If you are a long-term investor, and own cyclical stocks as an investment, the obvious psychological limitation that can give rise to ill-timed selling is the wild fluctuation in earnings that can give rise to even wilder fluctuations in stock price. The profile of an investor that successfully builds wealth over the decades through ownership in these types of companies is the following: (1) he or she must be highly liquid so that there is no forced selling at low prices when general economic conditions are rapidly darkening; (2) he or she must have an even-keeled personality that does not overreact to either good news or bad news; (3) and he or she ought to be capable of buying these stocks on the dips and lows as it can greatly increase the overall compounding rate.
These qualifications are distinguishable from, say, contemplating an investment in Colgate-Palmolive stock which doesn’t really fall all that much during harsh times meaning you could recover a decent value if you had faced a personal crunch, its earnings reports are pretty fair snapshot views of the business trajectory, and absent a few outliers, it doesn’t really matter all that much when you buy the stock because the annual compounding rate tends to settle within a tight band.
I was thinking about this abstract point when I saw the news today that Honeywell foreshadowed the probability of a weak earnings report in two weeks due to weakness in business jet, helicopter, and aftermarket product demand. The market’s response was about the greatest negative reaction you could expect for a business earning $5 billion per year in profits amid a generally stock market–the stock fell from $115 to $105 before closing the day at $106 for a 7.5% daily loss. My view is that this price shift in Honeywell stock represents a transition from the high end of fair value to a price that is pretty darn close to the actual fair value of the stock.
To get a feel for how there can be tremendous variance in the short term, profits of $2.83 per share in 2000 fell to $1.49 by 2004, rose to $3.76 by 2008, fell to $2.85 by 2009, and then rose to $6.50 now. During the 2000-2009 adverse measuring period, which started at a high and ended with a low, you would have seen only a $0.02 per share improvement in earnings over a full nine-year stretch. That is something you need to keep in mind about the experience of owning high-quality cyclicals–you’ve gotten 10% annual returns since 2000, but a condition of the experience is that almost a decade goes by (one fifth of your investing life!) without you seeing any traction.
It requires an honest acknowledgement of your emotional limitations to figure out if you can excel in this area or become someone who inevitably sells at a low point. There is no shame in acknowledging this. You can build million-dollar wealth shoveling funds into Nestle, Colgate-Palmolive, and Nike over long stretches of time. But you do sabotage yourself by planting a ticking time bomb every time you mis-appraise your risk profile.
And about those 10% returns from 2000 through October 2016. That starting valuation point in 2000 was at a cyclical high. If your timing was a little bit better, your returns shoot up by a high amount. Bought Honeywell in the months after 9/11? You get nearly 13% annual returns through the present. The “normal” year of 2005? You got 14% annually through the present day. The lows of March 2009? Nearly 25% annual returns through today. The “normal” year of 2011? 17% returns through today. When cash-producing assets fluctuate in price significantly, the general convergence in returns that you expect to happen over long periods of time due to the tendency of long-term owners to earn returns that match business performance doesn’t create the tightening relationship that you might intuitively think.
For most of the 20th century, Honeywell was called the poor man’s version of General Electric. It was ridiculed while GE always seemed one step ahead, especially at the time it built out its GE Capital financial division. Well, GE spent ten years treading water as its earnings reset following the unwinding of the financial portfolio while Honeywell’s industrial divisions plowed ahead. The 2009-2016 period has marked an unusual time in which Honeywell’s trailing five, ten, fifteen, and twenty year returns proved far superior to its competitor with the historically stronger reputation.
All of this is to say that I am largely nonplussed by this latest news item affecting Honeywell. It may make the company unpopular in the short term, but I doubt it will make even a scintilla of difference over a 15+ year time horizon. If you buy Honeywell and hold it for the long haul, you will get 10-13% annual returns and experience about 1.4x the volatility of the S&P 500 in general. If a bumpy ride seems unsettling, this isn’t for you. If you care about absolute wealth being created over 25+ year periods and use that exclusively as your north star, it is.