An interesting approach to individual stock selection involves looking at businesses that are indispensable to your career’s successful functioning.
If you work in HR, you have probably relied upon the services of Automatic Data Processing to assist with payroll and other employment-documentation needs. Lo and behold, ADP has a historical track record of 14% annual returns going back decades. It was one of the few companies to maintain a bond rating of AAA, only losing it a few years ago when it embarked on a stock repurchase binge.
If you manage an ice cream shop, you might have noticed how ubiquitous Mars Candy and Hershey toppings are for nearly every product, and have been so for decades. Unfortunately for investors, Mars Candy is a privately held company, but as for Hershey, it has been compounding at 11-13% rates for decades.
For the American farmer, the need to buy tractors, front end loaders, scraper systems, gator utility vehicles, cutters and shredders, and not to mention harvesting, hay, seeding, and tillage equipment from Deere & Company has been omnipresent throughout their lives, and the constant supplier has always been Deere & Company.
Sensing this reliance on Deere & Company, it would be an understandable inquiry for the American farmer to wonder whether he should buy shares of John Deere stock (DE) if he is able.
At first blush, Deere stock looks attractive at its recent price of $134 per share, which is a decent amount below the $175 per share high that the stock reached just last year. The earnings are strong at over $11 per share, for a P/E ratio of 12. The balance sheet is in good shape, with about $6 billion in debt, $2 billion in cash, and almost $3.5 billion in annual profits.
As anyone who is familiar with farming can attest, the industry is highly cyclical, and at least four or five years out of every 20 will be hard economic conditions. One to three of them will be absolutely brutal. During these brutal years, Deere survives better than the farmer does, but it still sees its profit margins cut in half while sales simultaneously fall by 50-70%. During the last recession, Deere stock fell from $94 at the start of 2008 to $28 during the 2009 low.
Think about that. Someone who had spent a life accumulating Deere stock, and say, ended up with 1000 shares at $94 for a total investment value of $94,000 come retirement age, saw the decades of compounding fall to $28,000 in value within a year. Retiring on a block of Deere stock in the summer of 2008 would have proven to be an incredibly scary experience if you reached a stage of your life where you were expecting the stock to help take care of you.
Now, if you’re a student of the economist Thomas Sowell, you probably also know that “lumpy profits” should lead to better returns than smooth profits because the irregularity of returns is something that should be compensated. People would rationally rather own the business that earns $60 in per share profit by delivering $10, $11, $12, $13, and $14 in earnings over a five-year stretch over the business that generates $8, $3, $7, $18, $24. If you own the latter, you should be compensated with higher returns for taking on the risk of the year when profits fall from $8 to $3.
When you study John Deere’s history, the risk hasn’t been particularly well compensated. If you bought in 1972 and held your Deere stock through today, you would have compounded at 9.7%. The S&P would have compounded at 9.9%. You basically would have been getting index-type results, but you would have been incorporating the risk of seeing a stock go from $94 to $28 in three occasions along the way. Deere has extremely volatile price swings compared to the index as a whole, but those price swings aren’t really compensated in terms of higher total returns. I’m not afraid to make an investment where every dollar could conceivably turn into $0.30 at some point, but if I do so, I better get market-beating returns as part of the tradeoff.
Fortunately for Deere’s shareholders, the management team isn’t stupid. It is launching Precision Agricultural and Seeding Technology as a $99-$149 per month subscription service to provide farmers with guidance on the seed selection and timing selections that will lead to the biggest outcomes for the farm. When farm equipment sales falter during a recession, the farming technology subscription may soften the blow. For now, Deere’s subscription technologies are less than 5% of its overall revenues, so not quite enough to stem the tide if a deep recession were to appear tomorrow.
My view is that Deere is the type of stock that should only be 2-4% of someone’s investment portfolio at cost, and it should be bought when the country is a bear market. If someone bought the stock at $28 per share in 2008, he’d have collected $27.23 in total dividends over that time (by 2020, he will have collected more dividends than the cost of his investment) and the price has climbed to $134.
The problem is, for the investor that bought in early 2008 at $94 and still held to this day, those $27.23 in dividends and $134 share price is only 5.5% compounding while a crazy obscene price decline had to be endured.
Some capital intensive businesses like John Deere are strong, but not so strong over the course of a full business cycle that they can do well from peak to trough and back that they can be purchased during ordinary or favorable economic conditions and still outperform. If you want to outperform over a multigenerational period, you have to wait for a bear market to make your move. The move towards increasing the share of farm technology subscription software is changing the future intrinsic value calculation, but at this point, it’s not yet substantial enough to provide protection during the next recession.
Deere is a great company. It will eventually give near market returns over a multigenerational period. But it will give its investors extreme volatility in the share price that does not result in additional additional returns above what an index investor can reap unless it is bought during recession. So, the facts suggest that an intelligent investor should buy Deere stock during a recession, but should otherwise, bide his time with companies that can be fought at fair prices and outperform.