- Corning was one of fifteen stocks appearing on Goldman Sachs recently published buy list.
- The stock as priced offers negative growth alpha of 53 basis points, which translates to 12% downside to my estimate of fair value.
- At present investors can expect a total long-term return of 10.8% from the stock.
In this post I have a look at Corning (NYSE:GLW), one of Goldman Sachs' fifteen picks for the present market.
I like Corning the company - in glass they are a class apart. As a value investor with a very strong quantitative bias, I'd like to examine what Corning might be worth to me. At the same time, I'd like to consider what Corning might be worth to others. Understanding the behavior of different market participants is particularly important at the time of an entry and exit into a position.
How do different market participants view Corning?
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 thirty-eight 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.
Corning scores well on value, regardless of whether it is compared with other stocks in the market, the technology sector, or the diversified electronics industry. The quality scores are weak but tending towards in-line in comparison to the broad market, and are weak in comparison with other stocks operating in the technology sector. The quality score is strong, but tends towards in-line in comparison with the diversified electronics industry. Growth scores tend towards in-line the market and diversified electronics industry, but are weak in comparison with the technology sector. Momentum is strong across the board.
AOM Model Recommendation
This stock is expected to appeal to a wide variety of stock selection styles, regardless of whether capital is being allocated to the market, a sector, or an industry. Growth style stock selectors seeking to allocate capital to the best candidates in the market or to the best candidates in the technology sector would be indifferent to Corning.
Overall, after analyzing fifteen stock selection and capital allocation strategy combinations, the system assigns an AOM Score of 77%, and an AOM Buy recommendation for Corning.
The AOM statistical scores for each of the fifteen 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 fifteen 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 fifteen 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 Corning:
Why look at Corning now?
Is the valuation a good reason to look at Corning now? The stock trades at a trailing twelve month P/E below the market P/E, the technology sector and the diversified electronics industry. The P/E for 2015 is at a level that suggests that there is some gain potential from earnings growth, as well as from an expansion in the multiple. The PEG ratio, is low, and is good in comparison with the market, other technology stocks and stocks in the diversified electronics industry.
Corning does offer an attractive dividend yield in comparison with stocks in the diversified equipment industry, but its yield lags the broad market and the technology sector. They have done a decent job, but not exceptional job in returning value through buybacks net of dilution over the past five of years. The value returned through buybacks over five years has been 6.76% and this works out to a 1.39% annualized rate. The total yield from dividends plus buybacks net of dilution is very acceptable at 3.22%.
Corning scores well in forward growth expectations in comparison with the market, technology sector and diversified electronics industry. Sales growth quarter on quarter has been positive, while historic sales growth over the past five years has outperformed other stocks in the diversified electronics industry. In most other respects the key growth criteria for Corning have underperformed the industry.
On quality, Corning is nothing exciting, but for the very strong institutional ownership, which might be viewed as a signal that knowledgeable investors have a high level of commitment in the company. The other positives on quality are gross, operating and profit margins, which are strong for the diversified electronic industry.
Momentum is strong though it has been weak over the past week.
Is Corning a suitable pick for alpha hunters?
Analyst price expectations
Recently Corning traded at $22. From Yahoo Finance!, we know that sixteen analysts expect an average price target of $22.06 (median $22), with a high target of $27 and a low target of $17. So far, the bulls have it.
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 Corning 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 us 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 1.25 for Corning. 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 towards 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 1.20, and I adjust it to 1.12 on account of the beta's tendency to converge towards one. The strong balance sheet and large-cap status of the stock add defensive characteristics to the stock, while cyclicality in earnings and beta take away defensive characteristics.
The coefficient of determination for Corning is 41.42%. This suggests that 41.42% of the price movement in Corning is explained by movements in the market: the residual price movement is based on company-specific factors.
This average coefficient of determination suggests that the market related risks are average. And since company specific risks can be diversified, Corning is a decent selection for a portfolio. However, the cyclicality of earnings and the high weekly price volatility for the stock versus the weekly price volatility for the S&P 500 makes me a bit uncomfortable with using a beta as low as 1.12 as measure of risk. I generally work with a market return expectation of 10.25%. The standard deviation for weekly price change at Corning over five years has been 4.32%, whereas it has been 2.15% for the S&P 500. I will set a personal target rate of total return of 11.33% for Corning: that is 10.25% market return plus 50% of the difference between standard deviation for weekly price change for Corning 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 1.19.
Over the past five years, the average weekly price change on Corning has been 0.21% (median 0.22%). The standard deviation over the period has been 4.32%. Thus for Corning, the range of normalcy (average plus or minus one standard deviation) for weekly returns is between a gain of 4.5% and a loss of 4.1%. Volatility has well contained on the downside since December 2012. And low volatility is nice to have in combination with decent valuation for a stock, in an expensive market. But is Corning well valued?
Source: MaxKapital Beta Calculator
Corning's performance since April 1, 2009 is poor: the stock has delivered an annualized return excluding dividends of 6.63%, compared with 17.53% excluding dividends which the S&P 500 delivered. The performance has not been good on a risk-adjusted basis, particularly when we consider the below market dividend yield, though that is no reason why it should not outperform going ahead.
We might believe that Corning 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 Corning 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 Corning 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 1.19, 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 Corning, we should be targeting a long-term return of 11.33%. 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 Corning's historic revenues and sales estimates for the current and coming fiscal years.
Seventeen analysts included on Reuters data estimate average operating earnings of $1.50 (High: $1.58, Low: $1.38) during the 2014, with eighteen analysts estimating that it will rise to an average of $1.67 (High: $1.82, Low: $1.50) during 2015. Two analysts assess long-term growth rates at 15.1% on average, with a high estimate of 17.6% and a low estimate of 12.6%.
I am comfortable with $1.36 as a fair representation of sustainable earnings. Earnings for Corning are very cyclical - so risk to incorrect earnings estimates is high.
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 Corning will pay out approximately 60% of earnings via dividends and buybacks (net of employee and other issuances) over the long term. An adjusted payout ratio of 60%, assuming nominal earnings growth of 6.82%, implies a return on incremental equity of 17.05%: the 40% of earnings retained, invested at a 17.05 % return on incremental equity, delivers the required 6.82% (40% * 17.05%) growth. This return on incremental equity is high considering that the recent return on equity is 8.59%, and has averaged 12.64% over five years. Bear in mind that we are looking at return on incremental equity, not return on equity. After adjusting shareholders equity for goodwill, cash, and investments I arrive at an estimated a return on incremental equity potential of 20.1% for Corning. Also consider that a 60% adjusted payout ratio is broadly in-line with what we have seen over the past five years.
If we use a very long-term growth expectation of 7.35%, Corning is worth $22. Corning Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 107.35% * $1.36 * 60% / (11.33%-7.35%) = $22. At this price, it is likely that an investor with a return expectation of 11.33% will be satisfied.
The growth estimate implied by the current market price of 7.35% 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 12.1%, we get a composite very long-term (fifty-year) growth rate of 6.82%, assuming that following five years growth at 12.1%, growth reverts to a 6.25% growth rate (an average of 8% global nominal GDP growth potential, and 4.5% US nominal GDP growth potential), for the next forty-five years. If Corning grows at a very long-tern long-term composite rate of 6.82%, we have negative growth alpha of 0.53%. And an investor buying at present levels can expect a long-term return of 10.8%.
If we use a very long-term growth expectation of 6.82%, Corning is rightly valued at $19.33 [106.82% * $1.36 * 60% / (11.33%-6.82%) = $19.22]. At this price, it is likely that an investor with a return expectation of 11.33% will be satisfied. So at present, we have 0.53% of negative long-term alpha, which translates to a 12% downside to "rightly valued", after which you can expect a very long-term total return of 11.33% from the stock.
However, from a trading perspective there is upside. The stock trades at 14.7 times 2014 operating earnings: this is not hugely expensive.
Also consider that the company has a buyback plan operational, and they have been buying back shares aggressively. The cash committed to buybacks is substantial in the context of the market capitalization of near $29 billion. And when we consider that 77.7% of the ownership is institutional, the buyback becomes even more influential during a period when non-institutional shareholders might sell in distress - this provides downside protection to extreme losses.
Source: Corning Quarterly Presentation
Corning is an attractive buy candidate as priced for those comfortable with a risk-adjusted return expectation of 10.80% 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, Corning is worth keeping an eye on for a decent entry opportunity at $19.33 or less - at present, it is too pricey for me.
In glass, Corning represents class. It is a good stock, but it is not presently an attractive buy candidate for new capital being deployed. Nonetheless, if owned, it is a good stock to hold for the present time. There is price support as a result of the buyback program. There is upside to per-share estimates on account of buybacks. And as time passes and earnings grow, it is likely that the share will grow to be well valued, even cheap at $22.