I have two core methods of sharing my investing ideas and strategies on Seeking Alpha. The first method is via public articles like this one, and the second is via the Cyclical Investor’s Club. Since launching the Cyclical Investor’s Club on 1/12/19, I’ve always tried to strike a reasonable balance between my public ideas, which everyone can read for free, and the private ideas, shared exclusively in the CIC. Over time, I have decided to break these ideas into two distinct categories where ideas about stocks that comprise the S&P 500 are made public and all the rest remain private. I’ve tried to abstain from first sharing an idea in the CIC, and then, after the price has run up, sharing the idea as still being a “buy” with the public, because I didn’t like the way that practice felt to me ethically.
The recent market dive happened so quickly, however, that there was no way I could write public articles in time for all the stocks I purchased in March. From February 28 through the end of March, I purchased 33 stocks (plus suggested members buy Berkshire Hathaway (BRK.B, BRK.A), which I already owned), and most of the stocks were purchased in the five trading days nearest the bottom of the market’s dip. I could barely keep up with the purchases via the real-time chat function in the Cyclical Investor’s Club, much less write full public articles about them all. Of those 34 stocks, 19 of them were components of the S&P 500, and I only managed to write about one of them publicly – Comcast (CMCSA) – at the very beginning of the downturn. So far, in addition to Comcast, I have now covered Hologic (HOLX), FLIR Systems (FLIR), Sysco Corporation (SYY), Tractor Supply (TSCO), Microchip Technology (MCHP), Align Technology (ALGN), Genuine Parts Company (GPC), Ameriprise Financial (AMP), Ross Stores (ROST), and AutoZone (AZO) in the series. Most of these stocks will no longer be “buys” at their current prices, but I will share both my “buy price” and my “sell price” for the stock in each article so that if we have a double-dip, readers will know the prices at which I think the stocks are buys, and if the market rips higher, readers will know the initial threshold at which I would consider selling and taking profits. After I’ve shared all the S&P 500 stocks I bought during the dip, I’ll analyze them as a group to see if we can discern any patterns that emerge or any mistakes I made that could help improve my investing approach in the future.
Today’s stock is Stryker Corporation (SYK), and it’s one I’ve done fairly well with since purchasing on 3/23/20.
It just so happened that bought this stock on the day the market bottomed. I didn’t know the market was bottoming that day. It simply happened to be the day the price of the stock crossed my $125.00 buy threshold. I had published that buy price ahead of time (just as I’m doing with all of these articles about what I bought on the dip) in my article “Don’t Stryker Until The Valuation Is Right” on 3/16/20, about a week before I made my purchase. I was fortunate in the case of Stryker because I essentially ended up bottom-ticking the stock, as it bottomed that day at $124.54, just below my purchase price.
Of course, not all stocks end up like this. There were several others that came within pennies of my buy price on 3/23/20 that didn’t fall quite far enough to trigger a sale, and now the prices many of those stocks are much higher. I don’t claim much precision on my buy prices, even though I share specific prices rather than ranges. I try to have buy prices which I think have a better-than-50% chance of hitting during a downturn, though, and I think the 30+ stocks I was able to buy during a -35% market drawdown (from what were generally very expensive valuations already) is a good enough success rate that I don’t feel compelled to loosen my purchasing standards anytime soon.
I’ve been getting a fair number of comments on this series of articles that essentially say, “If you bought a stock during the March sell-off, of course you did well,” and I want to proactively respond to that line of thinking here because it implies my success was due to market timing. While it’s true that if a person randomly threw a dart at a list of stocks on March 23rd, they probably had very good odds of hitting a winning stock over the follow three months, that doesn’t mean any gains from a stock purchased during this time can be necessarily be attributed to good timing. There is a simple way to measure the degree one can credit timing and the degree one can credit good stock selection, and that is by looking at relative performance compared to a broad market index like the S&P 500, which is what I did in the chart above.
The way to think about this is to think about the performance of SPY as the portion of one’s gains that can be attributed to buying on the right day (i.e., good timing). And in this case, buying on the day the market bottomed would have produced a +40.23% total return from SPY through today. If you purchased a different stock on the same day and the returns are greater than that of the market, then it’s generally fair to assume that one selected an above-average stock on that day. In this case, Stryker has returned +52.20% over the same time period, so, at least through the time period being measured in this article, Stryker was an above-average investment. That above-average performance cannot all be attributed to good timing if over the same time period it outperformed the market average. It is more likely the above-average performance came from good stock selection or luck.
While we can’t truly measure what resulted from luck and what didn’t, if we have a large enough sample size, and if there is outperformance among the whole group, then we can reduce the odds that luck best explains the overall outcomes of the group, even if for a position or two an investor got lucky and another position or two they got unlucky. If you get enough data points, the lucky returns will be drowned out by the other numbers. This series will have about 20 stocks in it when I am finished, all of which are part of the S&P 500 index, which is the same index I’m comparing the results against. So, we should be able to get a pretty read on whether I was just lucky over this time period, or whether my approach to investing has some validity to it when it comes to identifying good values in the stock market.
Next, I’ll take you through my process for identifying the value in Stryker.
Step 1: Determine the Cyclicality of Earnings
On the F.A.S.T. Graph above, the adjusted operating earnings for Stryker are represented by the shaded dark green area. Over the course of the past 20 years, Stryker has never had a year with negative EPS growth. I term businesses that have achieved this “secular growth” stocks, and they are an elite group. Last year, I sifted through about 5,000 stocks in order to see how many of these secular growth stocks there were that had grown earnings through two recessions, and I found less than 20. So, Stryker has truly been an elite business. This year, EPS is expected to fall -23% by analysts, so the streak may end, but Stryker’s success has been undeniable over the past two cycles. It is very rare to be able to buy stocks in this category at a good price.
With an essentially non-cyclical business like this one, fairly traditional valuation systems using P/E ratios and earnings growth estimates work reasonably well to predict future returns, so the full-cycle approach using traditional methods is what I used for Stryker (if earnings had been more cyclical, I would have used a different method of valuing the stock).
As I write this, Stryker’s blended P/E on the F.A.S.T. Graph is 25.79, while its normal P/E this past cycle has been 19.52. Even though earnings growth has never gone negative for the company in the past two decades, it doesn’t mean that earnings growth doesn’t slow during recessions. Also, earnings are expected to drop -23% due to the COVID-19 recession. For that reason, when we are in a recession as we are now, I use peak earnings and the current price to establish a P/E ratio because I have little faith in analysts’ predictions, and back in March, there weren’t much in the way of predictions to use anyway. When I do that for SYK, I get a little bit lower P/E of 20.76 than the blended P/E from F.A.S.T. Graphs. This P/E is probably optimistic because Stryker’s earnings didn’t fall during the last recession, and they are certain to fall this recession. However, I don’t think this will affect earnings for more than a year or so because of the unique nature of the virus’s effect on the business. It’s likely after a year or two the company’s earnings will recover, and it’s possible they could grow even if there are lingering economic effects on the rest of the economy after the main threat of COVID-19 has passed.
If, over the course of the next 10 years, SYK’s P/E were to revert to its normal 19.55 level from its current 20.76 level and everything else was held equal, it would produce a 10-year CAGR of about -0.61%. (My minimum threshold for purchasing a stock during the current recessionary downturn is a +1.00% expected 10-year CAGR from sentiment mean reversion. When I bought SYK in March, it had a P/E ratio of 13.74, which would have produced a 10-year sentiment mean reversion CAGR expectation of about +3.58%, well above my minimum threshold.)
Step 3: Current and Historical Earnings Patterns
We previously examined what would happen if market sentiment reverted to the mean. This is entirely determined by the mood of the market and is quite often disconnected, or only loosely connected, to the performance of the actual business over the short term. In this section, we will examine the actual earnings of the business. The goal here is simple: We want to know how much money we would earn (expressed in the form of a CAGR %) over the course of 10 years if we bought the business at today’s prices and kept all of the earnings for ourselves.
There are two main components of this: the first is the earnings yield, and the second is the rate at which the earnings can be expected to grow. Let’s start with the earnings yield. Using peak earnings, the current earnings yield is about +4.80%. The way I like to think about this is, if I bought the company’s whole business right now for $100, I would earn $4.80 per year on my investment if earnings remained the same for the next 10 years.
The next step is to estimate the company’s earnings growth during this time period. I do that by figuring out at what rate earnings grew during the last cycle and applying that rate to the next 10 years. This involves calculating the EPS growth rate since 2007, taking into account each year’s EPS growth or decline, and then backing out any share buybacks that occurred over that time period (because reducing shares will increase the EPS due to fewer shares).
Stryker has bought back some stock this cycle, but not a whole lot, and in more recent years when the price was pretty expensive, the company basically stopped buying. I will back these out when calculating my earnings growth estimate. After doing so, I calculate a cyclically adjusted earnings growth rate of approximately +10.50% over the course of the last cycle.
Next, I’ll apply that growth rate to current earnings, looking forward 10 years in order to get a final 10-year CAGR estimate. The way I think about this is, if I bought Stryker’s whole business for $100, it would pay me back $4.80 plus +10.50% growth the first year, and that amount would grow at +10.50% per year for 10 years after that. I want to know how much money I would have in total at the end of 10 years on my $100 investment, which I calculate to be about $186.88 (including the original $100). When I plug that growth into a CAGR calculator, it translates to a +6.45% 10-year CAGR estimate for the expected business earnings returns.
10-Year, Full-Cycle CAGR Estimate
Potential future returns can come from two main places: market sentiment returns or earnings returns. If we assume that market sentiment reverts to the mean from the last cycle over the next 10 years for SYK, it will produce a -0.61% CAGR. If the earnings yield and growth are similar to the last cycle, the company should produce somewhere around a +6.45% 10-year CAGR. If we put the two together, we get an expected 10-year, full-cycle CAGR of +5.84% at today’s price.
My Buy/Sell/Hold range for this category of stocks is: above a 12% CAGR is a Buy, below a 4% expected CAGR is a Sell, and in between 4% and 12% is a Hold. Currently, SYK is in between 4% and 12%, and that makes it a Hold at today’s prices. If SYK’s price were to keep rising without a corresponding rise in earnings, it would cross the “Sell” threshold at about $215, at which point I would consider putting a trailing stop in for the stock.
Stryker has turned out to be a great example of how value investing still works well in today’s market. Taking profits in Stryker when it was very expensive back in October 2019 when I first wrote about it, and then having the discipline to not buy the stock again until it was at a great price, is still a winning recipe for investors. The point I turned bullish isn’t in the graph above because I had just written an article a few days earlier where I shared my buy price for the stock. Here is what I said in that article.
Even though this part of the demonstration is complete and the goal of gaining 20-25% worth of free shares was a success, I am not actually buying Stryker stock yet because I prefer to have a margin of safety along with high expected future returns. So, personally, I will wait until Stryker has an expected 10-year CAGR over 12% before I consider buying the stock. Currently, I estimate that threshold would be crossed at about $125 per share.
And then, in the comment section of that article, about a week later, I shared that I had purchased the stock.
I’m back to Neutral on the stock again, but just as I shared my buy price before it occurred back in March (FYI, my buy price remains at $125 should we have a double-dip), but I’ve also shared my sell threshold of $215, which is a price the stock has already flirted with a few weeks ago. It’s likely I won’t sell as soon as it crosses that threshold, but will let it run about 10% above it before putting in a 10-15% trailing stop. This is a way for me to potentially capture upward momentum in the stock price once it goes beyond my Sell threshold.
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Disclosure: I am/we are long SYK, AMP, BRK.B, ALGN, FLIR, SYY, TSCO, GPC, AZO, MCHP, HOLX, ROST. 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.