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Last week we spoke to the Washington Hay Growers Convention in Kennewick, Washington. Those who grow hay have enjoyed a very similar boom in the last twelve years that wheat and corn growers have enjoyed. The parking lot was full of nearly new heavy duty trucks and the convention floor was packed with $400,000 to $700,000 farm implements from major manufacturers. These farmers have been feasting in the boom and it got me thinking about how to correctly value cyclical businesses, because at Smead Capital Management valuation matters dearly.
Whenever we examine a cyclical company (a company heavily dependent on positive cycles in their industry) we use ten-year smoothing of price-to-earnings ratios (P/E) as recommended by Robert Shiller. This keeps us away from buying into a business at what appears to be a low P/E ratio, because we are near a cyclical peak in earnings. Thanks to my anecdotal evidence last week, we chose to look at Deere (DE), Caterpillar (Cat) and Schlumberger (SLB). We believe these are three outstanding cyclical companies which are very susceptible to industry and commodity cycles. On a 2012 earnings basis, CAT and DE look attractive to us at 10.5 and 11.8 times earnings, while SLB appears fairly valued in a very positive era for the oil services industry. As you can see below, the smoothed P/E paints a drastically different picture.
Source: Thomson-Baseline
All three stocks trade for a ten-year P/E multiple exceeding the S&P 500 index and appear very over-valued to us. Schlumberger looks wildly overvalued on a ten-year smoothed basis and CAT and DE look significantly overvalued. To confirm where we are in the cycle for the heavy machinery, agricultural machinery and oil service industries, we researched price-to-book ratios (P/B) going back 30 years to see where we are from a popularity standpoint.
DEERE & COMPANY Price-to-Book
Source: Thomson-Baseline
CATERPILLER Price-to-Book
Source: Thomson-Baseline
SCHLUMBERGER Price-to-Book
Source: Thomson-Baseline
Deere has a P/B of 5.1 which coincides with the current massive popularity of agricultural commodities and emerging markets. Caterpillar sells at 3.5 times book, not high by recent standards but significantly above the S&P 500 index average of 2.5. Schlumberger's P/B is at the lower end of recent history, but is at a premium to the S&P 500 index.
To give investors additional perspective, we ran a smoothed P/E on three companies in our current portfolio of stocks.
Source: Thomson-BaselineAll three, Merck (MRK), Aflac (AFL) and JP Morgan (JPM), trade at current P/E ratios lower than the S&P 500 index and are in the lowest of the five P/E quintiles in the index. They also appear deeply undervalued on a ten-year smoothed basis. Lastly, they all appear very cheap from a backward-looking P/B basis as seen in the charts below.
MERCK Price-to-Book
Source: Thomson-Baseline
AFLAC Price-to-Book
Source: Thomson-Baseline
JP MORGAN CHASE Price-to-Book
Source: Thomson-Baseline
We believe low P/E ratios on current earnings among popular cyclical stocks in industries which have experienced boom times recently are a sucker’s game. Use a smoothed P/E to defend yourself. On the other hand, we believe the pharmaceutical, insurance and banking industries look like an attractive place to seek alpha today via MRK, AFL and JPM.
Best Wishes,
William Smead
The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.
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Hey William,
I'm a big fan of the approach outlined above.
One question on the approach though: Did you adjust for differences in margins or any other factors that would make future returns on capital different than past returns on capital? Were adjustments made for differences in growth rates from past to present? For example, can JPM or AFL carry as much leverage as they once did? Or has the business changed to an extent where less capital is needed to operate at the same levels of profitability?
Thanks. Keep up the posts. As an aside, GuruFocus had a great article at one point about the price relationship between the Morgan Stanley Consumer Staple Index (CMR) and the Morgan Stanley Cyclical Index (CYC.) Don't quote me on the exact numbers, but for the last 10 years, 20 years, and 30 years, that ratio has always averaged 116% (CYC to CMR.) There is massive variability around that 116% though. The range is from 85% to 150% (once again, don't quote me on those figures.) The point is, I think there is something to be said about migrating the portfolio from cyclical to more staple names based on valuation. At a minimum, this ratio gets you searching in a potentially attractive area.