Beginning in mid-January of 2018, I wrote a series of articles that examined how far some popular large-cap cyclical stocks might fall if we were to have a downturn within the next three years. While all 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 cyclical stocks in question. The four most frequent alternatives I suggested were the Invesco S&P 500 Low-Volatility ETF (NYSEARCA:SPLV), the Vanguard Utilities ETF (NYSEARCA:VPU), Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), and the Invesco S&P 500 Equal Weight ETF (NYSEARCA:RSP), or some mix of them. I called this series of articles the "How far could they fall?" series. The goal of the articles was to warn investors of the potential downside these stocks had while also offering alternative investment ideas that current shareholders could rotate into while the prices of the target stocks were high. Then, after the target stocks had fallen significantly, rotate from the defensive positions back into the target stocks. The idea was that this process would prevent buy-and-hold investors from suffering big declines while also producing free share gains in the target stocks compared to a buy-and-hold strategy.
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 defensive ETF dropped to $80, and the target stock 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 price eventually recovers, you have doubled your wealth compared to what it would have been if you held the target stock 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, and 6) wait for the stock to recover.
The "How far could they fall?" series essentially takes investors through this process with a fairly wide swath of large-cap names. In total there were 28 stocks in 2018 that I both wrote a warning article about and also offered a defensive alternative I thought would be better at the time. There were a few stocks I wrote "How far could they fall?" articles on that I decided not to offer alternatives on, like Ross Stores (ROST) and T. Rowe Price (TROW), that were too hard to predict at the time. I didn't track those. And there was one that I recognized should have been put in that category a few months later, W.W. Grainger (GWW). I noticed after I reread my original Grainger article that I explicitly said in the article Grainger's turnaround was too hard to predict, and I didn't even perform a risk/reward analysis on it because of that, but then I went ahead and offered an alternative idea anyway, which I shouldn't have done. I kept tracking Grainger's performance until the end of November 2018 when it was nearly perfectly even with my suggested alternative, and I decided to correct my mistake, call that idea a wash, and stop tracking it. So, going into 2019 we were tracking 27 large-cap cyclical ideas and how they were performing vs. my chosen defensive alternatives.
The deep correction that started in October and bottomed in December 2018 created an opportunity to rotate out of many of the defensive alternatives back into the target stocks. I wrote a fairly detailed description of those moves in my article "Tracking How Far They Fell: 2018's Rotational Winners", in which I went through all 14 of the 27 rotational ideas I'd been tracking that had been completed in 2018, and we've added two more completed rotations with Caterpillar (CAT) in January 2019 and Deere (DE) in May. So far, in 2019, I've also added two more new stocks to track, Realty Income (O) and Ingersoll-Rand (IR). Here is the table, which shows the free share gains achieved from the rotational strategy for the 16 completed rotational trades so far:
|Ticker||Free Shares Gained||Ticker||Free Shares Gained|
These are great gains, all achieved in a year-and-a-half or less. For those readers who aren't used to thinking in terms of free share gains, here were the average returns during the times when we were out of these target stocks and in the defensive alternatives: Defensive Alternatives: +4.61%, S&P 500: -5.67%, and Target Stocks: -24.45%. So, for a group of 16 stocks, we had incredible outperformance while we were rotated out of them, and we even significantly outperformed the S&P 500 with this group over this time period.
Stocks we are still tracking
I've learned a lot by tracking the performance of these ideas over the past year. One of the key lessons is that there are many different types of cycles that stocks can go through and it helps tremendously if one can understand the cycles more clearly. One of the most important ways to categorize any particular stock's cycles is by looking at their historical earnings cyclicality.
When I first started writing the "How far could they fall?," I focused almost entirely on price cyclicality because earnings for highly cyclical stocks don't tend to be reliable indicators of medium-term stock price movements. But the mistake that I made was not checking first to see if earnings were the primary driver of the stock price for some of the stocks I examined. For some of the stocks, earnings (along with market sentiment) did end up explaining the historical price movements better than the price movements alone.
This revealed itself pretty clearly during the -20% market correction we saw in Q4 of 2018. My strategy worked well during this correction for stocks with cyclical earnings, but since we have not yet experienced a recession, those stocks with less-cyclical earnings continued to perform relatively well, and most of them we are still tracking.
Recently, I have developed five ways to categorize the historical earnings cyclicality of stocks so that I can better classify the cyclicality of any given stock. For stocks whose earnings are less cyclical, I have developed a new, longer-term way to analyze them over the course of a full business cycle, and for stocks whose earnings are more cyclical, I use the same method I used during the "How far could they fall?" articles. Here is a quick breakdown of the five categories of earnings cyclicality I came up with.
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."
I always try to look at the group of stocks and alternatives from a slightly different angle each month. Last month I shared the various earnings cyclicality categories of the stocks. This month I'm going to place the stocks into three different categories, those that I think investors still have an above-average chance to gain +20% shares for free in the stock using the rotational strategy, those I think one can gain 0-20% more free shares, and those we are just looking to get back to even on.
Let's begin with those in which I was unwise to use this strategy because I didn't choose the best defensive alternative, because I timed the cycle for the stock in question poorly, because the particular historical cycles for the stock weren't much different from the index, or some combination of all three of these reasons. These would be the stocks in which we are looking to get back to even on. All the charts run from the publication date of my original warning article through the end of May, and I've included the performance of SPY as a reference point as well.
Aiming to get back to even
Costco recently reported good earnings again, but the stock really is priced to perfection here. Even though it has handily been crushing my Berkshire alternative, if you look at the December correction, the two stocks were almost back to even with one another. I think this provides some evidence that even though Berkshire has been underperforming over the past year, if we get a real economic slowdown, Berkshire is likely to hold up relatively well, and we should be able to rotate back into Costco and break even. I have Costco on my list for an update article using a 10-year full cycle analysis, probably later this month.
After pushing beyond the upper limits of even my most bullish estimates last month, CSX has started to pull back in a little bit. I expect that to continue, and I have CSX on my list for an update article this month. I still think there is a good chance to get back to even on this one.
I have been saying for many months now that I thought Paychex might be the one stock that we might have a tough time getting back to even with. Fortunately, SPLV has been a great defensive alternative and has returned 16.61% vs SPY's 5.83%, so it's not like we are doing poorly. I wrote a full-cycle analysis on ADP (ADP) last month and that stock was very overvalued. I think Paychex likely is as well, so it could still fall quite a bit during an economic slowdown, and give us a chance to break even. I'm putting Paychex on my list for a new full-cycle analysis as well.
Aiming for gains greater than 0% but less than 20%
Union Pacific (UNP)
I suggested three alternatives for this one so I've been using the blended performance of the three to track the results. The average of the three suggested defensive positions is +12.45%, quite a bit lower than UNP's +30.39% return, but significantly higher than the S&P 500's +3.24% return. During the December correction, UNP fell below the alternatives so I feel pretty confident that we should at least be able to break even, and depending on the nature of next recession, we still might be able to gain a few free shares. I published an updated full-cycle analysis of UNP this month, and it showed UNP to be overvalued.
Ah, Boeing. I last wrote an update article when the stock was making new highs, and in that article said that I thought free share gains of 15% were still possible. As of the end of May, we are at about 13% free share gains if we were to rotate back in today so I'm confident we'll be able to get that 15%, and possibly more.
Boeing has been a frustrating stock to write about from a bearish perspective. Well before its 737 Max issues, I warned about the potential downside for Boeing during a down-cycle, but the consensus among readers was that they would hold Boeing no matter what. And, Boeing appears to have the most die-hard shareholders in the market. I think the stock should be much lower given the headwinds the company faces, but the fact is the stock price has been remarkably resilient. I do think we will be able to get that 15% share gain, and potentially up to 20% free share gain if a really bad headline or poor earnings come out over the next few months.
Expected free share gains still +20% or more
S&P Global (SPGI)
I plan to write an update article on S&P Global soon, and it is performing well, but we saw during the December correction just how quickly the stock price can fall. I still feel confident we'll eventually be able to get a +20% free share gain out of this one. It's one I want to own if I can get it at a discounted price.
Southwest Airlines (LUV)
Southwest has performed pretty much as expected. If we would have seen a little better performance from Berkshire over the past year, we probably would have been able to rotate back into LUV with some big free share gains. As it stands today, we rotated back in right now, we could get about +15% free shares, but I think 20-30% is possible.
Best Buy (BBY)
Best Buy's bounce off the bottom surprised me. I was aiming for some bigger gains and missed the initial opportunity in December. We would be doing much better if RSP hadn't performed so poorly as a defensive investment. It's actually been doing worse than SPY, which is not what it was supposed to do. If I would have chosen SPLV or VPU as a defensive alternative we would already have been able to achieve 40-50% worth of free shares in Best Buy. That said, there is almost zero danger of missing out on free share gains from Best Buy. This stock will get crushed during the next downturn.
American Express (AXP)
At times, like with RSP, branching out from my core defensive investment mix of SPLV/VPU was a bad idea. The case of AXP was different, though. In this case, I tried to pick a mix of a secular growth stock with Fiserv (FISV) and pure defensiveness with VPU, sort of a defensive barbell if you will, and it has worked very well so far. Fiserv has done well as the market has risen, and VPU held up well during the correction. Combined they have returned +20.78% versus AXP's +19.25%, but I think the defensive mix will hold up much better during a downturn. A few months ago I decided not to use individual stocks as defensive alternatives going forward because of individual stock risk (like with Johnson & Johnson's baby powder (JNJ)), but I think there is probably some merit to potentially building a portfolio late in the business cycle that has a 50/50 mix of defense and secular growth stocks. It is certainly an area worthy of further research.
At any rate, AXP is a deep cyclical, and when credit tightens, we should see the stock price fall quite a bit from where it is today. I still feel confident we can gain shares in this one.
The more I learn about Progressive, the more I want to buy it. Buffett noted during Berkshire's annual meeting that he expects Geico and Progressive to be #1 and #2 in auto insurance in the future, and it was simply a question which would be #1 and which would be #2. I do believe we will get the opportunity to buy this one at a discount during the next correction or bear market. Even though it is making new highs, the defensive alternatives have been crushing SPY as well, and held up very well during the December correction. This really shows the benefit of staying invested (and simply getting defensive) rather than going to cash if you think it's time to take profits in one of your cyclical investments.
If I did a good job picking a defensive mix for AXP, one can see the difference it makes if you don't get the defensive mix right with Nike. RSP has been a total dog so far returning -2.74% compared to SPLV's +10.27%. Combined they are still doing better than Nike, which is still very much overvalued, so I think we'll be about to get 20%+ free share gains here, even with RSP dragging us down a little bit. Now that the momentum has shifted with Nike, I think it probably continues to move lower.
The total return for the 11 defensive alternative positions from 2018 we are still tracking through the month of May is +6.94%, the target stocks from this group have returned +16.45% through the same time period and SPY has returned +3.59%. So, the remaining defensive alternatives are outperforming the index, but currently trailing the target stocks. If we include the performance of the 16 completed rotational ideas at the time the rotations were completed, then the total return for all 27 ideas is defensive alternatives +5.56%, target stocks -7.79%, and SPY -1.90%. So, even though we are still waiting for some of these target stocks to come down off their highs, on the whole, the strategy is handily outperforming.
When the market was a little bit higher, I noticed a couple of other stocks that seemed to be likely trading near cyclical highs, and I suggested some more defensive alternatives for those as well.
Realty Income (O)
The defensive mix is slightly outperforming Realty Income, and all of them are doing better than the S&P 500. It might take a while, but I think we'll eventually get our expected +20% share gain from this idea.
Ingersol Rand (IR)
Ingersol Rand reported good earnings right after I wrote about it and had a good price jump last month. I think over time when the cycle turns, it will come down, though.
This has been a multi-faceted project that has evolved in important ways over the past year-and-a-half. It started as an effort to warn investors about the downside of highly cyclical stocks and to go a step farther and offer alternative investments that were more defensive. The project expanded to test a few other defensive ideas and see how they performed and went beyond the typical industrial stocks that everyone usually thinks of when they think of "cyclicals". Some of that expansion into other areas was successful, while some of it wasn't and is still playing out. We were fortunate enough to have a deep correction that gave us a preview for how the overall strategy works, but we still have yet to experience a recession or serious economic slowdown.
There are several things I've learned along the way, like how to better classify different levels of earnings cyclicality and select the best defensive investments. These are things I probably wouldn't have learned without the focus these tracking articles bring each month. Other things, like whether Berkshire Hathaway stock will hold up better during a deep downturn, we still have yet to find out. If it does, I think it's possible we avoid having a single losing idea out of about 30 ideas. It would be remarkable if the strategy is that successful.
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Disclosure: I am/we are long BRK.B, FDX, STT. 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.