Seeking Alpha

Tracking How Far They Fell: September 2019 Edition

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Includes: AXP, BA, BBY, BRK.A, BRK.B, CAT, CCL, CMI, COST, CSX, DE, EMR, ETN, FDX, GD, GWW, IR, LUV, MGA, MMM, NKE, NOC, O, PAYX, PGR, PNC, ROK, RSP, SPGI, SPLV, STT, TIF, UNP, UTX, VPU
by: Cory Cramer
Cory Cramer
Value, portfolio strategy, contrarian, medium-term horizon
Summary

In the first half of 2018, I warned investors about 28 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.

So far, we've had 18 successful rotations with large free share gains.

This article will track the performance of the remaining ideas through the month of September, as well as 2 more we've added in 2019.

Source

Introduction

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. 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 15 of the 28 rotational ideas I'd been tracking that had been completed in 2018. In 2019 we've added four more completed rotations with Caterpillar (CAT) in January, Deere (DE) in May, and Boeing (BA) and American Express (AXP) in August. So far, in 2019, I've also added two more new stocks to track, Realty Income (O) and Ingersoll-Rand (IR). There have been a few stocks along the way where I realized I had made some sort of error along the way and rotated back in without any gains. Here is the table, which shows the free share gains achieved from the rotational strategy for the 22 completed rotational trades so far, including those which only broke even or produced modest gains:

Ticker Free Shares Gained Ticker Free Shares Gained
CMI 53% EMR 30%
STT 38% GD 50%
MGA 40% ROK 35%
MMM 32% ETN 28%
NOC 47% CCL 33%
FDX 41% PNC 23%
TIF 29% UTX 29%
CAT 37% DE 34%
BA 20% (GWW) 0%
(PAYX) 0% (NKE) 3%
(AXP) 12% (BBY) 0%

With American Express, I closed out the idea last month with modest gains because the defensive alternatives had gotten overvalued, and I reinitiated a new idea with different defensive positions. I did a similar thing and switched the defensive positions with Best Buy back in August while it was about even with the initial defensive ideas. So we have completed about 2/3rds of the original ideas with very good gains on average. For those not used to thinking in terms of free share gains, here are the average returns of these 22 ideas while they were held: SPY -2.24%, defensive alternatives +8.36%, and target stocks -15.66%, which is pretty massive outperformance over a year and a half or so.

Now let's take a look at the 10 ideas we are still tracking.

Ideas we are still tracking

Getting back to even:

The 10 ideas we are still tracking are an interesting lot. Four of them, in retrospect, I would have used a different type of analysis if I had to do it all over again. In fact, one of the biggest lessons I learned from writing this series is that there are three major types of price cycles that stocks can go through; those caused by highly fluctuating earnings (classic cyclicals), those caused by highly fluctuating sentiment (these are the stocks my new sentiment cycle series is about), and those whose price cycles are caused by a mix of earnings fluctuations and market sentiment (for these, either method of analysis (price cycle or sentiment cycle) can work).

The earnings fluctuations of these four stocks are either low or moderate. Two of them (the two railroads), I've already started covering in the sentiment cycle series and I'm now tracking them there. The other two, I have yet to write update articles on, though I think I will.

One of the benefits of the rotational approach is that it is very forgiving when it comes to making mistakes. Usually, you will have a chance to rotate back into these high-quality stocks and breakeven, even if you made a small error along the way. So, my goal with these four stocks is to break even. I have identified my original error and improved my analysis going forward so I'm unlikely to make similar errors again.

Costco (COST) 3/8/18

ChartData by YCharts

I really do need to write a follow-up article on Costco for the sentiment cycle series. I think it's just a matter of time before it comes down to earth, but I haven't run the numbers on it yet. So far, it has generated incredible outperformance since I wrote my original warning article.

S&P Global (SPGI) 3/19/18

ChartData by YCharts

I also need to write a follow-up on S&P Global. While it has had big price cycles in the past (as have its peers). Its earnings have only been moderately cyclical, and a big portion of its price cycles have been driven by changes in market sentiment. I need to write a new analysis that takes this into account.

Union Pacific (UNP) 3/6/18

ChartData by YCharts

Union Pacific is moderately cyclical and it's likely we will be able to get some free share gains still out of this idea. The only reason we haven't yet, is that Berkshire Hathaway has underperformed as a defensive position so far, and it represents 1/3 of the defensive mix here. My goal with this one now is to get some small free share gains or at least back to even. We are currently tracking this one in the sentiment cycle series using more accurate numbers, and I think it belongs in that series more even though it is moderately cyclical.

CSX (CSX) 3/22/18

ChartData by YCharts

CSX is similar to Union Pacific. They both have moderately cyclical earnings. My goal here is to get back to even and track CSX in the sentiment cycle series instead.

Remaining 2018 Ideas:

There are only two more remaining ideas from 2018 for which we have yet to be able to complete our rotation.

Southwest Airlines (LUV) 4/4/18

ChartData by YCharts

With Southwest, we came very close to being able to rotate back in with solid gains back in December but just missed our goal. I think this opportunity will present itself again for a 20% free share gain.

Progressive (PGR) 6/19/18

ChartData by YCharts

Progressive has been very strong, but it has shown that it sometimes does have very deep price dives, so I think we will eventually be able to get some free share gains here.

Ideas from 2019:

Best Buy (BBY) 7/31/19

ChartData by YCharts

I feel very confident we'll be able to get additional free share gains in Best Buy if the economy has any weakness at all. We could already get about 15% if we rotated in today.

American Express 8/31/19

ChartData by YCharts

Again, I think it's going to take a little economic weakness to get an opportunity for free share gains in AXP, but it has a history of reasonably high cyclicality, so eventually, I think we'll get an opportunity.

Realty Income (O) 2/20/19

ChartData by YCharts

The Realty Income idea is interesting because while Realty Income has outperformed the S&P 500, it has performed about the same as the defensive alternatives. It might take a change in interest rate policy or a rise in the 10-year yield to push O lower, but the alternatives are keeping pace right now, so we can wait patiently.

Ingersol Rand (IR) 4/16/19

ChartData by YCharts

Again, Ingersoll-Rand is still going strong, but SPLV is more than keeping pace. Both have outperformed the index.

Conclusion

Of the ten ideas that we are still tracking the returns through the end of September were: SPY +9.24%, defensive alternatives +8.37%, and the target stocks +18.31%.

If we include the performance of the completed ideas, the results for all 32 ideas are: SPY +1.46%, defensive alternatives +8.36%, and the target stocks -4.70%. Even despite some of the missteps I made along the way, the strategy is working very well so far. I think if we can get back to even on some of the target stocks who turned out to have low and moderately cyclical earnings, and we can also make a few more winning rotations, we will be able to declare this experiment a success. And with a sample size of about 30 and ideas made in real-time instead of backtesting, this should help provide at least some evidence that the strategy can work for average retail investors.

I will continue to keep tracking these ideas and I will put Costco and SPGI on my list for 'full-cycle analysis' articles. And as most of you know, I have started a new series that focuses on stocks with less cyclical earnings than 'classic cyclicals' called my sentiment cycle series. Since we are going to have quite a bit of crossover between the remaining stocks in this series and there hasn't been too much notable action lately in the remaining stocks, I'm going to probably move to quarterly updates instead of monthly updates with this series unless something noteworthy happens between now and then, or I start finding several classic cyclcials that have become overvalued again and I add them to the 10 ideas we are still tracking.

Disclosure: I am/we are long SPLV, RSP, BRK.B. 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.