This will be the first in a series of articles that look at when risk can be disguised as opportunity. The article will cover six high profile and well-known industrial companies that have outperformed the S&P 500 as our economy has come out of the recession of 2008 and 2009. Each of the six companies we will look at experienced stress on their operating results during the recession, followed by steep and even precipitous drops in their stock prices. However, we intend to demonstrate that the drops in their stock prices were generally far in excess of what the stress on their operating results dictated. Although few investors saw it at the time, this spelled incredible opportunity.
As a general rule there is an undeniable relationship between earnings and stock price. Where earnings go, stock price is sure to follow. However, since there are exceptions to every rule, there will be occasions where earnings and price become disconnected. When price rises significantly above earnings, we call this overvaluation. On the other hand, when price falls significantly below earnings, we call this undervaluation. Consequently, on this basis the principles of valuation can be a reliable and profitable means that investors can use to make intelligent buy or sell decisions.
In addition to the correlated relationship between earnings and stock price, we further believe there is a causal relationship between earnings and dividends — in the long run. In other words, good earnings produce good dividends, growing earnings produce growing dividends and conversely falling earnings most often produce falling dividends. As a result, these principles have caused us to hold the general belief that falling earnings are a bad thing. Therefore, if we owned a company that had a precipitous drop in earnings, our policy was to immediately sell. Deteriorating fundamentals were simply considered a high risk negative and thus a sell signal.
This last point segues into another important investing principle regarding risk and return. Again, generally speaking, higher risk is associated with higher return while lower risk is associated with lower return. However, whenever we came across a company with falling earnings we immediately assumed that it was not only a high-risk investment, but also a low-return one. Therefore, we never considered investing in a company with falling earnings. But even more importantly, if we already owned the company and its earnings fell we sold.
In conjunction with this position regarding selling a company with falling earnings, we also held a position that a company whose stock price was falling while earnings were growing represented a buy. We have always believed that this scenario created an opportunity to buy a great business on sale. Therefore, we eschewed trading techniques such as stop losses in favor of making rational decisions, not mechanical ones. When price fell while earnings continued to grow, our policy was to add to this position and leverage our upside. We saw this as a method of reducing risk by lowering our cost basis and simultaneously enhancing our return potential.
There are many investors who are fixated solely on price and therefore steadfast in their belief that if a price of the stock they own drops they sell, regardless of the situation. Peter Lynch had a different viewpoint, which he expressed in his best-selling book "One Up on Wall Street" as follows:
"Just because you buy a stock and it goes up does not mean you are right. Just because you buy a stock and it goes down does not mean you are wrong."
To us this always meant that you don't make investing decisions based solely on price movement. Instead, we focus more on fundamental valuations based on earnings and cash flows. How can you ever find a bargain if you're not willing to buy an excellent business when market fears, especially irrational ones, erroneously drop the price of an excellent business? To summarize, we believe in averaging down when we believe the intrinsic value of the business is worth far more than the market may be pricing it at. We always make these judgments based on our expectations of present and future earnings power. Frankly, we continue to believe that this is a prudent and intelligent way to approach investing.
Teaching an Old Dog New Tricks
With the above positioning statements in mind, the recent great recession has given us reason to, at the very least, examine some of our sacred cow investing attitudes. The correlation and functional relationship between earnings and market price remains a foundational principle. However, the notion that a single drop in earnings is an unforgivable sin is being questioned. Recent evidence is suggesting that a drop in earnings for an established company may in truth be an exceptional opportunity for profit. Price drops tend to stimulate a fearful response which can blind investors from seeing the future benefit.
When we were in the throes of the recession and stock prices were dropping along with earnings, investors were in a heightened state of fear. When emotions run at such a fevered pitch, the ability to think rationally is severely curtailed. Faced with such extreme negative market reactions, people became afraid that their portfolios could go to zero. Therefore, panic set in and selling begot selling and the downward spiral accelerated, driving stock values to excessively low valuations. When this was happening no one was able to even contemplate the idea that it would end, or the simple fact that all bear markets eventually end with a bull market.
However, the real lesson that we feel that 20/20 hindsight is teaching us is the amazing resiliency of well-established operating businesses. We are learning that this is especially true for well diversified manufacturing companies and conglomerates. During the great recession many investors were fearful that these companies would fall so far into oblivion that they could never recover. But the truth is that the vast majority never experienced earnings drops as severe as their stock price drops indicated. Moreover, many were capable of coming off the bottom in almost rocket-ship like fashion. In some cases their stock prices and earnings soared to heights above what they had ever been, and in many other cases rapidly rose back to where they had originally fallen from.
Current political maneuverings with budget deficits are once again conjuring up the fear response for many investors. This was the primary motivating factor for preparing this series of articles. We think it's more likely than not that whatever political issues we face today, they will be eventually be solved. Therefore, whatever effect it may have on the markets and the operating results of established companies, it surely will once again be temporary. Consequently, the greatest risk does not lie in the political and economic issues themselves. Instead, the greatest risk lies in how we as investors react to the short-term volatility that these events could possibly bring.
The following tables prepared with F.A.S.T. Graphs™ review and summarize the results of six established industrials that experienced earnings and price drops during the great recession of 2008 and 2009. This first graph illustrates each company's annualized performance over the 15-plus year period since year-end 1996. The focal points of this graph are the column marked 15-year historical earnings growth (orange highlight) and the column marked annualized performance (green highlight). Note the strong, but not perfect, correlation between historical EPS growth and annualized performance.
15-Year Historical Performance
This second table focuses on the annualized performance since Dec. 31, 2008 to July 26, 2011 (yellow highlight). Year-end calendar year 2008 was chosen as our starting measurement point in order to not cherry pick perfect bottoms. These powerful and extraordinary annualized returns represent the opportunity that becomes available during times of economic or financial crisis. Unfortunately, most investors are usually too traumatized to be able to take advantage of these incredible opportunities as they reveal themselves. Our fears cause us to believe that the end is coming and the opportunities are consequently overlooked.
3-Year Post-Recession Performance
This article is offered as the introduction to a series of seven articles that will reveal the incredible opportunity that occurred as a result of the six industrials above coming out of the last great recession. The next six articles will look at each company individually to provide an illuminated view of how and why these incredible returns were generated.
However, the primary purpose of this series of articles is to shine a light of reason upon the realities of business cycles and the effects on markets. Thus far, recessions have never brought the Armageddon that many investors fear. Instead, each recession has brought incredible opportunities to those with the foresight and courage to behave and react appropriately. As the great motivational author Napoleon Hill so aptly put it: "Every adversity, every failure, every heartache carries with it the seed to an equal or greater benefit."
Once again we find ourselves in a heightened state of fear because of political events and their potential impact on our economy and markets. However, we contend that as usual, the fears are more dangerous than the events themselves. It is our hope that this series of articles will at least stimulate a willingness to consider the opportunities as well as the risks. The next article in this series will take a detailed look at Cummings Inc. (NYSE:CMI) and reveal the source of the 75% annualized return that this leading manufacturer of engines has generated for shareholders since year-end 2008.
Disclosure: Long IR, ITW at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
About the author:
Prior to forming his own investment firm, he was a partner in a 30-year-old established registered investment advisory in Tampa, Florida. Chuck holds a Bachelor of Science in economics and finance from the University of Tampa. He is a sought-after public speaker who is very passionate about spreading the critical message of prudence in money management. Chuck is a veteran of the Vietnam War and was awarded both the Bronze Star and the Vietnam Honor Medal.