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 or cyclical downturn, 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. In 2019 we've added three more completed rotations with Caterpillar (CAT) in January, Deere (DE) in May, and Boeing (BA) in August. 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 17 completed rotational trades so far:
|Ticker||Free Shares Gained||Ticker||Free Shares Gained|
For those investors who aren't used to thinking in terms of free share gains, the returns of the 17 completed rotations were +5.48% for the defensive alternatives, -4.89% for SPY, and -23.03% for the target stocks in the table above from the publication date of the idea until the rotation back into the target stock was complete.
Now we are going to examine the 12 stocks we are still tracking. This month we have a theme: Mistakes.
Mitigating Rotational Strategy Mistakes
One thing I haven't written about much in this series are the effects of mistakes on the rotational strategy. Currently, we have 17 success stories above with great results, but if the 12 remaining stocks we are still tracking perform poorly enough, then it might negate all the gains we made with the winners.
Assuming the investor has correctly chosen a high-quality long-term business to invest in, there are four key mistakes that can be made using this strategy. I had a large enough sample size that I have some examples of each, and that's what I'm going to focus on in this month's update.
The first type of mistake is not correctly identifying whether a stock's price cyclicality was primarily driven by the business's earnings or by the market's sentiment. Either one can cause the stock to be overvalued or undervalued, but if the business's earnings are not very cyclical, then one can more accurately predict when the stock price has become overvalued because of sentiment. So it's critical to identify the earnings cyclicality at the outset. That's something I didn't do in the early stages of this analysis back in the spring of 2018. I have since adjusted for it, but it resulted in some mistakes. (Now I have a new method for analyzing sentiment-driven cycles and a new series about these stocks using the same rotational strategy. The first full-length tracking articles for those will come out next month.)
The second type of mistake is choosing a poor alternative investment. This was the case when I chose RSP a defensive alternative this time around, and, if we only have small corrections like the market experienced in late 2018, and it takes several more years before the next recession, then Berkshire Hathaway might end up being a poor alternative investment as well.
The third type of mistake is misjudging the re-entry point. It's possible one can be expecting bigger gains from a rotation than the market provides. This could cause one to miss a rotation back into the target stock while the price is down.
The fourth type of mistake is misjudging the business cycle. Rotating into a defensive alternative investment instead of cash can help with this because one is still invested in the market and will benefit from a rising market. But they likely won't benefit as much as they would from a higher quality business if the cycle extends several years into the future.
What I've found is that this strategy is very forgiving and that you really have to make errors in multiple categories to do poorly using the strategy. It's when one misjudges the cyclical drivers of the stock, chooses a poor alternative, and doesn't get the business cycle correct when there can be serious underperformance. Typically, just making a single error doesn't result in catastrophic losses or underperformance.
Next, I'm going to look at real examples from the 12 stocks we are still tracking and if they correspond to some of these mistakes.
Misjudging The Cyclical Driver
Costco (COST) 3/8/18
The key mistake I made with Costco was misjudging the cyclical driver of the stock price. Costco's earnings are generally quite stable, it is the sentiment of the stock that tends to drive its price swings. I didn't distinguish between the two drivers (earnings and sentiment) when I first wrote about Costco. Cosco did have a P/E of about 30 when I wrote about it, so it probably was overvalued at the time, and I don't think I misjudged it too badly. However, it now trades at a P/E of 36, so its multiple has simply expanded since I wrote about it. It's not as if the appreciation of the stock price since then was mostly driven by earnings. For that reason, I think there is still a reasonable chance that during a recession we will at least be able to get back to even on this idea even if my initial assessment wasn't performed as well as I could do it now.
Paychex (PAYX) 7/11/18
With Paychex I made the same mistake I made with Costco. Paychex's actual earnings are not particularly cyclical and its price cycles are mostly driven by sentiment. However, choosing SPLV instead of Berkshire as an alternative (as I did with Costco) has provided us with great absolute returns that beat the market, and last week, after having noticed my initial mistake we could have rotated back into Paychex and broken even on a relative basis. (And they are still basically even at the end of August.)
This shows one of the real advantages of the rotational strategy as opposed to going to cash. Even though I made a mistake, the idea returned 20% in 18 months on an absolute basis, outperformed the market, and broke even on a relative basis. I now consider this idea a wash, much like the mistake I made with W.W. Grainger back in 2018, and I will stop tracking it as part of this series.
Earlier this year, I did perform a new analysis on Paychex using the appropriate 'sentiment cycle' approach, and so I will continue to track how it performs in that regard in future sentiment cycle tracking articles starting next month.
Nike (NKE) 8/14/18
Nike, like Paychex, is another business whose earnings actually aren't that cyclical, and whose price movements are instead mostly driven by sentiment. For that reason, I should have used a sentiment-focused analysis. Fortunately, half of my SPLV/RSP defensive mix (namely, SPLV) has performed quite well. The 50/50 SPLV/RSP mix has returned +10.20% versus Nike's +6.86%, for a modest 3% share gain if one rotated back in now.
In this example, I actually made two small mistakes. The first, as noted above, was putting Nike in the wrong cyclical category (earnings-driven instead of sentiment-driven). The second was choosing RSP as part of the defensive alternative. Now, it might be the case that during a recession, the equal-weighted RSP will perform better than Nike, but I don't think it will perform much better than the market as a whole, and it has underperformed this past year.
This demonstrates just how forgiving the long-only rotational strategy can sometimes be. Even though I didn't get a couple of things exactly right, the idea still made 10% in absolute terms over this past year, and outperformed SPY and the target stock. If one had gone to cash instead, they would have underperformed on all accounts.
Even though this idea is doing okay, since I did make a couple of small errors, I'm going to call this one a wash along with Paychex, and stop tracking it. At some point, I will perform a full-cycle analysis on Nike and perhaps start tracking it using the sentiment cycle approach. But since I noticed my mistakes and have a chance to correct them with a small gain, now, that's what I'm going to do.
Poor Alternative Investment
For this section, I want to stipulate that I think Berkshire Hathaway will end up being a good defensive investment during an actual recession scenario. My thesis with regard to picking it as a defensive alternative was that Berkshire would buy back lots of stock during a downturn and that would prop up the price of that stock relative to the rest of the market. Since we haven't had a recession yet, we don't know whether I was correct or not. That said, so far Berkshire has underperformed the S&P 500, and that is something I didn't expect. So for the time being, I'm including it in this section about choosing a poor defensive alternative.
S&P Global (SPGI) 3/19/18
As we can see, Berkshire has significantly underperformed the market over this time period, while SPGI has taken another leg up. But if one looks closely at the chart they will see that during the late-2018 correction, for a time, Berkshire was actually outperforming both SPGI and SPY, and this is precisely what I expected to happen during a full recession scenario. So I think this thesis is still intact. However, if I had chosen, say, SPLV instead of Berkshire, we probably could have rotated back into SPGI during the 2018 correction, and gone on to participate in some of the current upside SPGI has experienced.
Southwest Airlines (LUV) 4/4/18
This case is sort of the flip-side of what can happen picking a poor alternative investment. The call on Southwest was correct, and it continues to underperform Berkshire. However, if we would have chosen a better alternative (even SPY), we would have already had a great opportunity to rotate back in with some big share gains. As it stands, Berkshire has performed about the same as cash. This is another example where you really have to make more than one mistake to suffer using this strategy. (And I still expect this idea to perform quite well if we have an economic slowdown.)
Re-entry Point Misjudgement
Re-entry point misjudgment occurs when the target stock falls quite a bit compared to the alternative position, but the investor is looking for bigger gains and misses the bottom. I gave an example of this last month with Best Buy.
Best Buy (BBY) 4/17/18
The chart above is from July's update. As you can see, we could have rotated back into Best Buy from RSP back in December with about a 30% share gain, but I was looking for more than that. So, I ended up missing that opportunity. I had made a second mistake when it came to choosing the best defensive alternative as well, by choosing RSP. So, while RSP and BBY were pretty close to even last month, I changed the alternative to a 50/50 mix of SPLV/XMLV, and I was able to try to correct that minor mistake and set up a new trade for free.
Now, after one month, I already have the opportunity to rotate back into Best Buy with a ~21% free share gain. However, I still think there is more to gain here, especially since we were able to improve our defensive position. So, even though we missed one opportunity for free share gains it was not the end of the world since we hadn't had a recession yet.
This is another example of how forgiving this strategy can be. One is unlikely to suffer much from minor errors and it usually takes multiple mistakes to lose money or underperform.
The Rest of the Stocks We're Tracking
Union Pacific (UNP) 3/6/18
For Union Pacific, I mentioned three potential alternatives so I've been tracking an average of all three of them. On average, they have returned +19.63% compared to UNP's +27.40% and SPY's +10.22%. UNP is starting to see some weakness in the stock price now, and I expect that during a recession it will get hit pretty hard. It should be noted, however, that UNP's earnings are only moderately cyclical, so a good part of its price movement is also determined by sentiment. I'm also tracking this one in the sentiment cycle series as well.
CSX (CSX) 3/22/18
CSX is another stock I have followed up on using a sentiment approach. After running up to crazy-high levels, it is now showing some weakness, too. I still expect we'll probably be able to pick up some free shares during a recession.
American Express (AXP) 5/2/18
This was a little experiment I ran regarding the defensive alternatives where I decided to pair a secular growth stock Fiserv (FISV) with a very conservative Vanguard Utility ETF VPU. Combined they have returned +40.79%, which is more than I had imagined when I wrote about them last year. I think the pair is probably overvalued here, and if one rotated back into AXP today they would gain about 12% worth of free share shares. Since I think Fiserve and VPU have probably run up a bit too much here, I would go ahead and take that 12% relative gain, but instead of rotating back into AXP, much like we did with Best Buy, I will go ahead and rotate into a 50/50 mix of SPLV/XMLV. AXP is still a very cyclical stock, and I expect we can get more free share gains by staying defensive here. So, I'll go ahead and count this as a 12% gain, and start tracking the new idea from August 31, 2019, and see how many more free shares we can get during a downturn using an SPLV/XMLV mix.
Progressive (PGR) 6/19/18
In this case, VPU has outperformed, but RSP has underperformed. Combined they have returned +15.65%. That's about double SPY's return, but we are still waiting for Progressive to come down after a big run-up this year.
Realty Income (O) 2/20/19
The VNQ/SPLV mix has returned about +11.30% since I wrote about it in February. Even with Realty Income's big run-up the past two months, it's still underperforming the alternatives. We are eventually looking for a 20% free share gain with this one.
Ingersoll-Rand (IR) 4/16/19
The SPLV/SPY combo has returned about +4.94%, which is slightly trailing Ingersoll-Rand, but IR is starting to show some weakness.
Of the 12 ideas we were still tracking through the month of August, the defensive alternatives have returned +10.59%, SPY has returned: +7.92% and the Target Stocks have returned: +18.45%. If we include the completed rotations, the total running returns for all 29 ideas are Defensive Alternatives: +7.59% SPY: +0.41% and Target Stocks: -5.87%. So, even with several minor mistakes along the way, the rotational strategy is performing very well. And I think with some of the adjustments we've made, it will perform even better in the future.
This month we finished the Paychex and Nike ideas because they are not stocks that have highly cyclical earnings, and those ideas were more or less a wash. We also ended the current American Express idea with a +12% share gain, and then restarted it again with a different defensive mix going forward. This leaves us with a total of 10 stocks we are still tracking out of a total of 32. 3 of the original 30, W.W. Grainger, Paychex, and Nike were a breakeven after noticing there was something we could have done better with the analysis or strategy. 2 of the 30, Best Buy and American Express we changed the original defensive alternatives either after a share gain or breaking even. Of the remaining 25 ideas, 17 of the ideas produced big free share gains. That leaves us with 8 ideas in their original form that we are still tracking, plus the new Best Buy and AXP ideas using the new defensive alternatives.
So next month we will still be tracking 10 ideas. In addition to these, I will have a new group of stocks I've been writing about that are going through sentiment cycles where I use the same rotational strategy; so make sure to keep an eye out for that series as well. Overall, I've been very happy with the results of this original series. The basic approach has more or less been proven successful publicly in real-time, and the minor errors that were made I have learned a lot from and made adjustments for.
I can't point out enough that this strategy specifically seeks out high-quality businesses. It is not looking for inherently weak businesses. This makes it all the more challenging. So to see the success it has had so far is quite remarkable.
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Disclosure: I am/we are long BRK.B, FDX, XMLV. 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.