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 today, I’ve purchased 34 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 35 stocks, 20 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), AutoZone (AZO), Stryker (SYK), and AMETEK (AME) 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 PNC Financial (PNC), and it’s one I’ve done okay with since purchasing on 3/23/20.
PNC stock has performed well since I purchased it, but the returns are slightly trailing the S&P 500 index over the same time period.
The first 11 stocks in this series had all outperformed the index when I wrote about them, so PNC is the first laggard. 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 23th, they probably had very good odds of hitting a winning stock over the following three months, that doesn’t mean any gains from a stock purchased during this time can 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 March 23rd would have produced a +37.45% 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, PNC has returned only +32.33% over the same time period, so, at least through the time period being measured in this article, PNC has been a below-average investment.
In terms of timing, I couldn’t have timed my PNC purchase any better. I bought it essentially at its recent lows, but so far it still hasn’t proven to be better than simply buying the index on that day. So, even though this investment has returned over +30% in 3 months, it doesn’t say a whole lot about my stock-picking ability. PNC is a case where the critics may end up being right when they say anyone buying a stock on 3/23/20 would have good returns. Fortunately for me, of the 21 S&P 500 stocks I’ve purchased since February 28th, including Berkshire Hathaway which I already owned, only 4 of them are underperforming the S&P 500 index. Once I cover the rest of the stocks I purchased since March, I’ll see if any patterns emerge, but PNC shows that simply buying at the right time isn’t enough to claim stock-picking success.
My main purpose with these articles is three-fold. First, I’m sharing the process I used to select the stocks, and I’m highlighting individual adjustments I made to my process if they are relevant to the stocks in question. Occasionally, I’ll also mention how this fits into my overall portfolio strategy if it is particularly relevant for a given stock. Second, I share the precise buying and selling prices my process has established over the next 3-6 months, provided nothing major changes with a specific business. These should be useful guides for readers if they are considering buying or selling the stock. And third, I’m sharing the results of the process so that I can identify any potential mistakes or patterns that will allow me to improve the process in the future. Additionally, by sharing the results (which I hope will be good) I am promoting my usefulness as a stock analyst and portfolio strategist.
My previous PNC coverage
Since I don’t usually create much of a story or narrative for my stock articles and tend to focus a lot on historical numbers, I care a lot about the performance of my ideas. (I also personally buy the stocks I suggest are ‘buys’ to readers, which helps to keep me honest and not write ‘buy article’ after ‘buy article’ on a stock I don’t actually own myself.) Part of the reason I focus on the results of my ideas is that by examining how an idea or suggestion turned out, I can figure out what works and what doesn’t and make adjustments and improvements over time. This is relevant to PNC because when I first wrote about it back in 2018 in my article “How Far Could PNC Fall?”, I warned investors about the potential downside of PNC stock and suggested it was a “Sell”. For that analysis, I analyzed PNC from a purely cyclical perspective and focused entirely on its historical price cyclicality. In that article, I shared the following table of PNC’s historical drawdowns.This turned out to be a fairly good way to analyze PNC at the time. Here is the performance of the stock from 5/9/18 when I warned investors about the stock and suggested it was ‘sell’ through 3/23/20 when I bought the stock at what I consider a discount to fair value.
As you can see, the stock dramatically underperformed the index and also produced horrible absolute returns.
A few months later, on October 15th, 2018, as I often do, in a follow-up to my warning article about PNC, I published an article titled “Here’s The Price I’ll Start Buying PNC Financial” where I shared my ‘buy price’ (in this case buy prices) for the stock, well in advance of the stock price actually falling that far.
Operating under the assumption that after a closer examination everything checks out for PNC Financial, I’ll be a buyer with a 1% weighting at about $95.15, and another 1% portfolio weighting at $57.25, should the price fall that far.
I’m highlighting my previous articles on PNC so that I can point out that while my recent purchase around $80.64 fell right in the range of what I was aiming for back in 2018, I’ve made some adjustments to my analysis when it comes to moderately cyclical stocks like PNC. One of those adjustments is that during recessions, as the market is falling, I started taking only a single position rather than two potential positions. I was able to make this change because the universe of stocks I cover is now much bigger than it was in 2018, so it’s easier for me to spread my bets around to more stocks. The second adjustment was that in 2019 I started taking into account earnings cyclicality as well as price cyclicality, and for stocks with moderately cyclical earnings like PNC, I developed a new analytical technique that was more precise than relying on price cyclicality alone. Because of the addition of the new technique, I now start all of my analysis by examining historical earnings cyclicality and using that to guide what analysis is best to use for any given stock.
Step 1: Determine the Cyclicality of Earnings
On the F.A.S.T. Graph above, the adjusted operating earnings for PNC are represented by the shaded dark green area. Over the course of the past 20 years, PNC has experienced 8 years with negative EPS growth. While that is a lot of years with negative EPS growth, 6 of those 8 years EPS only fell in the single digits percentage-wise, and the years 2008 and 2009 were during the Great Financial Crisis so they were tied to a single recession. If we combine those two down years we get an approximate EPS decline of -33% for 2008/9. Overall, while the price of PNC stock has been highly cyclical, earnings have only been moderately cyclical. And for stocks with moderately cyclical earnings, performing what I call a “Full-Cycle Analysis” is a pretty good way to estimate the value of the stock. (If we would have seen historical earnings declines over about -50%, then it would have been harder to use a full-cycle analysis. And in those cases, I go back to my original method of using historical price declines to help us determine entry points for the stock.)
For the current recession, analysts are expecting a -44% decline in EPS. I have absolutely no idea if they will be correct or not, but what my analysis will do is assume that the cycle we are now in will be similar to the cycle we had from 2007 through February of 2020, and then I’ll build in a margin of safety on top of that.
Step 2: Full-Cycle Analysis
Next, I’m going to run what I call a “Full-Cycle Analysis,” which is the same analysis I performed that flagged PNC as a buy in March. 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, a little before the last cyclical peak.
As I write this, PNC’s blended P/E on the F.A.S.T. Graph is 11.51, while its normal P/E this past cycle has been 12.89. Since we are in a recession right now, I use peak earnings and the current price to establish a P/E ratio instead of the blended P/E on the F.A.S.T. Graph. I do this because as earnings drop, it inflates the P/E ratio, and I don’t expect earnings to stay down for the next 10-years. When I make that adjustment for PNC, I get a little bit lower P/E of 8.90 than the blended P/E from the F.A.S.T Graph.
If, over the course of the next 10 years, PNC’s P/E were to revert to its normal 12.89 level from its current 8.90 level and everything else was held equal, it would produce a 10-year CAGR of about +3.73%.
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. 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 +11.23%. The way I like to think about this is, if I bought the company’s whole business right now for $100, I would earn $11.23 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).
Due to the Great Recession in 2008/9, PNC has actually issued more shares this cycle than they have bought back. However, they have been steadily buying back stock since 2015. Interestingly, if they don’t have to issue new shares during the current recession (which is highly likely since they just raised a bunch of money with their BlackRock (BLK) sale) we could see better earnings growth during the current cycle than we did in the cycle that started in 2007.
While I won’t make adjustments for buybacks this cycle I will take into account all of PNC’s negative EPS growth years this cycle when estimating their earnings growth rate, and I calculate a cyclically adjusted earnings growth rate of approximately +6.40% over the course of the last cycle, which is decent.
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 PNC’s whole business for $100, it would pay me back $11.23 plus +6.40% growth the first year, and that amount would grow at +6.40% 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 $260.49 (including the original $100). When I plug that growth into a CAGR calculator, that translates to a +10.05% 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 PNC, it will produce a +3.73% CAGR. If the earnings yield and growth are similar to the last cycle, the company should produce somewhere around a +10.05% 10-year CAGR. If we put the two together, we get an expected 10-year, full-cycle CAGR of +13.78% 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, PNC is above 12%, and that makes it a Buy at today’s prices using my basic analysis. (But I have one more wrinkle I’m going to explain in the next section.) If PNC’s price were to keep rising without a corresponding rise in earnings, it would cross the “Sell” threshold at about $195, at which point I would consider putting a trailing stop in for the stock. However, we are a long, long way from that point at the moment.
Recession Adjustments & Blending Techniques
The price at which PNC would have crossed the 12% 10-year CAGR expectation was when it fell below about $117 per share, but, my ‘buy price’ for the stock was $81. In this section, I’m going to explain the reasons for the difference between those two numbers. Back on February 28th I determined that we were going into a recession, and I shared that assessment in the blog titled “Recession Mode Has Arrived” published on February 29th. Recessions create opportunities to buy a greater number of higher quality stocks at a deeper discount than during other times of the economic and market cycles. It therefore makes sense to aim for deeper values and higher quality during recessions.
But how far might we expect PNC to fall during a recession? Below is a graphical depiction of the table of PNC historical drawdowns I shared earlier from my 2018 article.
This chart begins in about 1973 and runs through March 23rd, 2020, the day I bought PNC. Only twice in the past nearly 50 years has PNC stock fell over -50% off its highs, and in both cases, if a person would have bought the stock after a -50% drawdown the purchase would have been profitable within the next year. By combining this information with PNC’s basic return expectations and a handful of other criteria I added for our current recession, I was able to come up with a buy price for PNC that I thought had a high probability of producing good returns over the next decade, and also had a high probability of actually occurring during a downturn. It just so happened that price hit on the day of the market’s recent bottom, but the timing of that was purely a coincidence.
I don’t know if that bottom will end up holding for the rest of this cycle (my bias is actually for a double-dip), but I think I did a fairly good job of picking up PNC at a good price.
As I’m finishing up writing this article the bank stress tests are coming out. It looks as though banks will not be able to buy back shares over the coming quarter and that dividends will remain frozen. This, in and of itself, has no effect on my approach or expectations for the stock long term. Even if dividends were completely cut for the next two years (which they might be) I base my long-term outlook for the stock on earnings, and the earnings will be whatever they will be regardless of dividends or buybacks. You’ll note that I back out buybacks from my earnings growth expectations anyway and usually I don’t even mention dividends at all in my articles unless we are dealing with a zero-growth business. If the banks retain their earnings for the next couple of years even though they end up not needing to, then that money will eventually find its way into long-term shareholders’ pockets in years 3, 4, and so on. And if they do end up needing the retained earnings, they would have needed them anyway, so they might as well save up the cash now. I expect things will get bad, but I don’t have a way to time the bottom, so I’m left with aiming for a good price. I think that if the price falls below $81.00, PNC will become a ‘Buy’ again, and since we are in a recession, at the current price, PNC remains a ‘Hold’.
If you have found my strategies interesting, useful, or profitable, consider supporting my continued research by joining the Cyclical Investor’s Club. It’s only $29/month, and it’s where I share my latest research and exclusive small-and-midcap ideas. Two-week trials are free.
Disclosure: I am/we are long PNC, BRK.B, TSCO, HOLX, MCHP, ALGN, SYY, AMP, GPC, FLIR, AZO, ROST, SYK, AME. 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.