Since I develop my own valuation techniques, and they aren’t simply copies of well-known techniques used by thousands of other analysts and investors, I always like to begin my articles by reviewing any coverage I’ve previously shared on a stock. Because many investors are not familiar with my style of analysis, reviewing previous results can help build some confidence that there is some validity to my techniques. I’ve only written one previous article that focused on Stanley Black & Decker (NYSE:SWK). It was published on November 19th, 2020, and titled “Stanley Black & Decker: A 10-year Full-Cycle Analysis” It was a bearish article. The only outright “Sell” rated article on Seeking Alpha over the past three years on the stock. In it, I reached two conclusions. The first was that SWK was overvalued enough to sell, and the second was that their shareholder returns were too low, and they should either increase their dividend, increase their buybacks, or improve their earnings growth in order to justify their capital allocation at the time. Here is the conclusion of the article:
Unfortunately, I missed bottom-ticking this stock back in March. Examining it today, it looks like a good time for those who were fortunate enough to buy it at a good price earlier this year to take profits because the expected long-term returns of the stock are very low based on the last economic cycle. While it’s true the majority of the market is expensive right now, I am still finding a few stocks that are trading at reasonable values.
Of the roughly 300 stocks I track using this method of analysis, SWK is currently ranked 178th in terms of value. Basically, it’s trading about the same as the equal-weighted stock market right now, which, on average, is overvalued. There are many other stocks that offer better returns in the market right now. The stock seems like a pretty easy “Sell” for me at today’s price for long-term investors.
Here is the total return of SWK since that bearish article 18 months ago:
SWK stock has fallen about -30% while the S&P 500 has risen +19%. That demonstrates the danger of holding on to an overvalued stock even if it is good quality. In the conclusion of that article, I noted that while the overall market was expensive, I was still finding opportunities in the market that would offer better future returns at the time. I was curious about that statement of mine, so I went and reviewed all of the stocks that I bought during the month of November 2020 when the SWK article was published in order to see what I actually found to buy that month. Below is a table of those stocks and their returns since I bought them (excluding REITs, which use an entirely different strategy that I don’t write about publicly).
|HF Sinclair (DINO)||76%|
|Phillips 66 (PSX) (X2 Double position)||56% x2|
|Ulta Beauty (ULTA)||87%|
|Signature Bank (SBNY)||121%|
|LKQ Corporation (LKQ)||55%*|
LKQ and Valero I wrote about publicly on Seeking Alpha around the same time I covered SWK in 2020 and I have since taken profits in them, so the returns are what I got when I sold. The rest I still hold. The ULTA and SBNY buys were reserved for members of my marketplace service, The Cyclical Investor’s Club.
The point I’m trying to drive home here is that Decker’s overvaluation in November of 2020 was pretty clear. An investor who understood that could have simply moved their money into the S&P 500 index fund and dramatically outperformed, and investors who performed additional valuation analysis on enough other stocks, could have found even more value in the market at that time in a variety of industries (banking, retail, refining, and auto parts) with equally high-quality businesses.
Now that we have reviewed the past, let’s examine present valuations and expectations for the future. I will also comment on why I think SWK’s recent performance is a precursor of what we should expect from much of the rest of the market over the next 6-18 months. The dynamic is something I’ve been writing about all year, but now, with SWK, we have a real-time example of why investors need to take this situation into account with their other investments (and those they are considering buying on a dip).
Decker – My Valuation Process
I always start every stock valuation with the question: How Cyclical Are Earnings? The answer to that question will help determine 1) if this is a stock with enough data I can confidently analyze, 2) if it is, what sort of analytical technique I should use, and 3) if there are any particular patterns I should be aware of.
Over the past two decades, SWK has had four years of earnings growth declines, and the current year is expected to be the fifth. In 2003 EPS fell a modest -4%, during the Great Recession EPS fell -16% in 2008 and -21% in 2009, and in 2012 EPS fell -11%. This year, so far, estimates are that EPS will fall -5%. Overall, I would describe SWK’s historical earnings as moderately cyclical. The “full-cycle analysis” I use is based on earnings and earnings growth and it is appropriate to use with this level of earnings cyclicality. We also have plenty of data here to work with for the analysis.
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. I then combine those expected returns together in the form of a 10-year CAGR expectation and use that to value the stock.
Market Sentiment Return Expectations
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. Since we have had a recent recession (albeit an unusual one) I’m starting this cycle in fiscal year 2015 and running it through 2022’s estimates.
Decker’s average P/E from 2015 to the present has been 18.41 (the blue bar circled in gold on the FAST Graph). Using 2022’s forward earnings estimates of $10.00 (also circled in gold), SWK has a current P/E of 12.36. If that 12.36 P/E were to revert to the average P/E of 18.41 over the course of the next 10 years and everything else was held the same, Decker’s price would rise and it would produce a 10-Year CAGR of about +4.06%. That’s the annual return we can expect from sentiment mean reversion if it takes 10 years to revert. If it takes less time to revert, the gains could be quicker and steeper.
What is most notable here is the change in analysts’ expectations over time. When I first wrote about SWK back in November of 2020, analysts were expecting $10.68 per share for 2022. This was before the really big additional rounds of government stimulus went out in early 2021. After all that, as early as last quarter, analysts were expecting $12.22 per share for this year. Those estimates have dramatically changed and moved lower. (More on this later in the article.)
Business Earnings Expectations
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, I 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 (which is an inverted P/E ratio, so, the Earnings/Price ratio). The current earnings yield is about +8.09%. The way I like to think about this is, if I bought the company’s whole business right now for $100, I would earn $8.09 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 2015, 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).
In my last article, I was a bit critical of SWK’s lack of return of capital to shareholders either via a higher dividend or increased stock buyback. It looks as though they might be increasing their buyback now, which is probably a good thing given the recent sell-off and SWK’s decent earnings growth rate. I will take this buyback into account while calculating my earnings growth estimates and I’ll will also take into account the expected -5% EPS decline this year. After doing that, I get an earnings growth estimate of about +6.62% over this time frame.
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 SWK’s whole business for $100, it would pay me back $8.09 plus +6.62% growth the first year, and that amount would grow at +6.62% 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 $217.06 (including the original $100). When I plug that growth into a CAGR calculator, that translates to a +8.06% 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 business earnings returns. If we assume that market sentiment reverts to the mean from the last cycle over the next 10 years for SWK, it will produce a +4.06% CAGR. If the earnings yield and growth are similar to the last cycle, the company should produce somewhere around a +8.06% 10-year CAGR. If we put the two together, we get an expected 10-year, full-cycle CAGR of +12.12% 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. Since 12.12% is slightly over my buy threshold, that makes SWK a good buying candidate provided everything else looks good. Unfortunately, I’m not quite ready to give the all-clear to buy SWK, yet, and in the rest of the article, I will explain why.
Recession Probability Is High
Currently, we have a situation where earnings growth is slowing, and likely to slow more. I’ve been warning readers about this situation with many stocks since the beginning of the year, and SWK’s recent price decline is an example of what I expect many other stocks to experience. We had a situation where 2022’s earnings were expected to be over $12 per share, and now they are expected to be $10 per share, which is lower than the $10.48 they earned last year. When that sort of disappointment happens, especially to a richly-valued stock like SWK, it typically produces deep price declines in the stock price.
SWK is currently down more than -40% off its highs. The problem is that, even though it has fallen a lot, it could fall even more if we have a recession. During the past two recessions, the price fell more than -60% off its highs as we can see in the historical price drawdown chart below.
And, going into the Great Recession in 2007, SWK had a peak monthly P/E of about 17, while this time around the P/E peaked at over 22. That means this cycle the stock was probably more overvalued than previous cyclical peaks and it would not necessarily require a recession of the same magnitude of 2008 and 2009 to send the stock price much lower from here.
At the macro level, we have government stimulus drying up quickly, the Federal Reserve as hawkish as I can ever remember them, and supply chain and energy induced inflation that is not directly in the Fed’s control. After the mid-term elections, we should expect a split government that produces zero cooperation in the event of anything short of a war with Russia. So, unlike the last three recessions, it does not seem obvious to me that anyone will be coming to rescue the economy when it falters. Due to the rapid withdrawal of stimulus money, growth is certain to slow and has a high probability of turning negative. I don’t see any reason to step in and buy a stock like SWK here, even though it is one of the first to fall and is much more attractive than when I first wrote about it.
With that said, I want to share two additional techniques that can help gain a valuation perspective during situations like this. The first is what I call a “Recession P/E” factor. And the second is a dividend-based analysis I call “Dividend Time Until Payback Analysis”.
Recession P/E Factor
The recession P/E factor is a valuation technique I find very useful during the early stages of a decline, especially before earnings expectations collapse during the heart of a recession. This factor simply looks at what the monthly average P/E ratio was during troughs of past recessions, and uses that as a rough guide for what we might expect during the next recession. For SWK, during the 2000 recession, the trough P/E was 9.19, in 2009 the P/E was 7.18, and in 2020 it was 9.30.
Right now, with a P/E around 12, even in a situation where earnings did not drop further than expected right now, we are looking at a very good chance of a -25% price decline to get to a 9 P/E of the previous “not-as-deep” recessions. And even deeper to get to a 7 P/E, more like a -40% drop from here. And when we look at previous market drawdowns from peak, that’s also pointing to this same range of decline with about -35% farther to go from here.
This is a reason not to be in a rush to buy, or at least not to take a full position in the stock, yet. However, we need to be a little careful because at least with SWK analysts, earnings expectations are rapidly becoming more realistic. Once analysts become fully negative about future earnings expectations, then the recession P/E factor isn’t quite as useful, so at some point, I will stop using it and go back to my just using my normal analysis without this factor once earnings expectations come down.
Determining when to do that might be more art than skill. Right now, for most of the stocks I’m using the recession P/E factor for, I roughly think it will be appropriate to remove it by next February or so. By then, it’s likely expectations for 2023’s earnings will have fallen quite a bit, and perhaps they will even be too conservative. Since what this factor really helps control for are analysts whose expectations for the next 1-2 years earnings are too high, once those expectations adjust and become more realistic, then we can just use a normal analysis at that point and see if the stock is still attractive at whatever price it happens to be trading at. This is how I am personally planning to determine when I’ll buy SWK stock.
Dividend Time Until Payback
Since Stanley Black & Decker has a long history of paying dividends, and it is a popular dividend paying stock, I also have a way to value the stock based solely on dividends and dividend growth. What follows is my standard explanation of the dividend time until payback analysis.
When it comes to the vast majority of individual stocks, risk increases with time. This situation is different for major stock indexes, where the longer one holds a major index like the S&P 500, the more likely it is their investment will succeed and produce positive returns. Many investors do not understand this very important distinction. The reason risk increases with time for individual stocks is because it becomes more difficult to predict the future the farther out in time we go. For example, analysts will probably be much closer to predicting SWK’s earnings next quarter than they will be predicting it in the same quarter 10 years from now. And I have zero confidence an analyst can predict what earnings will be 20 years from now. Whereas, when it comes to the S&P 500, an analyst might be able to get pretty close to predicting long-term earnings because the earnings average out over time to a somewhat predictable level. This fundamental fact when it comes to individual stocks is rarely, if ever, taken into account with traditional analysis like a DCF or dividend discount model, or most other models of dividend valuation. But it should be. What I set out to do with the form of analysis I will share in this article is to integrate the time-risk into the analysis. And the way I have done that is to frame the valuation question in terms of how long it is likely to take an investor to earn an amount equal to their investment in a stock back, strictly from dividends and dividend growth over time. In other words, if you invest $100 into a stock, what I want to know is how long it will take to earn $100 back only from the dividends. I call this measurement “Dividend Time Until Payback”.
Whether a dividend stock is a good value or not is then based on how far out an investor thinks they can forecast into the future and what they expect to earn in dividends. The time-risk will be subjective for each investor and might vary from stock to stock. But, my view is that for most reasonably high-quality stocks like those in the S&P 500 index, I can probably do a good job forecasting out 10 years into the future, so if I can earn my money back in that amount of time, then it’s likely to be a good dividend investment including time-risk into the equation. On the high end, other than maybe Berkshire Hathaway (BRK.A) (BRK.B), I don’t feel confident predicting the future of any individual stock 20 years into the future or more. So, any dividend stock that looks to take more time than that to pay me back an amount equal to my investment is too risky for me because the risk of disruption, competition, or changing consumer demand over the course of 20 years is too high. And in between 10 and 20 years is a range of payback periods where an investor might be able to make the case of making small adjustments for individual circumstances of each business depending on their predictability. But I think it’s fair to say any dividend stock that takes over 15 years to pay back an amount equal to its investment probably isn’t a “buy”, but perhaps, depending on other factors (like prevailing interest rates, inflation expectations, stability of the industry, etc.), individual cases can be made for those stocks that fall in the 11-14 years range.
Putting all this together, I think it’s fair to create a valuation range using dividend time until payback where 10 years or under is a “Buy”, 11-14 years is a fairly valued “Hold”, 15-19 years is a “Hold”, but overvalued, and 20 years and over is a “Sell” if there are better alternatives that can be found in the market.
In order to estimate how long it would take to earn our investment amount back via dividends, we first need to estimate what the starting dividend yield is, and then also estimate what the dividend growth rate is likely to be. Since most good companies’ dividends often rise year over year, I pull forward dividends expected for the current year rather than use the trailing twelve-month dividends.
If we assume SWK pays out $3.16 in dividends this year, then SWK’s current dividend yield is about 2.51%.
Next, we need to estimate how fast this dividend is likely to grow over time. This requires a little more judgment. Since I am using very long-term projections in most cases, I never want to assume that dividend growth, over the very long term, will exceed earnings growth (because dividends come from earnings). That said, there are situations where if a payout ratio is relatively low, dividend growth can potentially exceed earnings growth for some period of time. So, what I do, is if the payout ratio is under 50%, and dividends are growing faster than earnings, then I will blend the two growth rates together and use that as our dividend growth rate estimate. But if the payout ratio is above 50%, I will cap dividend growth rate expectations at whatever the earnings growth rate expectation is.
As I noted earlier in the article, my earnings growth expectation is +6.06%. According to FAST Graphs, the dividend growth rate CAGR over the same has been +4.84%. The dividend growth rate has been slower than the earnings growth rate. In these cases, I average these two growth rates together to get an average expected earnings growth rate going forward, which is +5.73%.
Ultimately, what I am interested in estimating is how long it would take to earn $100 on a theoretical investment of $100. We can do this by taking the current dividend yield of 2.51% and applying that to $100, which would pay us out $2.51 per year if the dividend never grew. But, we expect the dividend to grow at about +5.73% each year, so we need to take that into account as well. I assume that this money is collected by the investor and not reinvested in the stock and I go ahead and pull the first year’s dividend growth forward. So, at the end of the first year, I assume we would get paid $2.66 on our $100 investment. This process continues for however long it takes to collect $100 worth of dividends and when it crosses that threshold, it will be our “Dividend Time Until Payback” as measured in years.
Using this method, it will take about 21 years to earn our money back via only dividends with SWK.
There are several ways we can think about these results. First, on an absolute basis, as I noted earlier, I wouldn’t buy based on dividends unless the payback was 10 year or less. That wouldn’t happen until the price dropped to about $43 per share. That’s -65% lower than where the stock trades today. I don’t actually think the stock price will get that low if earnings continue to grow at 6% because most investors are not investing based solely on the dividend prospects.
On a relative dividend basis, I think using a 60/40 allocation is a pretty good relative benchmark for dividend growth stocks because the general goal of dividend growth investors is to get a reasonably dependable inflation protected yield. A 60/40 allocation does that via its mix of stocks and bonds rather than using only dividends and dividend growth. Right now, I estimate that it would take a basic 60/40 portfolio 22 years to earn its money back via the dividend yield. So, SWK is slightly undervalued on a relative basis at today’s price.
Human beings crave simple answers to complex issues. Investors, most of whom are human, crave the same thing. But sometimes things aren’t simple, and they need to include additional factors in order to make them more accurate. My basic valuation process is very accurate most of the time. But there are times, like during recessions, when additional factors must be used for optimal performance. It’s like using your windshield wipers when it rains. You don’t have to use them, but if you do, you’ll drive considerably better when it’s raining.
The recession P/E factor is a tool I’m using heavily right now. The thing is, with SWK, earnings expectations have already come down -20%. Most stocks are not anywhere near that sort of adjustment, yet (even though they should be). So we are really in a mushy sort of area when it comes time to value SWK. I think it’s part way to where it’s going, and certainly a much better value than it was when I last wrote about it. But I’m not ready to step in and buy here. I remember watching this stock back in March 2020 and it missing my buy price by a few pennies at the bottom of the market. So, there is never any guarantee that a particular stock will fall as far as I want it to fall. But there are enough signs around the edges, given how far the stock has fallen in the past, how expensive it was going into this downturn, how expensive on an absolute basis it still appears from dividend perspective, how far it is from the recession P/E, that I think it makes sense to wait for a lower price before stepping in to buy it right now. My rough estimate is that if we do indeed get a recession it has -30% downside potential from here. At that point, I would likely be a buyer.