Tracking How Far They Fell: One Year Anniversary. Analyzing What We've Learned.

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Includes: AXP, BA, BBY, BRK.B, CAT, CMI, COST, DE, EMR, FDX, FISV, GWW, JNJ, LUV, MMM, NKE, PAYX, PGR, RSP, SPLV, STT, TIF, UNP, VPU
by: Cory Cramer
Summary

In 2018, I warned investors about 27 cyclical stocks that could fall quite far in a bear market.

I suggested some alternative investments I thought would be more defensive and also suggested a rotational strategy that could increase one's shares of the target stocks at no extra cost.

This year marks the one year anniversary of the series.

In this article, I'll review the goals of the series and the performance of the ideas so far, as well as what we have learned about cyclical investing along the way.

anniversary

Source: Pixabay

Introduction

This month marks the one year anniversary of the beginning of the 'How far could they fall?' series and I thought this would be an appropriate time to reflect on the inspiration and purpose of the series. I am now entering my 4th year writing about cyclical strategies and investing on Seeking Alpha. The first two years I focused exclusively on sharing long ideas about deep cyclicals that were trading near cyclical lows and offered the potential for big rewards over the medium-term for investors brave enough to buy them. Of the 7 cyclical ideas I presented those first two years, 4 of them returned 90-110% within 2 years. I still hold the other three. Currently, one is flat, and two are negative.

What I noticed going into 2018 was that, not only were there not many cyclical values trading at good prices to write about, but many cyclical stocks were trading at such lofty prices there was a serious danger for investors to the downside. Since I had been committed to writing about long-only strategies since 2016, with the 'How far could they fall?' series, I set out to both warn investors about the downside risk of the stocks they held and to offer alternative investment ideas and strategies that could keep them fully invested in the market, while also reducing their risk.

This all culminated in three different and simultaneous goals for the series. First, I wanted to warn investors about the dangers of the cyclical stocks they held. Second, I wanted to publicly demonstrate that the long-only rotational strategy I was suggesting, could work in real life, not just during backtesting. And third, I wanted to track the results each month and learn as much as I could about the details of the strategy. For example, over the past year, we have been able to see which investments worked best as defensive alternatives; learned that there are different types of cyclicals and that each type requires a slightly different investment strategy; and, eventually, we'll learn which stocks we might not get an opportunity to rotate back into at a better price and how to deal with that situation.

In my view, readers had a lot to gain, even from my mistakes, so I tracked the performance of the ideas each month, so we could all see what was working along with where there was room for improvement, making small alterations to the strategy along the way. In this article, I'm going to briefly outline the rotational strategy for new readers, then group the stocks into a few different themes that correspond to the goals of the series and review those themes and what I have learned this past year.

Long-only Rotational Strategy Explained

Since my investing approach is very unique, I like to explain some of my assumptions and goals when it comes to why I analyze things the way I do. First, I assume that there are usually more quality businesses in the marketplace than there are great stock prices (especially if the business is decades old). This leads me to start with the assumption that if a company has had stock publicly traded for 25 years or more, then it's probably a pretty good business unless I can identify something specifically wrong with it. The first stock I wrote about in the 'How far could they fall?' series was Caterpillar (CAT) back on January 15th, 2018. So, when I write about a stock like Caterpillar, I assume most people who read the article are CAT shareholders who like the long-term prospects of the company. (Eventually, if the price falls to the point where I think there is a margin of safety near cyclical lows, I do a closer examination of the actual business itself, but I save most of that until the price gets close to where I would like it. If I find something about the business I don't like at that point, then I might hold off buying it, even if the price is good.)

But just because the very long-term prospects of a company are good does not mean that the stock is trading at a good price and that it cannot suffer big drawdowns. So, for most of the articles in my "How far could they fall?" series, I focused on stocks that had a long history of big drawdowns and recoveries, and I set out to warn current investors what sort of potential drawdown they might suffer, and I explained that I had developed a long-only strategy where they could not only avoid a big portion of that drawdown but actually gain free shares in the target company's stock while doing so. (Because remember, I assume there is nothing wrong with the company. The company is good, but the stock price was simply too high given where we were in the business cycle.)

In order for this strategy 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, and 6) wait for the stock to recover.

By doing this, one can increase the number of shares they previously owned, for free. For example, hypothetically, let's say we have determined CAT is a quality company with good long-term prospects, it trades at $100 per share, and we own 1 share. We determine, however, that we are late in the business cycle and that the risk/reward of the stock over the short-to-medium-term isn't very good, so we rotate into an ETF that is more defensive in nature that is also trading at $100 per share, and now own 1 share of the ETF instead. Then, over the course of the next year, CAT stock drops -50% down to $50 per share, while the defensive ETF stays at $100 per share. Now, at this point, we can rotate back into CAT, and instead of owning 1 share, we now own 2 shares worth $100. Since CAT is a quality company, over the next few years its stock price recovers its old price of $100 per share, but we now own 2 shares instead of 1, so we have $200 and we gained +100% compared to if we would have held CAT throughout the entire time period.

This is a purposely simplified example. Obviously, there are lots of permutations that the two investments can take (and we will see lots of examples in this tracking update) what I try to do is get the odds on my side as much as I can and maximize share gains as much as I can.

How successful was this strategy in 2018?

Well, by August of 2018, had 28 stocks I was tracking each month as part of the series. One of them, after I reviewed my original article during one of my monthly updates, I realized that I actually should have put in the 'too hard' pile instead of suggesting an alternative W.W. Grainger (GWW). Grainger's potential turnaround was simply too hard to predict using my strategy. So, at the end of November, when it was trading evenly with the suggested alternative, I decided to just call that one a 'wash' and stop tracking it. Anyone who rotated out after my original article had the opportunity then to rotate back in at about the same price. That left us with 27 rotational ideas to continue tracking.

In terms of my first goal of warning investors about the dangers of holding the stocks I wrote about, 19 of the 27 are currently trading below the alternatives I suggested at the time. After one year into a 3-to-4 year experiment, that's pretty good. During the trough of the bear market on Christmas Eve, 24 of the 27 defensive alternatives I suggested were trading higher than the stocks I warned about. So, I consider my first goal of warning investors about the downside risk of their stocks and suggesting to them better alternatives a success.

The second goal was to publicly demonstrate that the long-only rotational strategy I've been sharing could work in real-life and not just backtesting. Of the 27 stocks we tracked, we would have been able to gain significant shares for free by using the rotational strategy outlined above with 15 of them so far. Here is a table listing the share gain percentages of the stocks we successfully rotated out of, and then back into compared to simply buying and holding (all these are publicly documented here on SA).

Ticker Shares Gained Ticker Shares Gained
CMI 53% EMR 30%
STT 38% GD 50%
MGA 40% ROK 35%
3M 32% ETN 28%
NOC 47% CCL 33%
FDX 41% PNC 23%
TIF 29% UTX 29%
CAT 37%

I think that given we only had a very brief bear market, the results so far have shown strong evidence that the overall strategy can work in practice, especially when one keeps in mind that these ideas weren't all presented on a single day that happened to luckily time the market top. In fact, they were spread out over the course of about 8 months and I tried to cover the highest quality companies that I could find that also matched my cyclical parameters. Several of them fell low enough that I bought them myself, including Cummins (CMI), State Street (STT), FedEx (FDX), Tiffany (TIF), and Emerson Electric (EMR).

But, there is still a lot to learn from this project, and I want to outline some of the things I've learned along the way as we review the 12 stocks that we are still currently tracking.

Cyclical prices, or cyclical earnings?

Probably the most important thing I've learned during this process is that there are different types of cyclicality, and the investment strategy one uses has to be matched with the type of cycle (or cycles) the stock is going through. Of critical importance here is whether earnings are the key driver of price cyclicality and how that price cyclicality compares to the wider S&P 500. I didn't fully appreciate these things until a few months into tracking the results of this series. But if we look at 2 of the 3 stocks - Costco (COST) and Paychex (PAYX) - that have outperformed throughout the entire year, including during the bear market, you will see very stable long-term earnings on their F.A.S.T Graph charts:

costco fastgraph

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Data by YCharts

paychex fastgraph

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Data by YCharts

As you can see in the Y-charts, both Costco and Paychex have been outperforming the suggested alternatives. Additionally, though, we see in the FAST Graphs how steady the earnings (shaded dark green area) are and that they only tend to fall during economic recessions, and even then, they don't fall very much. This means that the price cyclicality I noted in my original warning articles is mostly going to be driven by sentiment because earnings are unlikely to fall unless we have an economic recession. So, with stocks like these, we can use a historical P/E approach for our valuation analysis and base our strategy on sentiment change and earnings declines during a recession scenario (this method differs from the method I use with stocks that have less stable earnings). Costco still appears to be trading high on sentiment, and if we shorten Paychex time-frame on the FAST Graph to 2006, which was the middle of the previous cycle, we'll get a better view of its current P/E-based valuation.

payx fastgraph

Taking this view, Paychex only looks moderately overvalued based on historic P/E measuring from a similar point in the last business cycle. I think if there is one stock out of this group of 27 I might miss rotating back in at a superior price, it's Paychex.

I continue to do a lot more research on different types of cycles stocks experience in the Cyclical Investor's Club. Currently, I've identified 9 major types of cyclical stocks, as well as multiple factors that layer on top of those individual cycles, and I've been developing investment strategies that are tailored to each type of cyclical. It's important to note that Costco and Paychex do go through cycles, they are just different than the cycles a deep classical industrial cyclical might experience, so they require a slightly different investment approach.

What are the best defensive alternatives?

Selecting good defensive alternatives is hard and the feedback I received about this portion of the strategy tended either to think that finding good defensive alternatives was very easy to do, or that it was impossible to do, and a long/short strategy was the only way to provide good defense. The truth is actually in between those extremes, finding good defensive alternatives is harder than it looks, but it is possible.

I would have done better from a performance standpoint if I had simply stuck with my initial two defensive ideas Vanguard Utilities ETF (VPU) and Invesco S&P 500 Low Volatility ETF (SPLV). Both of them have performed extremely well in terms of their ability to deliver both defense when the market fell and offense when the market rallied. There are strengths and weaknesses of each. VPU I selected because it was being undervalued by the market at the time and it had traditionally been defensive, so there was an aspect of valuation involved that might not always be available with VPU because there may be times when it is overvalued instead of undervalued. SPLV is better in that regard because there really isn't much timing or valuation involved. It adjusts on its own, quarterly. The tricky part with SPLV is that fees are a little higher, there is more turnover in the portfolio, and, it also requires some actual volatility in the market in order to tell it the best defensive stocks to pick. In 2017, we had a very low volatility year, so SPLV really needed that February 2018 pullback, before it could calibrate and anticipate which stocks would likely be less volatile in a bear market. Once one understands those potential limitations, I think a 50/50 combination of the two was probably the best defensive combination overall.

That said, I wanted to experiment with some other ideas, so, in several articles, I suggested Berkshire Hathaway (BRK.B) as a defensive alternative, as well as Invesco S&P 500 Equal Weight ETF (RSP). And, for American Express (AXP) I attempted to mix both offense with Fiserv (FISV) and defense with (VPU) and see if there was a strategy where we could use two entry points for different market scenarios when rotating back into AXP. Let's examine each of these defensive alternatives and see what we can learn.

I'll start with Union Pacific (UNP) because I mentioned three alternatives for it and we can see how they have done compared to UNP and SPY over the same time period:

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Data by YCharts

Currently, UNP is doing really well, but Christmas Eve it traded almost the same as SPLV, lower than VPU, and a little better than Berkshire. At that date, all of the investments were outperforming SPY. I think part of VPU's great performance had to do with valuation at the time of the article. If the article would have been written July 1st, VPU's performance wouldn't have been as great. However, a 50/50 combo of SPLV and VPU could have produced a good defensive position all the way up until the market peak in October. Berkshire has lagged, but since they started buying back shares this summer, they have slowly started to close the gap with the other investments (potential share buybacks were part of my initial defensive thesis with Berkshire). That said, Berkshire hasn't provided better downside protection than the S&P 500 yet:

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Data by YCharts
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Data by YCharts
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Data by YCharts

I think with Southwest Airlines (LUV) in particular, if we would have been in a 50/50 mix of SPLV/VPU instead of Berkshire, we could have rotated back into the stock near the Christmas Eve lows with an ~30% share gain. I still have a lot of confidence in Berkshire, but I think for this strategy it is simply best to avoid single stock risk. I also suggested Johnson and Johnson (JNJ) as an alternative for 3M (MMM), and that worked out okay, but I think the talcum powder controversy illustrates some of the danger involved in selecting individual stocks as defensive alternatives. So, I now have a policy of not using individual stocks for defense, and instead of using a 50/50 mix of 2 ETFs for that purpose.

One counterexample of this policy was the American Express vs. a 50/50 mix of VPU and Fiserv idea:

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Data by YCharts

Fiserv and VPU are doing exactly what they are supposed to do. When the market goes up, Fiserv is supposed to outperform, and if we have a bear, VPU is supposed to hold up better. Both are currently outperforming AXP, so I think there is some validity to using this approach. However, the merger that Fiserv just announced which sent the stock much higher could just as easily have sent it lower. Even though things appear to have gone right this time around, individual stock risk still seems too high for what I'm trying to accomplish with the strategy. Additionally, I like the idea of having an ETF pool from which to pull from to buy whatever individual stocks seem attractive during a downturn, and if we tailor the defensive position too tightly, as I did with AXP, and I decide to buy something else other than AXP during a downturn, it overly complicates things. So, I think there might be some usefulness of a strategy like this, but ultimately I want something simpler and more reliable.

Moving on to equal-weighting as a way to capture more potential upside while still offering some downside protection. It's possible that we just haven't seen a deep enough drawdown in the market for equal-weighting to shine. But thus far, it hasn't performed any better than SPY when it comes to a combination of offense and defense when we look at the Best Buy (BBY) and Nike (NKE) ideas:

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Data by YCharts
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Data by YCharts

Another interesting aspect of this project is what has happened with a stock like Boeing (BA). Boeing is probably the most beloved stock I've written about in the series, and every couple of months it has swung back and forth between underperforming and then outperforming SPLV. I plan to revisit Boeing soon, because it is unique in that even though it was fairly overvalued when I wrote about it, earnings might have caught up to the high expectations of last year, and I think the strategy ultimately needs to have a policy in place for how to deal with earnings catching up to price scenarios.

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Data by YCharts

With regard to Progressive (PGR), I had a bit of a revelation this month as I was pondering the car business a bit since one of my cars had a catastrophic failure last week and I had to replace it. With the ever-expanding loan terms we are seeing (at the dealership I was at they were pushing a 72-month term on an 8-year-old car), the real winners might be the insurers since cars with loans typically require comprehensive insurance coverage. It's just something that crossed my mind. Progressive has been holding up well.

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Data by YCharts

And last but not least, is Deere (DE), which I wrote a follow-up on this month (along with Southwest Airlines). Deere is holding up surprisingly well, but think it likely has a lot farther to fall over the medium-term.

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Data by YCharts

Conclusion

This has been a bit of a long article, but I think appropriately so for an anniversary article. I think we learned a lot over the past year. We learned that it is possible to get defensive when cyclical stocks get overvalued and that we can gain free shares by rotating back into them at lower prices. We learned that there are lots of different types of cyclicals and we need to match the valuation method and strategy to the type of stock we are dealing with. We learned a 50/50 mix of good defensive ETFs offers the simplest and most consistent defensive position, and also that we should probably avoid individual stocks for defense (as a side note, I wrote separately about several individual stocks I thought might offer good defense last year and most of those didn't do any better than the S&P 500). We also learned that equal-weighting, at least thus far, didn't work any better than SPY for defense.

For the 12 stocks we are still currently tracking, the target stocks have returned +7.74%, the S&P 500 +0.88%, and the defensive alternatives +5.46%. Considering these don't include the 15 stocks we've already successfully had share gains in and that market has staged a dramatic bounce since the bear market lows, I think the defensive alternatives are hanging in well. Costco has started to pull in a little bit, bringing it closer to fair value. And, I think since we've seen a fairly big drop in commodity prices this fall, by this summer we'll start seeing the transports like the railroads get hit a little harder. Overall, I think the only stock that I'm a little worried we might not be able to at least break even on is Paychex. But time will tell. I'll continue to keep tracking these through the next recession and see what more we can learn.

Disclosure: I am/we are long TIF, EMR, FDX, BRK.B, STT, CMI. 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.