Introduction

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 35 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 36 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), AMETEK (AME), PNC Financial (PNC), BlackRock (BLK), and Dollar Tree (DLTR) 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 U.S. Bancorp (USB), and while I initially missed the stock during the March sell-off, it made another buyable dip in May and I've done fairly well with since purchasing on 5/13/20.

Even though I missed this stock when it initially fell below my buy price of $30.56 at the March bottom, I didn't miss my second chance in May. Since then, it has been handily outperforming the S&P 500, roughly doubling the index performance even though it has pulled back substantially from its June peak. And even though it is the 17th stock I've covered in the series, it is the first true cyclical stock I've covered. So this will use an entirely different type of analysis from my previous articles.

The lack of cyclicals I bought during the downturn wasn't due to cyclicals not selling off rather deeply. They certainly did. It had more to do with the fact that the unique nature of COVID-19 has made many cyclical industries uninvestable. Airlines, cruise lines, automakers, plane makers, travel and leisure stocks, most energy stocks, all seemed to me as though they could become permanently impaired, or have extended, multi-year recovery times for the stock prices. By avoiding these classes of stocks, a lot of cyclicals were taken off my list as potential investments during this recession. So no matter how low the prices fell, I wasn't going to be a buyer. This severely limited number of deeply cyclical stocks I purchased during the downturn, and only 3 of the 20 stocks in this series will be deep cyclicals.

The main purposes of this article are three-fold. First, I'm sharing the process I used to select the stocks I bought during the downturn, 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.

Next, I'll take you through my process for identifying the value in U.S. Bancorp.

Step 1: Determine the Cyclicality of Earnings

I already spilled the metaphorical beans earlier in this article when I noted that U.S. Bancorp was a deep cyclical, but we can see that cyclicality fairly clearly with their earnings in the F.A.S.T Graph above. The dark green shaded area on the graph represents their adjusted operating earnings, and in both the 2001 recession, and especially during the great financial crisis, we saw significant earnings declines. From 2007 to 2009 earnings fell over -60%, and in 2001 they declined at least -39% (we don't have the preceding year in the graph so it may have been deeper when combined with 2000). Generally, I treat any earnings decline of -50% or more as enough to get a stock categorized as 'cyclical', or a 'deep cyclical'. The significance of this categorization is that I use a different type of analysis (that is a bit unorthodox) for deeply cyclical stocks, and that analysis focuses on historical price cyclicality rather than earnings in order to estimate good entry prices for the stock in question.

The reason I don't use traditional metrics like P/E ratios for cyclicals is that earnings fluctuate so much that they can send the wrong message about value. As earnings fall dramatically, P/E ratios rise, making the stock look expensive even though the price is quite cheap if earnings rebound in a timely manner. So I mostly avoid using P/Es or similar metrics as a value guide for deeply cyclical stocks. The one time to look at P/Es I highlighted in the F.A.S.T Graph, and that is examining the peak P/Es. What I'm looking for here is to see whether the peak (in this case monthly) P/Es are similar for both cycles. If they aren't similar it might mean that one cycle can be expected to be different than the other, and a lot of my assumptions using this strategy rely on the cycles being somewhat similar to those of the past. In this case, USB's peak P/E in 2007 was 13.82 and in 2020 was 14.44. Those are similar enough that it doesn't raise any red flags about the valuation of USB going into the recession being dramatically different than it was in the past, and we can proceed without making any major adjustments to the approach.

Step 2: Historical Price Cyclicality

Once I've established that a stock is a deep cyclical, the next thing I examine is what their historical deep drawdowns have looked like. In most cases, I require there be at least enough data to include two recessions, and in USB's case, this isn't a problem as they have data going back several decades and we can easily examine the last three recessions.

The first notable thing about U.S. Bancorp's historical cyclicality is that it is very synchronous with the economic cycle. All of USB's previous significant drawdowns in price corresponded with US recessions, and they also roughly corresponded to the severity of those recessions, with the early 1990s recession being relatively mild and the Great Recession being more severe.

The next thing worth noting is that duration of the time the stock spent below its previous peak during every downturn was 5 years or less. 5 years is usually the high-end of what I like to see for typical cyclical stock recovery time. Beyond 5 years and I only invest if the stock is a very deep cyclical and I can capture outsized gains by holding for very long periods of time.

Basically, U.S. Bancorp looks like a fairly plain vanilla cyclical that offers the opportunity for outsized gains when the price falls during recessions. It's not particularly hard to assess in this regard. The only question is which historical downturn is most reasonable to us as a guide for the current downturn. There's not really an easy answer to that question, but intuitively, the market is behaving a lot as it did in 1999, with tech making new highs while financials, oil, and tobacco struggle. So, I want to at least make sure I am prepared for a drawdown on par with the 1999 drawdown (more on this later).

Next, let's look at the impairment tests I run cyclical candidates through in order to see if there are any red flags that might indicate this time is significantly different from past cycles. I'll frame these as a series of questions, and as long as USB passes the tests, I'll buy it.

Step 3: Impairment Tests

Are revenues during this cyclical peak higher than the last one?

The reason I look at this is that if revenues are lower than the previous cyclical peak, it can be a sign that the business is either being disrupted or in secular decline.

In USB's case, revenues are far above the last cyclical peak in 2007. I also like to take a look at 3-year revenue growth leading up to the peak of the cycle to make sure that it is at least positive.

And this looks fine, too. It should be noted that these tests aren't always passed by the stocks I examine. If we take a look at Wells Fargo (WFC), a bank I avoided, we see that it would not have passed this test.

While Wells Fargo's current revenue is higher than the 2007 peak, it's obvious from looking at the chart that revenues have gone nowhere since 2010, and here is what they have done the past three years.

Even before the pandemic, 3-year revenue was -2.50%. I avoid stocks like this because usually there is something going on to cause this, and they often turn out to be value traps. And we can see that when we examine the comparative returns of USB vs. WFC since the March 23rd market bottom:

I thought that I would include this comparison because usually, I don't write many articles about the stocks I avoid, and I think sometimes readers get the impression that my impairment tests don't really do too much. Readers often want to hear a story about the internal workings of the business and how that will lead to a bright future for the stock price etc. I don't usually do that. My tests are very stringent, though. Out of over a thousand stocks that can be classified a 'cyclical', I am currently only tracking 50 as potential buys and the declines we experienced in March were only deep enough to trigger buys in about 10 of those 50. If we just take the S&P 500, there are only about 30 current cyclical candidates that I'm tracking. There are far more 'Wells Fargos' than there are 'U.S. Bancorps' in the market, and my view is that if I can avoid the 'Wells Fargos' effectively, my odds of achieving above-average returns are greatly improved.

While passing all of my screens and tests doesn't guarantee success all of the time, (I have a few energy stocks that have really been crushed the past few years) the probabilities are dramatically in my favor if the companies can both pass these tests and meet my price requirements. The process of inversion I'm using here (eliminating stocks with problems and/or no history of success, rather than finding 'great' stocks) is a fairly effective way at finding unique values in the market because most investors are looking for good stocks and business rather than explicitly trying to avoiding bad ones.

Could the business have a hidden fatal flaw?

Since, by definition, the fatal flaw in the business model is "hidden" and cannot be easily seen, my test for this is whether the cyclical business in question has experienced two full business cycles, because typically recessions are where the flaws are exposed, and sometimes businesses can get lucky and avoid trouble in one recession but have the flaw eventually catch up to them during the next. I typically pre-screen for this before I write an article, and USB passes this test, since it recovered fine from the past two recessions.

Is there a clear and disruptive threat to its core business?

This is a hard question to answer right now. We really don't know what interest rates are going to look like over the next several years. Will they stay low 'forever'? Will they go negative? Will increasing technology and a variety of shadow banking services slowly make traditional banking obsolete?

I don't know.

But for USB, going into this recession, we hadn't seen signs that a disruption was underway, yet. So I continue to defer to history and assume that some form of the past will likely repeat itself. That said, I am limiting myself to no more than 10% portfolio weighting to banks or similar financial institutions. Since I bought several during the March downturn, I think the only one I'm likely to add on a market double-dip -- should we have it -- is JPMorgan Chase (JPM), which I don't own yet. So, if this whole industry never recovers this cycle, I will at least have limited the overall damage it does to my portfolio.

Has the stock experienced a recent super-cycle?

Occasionally, stocks go through big super-cycles, valuations get thrown out the window by investors and the stock prices get bid up to crazy high levels. This can cause a problem for a strategy like mine that measures declines from peak prices, because if the peak prices are ridiculously high, then a stock might fall -50% off its highs and still not exactly be a good value.

I don't have a clear way to identify super-cycles. It's kind of an "I'll know it when I see it" sort of thing. But my quick way to check is to look at a log-scale version of a long-term historical price chart. Super-cycles tend to show up pretty well on these charts without giving as many false positives as a normal long-term price chart might.

Leading into 1999 one might have been able to make the case for a super-cycle, but overall, this cycle looks well within the bounds of a normal price cycle for USB, so I'm not concerned about a super-cycle this time around.

Is management corrupt or incompetent?

I don't think I've ever read or heard an unkind word about management, and during the Great Financial Crisis U.S. Bancorp's name was hardly mentioned. So, I don't see any evidence that this is something to worry about here.

Has the price dropped enough to produce alpha in the past?

Since the price has declined almost -50% off its highs, what I'm going to do here is backtest what would have happened if we would have purchased the stock after the price fell -50% off its highs and then sold it after we achieved a +100% simple return.

For this section of the analysis, I'm going to go back in time and see what sort of returns investing in USB after a major decline would have produced. In the table below, I assume the stock was purchased after it had declined -50% from its highs and then sold after it recovered its previous peak stock price. So, for each investment, the pure return is ~100%, and they do not include dividends. I annualized that return and then compared it to the S&P 500 if bought and sold on the same dates, annualized. The goal is to see if historically this would be an alpha-producing strategy, so the last column is the alpha produced by the investment annualized relative to the S&P 500.

Buying after a -50% decline during the 1999 downturn would have taken almost 4 years to double and would have produced very good annualized gains of +26.09% and also dramatically outperformed the S&P 500 which suffered a loss over this time-frame. Given the high valuations of the mega-cap tech stocks in the cap-weighted S&P 500 index right now, I think there are above-average odds that a 1999 scenario could repeat in one form or another. So, this is promising for USB if purchased -50% off its highs.

During the 2008 decline, banks were hit much harder and took longer to recover, but even then USB was able to produce annualized returns over 20% and slightly outperform the index if purchased at -50% off its highs.

What is a reasonable investment strategy?

Given USB's long history of recovering in a timely manner from downturns, that going into this recession it was similarly valued compared to the last recession, and that buying the stock at -50% off its highs both had a reasonable chance of occurring during a recession, and also historically produced outsized returns, I took an approximate 1% portfolio weighted position in the stock when the price fell below my 'buy price' of $30.56 (which was about -50% off its highs). I will not consider selling until the price has doubled to $61.12, more than 5 years has elapsed, or something dramatically changes for the worst in the business.

Conclusion

Solid cyclical stocks like U.S. Bancorp have been rare finds during the current recession. The future is very unclear. We don't know what will happen with interest rates, loan losses, central bank programs, federal government stimulus, and politics over the next year or two. I am of the opinion it's best to just admit that we don't know. It's typical, during deep recessions, for us not to know the near future. We didn't know what was going to happen in late 2008 and early 2009. We didn't know during the 2001 recession after 9/11 what would happen. And we don't know exactly what a post-coronavirus world is going to look like. But my view is that when the prices are very good for what has traditionally been a very good business, I take my chances and buy. And that is what I have done with U.S. Bancorp. I think there is a very good chance the market could take a double-dip, so consider putting this one on your shopping list in case that happens.

Read the Original post here.