Introduction
I have two core methods of sharing my investing ideas and strategies on Seeking Alpha. The first method is via public articles like this one, and the second is via the Cyclical Investor's Club. Since launching the Cyclical Investor's Club on 1/12/19, I've always tried to strike a reasonable balance between my public ideas, which everyone can read for free, and the private ideas, shared exclusively in the CIC. Over time, I have decided to break these ideas into two distinct categories where ideas about stocks that comprise the S&P 500 are made public and all the rest remain private. I've tried to abstain from first sharing an idea in the CIC, and then, after the price has run up, sharing it with the public because I simply didn't like the way it felt to me ethically.
The recent market dive happened so quickly, however, that there was no way I could write public articles in time for all the stocks I purchased in March. From February 28 through the end of March, I purchased 33 stocks (plus suggested members buy Berkshire Hathaway (BRK.B, BRK.A), which I already owned), and most of the stocks were purchased in the five trading days nearest the bottom of the market's dip. I could barely keep up with the purchases via the real-time chat function in the Cyclical Investor's Club, much less write full public articles about them all. Of those 34 stocks, 19 of them were components of the S&P 500, and I only managed to write about one of them publicly - Comcast (CMCSA) - at the very beginning of the downturn. So far, in addition to Comcast, I have now covered Hologic (HOLX), FLIR Systems (FLIR), Sysco Corporation (SYY), Tractor Supply (TSCO), Microchip Technology (MCHP), and Align Technology (ALGN) in the series. Most of these stocks will no longer be "buys" at their current prices, but I will share both my "buy price" and my "sell price" for the stock in each article so that if we have a double-dip, readers will know the prices at which I think the stocks are buys, and if the market rips higher, readers will know the initial threshold at which I would consider selling and taking profits. After I've shared all the S&P 500 stocks I bought during the dip, I'll analyze them as a group to see if we can discern any patterns that emerge or any mistakes I made that could help improve my investing approach in the future.
Today's stock is Genuine Part Company (NYSE:GPC), and it's one I've done quite well with since purchasing on 3/23/20.
Data by YCharts
Over this period of time, we have roughly doubled the return of the S&P 500. Interestingly, this purchase came on the day the market bottomed, so, generally speaking, this stock purchase was timed well. It's worth noting that I only bought four stocks on that particular day (so only about 12% of the stocks I purchased that month came on the day of the market bottom). My aim is not for this article to be a lesson in timing, however, and we can see that if it was all about timing, and not identifying value, that GPC would have had similar performance as the index since they bottomed on the same day. Since GPC was trading below fair value and with a substantial margin of safety, while the market was roughly trading at fair value when it touched bottom by my estimates, we can see that so far in this recovery, GPC has significantly outperformed the index.
Next, I'll take you through my process for identifying the value in GPC.
Step 1: Determine the Cyclicality of Earnings
On the F.A.S.T. Graph above, the adjusted operating earnings for Genuine Parts Company is represented by the shaded dark green area. Leading up to the current downturn, GPC had experienced 5 years of negative EPS growth. I have annotated the F.A.S.T. Graph with red circles to highlight those negative growth years. Probably, what is most notable about them is they are all quite shallow, with four years of negative EPS growth in the single digits, and only one year, 2009, falling -14% (a little more than that if we take 2008 and 2009 combined). It's also worth noting that right now, during this recession, EPS is expected to decline -31% from last year. While this is deeper than the last recession, right now, analysts expect a fairly quick recovery, and for the business to recover the 2019 earnings peak by 2022. Personally, I don't place much value in what analysts think about the next two years because I don't think we really know what will happen. But I do think that if I expect a -17% decline as we experienced during the last recession of 2008/9 and we build-in a substantial margin of safety when it comes to our forward return expectations, then we can likely do a reasonably good job estimating a good buy price for the stock that offers an adequate risk/reward even if we don't know exactly what the immediate future holds. The good part about approaching the uncertainty over recession earnings in this way is that often when sharp stock price declines occur (as they did in March), we have very limited knowledge about how far earnings might decline over the next year. But we have very clear knowledge about how far they fell during previous declines and we have that knowledge before the next decline occurs. While no two earnings declines are exactly the same, often they are similar and using the past a guideline can usually get us in the right ballpark.
With a low-to-moderately cyclical businesses like this one, fairly traditional valuation systems using P/E ratios and earnings growth estimates work reasonably well to predict future returns as long as we try our best to account for that modest earnings cyclicality, so the full-cycle approach using traditional methods is what I used for Genuine Parts Company (if earnings had been more cyclical, I would have used a different method of valuing the stock).
Step 2: Full-Cycle Analysis
Next, I'm going to run what I call a "Full-Cycle Analysis," which is the same analysis I performed that flagged GPC as a buy in March. As part of the analysis, I calculate what I consider to be the two main drivers of future total returns: Market Sentiment returns and Business returns.
In order to estimate what sort of returns we might expect over the next 10 years, let's begin by examining what return we could expect 10 years from now if the P/E multiple were to revert to its mean from the previous economic cycle. I start the previous cycle around the end of 2007, a little before the last cyclical peak.
As I write this, GPC's blended P/E on the FAST Graph is 17.18, while its normal P/E this past cycle has been 17.76. My view is that the blended P/E ratio is probably a little high because blended P/Es look forward a quarter or two and combine those estimates with current earnings, so this blended P/E is assuming that earnings will indeed be lower over the next couple of quarters (based on analysts' projections) which raises the P/E ratio because the "E" is reduced. Since I don't have a lot of faith in analysts' projects during the middle of a decline like this, I like to use peak forward earnings. These are the earnings analysts were expecting for the remainder of the year back in February before the recession. And if we create a P/E from peak earnings expectations using today's price, we get a peak earnings P/E of about 15.61, which is quite a bit lower than the long-term average of 17.76. This suggests that while GPC has risen quite far off the bottom, it could still have more upside from here over the long term.
If, over the course of the next 10 years, GPC's P/E were to revert to its normal 17.76 level from its current 15.61 level and everything else was held equal, it would produce a 10-year CAGR of about +1.31%. (My minimum threshold for purchasing a stock during the current recessionary downturn is a +1.00% expected 10-year CAGR from sentiment mean reversion. When I bought GPC, it had a P/E ratio of 9.29, which would have produced a 10-year sentiment mean reversion CAGR expectation of about +6.70%, well above my minimum threshold.)
Step 3: 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. Using peak earnings, the current earnings yield is still quite reasonable today at about +6.41%. The way I like to think about this is, if I bought the company's whole business right now for $100, I would earn $6.41 per year on my investment if earnings remained the same for the next 10 years. (Back in March when I bought the stock, this number was about $10.76, so you can see the dramatic difference it makes buying at a lower price in terms of the expected return on investment one gets.)
The next step is to estimate the company's 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.
Data by YCharts
GPC has been a fairly steady buyer of its own stock over the course of this cycle. Really, the only time they weren't buying back at least a little bit of stock was during the heart of the last recession in 2009. I'll back these stock repurchases out of my earnings growth estimates. After backing out the share repurchases when I go back to 2007 through today, I get a cyclically adjusted earnings growth rate of +4.35%, which is a pretty slow growth rate over this period, but adequate if we buy the stock at a deep enough discount.
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 GPC's whole business for $100, it would pay me back $6.41 plus 4.35% growth the first year, and that amount would grow at +4.35% per year for 10 years each year after that. 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 $181.13 (including the original $100). When I plug that growth into a CAGR calculator, that translates to a +7.37% 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 for GPC, it will produce a +1.31% CAGR. If the earnings yield and growth are similar to the last cycle, the company should produce somewhere around a +7.37% 10-year CAGR. If we put the two together, we get an expected 10-year, full-cycle CAGR of +8.68% at today's price.
My Buy/Sell/Hold range for this category of stocks is: above a 12% CAGR is a Buy, below a 4% expected CAGR is a Sell, and in between 4% and 12% is a Hold. Right now, GPC is in the "Hold" category. Assuming earnings don't make new highs, GPC would cross the sell threshold around $112 per share, and at that point I would develop an exit strategy for the position, perhaps putting in a trailing stop. But I plan to hold until we at least rise above that price.
The Dividend Angle
My long-time readers will have probably noticed that I rarely write about dividends even though there are a lot of dividend investors on Seeking Alpha. The reason for that is because, over the long-term, in my view, dividends come from earnings and cash flows, and that eventually retained earnings that aren't paid out in dividends will usually be reflected in a higher stock price. I am indifferent as to where my profits come from. If they come from capital gains, that's fine with me, and if they come from dividends, then that's fine, too. There are some situations, like with mature companies with no real earnings growth, where I think they should pay dividends to investors and I don't invest in those businesses unless they do. In those cases, however, I typically require a 7% to 9% initial dividend yield before I get interested. I own a couple of tobacco companies that fit this category, but usually, stocks with very high dividend yields don't meet my quality standards and their yields are very high for good reasons, so I avoid them.
Interestingly, though, because I aim for value prices, I often 'accidentally' end up buying stocks with relatively high dividend yields. Genuine Parts Company is a good example of this.
Data by YCharts
When I purchased GPC, it had over a 6% dividend yield. That's a fairly high yield, but in the big scheme of things, it makes sense. They only grew earnings a little over 4% per year during a cycle when inflation averaged about 2%. So, we are getting a little bit of real earnings growth from GPC, but not a whole lot. It makes sense for them, if they can't grow earnings very fast, to pay out a reasonably high dividend to investors. And if you compare the 6% yield on cost I got with GPC with slow earnings growth to the 7% to 9% I aim for with stocks that have almost no real earnings growth, we see that it fits in right about where you would expect for a stock of its type. The slower the earnings growth, the more capital you would expect gets returned to shareholders.
But if we take a stock I covered earlier in this series, Align Technologies, which has grown earnings over 20% per year this cycle, I see no need to demand a dividend at all from them. They appear to be putting their capital to work just fine growing their business. So, it makes no difference to me whether or not a stock pays a dividend as long as their capital allocation makes sense to me.
Interestingly, though, I tend to end up with a fair amount of healthy dividends anyway, more or less accidentally. When this series is finished I plan to go back and see what my overall yield-on-cost was for this group of stocks. I suspect that it's as good or better than many dividend and dividend growth ETFs.
Conclusion
I think it's fair to expect a lot of continued volatility in the market over the course of the next 6-12 months. A double-dip or new highs for the market are both on the table. Should we have a double-dip, my buy price for GPC is $52.50. I think it offers a good risk/reward at that price even in the case of an extended recession. It may be one you wish to put on your shopping list.
If you have found my strategies interesting, useful, or profitable, consider supporting my continued research by joining the Cyclical Investor's Club. It's only $29/month, and it's where I share my latest research and exclusive small-and-midcap ideas. Two-week trials are free.
