How To Approach A Cheap Stock In A Pricey Market: The Case Of Deere

| About: Deere & (DE)

Deere (NYSE:DE) is a cheap stock. There is just no getting around it. Pretty much every manner of measurement by every source of data says the same thing. It is cheap on price to earnings, book, sales, and cash flow. It is cheap in context of its whole history. It is cheap in context of the present market as a whole. It has a PE of 10 against a long term norm of 12.5. It sells around one times sales. Its one-year forward EPS is projected as slightly negative, but its 10-year historical earnings growth is around 13% and longer term forward forecasts are around 10%. If that isn't cheap, it's hard to know what cheap would be.

Ah, the market. The market as a whole is somewhat pricey. Probably. It isn't pricey on quite the number of measures by which Deere is cheap, and it's not bonkers the way it was in 2000 or even 2007, but hey, it's pricey. Current PE as generally measured is around 16 and forward PE around 15 - OK, but fully valued. Profit margins are high. Future growth expectations for earnings can hardly exceed a nominal 5-6% even if the current glide path is assumed with no recessions any time soon. The Shiller 10-year PE (NYSEARCA:CAPE) is around 25. That's 1929 or 1968 territory (but not the bubble high territory reached in recent years around 35 or so). Market participants have decided not to worry about the Shiller PE. All in all, though, the market is at best fully valued or a bit to the overvalued side.

One thing is entirely clear: Deere is quite a bit cheaper than the market as a whole. Its price action has been dragging for a year (until a recent pop) while the market ripped to the upside. The question is why. Momentum investors and value investors have different views of this. Here's what two of them had to say:

Jesse Livermore: "Don't tell me the story. Don't tell me the earnings and dividends. The market is ripping and this dog won't budge. People saying nice things about it just makes it worse. Somebody knows something, mark my words. They are smarter and better informed than you and me. Run like hell in the other direction."

Warren Buffett: "Looks pretty cheap at first glance, throws off cash, pays a dividend. Buying back its stock at a cheap price. Sells a product the world has to have and has to replace every few years. Sells to solid folks who tend to pay their bills. I'll have to look a little deeper, maybe call Howie and ask how things really are on the farm."

Okay, so those are two sides of my own head talking to each other, the Livermore side and the Buffett side. The thing is, you take a good bit on yourself if you decide you know more than Mr. Market. That's especially true if you mean to back your opinion with cold hard cash. Better test my view in a little more formal debate. Here goes:

Mr. Market, You've Got It Wrong About Deere, And Here's Why:

Deere is an iconic brand. It has a strong global identity. When you see a piece of green and yellow equipment you know who made it. How much would you have to spend to recreate that brand?

Deere has one of the longest histories of business success of any company in the world. It started in 1837 and is going great guns today. They have survivor qualities and have been doing things right for a long time.

Deere is engaged in providing equipment to an industry which is likely to grow faster than the U.S. and global economies. Global population is increasing, and an increase in global wealth means an increase in food demand. The amount of prime farmland is more or less fixed. This means a huge long term growth opportunity for anything that improves farming efficiency.

Deere is the industry leader. Its scale amounts to a moat.

Deere is out of favor in the market and appears cheap not only relative to its history but also to the price of sectors with less assured long term growth and also to its fellow industrials.

Deere management has a ton of conviction about the future. After all, they just increased the planned stock buyback to $8 billion.

Barron's loves Deere. They recently made it one of their top 2014 value picks. (Barron's 10 Favorite Stocks for 2014 -

Deere may be a classic time-horizon arbitrage stock. Next year's earnings are likely to be down, but the longer term picture is much brighter. Much of a stock's value is in earnings and dividends that are much farther out. It's just a matter of when you, Mr. Market, wise up on this.

Nope, Jim, You're The One Who's Got It Wrong:

Deere is susceptible to cycles in both construction and agriculture. There is good evidence that the agricultural cycle is peaking. Prime land prices in areas like the U.S. Midwest are historically high despite recent declines in crop prices. (See 2012 Farmland Value Survey Iowa State University; also Agricultural Credit Survey | Federal Reserve Bank of Kansas City.) A few lean years in the farm belt could produce results that make Deere look a lot less statistically cheap.

True, Deere has shown good growth over the past decade and longer, but its growth is "lumpy." The agricultural cycle is not correlated strongly to other economic cycles. Imagine what would happen if two or three bad years for agriculture took place while the rest of the economy continued to recover: not good for Deere stock, not good at all.

Deere is a stock which can underperform for a long time. Check out longer term price charts. From 1982 to 1993 Deere went up about 7% a year while the market was doing at least double that. For other periods it did pretty much nothing for a decade. From 1993 to 2006 Deere ripped upward at 15% or so, but those were the growth years of the agricultural super-cycle, weren't they?

Deere has a lot of debt - about four times as much debt as equity. Imagine how the debt service would eat into earnings with just a moderate drop in sales.

Okay, a substantial part of the debt serves to finance buyers of its equipment. That can be great: a large finance arm is a good secondary profit center in reasonably good times. But if crop prices go bad and farm prices also drop, what's the likely effect? Does Deere end up with lots of repossessed tractors?

The management loves Deere stock $8 billion worth with the company's own cash, but not so much with their own cash. You see only insider sales. I know: diversification, kids' college, etc.. But $8 billion of buybacks with equity already only at 20% of capital? Whew!

Barron's hates Deere (as of August 1, 2013, at roughly the current price), citing debt, corn prices and the end of subsidies, the agricultural cycle. (Deere Stock Priced for Perfection - Duh! Sounds a lot like the argument you heard at a social event, Jim, from a young investment banker who said that Deere was toast and the management would eventually get turned out. Do you think he actually knew something?

Deere is hitched up to a great long term growth story. They're making more people, but they're not making more land. The answer: more tractors, etc. Maybe. But what do we mean by "long term"? And "story"? The road to stock market perdition is paved with good "stories."

How many pieces of farm equipment can you use on an acre anyway?

And, Jim, remember something you learned about cyclicals more than 50 years ago, and which has generally been borne out. They always appear cheap at the top (on peak earnings) and expensive at the bottom (on very depressed earnings or even no earnings at all).

Summation on Deere

You will notice that I do not attempt detailed adjustments of estimated sales, earnings, or cash flow. I have considered analyst estimates carefully, and you should too, but you should realize that a 10 PE isn't the whole story. We can't really predict well enough where the E of the ratio falls in the long term growth band. It's fair to say that Deere looks cheap on current stats, but that current stats are only a starting point for consideration. Deere may indeed be a classic time-horizon arbitrage stock. Its short to intermediate results are hard to estimate. Its long term results may be much more predictable and promising, but what is our level of certainty about that? Nothing about Deere is quite as certain as the numbers and the story would have it, so we have to deal in probabilities. Here are my estimates:

What are the chances that the young investment banker was right and Deere is headed for very bad times, a debt crisis, and a management ouster? Less than 10%, I think.

What are the chances of sustained hard times over a few years, enough to make Deere a poor intermediate term investment? This may be the main case that motivates the Deere bears. I have to put the probability as around 35%.

What is the likelihood that Deere has a year or two of lower earnings but continues progress in dividend and EPS in the intermediate term? I put the probability of that around 45%.

What are the chances that Deere has the anticipated flattish to down earnings next year but then surges right ahead? I would say, again, around 10%.

What does it add up to?

Aside from the great momentum leaders of this market no stock has received more recent attention than Deere. Every SA author seems to have a public opinion on it. Most (but not all) articles have been positive. Jesse Livermore would take a very negative view of this in a stock so firmly in the doldrums, although the recent earnings report and buyback announcement caused Deere to perk up a bit.

There's also the matter of the market. You might hold back with your reserve cash if you think a correction is probable any time soon. If not, you might be more easily tempted.

So What Do You Do About Deere

There are really three options:

(1) You do nothing. You find a different use for cash or hold it in hopes the market corrects and presents you with better opportunities.

(2) You buy but pay attention to position size. Deere's dependence on agriculture puts it on a different cycle from the rest of the market. This cuts both ways, but it does make Deere more of a diversifier than many industrials. You take a small position and see if price moves in a way that would attract the attention of Jesse Livermore.

(3) You decide that you feel better about the odds with Deere at a lower price and employ an option strategy, a call write or a put sell. You can infer from the numbers that the options market views Deere as a volatile stock. If volatility doesn't bother you, it presents an opportunity to fish for a position in Deere at a lower price.

My personal solution: I have an outstanding put write in Deere which would be profitable if closed today or would have me buy Deere at a cost of about 78-79. That price more or less reflects the balance of probabilities for Deere as I see them. The position in my portfolio is small to moderate.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have an outstanding put write on DE.

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