Investors in Analog Devices (NASDAQ:ADI) have enjoyed an 11% year-to-date return. This return coupled with a 2.95% dividend yield has left almost all holders of the stock delighted to have owned shares. Even though the company has done very well this year, I believe that investors should consider selling shares. Through this analysis, I will present the bearish case for Analog Devices and explain why I believe that we may see a price decline in the near future.
A History of Returns
In order to objectively analyze ADI from a fundamental standpoint, 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. Return on assets is very important to monitor in that through return on assets, an analyst can understand how efficiently the company uses its operational property to generate profits for the firm. Return on equity is the net income of the firm divided by directly-invested shareholder equity and this key metric tells the researcher how well management uses investments to generate profits for the firm. In the chart below, 5 years of return on assets and return on equity can be seen for ADI.
Over the past 5 years, it can be seen that ADI has had a volatile history of returns. Beginning in 2008, ADI experienced a fundamental gain in performance in which return on assets and return on equity increased until the fourth quarter of that year. This increase in performance was associated with an 18% gain in stock price. Immediately after this period, the firm entered a stage of decline, much like most companies of this time, and performance fell from the fourth quarter of 2008 until the fourth quarter of 2009. During this period, the share price experienced a likewise decrease of around 15%. In the fourth quarter of 2009, ADI began a period of strong performance in which it increased return on assets and return on equity until the middle of 2011. This period of increased performance was coupled with a gain of around 25% in the stock price. Since the middle of 2011, the fundamental returns of the organization have declined. During the past year and a half, the stock price has risen around 15%. The chart below shows a summary of these time periods.
From the table above, a simple relationship can be extrapolated. As a firm increases its fundamental performance, it tends to experience an increase in stock price. This makes intuitive sense in that as a firm betters itself, the market tends to reward it by allocating greater quantities of capital to the security. Investors seek to park capital with firms that deliver performance and withdraw capital from firms in decline. This relationship has been true over the past 5 years - until now. Over the past year, the firm has experienced a significant pullback in performance in that returns on assets and return on equity have both declined by several percentage points. If history and intuition is to be a rough guide to the future, then ADI should experience share price declines in the near future. ADI is experiencing moderate and declining firm-level performance and I believe that share price will eventually "wake-up" to this fact and decline in the future. In light of the deteriorating fundamentals of this organization, as measured by return on assets and return on equity, I recommend shorting the security in the near future.
Even though I believe that the odds currently favor shorting ADI, I do not believe that investors should immediately short the security. I believe that through patience, investors can best time their investment. ADI has been in a moderately-strong uptrend for the past year and I believe that investors should wait until the trend breaks down prior to initiating a short. As seen in the chart below, I believe that an appropriate participation level is $37.50. If price is able to close below $37.50 on a weekly-basis, then I believe investors should consider shorting ADI. I believe that investors should immediately seek to protect capital by placing a stop-loss at $42.00 per share. If price exceeds this level, then a new yearly-high will have been made and a short position will be inappropriate. If price is able to decline as this thesis predicts, then I believe investors should consider exiting one-half of their short position at $30.50. Not only is $30.50 where the current fundamental decoupling began, but it is also a location of significant technical support. For the remaining position, I believe that investors should consider exiting all shares at $26.50. This level has been a historic support point for the past 5 years and I believe price will stall here and reverse course in the future.
The table below shows a breakdown of the trade recommendation. It can be seen that investors stand to gain $2.00 for every $1.00 they are willing to risk. Probabilistically speaking, this analysis needs a 50% chance of being correct for investors to consider shorting ADI using this suggested systematic approach. I believe that it has fundamentally been seen that price should be declining right now due to a deterioration of firm-level performance. If investors agree with this synopsis, then they should consider shorting ADI in the near future.