpoint, but not quite yet from a mathematical standpoint. For this reason, I believe that MMM may decline in the near future as math catches up with the firm. After all, assets have increased 25% and revenue has only increased 16% in the past two years. If not for the uncanny timing of earnings increases coupled with slowing asset increases, return on assets would be declining at an even greater rate.
Technically speaking, the writing is on the wall. The uptrend that began in October of 2011 has ended and price is experiencing a textbook pullback to the old trend line, as seen in the chart below. Not only has this pullback been met with added selling, but price looks poised to begin a new downtrend in the near future. Last month, the price attempted to climb above the highly-significant level of $90 per share, but this attempt was met with strong selling. For this reason, I believe that investors should short MMM in the near future. In order to protect against a false signal, I suggest that traders wait until price breaks below $86.50 per share prior to initiating a trade. This will ensure that traders are only participating when price has technically resumed its current breakdown and will tilt the probabilities in favor of the bears. I believe that this trade should have a stop-loss at $92 per share due to the fact that price will have rejected a downtrend at this point. In order to manage this trade, I believe that individuals should look to exit the one-third of their position at the target of $82.50, since this has historically acted as a place where buyers and sellers struggle for control. By exiting a portion of our position here, we book profits in anticipation of a price reversal. I feel the final two-thirds of shares should be exited at the second target of $62.50 per share. This represents a multi-year low and I believe buyers will flock in droves to defend this level. This trade provides a very favorable reward to risk ratio in that for every $1 you are willing to risk, you stand to gain $3.79 in return. Statistically speaking, if this analysis even has a 26.40% chance of being correct, you are mathematically wise to consider shorting MMM if the price falls below $85.50. A summary of the trade recommendation and annotated chart can be seen below.