The valuation compressions for “defensive” companies continue to catch investors off-guard. 3M (MMM) is the latest example, as shares have gotten crushed recently seemingly out of the blue. MMM stock is certainly not the sort of one that you imagine would drop 13% on earnings and it was reportedly its worst one-day decline in 30 years. Following that, the stock has continued to decline steadily. Impressively, MMM stock has gone from 52-week highs to 52-week lows following just this one earnings report:
Unfortunately, as nice a company as 3M may be, even after this decline, it's still not that close to being an attractive value. Instead, its part of a broader trend where investors are reconsidering the valuation ratios that defensive stocks are worth. MMM stock had long been trading at an elevated P/E ratio - over 20x since 2014 and closer to 30x for a good chunk of 2018:
That's even as its growth rate has slowed down dramatically in recent years. The company grew earnings from 6 per share nearly a decade ago to just 8 per share in 2017. And now, even with the massive benefits of the tax cut, they're only getting to the low 9s. That still doesn't make the stock look like a bargain even now. 15x projected earnings for this year only gets you to the $140s, for example. If MMM stock stops falling at 18x earnings - its five-year floor valuation ratio, then the stock looks like a buy here. But there's no guarantee the market will continue assigning 3M a premium valuation now that the growth is largely gone.
Additionally, while we may think of 3M as the post-it note company, it's actually exposed to a fairly high number of more cyclical end markets, such as housing and automotive. Autos, in particular, could be a problem in coming quarters. And for what it's worth, all of 3M's major product categories came up short of expectations in this most recent earnings report, indicating that it is getting hit by the same industrial slowdown we've seen elsewhere.
The company also has lingering legal liabilities. Many investors would deduct a point or two from a company's ideal P/E ratio for that sort of risk. Yes, many investors own MMM stock for the dividend; it has a 60 year dividend hike streak after all. While the 3.3% starting yield is reasonably attractive, keep in mind that the dividend should grow at a rather tepid rate going forward as the payout ratio is relatively high already and earnings growth has tapered off.
3M: A Warning For Passive Investors
One reason why MMM stock likely got and stayed at such a high valuation is due to being a member of the Dow Jones index. That index is quite misleading, as it is price-weighted. Thus, companies like 3M with a high share price get an artificially high weight in the index for no good economic reason. Then all the ETFs and funds that track the Dow have to own a ton of MMM stock to keep up with the index. Unfortunately, all these passive money flows, while driving up MMM's value along with the index's inexorable climb, haven't done anything to make the underlying business any more valuable.
During a rising market, stocks like 3M with a big passive component keep going up and up simply due to people putting money in the market. When big news hits, however, such as 3M's recent earnings miss, active managers take over again. We're now seeing larger and larger reactions in stocks following earnings (see this article for examples). I suspect it is due to passive funds driving up stocks beyond where fundamentals support, leading to bigger reactions when news forces humans to take over and reprice a stock back to reality.
It leads to an interesting question. What other major stocks will take a hit going forward? You can argue the same dynamics apply to something like Boeing (BA) for example. It has the same excessive passive money flows due to being included in all the Dow Jones ETFs with huge weighting – like 3M. BA stock has approached making up 10% of the entire Dow index recently, thus attracting huge passive money.
This is because Boeing has an even higher share price, and thus Dow weight, than 3M. Even putting aside the issues with the recent plane crashes that called the Boeing Max program into question, it's hard to understand what the market is thinking here. Why is a highly cyclical firm like Boeing consistently worth more than 20x earnings? Why won't the market decide to suddenly drop it back toward a more normal P/E ratio, as investors have done to Kraft, Anheuser-Busch, General Mills, and so on in recent years?
There's no inherent reasons why these firms should permanently trade at 20x earnings+ when the market as a whole averages a closer to 15x median over time. Keep in mind that the S&P 500, by virtue of being made up of a ton of large companies, has a lot of defensive higher-quality names like 3M and Boeing in it. Despite that, over time, 20x earnings is quite expensive for your average S&P stock. When paying 20x for something, make sure you're getting a company that is truly worth it, not one like MMM that had been riding primarily on its reputation for being solid and stable along with blind passive money inflows as the whole market goes up.
If you're looking for more stocks like this, McDonald's (MCD) seems like another great example where an elevated price has put a ton of “unexpected” risk into the stock that may suddenly materialize on a bad earnings report.
Again, like 3M and Boeing, it has large passive exposure due to being highly weighted in Dow Jones ETFs. The company has had modest growth in recent years. Big moves, such as all day breakfast, haven't moved the needle as much as hoped and franchisers are getting annoyed. And yet the stock price is still riding high – for now. For all the complaints people make about tech stocks getting overvalued, you can get serious overvaluation in more traditional stocks as well - don't let an impressive dividend history make you think otherwise.
Setting up for a correction, perhaps? While stocks can detach from their fundamentals for quite awhile, it won't last forever. As we saw with 3M, a stock can't outrun its earnings growth indefinitely.
This is an excerpt of an Ian's Insider Corner report published in April for our service's subscribers. Membership includes an active chat room, weekly updates, and my responses to your questions.
Disclosure: I/we 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.