- When profitability declines by 20% and the stock rises 117%, something's got to give, and it's rarely the case that profits rise to bring valuation back to Earth.
- Although the dividend is sustainable, the yield is paltry at the moment and there are much better income alternatives elsewhere.
- In my view, the returns I earned from selling puts are actually far superior to the returns earned by stock investors.
It's been a little over 10 months since I wrote a cautious piece about Regal Beloit (RBC) and in that time, the shares are up a staggering 117% against a gain of "just" 36% for the S&P 500. Much has obviously happened since then, so I thought I'd take another look at the company to see if it's worth buying now. I'll make this determination by looking at the financial history, and by looking at the stock as a thing quite distinct from the underlying business.
I also want to write about my philosophy around short puts, and describe why I think the 8% return I earned in seven months is preferable to the returns earned by stock investors here. This requires some explanation, obviously, so please stay tuned.
I am feeling in a particularly merciful mood, dear readers, and for that reason I'm giving you an "out." I'll present my primary findings in this paragraph so you won't have to wade through the silly jokes and self-congratulation that is sure to follow. I think there's a disconnect when financial performance suffers and when stock prices rise. At some point either the profitability will have to rise dramatically or the stock will have to fall to return the world to "normal."
I think it's much easier for the stock to fall, and that's what I think will happen in this case. Over the past year, profitability dropped by ~20%, and the shares are now trading at a multi-year high valuation. This is unsustainable in my view. Finally, I think the short put trade was preferable to the stock performance here for two reasons. First, a 14% annualised return should never be something to sneeze at. Second, unlike the share price returns, the money I made selling puts isn't in danger of evaporating in an afternoon. I go deeper into my thinking about short puts in the article below. If you want to read all of that, you need to hazard the proverbial minefield of self-congratulation and bad puns below. You've been warned.
The company just published its annual report, and I must say that I'm mostly not impressed. Sales dropped by ~10.2%, and net income collapsed by ~21% from the previous year. As a result of a 3.8% reduction in share count, EPS dropped by "only" ~18%. In fairness, the company did manage to reduce cost of sales by ~11.75%, and operating expenses by ~5.75%. These positives couldn't overcome the $331 million revenue drop, though.
I wrote "mostly" above, because I do like the fact that the capital structure is much less risky now. Specifically, long-term debt declined by a whopping 26% compared to the previous year. I also like the fact that the company increased the dividend in a sustainable way. In spite of the fact that the dividends per share increased by ~1.7%, the payout ratio from cash from operations improved fairly dramatically. In my previous screed on this company, I suggested that the dividend is sustainable and nothing that's happened since has changed my mind on this point. For that reason, I'd be very happy to eat crow and buy this company at the right price.
Source: Company filings, Author calculations
My regular reader-victims know that I use the phrase "at the right price" as a rhetorical device to drive home the point that a great company with a sustainable business (like this one) can be a bad investment if the investor overpays for it. This is because there's a negative relationship between the price paid for something, and the subsequent returns on that thing. The more you pay, the less you get. I could go on, and on, and on about this, but I think a picture is worth more than 100,000 of my words here, so here you go, dear readers. The following chart presents the dividend yield over time, and the price over time. Please note the negative relationship between price and yield. The more you pay, the less you get.
For that reason, I want to never overpay for an investment. That's a euphemistic way of saying that when it comes to stocks, I'm very much a cheapskate. It's a burden, but I bear it. I measure the cheapness of a stock in a few ways, ranging from the simple to the more complex. On the simple side, I look at the ratio of price to some measure of economic value, like earnings, free cash flow and the like. When last I looked at this stock, it was trading at a PE of ~11. Today, after posting a financial performance that could most charitably be described as "mixed," the shares are nearly three times more expensive per the following:
I like to see a stock trading at a valuation discount relative to its own history, and we see the reverse of that in this case. In spite of a slowdown in sales and profitability, the market is paying record amounts for $1 of future earnings. This is too risky in my estimation, and I will therefore continue to avoid the shares.
As you may remember, dear readers, in my previous missive on this name, I recommended selling the November puts with a strike of $60 for $4.90. These expired, so I earned an 8% return in seven months. In spite of the fact that the shares have done much better than that over the past year, I consider my return superior as it was made at much lower risk. This gets to the heart of my philosophy around short puts, and I think it's helpful to share it with you, dear readers.
We're not really equipped to think in terms of "risk-adjusted" returns. We think in terms of "returns," and where these are concerned, obviously higher is better. As retail investors, we often forget that what the market giveth in higher stock prices, it can easily taketh awayeth. We may assume that we can time our exit, and get out before the crash. In my view, this is magical thinking, belied by decades of market history.
As a put writer, I take a different approach to investing in stocks, and I keep the following in mind:
At any moment, the probability that the current stock price is the "right" price is low. This is evidenced by the fact that prices are incredibly volatile, and are driven by a host of forces beyond the fortunes of the underlying business. Investors seem to care more about trying to parse the comments of a central banker than they do about looking at the opportunities and threats to a given enterprise. A stock price can be moved by a change in mood of some Wall Street analyst, and God only knows what motivates those people.
Whatever the current price, it's always preferable to buy at a lower price by selling put options that would result in a purchase price significantly below the current market price. Over time, insisting on paying a lower price for the same asset is mathematically guaranteed to outperform... when the shares are "put" to you.
Sometimes (most of the time), the put option expires worthless and isn't exercised. This means that as a seller of puts, you've got to be very comfortable with the idea that you're sometimes going to make less returns than the stock investor. Sometimes you'll make significantly less than the stock investor. There are two sources of consolation, though. First, the risk you take on to earn your returns is significantly lower than the risk the stock investor takes. Over time this matters a great deal. Second, the returns are objectively significant. For example, the put options I wrote on Regal Beloit earned an annualised return of ~14%. That is a spectacular return earned at significantly lower risk.
So, while many people would be disappointed with a "mere" 8% return in this case, I'm quite happy with it.
I like to repeat success when I can. The problem is that the shares are so far above a price than I'd be willing to pay that I can't recommend a short put at the moment. I think the company is fine, but the stock is morbidly expensive. Specifically, I'd still be willing to pay ~$60 for these shares since not much has changed my mind here. The problem is that August puts with a strike of $60 are currently bid at $0. If the shares fall, as I expect they will over the next six months, I'd be happy to write some puts. At the moment, though, the exercise is pointless.
I think Regal Beloit is a fine business with a sustainable dividend. The problem is the stock. It was a bit richly priced before, and it's now morbidly expensive. In my view, when profitability declines by 20% and shares skyrocket, there's something amiss and something will have to give at some point. Either profitability will have to skyrocket to bring valuations back to something like normal, or the stock will have to fall.
In my view, it's much easier for the stock to fall than for profitability to explode, so I can't recommend buying at current prices. Although I missed the massive uptick in the stock, I am happy with my short put trade here. Unlike the returns earned from the stock over the past several months, the returns on my short puts won't evaporate. If you're a shareholder, congratulations. I think now might be a time to either sell or at the very least write a covered call. If you're just coming to this stock, I strongly recommend avoiding the name until price falls to match value.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.