This is part six of a seven-part series that is looking at the incredible opportunity that a cyclical company can represent as earnings recover coming out of a recession. A primary objective of this series is to illustrate that price drops of well-established companies are usually temporary even after earnings are cyclically weak.
Part one, 6 High Profile Industrials With Staggering 3-Year Performance, provided a cursory view of six industrial companies. In the part prior to this one, we looked at Ingersoll-Rand (IR) in Rand: Profit by Investing in Recovering, Large, Well-Entrenched Cyclicals You can find the entire series here.
Johnson Controls (JCI): Its Businesses
Johnson Controls operates three core businesses that generate approximately $40 billion a year in revenues. Its largest segment representing 48% of sales is its automotive interior segment. The second largest segment, representing 37% of sales, is its building interior controls business, and its third segment representing 15% of sales is its power segment which is predominately automotive batteries. To put these businesses into perspective, approximate 63% of its business is related to and/or dependent on the automotive sector.
The following slide excerpt from a presentation made by management on June 27 at the Power Solutions Analyst Day summarizes the company's core businesses. The fact that the slide was titled "Three world-class growth businesses" offers an interesting insight and perspective on this quality company. As we will illustrate, Johnson Controls has a legacy of generating an above average and very consistent level of earnings growth. However, the great recession of 2008-09 brought an abrupt change as it interjected a high level of cyclicality into the company's earnings record.
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The following earnings and price correlated F.A.S.T. Graphs™ on Johnson Controls from 1992 to calendar year 2007, one year before the great recession of 2008, illustrates a remarkable pattern of earnings growth and price performance. JCI grew earnings (the orange line with white triangles) at an average rate of 16.7% per annum with a remarkable degree of consistency. The black line on the graph represents monthly closing stock prices which clearly followed earnings consistently higher over this time frame. This is a picture that represents a quintessential example of a true growth stock. However, this series was written about cyclical stocks, which up to this point Johnson Controls would not typify.
The associated performance results on the earnings and price correlated graph above shows that shareholders earned a 16.8% annual capital appreciation which almost perfectly mirrored earnings growth. Add in a dividend that was increased every year, and the total annual rate of return increases to 17.5% per annum. This is growth in its purest form.
As previously pointed out, over 60% of Johnson Controls’ business is exposed to the extremely cyclical automotive industry. Therefore, it's a testament to the quality of the management of this company that it was able to generate such an exemplary record of earnings growth up to calendar year 2007. However, when the recession of 2008 brought with it an extreme level of stress on the automotive sector, Johnson Controls was unable to avoid succumbing to the cyclicality of the major industry it served.
Therefore, fiscal year 2009 (ending September 30) experienced an earnings collapse of 80%, as earnings fell from $2.38 to $0.48. This instigated the stock price to fall from an overvalued price of $43.72 on the way down to $8.35 by February of 2009. But when the recession ended, earnings recovered to $2.04 in fiscal 2010 and are expected to reach $2.45 this fiscal year, which will be its highest level of earnings ever. Of course, as the graph depicts, the stock price recovery was just as swift as the earnings recovery.
One of the lessons learned here is how quickly that the earnings and price of a well-entrenched quality business can recover when business conditions normalize. When stock prices fall like they did for Johnson Controls, traumatized investors almost always feel that they can never recover their losses. But as the following graphics illustrate, recovery can be swift and sure. Frankly, this was a big surprise to us, but our graphs clearly illustrate how and why the recovery happened and in much more vivid detail than a mere stock price chart could have shown.
It's also noteworthy to recognize that the earnings growth rate for JCI has reasserted itself to an average growth of 12% per annum. So when we look at the company fundamentally today, we see a reasonable price earnings ratio of 15.1, a dividend yield of 1.8%, and a debt to equity ratio of only 20%. Consequently, we find it equally surprising how swiftly the company's fundamentals deteriorated during the recession and how quickly it was able to recover fundamentally speaking.
When we review the associated performance results with the above graph, we once again find the uncanny correlation between earnings growth and shareholder returns. Now that the earnings growth rate has returned to an average of 12% per annum, shareholder capital appreciation of 12% per annum directly reflects the earnings achievement. But perhaps most interesting of all when reviewing these performance results is the fact that Johnson Controls maintained its dividend throughout its earnings interruption. Consequently, shareholders relying on dividend income were not hurt by the enormous volatility of Johnson Controls’ stock price.
For a more detailed look at JCI, see this video.
A Candid Confession
The primary reason we were compelled to write a series of articles was partially stimulated by Johnson Controls. In March of 2005 we invested in this terrific business at an approximate price of $19 per share. By June of 2006 we felt the stock had become overvalued and sold our position at approximately $29 a share. By September of 2006 the stock had fallen to $22 a share and our decision looked like a good one. However, by the end of October 2007 the stock price rallied to almost $44 per share, and our decision looked shortsighted.
On the other hand, at $44 a share Johnson Controls was clearly overvalued and promptly fell back down to $32 per share by January of 2008. At $32 a share, the stock was once again trading at 15 times earnings which we considered a fair price so we re-purchased about a third of the number of shares that we originally sold. Our intent was to eventually rebuild our full position. By April 2008 the stock had rallied to over $35 a share, which we felt was modestly overvalued so we refrained from adding to our position.
What happened next was an experience that we would never care to relive. Of course, we are referring to the great recession which caused Johnson Controls’ stock to initially fall to approximately $28 per share, then staged a minor rally back to approximately $31 a share and then all hell broke loose. Earnings per share began to collapse and along with falling earnings, Johnson Controls’ stock price plunged to approximately $8.35 a share. Then the real mistake was made. The stock price rallied back to $13 a share by April 2009 and we sold out.
The moral of this story is that our actions were consistent with our investment philosophy. If a company’s stock price falls, even precipitously, while earnings continue to advance, we consider this a buy signal. We are always comfortable buying into a situation where we think our investment is being made at below intrinsic value. However, when earnings are collapsing along with stock prices, we always consider this a deteriorating fundamental and a sell signal.
We still believe this to be a sound and prudent approach, and therefore we do not really regret our action. On the other hand, the Johnson Controls experience has at least caused us to re-examine our tenets in order to see if there are any lessons to be learned. As an interesting aside, we did make money on our total Johnson Controls transactions. However, our profits are dwarfed in relation to what we could have earned had we added to our Johnson Controls shares instead of selling them. The compounded annualized rate of return for Johnson Controls shares since Dec. 31, 2008 has averaged over 32% per annum, which would have more than doubled our investment.
The Johnson Controls story represents another example of how fundamental values are much more important than stock price volatility. Ben Graham tried to teach us a most important investing lesson with his now infamous metaphor: "In the short run the stock market is a voting machine (price volatility), but in the long run it's a weighing machine (intrinsic value)." Unfortunately, this seems to be a hard lesson for investors to learn. When stock prices are fluctuating wildly, it is very difficult for investors to keep their wits about them.
We see it as almost our sacred mission to educate investors on the importance of fundamental values over stock price volatility. Unfortunately, every investor has access to the price movement of her portfolio based on each month’s ending account value. Moreover, with online access, most investors can check the value of their stock portfolios day-by-day or even minute-by-minute. However, very few investors have an easy and reliable method of evaluating the intrinsic value of their holdings. We are thankful that our graphs research tool provides us this vital information at a glance. In our next and last installment of this series, we will look at Illinois Tool Works (ITW) through the lens of our fundamental research tool. This high-quality company, like Johnson Controls, was one that we once owned that also taught us a valuable lesson.
Disclosure: No position 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.