About a year-and-a-half ago, on January 30th, 2018, I published an article titled "How Far Could 3M Fall?" in which I suggested that 3M (MMM) was moderately overvalued and suggested that Johnson & Johnson (JNJ) was a better alternative. I thought that investors who rotated out of 3M and into JNJ would eventually have an opportunity to rotate back into 3M after the price had fallen and they would be able to gain 30% more free shares of 3M than they owned in January if they still liked the long-term prospects of 3M. In October of 2018, that idea came to fruition and investors who rotated into JNJ had the opportunity to rotate back into 3M and gain 30% more shares than they would have had in January of 2018 for free. So, the basic idea was successful.
Additionally, in October of 2018, I published an article titled "I'm Holding Off Buying 3M." In that article, I explained that I didn't like 3M's debt-to-equity ratio and how they had been borrowing money in order to buy back shares of the company.
Overall, I did a pretty good job warning investors about 3M's dangers near the top of the cycle and also why I was holding off recommending or buying the stock after the price had dropped significantly. However, the method I was using to analyze 3M wasn't the best method because 3M's earnings hadn't historically been very cyclical and the method of analysis I was using at the time worked best with stocks whose earnings were highly cyclical. I noted that issue in the original article, but I didn't have a good way to deal with it at the time. After doing some more research over the course of the past year, I have now developed a technique for analyzing stocks like 3M, whose earnings aren't particularly cyclical, while still taking economic cycles into account. I call this approach, a 10-year, full-cycle analysis.
One of the major assumptions that I make for both approaches is that history is the most reliable guide to the future. My experience has been that 80% of the time, even if we looked at nothing else, a stock will behave in a similar manner as it did the previous cycle or two unless there is a disruption to its core business. For this reason, I don't rely much on predictions of future earnings or sentiment that aren't supported by their existence during past cycles. That doesn't mean that "this time is different" isn't true sometimes. It just means that my analysis isn't counting on this time being much different. That said, if I think a stock is currently a "buy" based on my 10-year, full-cycle analysis, before I invest, I will examine the forward-looking trends and narratives more carefully to make sure there aren't major changes in the works that could affect the business.
The main difference you'll find between my analysis and others' is that: 1) I focus on a clear 10-year time frame and the compound annual rate of growth (CARG) one might expect over that period of time; 2) I assume we will experience a recession during that time period, and I build that into the expected returns; 3) I try to calculate the expected returns based on a full business cycle; 4) I weight shareholder yields from dividends (and potentially from buybacks) more heavily because that is money actually being returned to shareholders; 5) I provide an "opportunity risk/reward analysis" if a stock is not currently a "buy" so that we can get an idea of how likely it is the stock will trade low enough to become a "buy" over the next 4-5 years if we have a recession.
As part of the analysis, I calculate what I consider to be the three main drivers of future total returns: 1) Market Sentiment Returns, 2) Full-Cycle Organic Earnings Growth Returns, and 3) Shareholder Weighted Business Returns. Then, I combine all three of those CARG estimates together to get an expected 10-year, full-cycle CARG estimate. Currently, I consider an expected CARG > 15% a "buy," 12-15% an "outperform," 8-12% a "market perform," 4-8% an "underperform" and < 4% a "sell."
With that, let's get into the analysis.
How Cyclical Are Earnings?
Since I use different approaches for analyzing a stock based on how cyclical its earnings are, historical earnings cyclicality is the first thing I like to examine. Let's take a look at 3M's historical earnings using a F.A.S.T. Graph, which is a great tool for this sort of analysis:
I break down earnings cyclicality into five basic categories. The first category I call 'secular growth.' This category describes earnings that continue to rise every year even during economic recessions. The next three categories are 'low', 'moderate', and 'deep.' 'Low' is usually for businesses which have earnings that have a history of declining in the single digits percentage-wise during downturns but not much farther than that. 'Deep' I consider earnings that fall more than -50%, and 'moderate' somewhere in between low and deep. And last, but not least, are businesses whose earnings go negative during cyclical downturns, but recover soon after that, which I call 'highly cyclical.'
Over the past 20 years, 3M has experienced earnings declines of -7%, -9%, and they are expected to decline -9% this year. This places 3M's historic earnings cyclicality in the 'low' category. Examining 3M's historical price cyclicality, as I did in my original article, can also work for stocks of this type whose earnings aren't particularly cyclical. So, there wasn't anything wrong with approaching it that way, but the fact that earnings haven't been very cyclical historically means that we can actually break down what is likely to drive 3M's longer 10-year expected returns much better and easier than if the earnings were more cyclical. So let's take a look at 3M stock's three likely drivers of future returns over the next decade and see what we can expect if we invest in 3M stock today.
Market Sentiment Returns
In order to estimate what sort of returns we might expect over the next 10 years, let's begin by examining what sort of return I could expect 10 years from now if the P/E multiple were to revert to its mean from the previous economic cycle. In order to estimate that, I'm going to shorten the time frame of the F.A.S.T. Graph so it starts in 2006.
3M's current blended P/E of 17.2 is lower than the normal P/E of 18 it has traded at over the course of this past cycle. If 3M were to revert to its normal P/E in ten years' time, then it would produce a CARG of +0.46%. One might think that a stock that is approximately -32% off its highs would produce a better return if it reverted to its mean, but the fact is that 3M was dramatically overvalued in January of 2018 based on a historical P/E basis, and it is just now getting close to its historical valuation.
Full-Cycle Organic Earnings Growth Returns
If we begin our measurement around the same point we were last cycle, which I estimate to be about 2006, and we adjust the annually compounded EPS growth for the amount of stock that was repurchased over this time period, we can estimate how much CARG from organic earnings growth we can expect over the next 10 years if the next cycle is similar to the previous one.
Since 2006, 3M has purchased about 1/4 of the company. This can make EPS growth look really good over this time period, but what I want to know is what sort of earnings growth it would have had if these buybacks weren't made. I also want to take into account the 2008 recession because we are likely to have another one at some point over the next 10 years. This will give us a more realistic view of what 3M's organic earnings growth might be over the next 10 years. My calculations show that we can expect about +1.30% CARG from organic earnings growth over the next ten years if there is a recession at some point during that time period. So, even though 3M's earnings have been relatively stable this past cycle, they haven't had much organic earnings growth. In fact, once buybacks are taken out and a recession taken into account, their earnings growth is pretty close to that of inflation.
Shareholder-Weighted Business Returns
These return estimates are more complicated than the first two, but the idea behind this is to figure out how much the company is making in cash and/or earnings per share while taking into account debt and cash levels, how much of a dividend yield it is paying to shareholders, what percentage of shares it is buying back annually, and how much cash the company is keeping for itself, all on a per share basis. Once that is complete, I assume any money the business keeps for itself will accrue over a 10-year time period, but I don't assume that it will compound (since I estimated the earnings growth in the last section).
For buybacks, if the company is buying back shares when sentiment is below average, I will assume the value of the buybacks will compound over time. If it is buying back when sentiment is higher than average, I will assume the buybacks accrue but do not compound value over the 10-year time period. (This is just a way to weight the value of buybacks over time for the estimate, it isn't intended to be mathematically precise - which is fine for me, because we never know exactly what price the buybacks will be made over time anyway, so there's no sense in pretending we do.) I will assume that dividends paid to shareholders compound their value over time because shareholders can immediately reinvest the dividends in the best investment available.
As I noted, this process is intended to estimate how much money the business is likely to make and how much of that money will likely be returned to shareholders via dividends and buybacks. I limit the expectation of shareholder returns by how much cash is currently being generated and the company's apparent intention of investing that cash itself or returning it to shareholders. If buybacks and dividends are consistently greater than cash flows and earnings, I will assume they are unsustainable through a full cycle that includes a recession, and I limit the shareholder return expectations to actual cash flows and/or earnings estimates I think are reasonable.
First, let's revisit those buybacks and see what sort of returns we might expect from them in the future. I'll look at both 1-year and 3-year time frames.
Looking at the 1, 3, and 12-year buyback history, I think it's fair to estimate that 3M could buy back 1.75% of its shares annually over the next 10 years.
The dividend yield according to FastGraphs is 3.3%. So, investors might expect a shareholder yield over the next 10 years of about 5.05% annually. Now what I want to do is see if 3M is earning enough to support that yield:
Looking at earnings, it appears as though 3M is earning enough money to support the expected buybacks and dividends.
For non-financial institutions, I also like to take a look at free-cash-flow-to-equity/enterprise value yield as well as a way to capture how much cash, debt, and cash flow the company has relative to its price on a per share basis. I've found this is a good way to expose companies which are borrowing money to buy back shares or pay dividends and also to credit companies that have a large cash pile that the market might not be taking into consideration. (Recall that the reason I didn't buy 3M last October was their debt-to-equity ratio and continued share buybacks.)
As of the end of last quarter, their FCFE/EV was 3.7%, not enough to support the current expected 5.05% shareholder yield over the long term. When I update the FCFE/EV beyond the end of the last quarter manually, since the price has dropped since then, I get a current ECFE/EV of 4.4%.
The reason 4.4% is less than the 5.38% earnings yield is because of the debt that 3M has been taking on to buy back shares and increase dividends over the course of the past cycle.
Long-term debt has gone up a whopping 500% this cycle. That is likely to be a drag on 3M's ability to keep buying back shares next cycle at the same pace it did this cycle. For that reason, I am limiting my shareholder yield expectation to +4.40% CARG over the next 10-years.
Future Return Expectations
Putting all three - market sentiment returns (+0.46%), earnings growth returns (+1.30%), and business/shareholder returns (4.40%) - together, I estimate a full-cycle 10-year CARG return of +6.16%. That level of expected return puts 3M in the 'underperform' category for me based on its 10-year expected total returns.
In order to estimate the opportunity risk/reward, I use F.A.S.T. Graphs' forecasting tool to estimate future price appreciation, including dividends, for the next 2-3 years using analysts' estimates. Then I assume we will have a recession after that point. What I want to know is if a recession begins in 2-3 years, whether I will have a reasonable chance to buy 3M at a significantly lower price than it trades today or if I would likely never get a chance at a lower price.
If I assume that sentiment will rise for 3M over the next 2-3 years and it will trade at 22.5 P/E ratio by 2022, if we use analyst's estimates and include dividends, we could expect a price of $266.88. Let's take a look at 3M's historic price declines to see how far the stock could fall from those levels during a recession.
|Year||~Duration||~Time till bottom||~Decline|
|1970||13 years||5 years||50%|
|1987||2.5 years||1 month||37%|
If history is a reasonable guide to the future, we could expect a price decline of -35-50%, which would give us a price range of $133.44-$173.42 4-5 years from now, a range that is below the current price of 3M. So, using this estimate, which is a fairly generous one, there is little danger in waiting for a better price. Additionally, during the last recession, we saw 3M trade at a P/E below 9, which would imply an even deeper drawdown from a P/E of 22.5 than the historic price cyclicality suggests. So, overall, I don't see much opportunity risk in waiting for a better price before buying 3M.
Even though 3M's price has fallen by over -30% and it is currently trading slightly below its historic P/E multiple, the growth expectations going forward are mostly non-existent. The stock isn't quite a 'sell', as it was in January of 2018, but the price would have to drop a lot more before I would consider it a good value. Even from a dividend growth perspective, while the stock has a good history, I wouldn't expect much growth in the dividend going forward because earnings aren't growing enough to support big raises. Personally, I would probably look for an expected shareholder yield in the 7-8% range before I would get interested in the stock from purely an income perspective unless one thinks interest rates are headed back down near zero for an extended period of time.
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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.