- Aetna was one of 15 stocks appearing on Goldman Sachs' recently-published buy list.
- The stock as priced offers negative growth alpha of 30 basis points, which translates to 6% downside to my estimate of fair value.
- At present, investors can expect a total long-term return of 10.76% from the stock.
Aetna taught me an important lesson a long time ago. It was approaching May 2006, and Aetna dipped 20% one fine day. I ran my numbers and modeled in declining long-term margin expectations, and thought, this is a great buy. I felt mighty pleased with myself until late in July that year, when the stock took another 16% one-day hit.
This was not long after I had chucked up a great job because the weather in Aberdeen bothered me. And a group of friends suggested that I set up shop to help them better manage their capital. Remember, this was in 2006, when the market was very bullish and not making money was a sin. It was an embarrassment, to say the least. Things worked out well in the long term. And I did learn that a value opportunity often becomes a deep value opportunity.
I'm a value investor with a very strong quantitative bias. I learned to recognize that different folks think in different ways. And I now recognize that if enough people think differently, I will be on the wrong side of the trade.
If I had a sense of how different people thought, I'd be able to pass on a value opportunity to wait on a deep value opportunity. It worked well on timing an entry into Apple, which I felt was a great buy at $525 ($75 post-split), but waited to buy later. On the other hand, it does not always work: market timing is awfully difficult, and timing an entry for a specific stock is no different. Ultimately, to avoid trying to be smart on timing, which I'd never get right anyway, I decided to stick with an allocation model. But understanding behavior of different market participants became an important factor in determining how to scale into a position in specific stocks.
How do different market participants view Aetna?
A couple of years ago, I had written some code to facilitate stock selection. It would help if you read about the build-out of that system here and here, as that will allow you to appreciate the model output later in this post better.
AOM Statistical Scores
The AOM statistical scores are a statistical evaluation of 38 key indicators for the company, grouped into value, growth, quality and momentum categories. It illustrates how the key indicators for the stock perform in comparison to the market capitalization weighted scores for the market, the stock's sector and the stock's industry of operation.
Aetna scores high on value, regardless of whether we view value in the context of the company in comparison to the market, or its sector or industry of operations. The quality scores are weak in comparison to the broad market and other stocks operating in the same sector. However, quality is in line with the healthcare plans industry. Growth scores are in line with a market and the healthcare sector, but below growth scores for the healthcare plans industry. Momentum is strong.
AOM Model Recommendation
This stock is expected to appeal to value and momentum investors, regardless of whether they select stocks based on evaluation of key criteria versus the market, or versus other stocks in the same sector or industry of operations. It is also expected to appeal to balanced investors (those who consider value, growth, quality and momentum criteria as having equal importance) selecting stocks by comparison of key criteria versus the broad market, or versus other stocks in the same sector or industry of operations. Growth investors (except those who allocate capital at market level, who might view the stock favorably) can be expected to be indifferent to the stock.
Overall, after analyzing 15 stock selections and capital allocation strategy combinations, the system assigns an AOM Score of 72% and an AOM Buy recommendation for Aetna.
The AOM statistical scores for each of the 15 strategy combinations are unique and not comparable with each other. The AOM Score is very different from AOM Statistical scores: it evaluates and rates the AOM Statistical scores for each of the 15 strategy combinations, and uses a unique technique to make the statistical scores across the strategy combinations comparable. The output is the AOM Score: a quantitative assessment of the output from the 15 strategy combinations. The AOM Recommendation is a plain-English recommendation based on the quintile the AOM Score falls in.
I'll hasten to add that this is a package aimed at generating ideas, it does not intend to, and nor does it replace the due diligence we must do as investors. It is a tool that uses quantitative techniques to understand the behavior of different market participants, and then brings that data together so that users can hear the voice of the market through the noise. The AOM system can guide you where to look, but make no mistake about it - it cannot look for you.
The Case for Aetna:
Why look at Aetna now?
Valuation remains a good reason to look at Aetna now. The stock trades at a trailing twelve-month P/E below the market P/E. The P/E for 2015 is at a level that suggests that there is gain potential from earnings growth, as well as from an expansion in the multiple. Even the PEG ratio is reasonable in comparison with the market, the healthcare sector, and the healthcare plans industry.
And while the dividend yield is well below dividend yield for the market and the healthcare industry, Aetna does offer an attractive dividend yield in comparison with stocks in their industry of operations. This is great when considering the additional value returned to owners via buybacks, net of dilution on account of employee and other issuances, over the past five and ten years. Over the past five and ten years, annual average diluted shares outstanding have declined 20.1% and 42.8%, respectively. Since this is a decline in share count net of employee and other issuances, we know that value has been returned to shareholders at an annualized rate of 5.43% over ten years and 4.39% over five years: Aetna has done a good job of returning capital to shareholders over the long term. However, what is a tad worrying is that annual average diluted share count has crept up over the last couple of years, and that more than negates the value of the currently meager dividend.
Aetna scores poorly on key growth criteria. However, quarter-on-quarter growth for sales and earnings has done quite nicely recently. Despite the weak growth scores, Aetna remains a leader in growth in the large-capitalization healthcare plans industry, and at present, we are leaning on large-capitalization to seek out a degree of defensive characteristics, because the market is expensive. If it is growth you are looking for, stronger growth can be found in the healthcare plan industry in the mid-cap space - in companies like Centene (NYSE:CNC), Health Net (NYSE:HNT), Molina (NYSE:MOH) and Wealthcare Health Plans (NYSE:WCG).
On quality, Aetna is nothing exciting: it is very much in line with the healthcare plans industry. It is encouraging that return on equity, operating margin and profit margin are ahead of the industry average: this suggests the company is executing well. It is also encouraging that institutional owners strongly back Aetna, though this institutional interest is very much a theme for the healthcare plan industry.
Momentum is pretty strong, no matter which way you look at it.
Is Aetna a suitable pick for alpha hunters?
Analyst price expectations
Recently, Aetna traded at $80.99. From Yahoo Finance, we know that eighteen analysts expect an average price target of $84.89 (median $86.59), with a high target of $90 and a low target of $73. So far, the bulls are winning.
Source: Yahoo Finance
One of the classic conundrums for value investors is that value stocks tend to go from being very cheap to being rightly valued, and back to being cheap. When a stock is rightly valued, it is priced to hold. When it is cheap, it is priced to buy. And one way to determine whether it is cheap or not is to estimate the alpha available with the stock as currently priced.
Alpha is the difference between actual returns and risk-adjusted returns an investor should expect from a stock. So we will really never know the extent of alpha created until the actual return is earned. But we can always try to estimate alpha.
Mathematically, the worth of Aetna is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate]. If you do use the above formula, please read this explanatory note.
So let's have a closer look at the different parameters used to determine value.
Beta, co-efficient of determination and alpha intercept considerations
Value Line reports a beta of 0.85 for Aetna. The Value Line beta is calculated as a five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, adjusted for beta's tendency to converge toward one.
I calculate the raw beta based on the five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the S&P 500 at 0.96, and I adjust it to 0.99 on account of the beta's tendency to converge toward one. This low beta adds defensive characteristics to the stock, which is always nice in what is perceived as an overvalued market.
The coefficient of determination for Aetna is 29.62%. This suggests that only 29.62% of the price movement in Aetna is explained by movements in the market: the residual price movement is based on company-specific factors. This low coefficient of determination suggests that the market-related risks are low. And because company-specific risks can be diversified, Aetna is a great pick for most portfolios at the present time. The low level of the coefficient of determination for Aetna makes me a bit uncomfortable with using beta as a reliable measure of risk. I generally work with a market return expectation of 10.25%. The standard deviation for weekly price change at Aetna over five years has been 3.79%, whereas it has been 2.15% for the S&P 500. I will set a personal target rate of total return of 11.06% for Aetna: that is 10.25% market return plus 50% of the difference between standard deviation for a weekly price change for Aetna and the standard deviation for weekly price change for the S&P 500. This equates to the return expectation for a stock with a beta of 1.14.
The good news is that Aetna has an alpha intercept of 0.22%: this means that if the S&P 500 returns 0%, the stock can be expected to return 0.22%. But because of the low coefficient of determination, the raw beta and alpha are less meaningful.
Over the past five years, the average weekly price change on Aetna has been 0.52% (median 0.47%). The standard deviation over the period has been 3.79%. Thus, for Aetna, the range of normalcy (average plus or minus one standard deviation) for weekly returns is between a gain of 4.3% and a loss of 3.3%. Volatility has been on the decline since mid-2012: and that is good in that strong long-term returns often accompany low volatility. And low volatility is nice to have in combination with decent valuation for a stock in an expensive market. But is Aetna well-valued?
Source: MaxKapital Beta Calculator
We might believe that Aetna is attractively valued. But thus far, its attractiveness has been viewed relative to other stocks in its sector, industry or the coverage universe in the analysis of the perception of different market participants. We also know that Aetna is cheap relative to the broad markets. What we do not know is whether the stock is priced to deliver a long-term return in line with our long-term expectations on a standalone basis and regardless of broad market valuations.
Mathematically, the worth of Aetna is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate].
What is our long-term return expectation for a stock with a beta of 1.14, a long-term risk-free rate of 4.50% and an equity risk premium of 5.75%? You can read more about where I get my estimates for long-term market returns and equity risk premium here. It is calculated as Risk-Free Rate plus Beta Multiplied by Market Return less Risk-Free Rate. Thus, for Aetna, we should be targeting a long-term return of 11.06%. Is the stock priced to deliver that return?
Earnings tend to be volatile from year to year over the course of the economic cycle. When I speak of sustainable earnings, I mean the level of earnings that can be expected to occur over the course of an economic cycle, which can be grown at estimated growth rates over a long period of time. This chart below displays normalized trailing twelve-month earnings over the past five years, together with analyst expectations for the current and coming three years. It also shows Aetna's historic revenues and sales estimates for the current and coming fiscal years.
Twenty-two analysts included on Reuters data estimate average operating earnings of $6.50 (High: $6.75, Low: $6.20) during 2014, with 21 analysts estimating that it will rise to an average of $7.17 (High: $7.80, Low: $6.75) during 2015. Five analysts assess long-term growth rates at 9.66%, on average, with a high estimate of 11% and a low estimate of 8.5%.
While growth potential exists, both growth and growth expectations are moderate. Growth can be exciting - but don't let its absence depress you. It is most common to see superior long-term returns generated via a combination of slow and steady growth, alpha and dividends. In fact, look no further than Aetna for an illustration for the power of value investing - since April 1, 2009, the stock has delivered an annualized return excluding dividends of 27.40%, compared with 17.42% excluding dividends which the S&P 500 delivered.
I'm comfortable with $5.69 as a fair representation of sustainable earnings. Operating earnings for the trailing twelve months to March 2014 are $6.33, but earnings for Aetna are very cyclical - earnings are strongly influenced by the economic and interest rate cycle, and so I estimate sustainable earnings at $5.69 - a lower cyclically-adjusted level. Please keep in mind that the $5.69 you see in the chart below represents the reported earnings over the past twelve months: it is identical to my estimate of sustainable earnings (cyclically-adjusted earnings) by coincidence.
The adjusted payout potential is that part of sustainable earnings that we can expect the company to return to shareholders via dividends and buybacks, net of dilution on account of employee and other issuances. I expect Aetna will pay out approximately 65% of earnings via dividends and buybacks (approximately 15% to 20% via dividends, and another 50% to 45% via buybacks) over the long term. An adjusted payout ratio of 65%, assuming nominal earnings growth of 5.91%, implies a return on incremental equity of 16.85%: the 35% of earnings retained, invested at a 16.85% return on equity, delivers the required 5.91% (35% * 16.85%) growth. This return on incremental equity is not unreasonable to expect, considering that the recent return on equity is 16.72%, and it has averaged 16.85% over the past five years.
If we use a very long-term growth expectation of 6.21%, Aetna is worth $80.99. Aetna Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 106.21% * $5.69 * 65% / (11.06%-6.21%) = $80.99. At this price, it is likely that an investor with a return expectation of 11.06% will be satisfied.
The growth estimate implied by the current market price of 6.21% is high.
Alpha is estimated as the difference between actual returns and the risk-adjusted return expectation. If we accept analyst estimates of forward five-year growth of 9.66%, we get a composite very long-term (fifty-year) growth rate of 5.91%, assuming the following five years' growth at 9.66%, growth reverts to a 5.5% growth rate for the next forty-five years. If Aetna grows at a long-term rate of 5.91%, we have negative growth alpha of 0.30%. And an investor buying at present levels can expect a long-term return of 10.76%. In my view, Aetna is capable of sustaining a very long-term growth rate of 5.5%, which is essentially in line with U.S. potential nominal GDP growth rates adjusted upward for an international growth opportunity.
If we use a very long-term growth expectation of 5.91%, Aetna is rightly valued at $76 [105.91% * $5.69 * 65% / (11.06%-5.91%) = $76]. So at present, we have 0.30% of negative long-term alpha, which translates to a 6% downside to "rightly valued," after which you can expect a very long-term total return of 11.06% from the stock.
However, from a trading perspective, there is upside to 90 [105.91% * $5.69 * 65% / (10.25%-5.91%) = $90]. This price target reflects very long-term growth expectations of 5.91%, an adjusted payout ratio of 65% and an investor return expectation of 10.25% consistent with a beta of 1. I have shied away from a lower return expectation on account of the low co-efficient of determination, which makes the beta less reliable as a measure of market risk. And this is not the most bullish perspective either. Since recession probability is low, I could well estimate sustainable earnings at $6.33, which is the operating earnings over the past twelve months to March 2014. That would take the upside to $100 [105.91% * $6.33 * 65% / (10.25%-5.91%)]. If this occurs, it would be very unusual - the stock would trade at a multiple of near 16 times operating earnings. Now this multiple is not terribly high, but it is considerably higher than the PE ratio over the past five years.
To conclude, Aetna is an attractive buy candidate as priced for those comfortable with a risk-adjusted return expectation of 10.25% or lower. It is also an attractive buy for those with conviction that this expensive market shall continue to trade with a bullish bias for a while yet. However, in my view, Aetna is worth keeping an eye on for a decent entry opportunity at $76 or less - at present, it is too pricey for me.