The recent coronavirus pandemic has caused me to take some interesting actions in my portfolio recently. Since I think a recession or serious economic slowdown is highly likely, I raised a lot of cash last week, and on Friday morning I was about 70% cash. If you are interested you can read about those actions and the thinking behind them here. There is a bit of irony that immediately after raising cash from my 'default ETFs' I started buying individual stocks that I judged to be good values. Comcast (NASDAQ:CMCSA) was one of those stocks. In this article, I'll take you through my reasoning for that purchase.
I always start off my analysis of any stock by trying to form a foundation using historical numbers. Sometimes, adjustments need to be made to assumptions based on those numbers, but my view is that I want the numbers to at least look reasonable in order to get me interested based on their likely future 10-year returns.
So, as part of my historical analysis, I calculate what I consider to be the two main drivers of future total returns: Market Sentiment returns and Business/Shareholder returns. I then combine the CAGR estimates from Market Sentiment and Business/Shareholder returns to get an expected 10-year, full-cycle CAGR estimate. Currently, I consider an expected 10-year CAGR > 12% a "Buy," 4-12% a "Hold" and < 4% a "Sell."
How Cyclical Are Earnings?
Since I use different approaches for analyzing a stock based on how cyclical earnings are, historical earnings cyclicality is the first thing I examine. Let's take a look at Comcast's historical earnings using a F.A.S.T. Graph to examine that cyclicality:
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-digit percentage-wise during downturns, but not much further 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." For businesses that have earnings in the deep or highly cyclical categories, I use an entirely different type of analysis, so it's important to determine at the outset which category a stock falls into.
Since 2004 when Comcast started earning money, its EPS growth has only gone one direction: Up. This puts Comcast into the 'secular growth' category and on a scale of 1-8 I would rate its earnings cyclicality a '1.' For secular growth stocks, it is useful to use historical P/E ratios as a guide for potential future returns. That said, unlike the last recession, in which Comcast grew EPS straight through the recession, I don't think we should expect that this time around. Cable television subscriptions have started to fall the past couple of years even though we are not in a recession, and I expect that trend to continue. Cord-cutting (I cut my cord from cable over a decade ago) should be expected to continue and Comcast will have to invest in its new streaming service over the next several years. A recession will almost certainly produce negative EPS growth for a couple of years when it occurs. So, while Comcast is not highly cyclical, we shouldn't expect earnings to go up in a straight line from here as they did during the past cycle.
Sentiment Mean Reversion
In order to estimate what sort of returns we might expect over the next 10 years, let's begin by examining what 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 about 2007, a little before the last cyclical peak.
Comcast's current blended P/E is 12.87, while its normal P/E this past cycle has been 18.39. If over the course of the next 10 years, the P/E were to revert to 18.39 and everything else was held equal, it would produce a 10-year CAGR of about +3.63%.
Current and Historical Earnings Patterns
We previously examined what would happen if market sentiment reverted to the mean. This is entirely determined by the mood of the market and is quite often disconnected, or only loosely connected, to the performance of the actual business. In this section, we will examine the actual earnings of the business. The goal here is simple: We want to know how much money we would earn (expressed in the form of a CAGR %) over the course of 10 years if we bought the business at today's prices and kept all of the earnings for ourselves.
There are two main components of this: the first is the earnings yield and the second is the rate at which the earnings can be expected to grow. Let's start with the earnings yield.
Comcast's current forward earnings yield is +7.97%. The way I like to think about this is, if I bought Comcast's whole business for $100, I would earn $7.97 per year on my investment if earnings remained the same for the next 10 years.
However, business earnings do not typically stay the same every year. Sometimes earnings grow, sometimes they shrink, and sometimes they fluctuate both up and down. So, in order to estimate how much money the business might earn over 10 years, one needs to estimate how the annual earnings might change over that time period.
My approach, for businesses whose earnings are not highly cyclical, is to base my forward expectations on the earnings of at least one full previous economic cycle (so that at least one recession is included in the estimate). For businesses whose earnings are highly cyclical, earnings history is not very reliable, so I use the price history from at least two previous economic cycles for those highly cyclical stocks. Since Comcast has steady earnings, examining the last cycle as a starting point makes sense.
I also like to take a look at the free-cash-flow-to-equity/market cap yield. This usually allows me to quickly identify M&A and potential debt problems I might need to examine.
The current FCFE/MC yield is 11.10%, which is quite good. The big spike down was caused by its Sky acquisition a couple of years ago. As a general rule, I try to avoid businesses that have made big acquisitions during this cycle. Usually, they overpay and over-leverage and it takes a while for businesses to deal with that when acquisitions don't live up to expectations. So, this is a strike against Comcast using my methods. However, I think the company has made very good decisions in the past growing its business, so, even though I would prefer a company that hadn't made any big acquisitions this cycle, I'm willing to give Comcast the benefit of the doubt here.
Now we know what Comcast is currently earning, and I think it is reasonable to expect the future to at least be somewhat similar to the present and the past. The next step is to estimate its earnings growth during this time period. I do that by figuring out at what rate earnings grew during the last cycle and applying that rate to the next 10 years. This involves calculating the EPS growth rate since 2007, taking into account each year's EPS growth or decline, and then backing out any share buybacks that occurred over that time period (because reducing shares will increase the EPS due to fewer shares).
Let's start by looking at how much shares were reduced since 2007.
Comcast has reduced its shares outstanding by about -12% over the course of this cycle. I'll back these out for earnings growth estimates. When I go back to 2007 through today, I get a cyclically adjusted earnings growth rate for Comcast of +18.40%, which is an incredible earnings growth rate. But, at this point, I think we need to use some judgment about how sustainable that growth rate is. We know that the transition to streaming and the disruption of cable TV aren't probably going to be a money-maker. The company is really just trying to maintain its profits at this point. And I think it's also fair to say that cord-cutting will probably increase during a recession, unlike last recession when there wasn't as much of an option for many people who wanted home entertainment. So, assuming an 18% growth rate over the next decade seems unrealistic to me.
Since I like to spread my bets around and take small positions in lots of stocks, I don't have the time to deeply study any single stock or business. So, I'll lean on analysts here for a ballpark estimate of what they think earnings will do over the next few years.
Analysts currently think EPS will rise 2%, 7%, 16%, and 11% over the next four years. These are all slower than the 18% historical rate we've had this cycle and they likely do not include a recession assumption during this time frame. I think we likely will have a recession or serious economic slowdown later this year. So, my estimates would probably include earnings declines for the next two years in the -10% to -20% range, followed by a rise into the mid-teens for the rest of the decade. As a rough 10-year estimate, 10% earnings growth per year on average seems like a reasonable middle between what they have been able to do historically, including more damage from a recession this time around than last, but also an eventual recovery. It's not a perfect or sophisticated estimate, but I think it's a reasonable, ballpark guess.
Next, I'll apply that growth rate to current earnings looking forward 10 years in order to get a final 10-year CAGR estimate. The way I think about this is, if I bought Comcast's whole business for $100, it would pay me back $7.97 the first year, and that amount would grow at +10.00% per year for 10 years. I want to know how much money I would have in total at the end of 10 years on my $100 investment, which I calculate to be about $239.72. When I plug that growth into a CAGR calculator, that translates to a +9.14% 10-year CAGR estimate for the expected earnings returns.
10-Year, Full-Cycle CAGR Estimate
Potential future returns can come from two main places: market sentiment returns or earnings returns. If we assume that market sentiment reverts to the mean from the last cycle over the next 10 years, it will produce a +3.63% CAGR. If the earnings yield and growth are similar to the last cycle, the company should produce somewhere between a +9.14% 10-year CAGR. If we put the two together, we get an expected 10-year, full-cycle CAGR of +12.77%. Since this is above my 12% 10-year expected CAGR threshold, I rate Comcast a 'buy.' And, I have taken an ~1% portfolio position in the stock.
I'm going to make a few remarks about the larger context of this purchase since it comes at a time of great volatility in the market. I currently have a lot of cash, and my strategy is to let this market come to me and to invest in it as I see values available in the marketplace. Whenever I see value, I'm going to take a small position no matter what the market is doing on any particular day or what I think the market will do over the next few months. If the market falls over the course of the next year, it will be tempting to look back and wonder what I was doing buying so soon during what I expected to be a possible recession. Or, if I'm wrong and the market goes on to make new highs, it will be tempting to ask myself why I didn't take bigger positions. Either of these scenarios could happen, or, the market might just chop around for a while. The main thing is that I have my plan, and it's a plan where I am comfortable no matter what the broader outcome eventually is. I see enough risk, not just from coronavirus, but from valuations, that I'm happy holding a lot of cash right now. However, if something looks like a good value, I'm not going to hold back from starting a position. Some stocks do reasonably well during some downturns if they are at good valuations going in. I think Comcast is at a good valuation here.
I think it's also worth asking why the stock might be trading so cheaply right now if the rest of the market is expensive. My theory is that many investors believe that 5G adoption will be disruptive to Comcast's internet business and that the disruption will be remarkably fast and that is why they are avoiding the stock. I'm willing to take the other side of the bet. Comcast is a well-run, proven, and profitable company. I know that in a way that I don't know how disruptive 5G will be, and especially how fast the rate of that disruption will be. Time, of course, will tell. Which is why I love investing. Ultimately, as long as we designate a time frame, someone will be proven correct.
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