For the past two years, I have been warning investors about the dangers of overvalued, high-quality stocks and sharing a long-only rotational strategy to help mitigate the dangers of these highly-priced stocks. The basic idea is that when the expected 10-year forward returns of the target stocks (in this case Paychex (PAYX)) get low enough, one rotates out of the stock and into a pair of ETFs with the goal that the ETFs will be more defensive during a downturn. Then, when the price of the target stock falls more than the defensive ETFs, the investor who likes the target company can rotate back in and own more shares than they would have had if they just held the stock the entire time.
In my June 22nd, 2019 article, “Paychex: A 10-Year, Full-Cycle Analysis,” I made the case that Paychex was a Sell.
Paychex has likely attracted investors because of its steady earnings growth. However, at its current price, if the next economic cycle is similar to the last one, buying Paychex here will likely produce very low returns over the next 10 years. If we were to have a recession within the next few years, based on Paychex’s history, it is likely that the stock will be available at a better price.
I can certainly see the attraction of Paychex stock for investors. It has steady earnings growth and a pretty decent dividend. But a 30+ P/E is quite a high price to pay. Eventually, the economy will sputter, and even if Paychex earnings growth only goes modestly negative, the stock price is likely to fall quite far. I still think it would be wise to rotate into something more defensive like SPLV, which has a more limited downside in a bear market.
At the time, my two standard alternative “default ETFs” were the Invesco S&P 500 Low Volatility ETF (SPLV) and the Invesco Mid-Cap Low Volatility ETF (XMLV). I tracked the results of my strategy (along with what would eventually become 42 other stocks I suggested selling due to high valuation this past year). The goal was to rotate half the funds back into Paychex once one could achieve a 20-25% “free share gain” and to rotate the other half of the funds back in once the stock was trading at fair value again. (For me, fair value, in this case, was an expected 10-year CAGR of 8%).
In this article, I’m going to examine whether it is time for investors who were bullish on Paychex’s long-term prospects who rotated out of Paychex back in June, to now rotate back in.
“Free Share Gain” Returns
Normally, this is a fairly simple process of checking the results of the default ETF versus the target stock, but we had a rare event take place at the end of February where it became clear we were headed for a recession. When that happens, we move all of our “default ETF money” into cash. I meticulously documented that in my last update article, “Going To Cash: Rotational Strategy Update (February 2020).” The way I’m tracking the results now that the default money has been moved to cash is to calculate the returns on a theoretical $10,000 up to the point it was moved to cash, and then to compare that cash amount (which does not grow when it is held in cash) to the theoretical growth of $10,000 kept in the target stock.
In this case, when the money from SPLV and XMLV was moved to cash, it would have been worth $9,506 so it would have been down about -5% over the holding period. But the primary goal of this strategy was to increase our shares in Paychex for free, so let’s see what Paychex would have returned.
Paychex’s stock has fallen about -38% since my warning article and a $10,000 investment would now be worth $6,138. The money that was first put in SPLV and XMLV, then into cash, would now be worth $9,506. An investor who followed this strategy could now take that $9,506 and buy +54.94% more Paychex stock than they owned back in June. In other words, an investor who owned 100 shares of Paychex’s stock on June 22nd, 2019, could now buy 154 shares of the stock without spending any more money. This is above our 20-25% “free share gain” goal for the first part of the strategy, and so this part of the rotation is now complete.
Paychex now joins eleven previous “free share gain” winners in the series so far.
What about the second half of the money?
The first part of the approach was to rotate back in after a 20-25% “free share gain” was possible. The second half of the money is to be rotated back in when the forward 10-year full-cycle CAGR estimate is near fair value at about 8%. So, next, I’m going to run what I call a “Full Cycle Analysis,” which is the same analysis I performed back in June that identified Paychex’s stock as being overvalued enough to sell. As part of the analysis, I calculate what I consider to be the two main drivers of future total returns: Market Sentiment returns and Business returns.
In order to estimate what sort of returns we might expect over the next 10 years, let’s begin by examining what return we could expect 10 years from now if the P/E multiple were to revert to its mean from the previous economic cycle. I start the previous cycle around 2007, about a year before the last recession.
As I write this, Paychex’s forward PE is 16.76 while its normal P/E this past cycle has been 24.40. If, over the course of the next 10 years, Paychex’s P/E were to revert to its normal 24.40 level and everything else was held equal, it would produce a 10-year CAGR of about +3.82%. (At the time of my original analysis, this return was expected to be -2.14%.)
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. 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.
Paychex’s forward earnings yield is currently +5.96%. The way I like to think about this is, if I bought the company’s whole business for $100, I would earn $5.96 per year on my investment if earnings remained the same for the next 10 years.
The next step is to estimate its 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).
Let’s start by looking at how much shares were reduced since 2007.
Paychex has reduced its shares outstanding by about -6% over the course of this cycle. I’ll back these out for earnings growth estimates. When I go back to 2007 through today, I get a cyclically adjusted earnings growth rate of +6.46%, which is a pretty average growth rate.
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 Paychex’s whole business for $100, it would pay me back $5.96 the first year, and that amount would grow at +6.46% per year for 10 years. 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 $185.53. When I plug that growth into a CAGR calculator, that translates to a +6.38% 10-year CAGR estimate for the expected 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, it will produce a +3.82% CAGR. If the earnings yield and growth are similar to the last cycle, the company should produce somewhere around a +6.38% 10-year CAGR. If we put the two together, we get an expected 10-year, full-cycle CAGR of +10.20%. Since this expected forward 10-year return is above 8%, Paychex is now trading near what I consider “fair value,” and for the purposes of this demonstration of the rotational strategy, an investor could now rotate the second half of the money back into Paychex. Next, let’s see how the “fair value” portion of the rotational strategy performed.
“Fair Value” Returns
Sometimes, the “free share gain” portion of the rotation and the “fair value” portion of the rotation meet their goals at different times, and so the returns are different. In this case, the stock price has moved so fast, they met their goals at the same time, thus producing identical gains for both parts of the rotation at +54.94%.
Paychex will now join nine previous rotational “fair value” winners.
|Ticker||Free Share Gains from Full-Cycle Analysis|
And now, this completes the demonstration of the rotational strategy with Paychex. The first half of the rotation gained about 54% more free shares, and the second half also gained about 54% more free shares. I have 33 additional high-quality stocks I’m still tracking, though, so we should have a fairly large sample from which to judge and analyze the strategy in the future.
When To Buy For Value Investors?
My basic threshold for buying a stock with a margin of safety and good forward returns is for the 10-Year Full-Cycle CAGR to be greater than 12%. But since we are going into a recession, I have a slightly stricter standard that I’m currently applying. First, I want the business’s 3-year revenues to have at least appreciated by 10%. So let’s check that first.
Revenue looks fine. The next thing I want is for the business earnings portion of the CAGR to be at least 9%, and I also want the PE to be at least within 20% of the PE during the trough of the last recession. These let me know that I’m not relying too much on future market sentiment changes for all of my potential returns, and it tries to get us at least somewhat close to the bottom in terms of PE. (The earnings of these companies will certainly drop over the course of the next year, so using the PE is really just a way to avoid buying way too early if the market has a history of sending the stock really low during recessions. It’s not particularly good at picking exact bottoms.)
The price at which Paychex will meet all these criteria based on current forward earnings is about $32.50, and that’s the price I would, as a value investor, be a buyer of the stock. This isn’t a ‘target price’, as much as it is a price that I think has a greater than 50% chance of occurring during this downcycle.
So far, during this downcycle, I have purchased 23 stocks using this method, so plenty of the prices are hitting right now, but there is never any guarantee that all the stocks I’m watching will hit. I’m always trying to strike a balance between the likelihood of getting a lower price, and the likelihood of the price never dropping that far, so the price above is my best attempt to find a good balance.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.