Seeking Alpha

Tracking How Far They Fell: Q4 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 that 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.

This will mark the two-year anniversary since the first article in the series was published.

Source

Introduction

Beginning in mid-January 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 (BRK.A, 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 that 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 last year's 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 added four more completed rotations with Caterpillar (CAT) in January, Deere (DE) in May, and Boeing (BA) and American Express (AXP) in August. In early 2019, I 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 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 (AXP), I closed out the idea in September 2019 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 (BBY) 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 on a relative basis in less than a year in most cases.

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. For 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 two major types of price cycles that stocks can go through: those caused by highly fluctuating earnings (classic cyclicals) and those caused by highly fluctuating sentiment (these are the stocks my new sentiment cycle series is about).

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 as well.

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 break even, 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 less likely to make similar errors again.

Costco (COST) - 3/8/18

ChartData by YCharts

Costco is interesting because while I misjudged the type of cycles it had historically gone though, and my initial analysis, frankly, wasn't all that good, I do think the stock was overvalued when I first wrote about it. The problem is that it has only become more overvalued since then. There's not much I can do about that other than wait. Compounding that problem is that my suggested alternative, Berkshire Hathaway, has become even more undervalue since I suggested it. This has caused a situation where, if we were to rotate back into Costco today, we would own -47% fewer shares than when we rotated out. I expect that gap to close over time, and I still think there is a chance to at least get back to even with this idea.

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

ChartData by YCharts

This is another idea where Berkshire has underperformed so far. In retrospect, I should have probably put this one in the "too hard" pile, since SPGI's business has changed so much over the course of this cycle. However, I do think the stock price is going to be volatile during times when the market is weak, and that it will experience fairly big cycles in the future. We could have actually gained a few shares in this one back during the 2018 correction, but the stock has had a big rally since then. I expect we'll have another chance to get back to even if and when the market cools down. If we rotated back into SPGI today, we would own about -31% fewer shares than when we rotated out.

Union Pacific (UNP) - 3/6/18

ChartData by YCharts

Union Pacific is a moderately cyclical stock that is trading pretty high right now. I actually covered this stock in my sentiment cycle series in 2019, and that rotational idea is already completed with solid free share gains. Given where it is trading today, I should probably take another look at it. Back in 2018, for this series, I suggested three potential alternatives, so for tracking purposes, I average their performance together. On average, the three alternative ideas have returned +26.81% vs. +42.99% for UNP. If one rotated back in now, they would be able to buy about -13% fewer shares than when they rotated out.

CSX Corp. (CSX) - 3/22/18

ChartData by YCharts

CSX is another idea we track in the new sentiment cycle series as well. If we rotated back in today, we could buy -17% fewer shares of CSX than when we rotated out.

Southwest Airlines (LUV) - 4/4/18

ChartData by YCharts

We briefly had the opportunity to gain +20% free shares with the Southwest idea back during the 2018 correction, but I missed it. Right now, we could gain about +16% more shares. If I just could have gotten some better performance out of Berkshire the past couple of years, the rotational strategy would have performed better in all of the stocks I've reviewed so far. I don't think that's any fault of Berkshire's, it is just that the market has become irrational as of late. I think time will eventually be on my side here, and we are very close to rotating this one back in already.

Progressive Corp. (PGR) - 6/19/18

ChartData by YCharts

The average return of my alternative ideas here has been about +24.10% vs. Progressive Corp.'s +21.84%, so, they are pretty much even so far. If we rotated back in today, we would only have about a +2% free share gain.

Best Buy - 7/31/19

ChartData by YCharts

I really missed a big opportunity to gain a lot of shares with Best Buy during the 2018 correction. The stock had been so cyclical in the past, I thought there were more free shares to be had. Now, after making some adjustments to the defensive alternatives when they were even with Best Buy in mid-2019, Best Buy stock has risen even more. Today, we would receive -10% fewer shares if we rotated back in. So, this one wasn't an error in my initial assessment of the company as highly cyclical. The stock fell plenty far in 2018. I just got a little too greedy looking for more free shares. I do think that the price will come back down again, though.

American Express - 8/31/19

ChartData by YCharts

American Express has performed about the same as the alternative, but they have all underperformed SPY.

Realty Income - 2/20/19

ChartData by YCharts

Realty Income, after almost a year since I wrote about it, has finally started to break down a little bit. We still have a way to go before we achieve our 20% free share gain with this one, but at least we are seeing things begin to move in the right direction. If we rotated back in today, we would have about a +4% free share gain.

Ingersoll-Rand - 4/16/19

ChartData by YCharts

Ingersoll-Rand was a newer idea from 2019 and the last of the series before I started working on more moderately cyclical stocks. So far, it has held up well and is performing a little better than the alternatives. If we rotated back in now, we would have about -5% fewer shares than when we rotated out.

In total, the average return of the defensive alternatives I suggested which we are still tracking through the end of the year was +13.65% compared to the target stocks' average return of +25.27%, and SPY average return if purchased at the same time instead of my defensive alternatives was +19.04%. So, the defensive ideas on stocks we are still tracking still have a lot of work to do.

If we combine these returns with the realized returns of the rotational ideas that are already completed, the returns are: defensive alternatives +10.01%, target stocks -2.87%, and SPY +4.41%. It's important to point out that these returns are not time-weighted or anything, so the absolute return isn't all that important. What we are measuring here is the relative performance of the ideas in order to see if the strategy would produce alpha, and how much. The results are very encouraging considering we have a sample size of 32 positions.

I would like to also share this in graphic form, which measures the percentage of free shares gained or lost, which is something I'm started doing in my new sentiment cycle series, and I think it really helps visualize the results.

The x-axis represents the range of free share gains and the y-axis the number of positions that fell into that range. This contains both the realized finished trades and the ones we are still tracking. If the results of the strategy were random, we would expect a bell curve, with the three categories that contain the -10% to +10% range to hold the majority of the free share gain returns. That is not what we see, though. Instead, we see that that the distribution is skewed quite far to the left. This implies that the results of the strategy were not the result of random luck.

My ultimate goal is to have none of the 32 positions return a loss of shares. And I think there is still a reasonably good chance that could happen. Currently, we only have 6 of the 32 positions that need to turn positive in order to meet that goal. However, when I started writing this series, I mostly only forecast out three years into the future. Because of that, I'm not going to track the results much beyond three years unless we are clearly in the midst of a falling market. So, for most of the remaining ideas, that means we only have about 18 months left until I throw the towel in and bring this series to an end. Any alternative ideas that are still trailing the target stocks at that point will be declared losers, and I will accept the results.

Until that time, I plan to keep giving quarterly updates unless something interesting happens along the way and it makes sense to give more frequent updates.

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