In mid-January, I began writing a series of articles that examined how far some popular large-cap industrial stocks might fall if we were to have a downturn within the next five years. I continued the series into the spring, and during the months of March and April, I wrote about 12 service sector stocks that had high historical price cyclicality. The stocks covered in those articles were: Union Pacific (UNP), Costco (COST), FedEx (FDX), S&P Global (SPGI), CSX (CSX), Carnival (CCL), Southwest Airlines (LUV), Paychex (PAYX), Magna International (MGA), Best Buy (BBY), W.W. Grainger (GWW), and Tiffany (TIF).
While most of the articles were generally bearish in nature and meant to be a warning to current investors that even the stocks of good companies could fall quite far during a bear market, I didn't stop there. In each article, I suggested alternative investment ideas for the stocks in question. For several stocks, I suggested that Berkshire Hathaway (BRK.A) (BRK.B) would be a good defensive alternative. For others, I suggested the Invesco S&P 500 Low Volatility ETF (SPLV), the Vanguard Utilities ETF (VPU) or a split between the two of them. In the case of Union Pacific, I suggested all three.
The basic strategy I've been proposing in this series is that when the risk/reward - even for good stocks - becomes tilted too far toward the risk end of the spectrum and the stocks are overvalued once we consider the inclusion of a bear market within the next three years, that investors should rotate out of these stocks and into more defensive positions. The ETFs that I have suggested were chosen because I thought that if the market kept rising, the ETFs would likely capture some of the upside that cash wouldn't. But, if the market went down, the ETFs would likely fall a little bit less than the S&P 500. I assumed that investors liked the companies themselves, and would like to own more shares of the companies, and also that if investors could manage it, that they would like to avoid holding through very big price declines that might include drawdowns in excess of 50%.
Given these assumptions, the goal of this strategy is to increase the shares of the target companies one owns without spending any more money to do so. For example, if one rotated out of the target stock and into the defensive ETF while they were both priced at $100 per share, then during a bear market the ETF might drop to $80, and the target company to $40 per share. At that point, you can rotate back into the target company stock and own twice the number of shares at no extra cost. Then when the stock eventually recovers, you have doubled your wealth compared to what it would have been if you held the company through the entire period (minus taxes, of course).
In order for all this to work one needs to 1) identify a quality company 2) understand when it is overvalued 3) get somewhat close at identifying the late-stages of the business cycle 4) correctly identify a more defensive alternative 5) have the guts to rotate back into the stock when it looks like the world is ending near the bottom of the cycle.
My goal is to provide research, strategies, and ideas that help investors do this.
I'm going to be posting total return YCharts for each one of these stocks and their suggested alternatives in this article. The dates for the charts are from the day of publication of the article until the end of August for each stock. I think it's important to post the charts for each stock because, while the sum total return is important, it is equally important to see the price relationships between the stocks and their alternatives as they move through time. I'll also include SPY as a reference point as well. The reason for these parameters is to keep me consistent and honest with the tracking of the performance over time so readers know I'm not cherry-picking dates. Even without a PRO-subscription, readers can go to my profile and see the publication dates of the articles if they would like to double-check my work.
Berkshire Hathaway begins a recovery
For the entire month of March, in one form or another, I recommended Berkshire Hathaway stock as a good defensive alternative to the target stocks I wrote about. Much to my dismay, Berkshire stock dramatically underperformed through the month of June. The thesis behind the Berkshire idea was that in the event of a downturn, Warren Buffett would likely buy back stock because Berkshire was the best large-cap value in the market and it was unlikely after a 20% market decline anything else would be a better purchase than Berkshire itself. In the meantime, until the next correction, I expected Berkshire stock to trade pretty much in line with S&P 500.
I was wrong with regard to that expectation. In just a few months' time, over a 10% divergence opened up between Berkshire and the S&P 500 index. Regular readers of this series know how perplexed I was about this development and I spent two or three months working through various reasons why this divergence might have happened. Despite not being able to precisely put my finger on the cause, I doubled my personal Berkshire position at around $187 per share and crossed my fingers I wasn't missing something big.
A few weeks later, Buffett announced that he was altering the policy on buybacks to give him and Charlie more latitude on when shares could be repurchased. Now instead of 1.2x book value, the pair could purchase stock whenever they deemed it below intrinsic value conservatively measured. The stock price moved in anticipation of this, and Buffett began buying shares back in August. Though it is unclear how big the purchases have been, the price action of Berkshire on down market days has been much better, and I expect the stock price to continue to steadily rise. It's unknown at what price Buffett will stop buying back shares, but, as I said earlier, I would at least expect it to perform as well as the S&P 500, so we should have at least another 5% outperformance to go from here before that happens. Note in the charts below, that is about what it would take for Berkshire to close the gap with the index.
Even if Berkshire Hathaway eventually closes in on the S&P 500's performance over the next few months, Costco will be handily outperforming them both. I thought I would go back to my original article and see if this sort of performance was predicted by my model. Here is the forecasting chart from F.A.S.T. Graphs used to estimate Costco's future price gains and my commentary about it at the time from the original Costco article.
Currently, Costco is trading at a blended P/E ratio of 34.8, so most of the price gains we've seen since the article was published are due to multiple expansion. To put this into perspective, Costco's multiple before the Great Recession peaked at about 25.3. We have to go back to before the 2001 recession to get multiples this high for Costco. Back then the multiple peaked about 41.8, and during that recession, the stock price dropped 52%. I built a custom F.A.S.T. Graph model using that 41.8 multiple and a 50% drawdown expectations after 2 years and it shows Costco stock would likely fall to $173.47 under that scenario, which is still lower than where it was trading when I wrote my original article. I should add that these are extremely optimistic forecasts. It doesn't seem reasonable to think that a company the size of Costco can grow earnings at the same rate they were expected to do 20 years ago.
In many ways, Costco is trending a lot like Coke (KO) did in the 1990s. Everyone knows what a great company Coca-Cola is, but at a certain point, when Coke's multiple hit 40, then 50, then 60, rational investors should have known it would take many years - decades even - to justify those valuations. And in fact, it took Coke 13 years, including dividends, to recover those 1998 highs. Investors were right about the quality of the company but wrong about the valuation. I feel the same about Costco at these levels. That being said, it's understandable why most investors wouldn't want to sell. They own the stock of a great company and the price just keeps going higher. I have a similar situation with my Apple (AAPL) stock right now. But, if Apple's multiple hits 30, that's where I would probably draw the line and sell. The law of large numbers is a real thing for a company that size. So I still think getting defensive with regard to Costco was the right thing to do, but I think we have to expect the stock will keep rising right up until the next bear market begins.
For the first time since I wrote about FedEx back in March, Berkshire's stock performance is finally better than FedEx's. I don't see any big upside earnings surprises from FedEx in the near future, so I expect we'll start to see Berkshire stock begin to slowly pull away over the next few months.
S&P Global is now trending back in-line with the index, which is what I would expect as normal. Now I just need Berkshire to continue trending higher. My expectation is that these three should trade mostly together until the next bear market where I expect Berkshire to fall less than the others during the downturn.
Southwest Airlines has continued to rally through August. It had already traded fairly far off its highs when I wrote about it in April. I'm not really sure how it's going to trade between now and the next bear market, but I certainly expect it to fall farther than Berkshire when the bear market occurs.
Railroads & Oil
I took a pretty hard look at railroads this month, especially given CSX's strong performance since I wrote about it. I included Norfolk Southern (NSC) in my research even though I hadn't written about it, and it had very similar performance to Union Pacific, while CSX has been performing exponentially better. What made me curious about the stocks was how different they behaved during the past two recessions. (During one they fell early, and during the other, they fell later along with the wider market.) Eventually, the best hypothesis I could come up with was that the rise of fracking in the US beginning in about 2005 may have shifted the dynamics of the rail industry and linked their prices more closely to oil and commodity prices in general than to the wider economy. This would also help explain the dive railroad stocks took in 2015 after oil prices collapsed.
One of the things I like about these tracking updates is that I can loosen up a little bit and just let readers know what I'm researching and thinking about without having to make fully researched and bullet-proof theses with solid conclusions. So, let it be noted that this is more about what I'm currently examining than it is a solid conclusion that I've arrived at regarding railroad stocks.
I decided to use the S&P GSCI commodity index (GSG) as a proxy for what might explain the movements of railroad stocks the past few years. About 60% of the index is tied to energy in some way, the rest to other commodities. The index is represented by the green line in the chart above, and from January 2015 to January 2017 it tracked very closely to all three railroad stocks in the chart. Then, in 2017, CSX and Norfolk Southern began performing exponentially better than the index - yet trending the same - until the summer of 2018 when GSG began to trend down. It's worth noting that the S&P 500 (SPY), represented by the purple line, didn't experience nearly as deep of a drop as the railroads and commodities did in 2015.
What's more interesting is that the commodity index downtrend started about six months before the railroad stocks fell:
In this chart, we see that from 2011 to 2013 the commodity index was trending very similarly to that of the railroads (this time with Union Pacific being the outperformer instead of CSX). But then the stocks continued to climb while commodities leveled off and then dove in the second half of 2014. It took about six months for the railroad stocks to follow and begin matching the commodity trend downward.
Now let's flashforward to 2018.
We are really starting to see the railroad stocks begin to outperform the commodity index, and since July, the commodities are actually trending down a bit. I don't think there is a full divergence here yet. In fact, I've been investing in some oil industry stocks this year (and will likely continue to do so) because I think oil goes higher before we have a recession. That said, if commodities were to trend down for another six months, it could signal a top for railroad stocks, especially if they keep rising over that time period.
This is all highly speculative on my part, but I just thought I'd share what I've been thinking about and keeping an eye on this month. It probably won't help me much this cycle since I don't own any railroad stocks right now, but it could come in handy if I buy some during the next downcycle.
I consider Carnival stock a leading indicator since it tends to fall before the general market does. It also tends to rally after that initial fall, and now I think we are seeing some of that rally. The longer we go without a wider bear market the more likely the stock will potentially recover its old highs, but even if it does (and there is no guarantee it will) I think the recovery will be short-lived, so I'm waiting for a full bear market or recession before I look to buy this stock.
If Magna International stock stays beaten down for the next couple weeks I'll probably write a follow-up article on it with my 'buy' prices listed and explained. I do think that one of the best services I provide readers is issuing warnings for stocks like Magna, so shareholders at least know what sort of downside is possible for the stock. It's currently down -10% since I wrote about it, but down over -20% from its highs.
Paychex has been kind of a classic example of what I usually expect using a rotational strategy. While the economy is strong, we should expect outperformance of the stock compared to the SPY and we should probably expect the defensive alternative to underperform a little bit. But, when the bear market occurs we should expect the defensive alternative to fall far less than the target stock, making up for the gains the target stock made before the bear market. Time will tell if this plays out how I expect it to but the trend we are seeing now isn't surprising.
With regard to Best Buy, while it has fluctuated wildly, I think we are going to need to get through the holiday season to see if it breaks higher or lower relative to the index.
I wrote more extensively on Grainger last month and determined this is one I should have put in the 'too hard' pile instead of offering an alternative. Its turnaround seems to be doing well. This could be one I'm eventually wrong about.
Tiffany stock had been flirting with becoming the only stock to totally break the model I use to estimate forward stock gains in my risk/reward analysis, but last month I warned investors about Tiffany's potential Chinese currency risk. Since last month's update, the stock has fallen about 10% and is now back within the parameters of the model. It has still performed ~15% better than my alternative, though.
The market made new all-time highs his this month and that is reflected in the very strong performance of +13.13% from the target stocks through August. That compares to a +8.99% from the S&P 500 if the investments were made at the same time, and +5.26% from the defensive alternatives I suggested. The defensive alternatives have caught up a little bit since the end of July when the numbers were +11.56%, +5.71%, and +2.06%, respectively. That is mostly due to Berkshire's stock price beginning to recover. Hopefully, that recovery will continue over the next few months.
If one includes all 27 stocks I've written about in the "How far could they fall?" series (the rest of them are tracked here), the target stocks have returned +3.16%, the SPY +7.77%, and the defensive alternatives +6.55%. Overall I'm pretty happy with how things are tracking. In particular, for the stocks like industrials that tend to fall earlier than the rest of the market, the defensive stocks have significantly outperformed, and I think that is a reasonable indicator of how they might perform during an actual recession. Also, the defensive alternatives are significantly outperforming cash, which was the real 'default' alternative I was trying to contrast against in the articles. Additionally, the defensive alternatives are performing fairly close to the S&P 500 even though the index is making new all-time highs. And finally, I am very pleased that only one defensive investment out 27, Johnson & Johnson (JNJ), is currently negative (down about 3% since publication).
Last month I only wrote one "How far could they fall?" article, and it was about Nike (NKE). The article was published before the advertising controversy, so it will be interesting to see if that serves as a catalyst to send the stock lower over the next few months and quarters. I plan to track it with the service sector stocks beginning next month.
As for the rest of this month, I don't have any new 'How far could they fall?' articles on tap for certain yet, but I have been spending considerable time researching stocks in the technology sector. There are some portions of technology, like semiconductors, where I have fairly high confidence my rotational approach can work. But there are others where it becomes hard to predict how much the companies have changed from one cycle to the next and to find good defensive alternatives. I spent a considerable amount of time working on Adobe Systems (ADBE), for example, but ultimately didn't quite have the conviction that my model would work well for the company. So, I've done a lot of work in the background this month that never quite made it to publication. My plan is to simply keep working and researching until I'm happy enough with an approach to at least cover a few technology companies.
In the meantime, I have a good variety of 'buy' articles, 'this is the price I'll start buying' articles, and perhaps a couple more 'playing defense' articles I'm working on now for September. So, I should be putting out a good mix of articles this month. Thanks for reading, and I would be happy to answer any questions in the comments section.
Disclosure: I am/we are long AAPL, BRK.B. 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.