I've mostly been bullish on Deere & Co. (DE, Financial), but my narrative has changed based on basic theoretical concepts.
I will present a quantitative and pricing perspective as well as look at a few idiosyncrasies and valuation metrics.
Bull case
Performance and outlook
The stock hasn't lived up to expectations in the past six months with a drawdown of more than 8%. I suspect the drawdown to be largely due to investors' fear of inflation or input costs, or it could just have been a scenario of investors cashing in profits. Regardless of what's happened in the past, this discussion focues on the future.
Since we're on the topic of performance, I thought I'd outline the previous quarters' results. In its third quarter, the farming and heavy equipment manufacturer exceeded its estimates with a revenue beat of $1.2 billion and an earnings per share beat of 75 cents.
Regarding the outlook, Chairman and CEO John C. May said, "Looking ahead, we expect demand for farm and construction equipment to continue benefiting from favorable fundamentals. We are, at the same time, excited by the growing engagement with our digital platform, the John Deere Operations Center, as well as the continued adoption of precision technologies, which unlock greater value for our customers."
I personally think Deere is headed into another dimension. Artificial intelligence and autonomous operating equipment is a major trend around the globe and Deere has already established itself in the market. The company has emphasized the very concept of precision farming, which has grown by 29% year over year.
Its operating cash flow of $7.74 billion exceeds the industry average by 3,224.84%. This could result in Deere spending heavily on research and development to outperform its competitors, while its shareholders don't feel the brunt due to its heavy pockets.
Valuation
When comparing fundamental price multiples in order to draw a consensus, I found:
We're in a stalemate here because Deere's price-earnings ratio is 10.93% below its five-year average, while its price-earnings to growth ratio is well below the overvalued threshold of 1.
The fact of the matter is that we can't look at it all in isolation, Deere's enterprise value/Ebitda is 16.86% above the sector median (which is bad), and its price-sales ratio is 50.34% above its five-year average (which is also bad).
Valuation always needs to be looked at intuitively, and I'd argue that pricing metrics are more relevant.
Bear case
Pricing metrics
The cornerstone of asset pricing lies within the Sharpe ratio, which measures the return on the asset in excess of the risk-free rate with respect to the volatility, as seen below.
Deere holds a Sharpe ratio of 0.039 (calculation below), which is subpar since 1.00 is considered good, 2.00 is considered very good and 3.00 is considered excellent, while anything below 1.00 is considered a sell.
Sharpe ratio = (Retrun on Equity - Risk-Free Rate)/Standard Deviation. As such, (7.94% - 1.45%)/1.68 = 0.039.
As you can see, the Sharpe ratio isn't presenting what it should. Readers should understand that most institutional managers set the pace in the markets these days and use machine learning techniques to determine which stocks to buy and which to sell.
The predominant factor used by the machines is the Sharpe ratio, and based on the basic financial theory, the ratio isn't adding up. So, based on pricing metrics, Deere is a sell.
Asset correlations and backtesting
Source: Portfolio Visualizer
The long-term bond yields are anticipated to rise as they're positively correlated to the benchmark rate. With the interest rate anticipated to rise, we'd expect the 10-year bond price to rise and, historically speaking, Deere's share price has a negative correlation with the price of long-term bonds.
This is obviously a statistic in isolation, so I decided to do a backtest with the following weights.
Source: Portfolio Visualizer
The results I found were:
Source: Portfolio Visualizer
The portfolio that outweighs the S&P 500 outperforms the overweight Deere portfolio and the evenly weighted portfolio.
Based on the backtesting model, even if you reinvest your Deere dividends, you'll underperform the S&P 500.
Final word
After covering all the bases, it's safe to say that Deere is a risky asset at the moment. I, however, remain neutral on the stock and don't think it's a bear just yet.
