By: Chuck Carnevale, F.A.S.T. Graphs, Inc.
We have long held the investing philosophy that the best companies to invest in, are those that have the most consistent and highest earnings growth over time. This philosophy is oriented to the long-term buy and hold investor. In other words, we feel that companies with the best long-term track records are the most likely to produce consistent and reliable future returns. It only makes sense to us, that a consistent long-term record of operating excellence does not occur by chance or happenstance.
Originally, and in order to validate our thesis, we developed F.A.S.T. Graphs™, the fundamentals analyzer software tool that correlates earnings and price over time. The earnings and price relationship made perfect sense, but we had no way of viewing real world evidence to prove it. However, after reviewing literally thousands of companies through the lens of our elegant research tool, the evidence is undeniable. In truth and fact, there is a high correlation and therefore a functional relationship between earnings (the businesses’ operating results) and the long-term price movement of their stock.
The ACAP Strategic Fund's managers see a "significant scarcity of attractive asset allocation choices globally," but also a strong environment for fundamental stock picking. Q2 2021 hedge fund letters, conferences and more According to a copy of the fund's second-quarter investor update, which ValueWalk has been able to review, its managers currently hold a balanced Read More
Consequently, we naturally and typically screened for, and focused on, those companies that had the most consistent, and therefore we felt reliable operating records to invest in. As a result, we tended to ignore cyclical stocks due to the unpredictable nature of their businesses and their volatile stock price movements. As a general rule, our investing strategy has served us well, and tends to validate itself over time. However, the great recession of 2008 and 2009 has motivated us to look beyond our original investing themes. Thus far coming out of the recent recession, it seems that consistent growth is being ignored in favor of cyclical recoveries.
The most interesting aspect of this fact is that it does not refute our earnings and price principle. Instead, it validates the relationship between earnings and price even more, just from a different perspective. It remains true, that if earnings go up, stock price will follow. However, it’s also true that whether earnings go up, down or sideways, stock prices are also sure to follow. Eventually, we believe that consistent earnings generators will reward their shareholders with rising stock prices. But at this particular moment in time, cyclical stocks with recovering earnings have dominated short-term performance.
About Ingersoll-Rand Corp. (IR)
Ingersoll Rand Corp. (IR) whose global headquarters are in Dublin, Ireland, traces its roots back to the late 1800s. Today this diversified industrial is best recognized by these following worldwide brands:
“Ingersoll Rand (NYSE:IR) is a world leader in creating and sustaining safe, comfortable and efficient environments in commercial, residential and industrial markets. Our people and our family of brands—including Club Car®, Hussmann®, Ingersoll Rand®, Schlage®, Thermo King® and Trane® —work together to enhance the quality and comfort of air in homes and buildings, transport and protect food and perishables, secure homes and commercial properties, and increase industrial productivity and efficiency. We are a $14 billion global business committed to sustainable business practices within our company and for our customers.”
Ingersoll-Rand Corp. Earnings and Price Correlation
Ingersoll-Rand is the fourth of six cyclical companies that this series of articles is reviewing. Of the six examples, Ingersoll-Rand Corp. (IR) has the most cyclical operating record of the lot. The following graph plots earnings only for Ingersoll-Rand since calendar year 1997. From this graphic we can glean the undeniable fact that this company is very sensitive to the economy. Earnings per share fell 38% during the recession of calendar year 2001 and once again fell by over 50% in the recession of 2008 and 2009.
On the other hand, when the economy was strong from calendar year 2003 to calendar year 2006, earnings growth was also very strong, averaging approximately 30% per annum. However, as the graphic below shows, the cyclical nature of this business once again became manifest. From calendar year 2006 to calendar year 2009, earnings per share fell from $3.42 down to $1.62. Therefore, it’s safe to say that the earnings predictability for this diversified industrial is very uncertain.
On our next graph, we add three important fundamental metrics. First and foremost, we overlay the black line representing monthly closing stock price to the company’s orange earnings line. The long-term correlation between earnings and price becomes vividly clear. The light blue shaded area, which represents dividends paid out of earnings (the green shaded area), is also included. Finally, the dark blue line representing the historical normal PE ratio is illustrated to provide a market normal pricing perspective. It’s interesting to note that the historical normal PE ratio (the blue line) and the earnings justified valuation line (orange line) calculate at very close values.
When you review the long-term performance associated with the 15-year earnings and price correlated graph above, the earnings and price relationship becomes even clearer. Since Ingersoll-Rand Corp. started out at fair value (the black line touching the orange line) and ended this time period only modestly undervalued, earnings growth and shareholder returns closely correlate. The 7.1% earnings growth rate generated 6.5% per annum of capital appreciation. On the other hand, note the effect that weaker earnings had on dividends during both the recession of 2001 and the great recession of 2008 and 2009.
From the above earnings and price correlated graph we can see two extreme market reactions to earnings results. First, we see that stock price fell much farther than earnings weakness justified. However, this was followed by a strong price advance that initially exceeded the earnings recovery through the first quarter of 2011 before coming back down to reality. What we can learn from this is how profitable it can be to invest in a recovering cyclical stock.
The following earnings and price correlated graph reviews Ingersoll-Rand Corp. (IR) since the beginning of calendar year 2009. Here we can see how stock price responded to rapidly recovering earnings. The 62% earnings recovery in 2010 after coming off of the low earnings base in 2009, stimulated investor interest.
The associated performance results for the period 2009 to current time reflects an exceptional annualized rate of return of almost 35% per annum. Note that this is in spite of the fact that Ingersoll-Rand‘s dividend was severely cut in 2009 and 2010.
(For a more detailed look at Ingersoll-Rand watch this short video.)
Stock price volatility can be very unnerving for most investors. When stock prices are dropping, many investors go into a heightened state of fear and become afraid that the price can go to zero. Although it is true that this can happen on occasion, it’s also true that it’s a rarity. In most cases, large well-entrenched multinational companies with long histories and legacies tend to be very resilient. Even when earnings are falling during a recession, the historical evidence implies an eventual recovery. Therefore, it is often during times of crisis when the best opportunities appear.
Unfortunately, fear tends to blind those investors who can only see the downside. The venerable Warren Buffett advises us “to be greedy when others are fearful, and fearful when others are greedy.” Many investors find this impossible advice to heed. Therefore, people tend to buy stocks when they should sell stocks and sell stocks when they should be buying them. This validates another old Wall Street adage that states “in times of crisis money moves from week hands to strong hands.”
A central message of this series of articles is to encourage people to try to keep their emotions in check when dealing with their investment portfolios. These articles are not advocating investing in cyclical stocks per se. Instead, we’re utilizing cyclical stocks to illustrate the transient nature of stock price movements. In other words, the price of a common stock, whether cyclical or not, rarely moves in one direction forever. Sooner or later the trend will change direction.
Disclosure: No positions 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.