2023-03-28 16:42:52 ET
Summary
- McCormick stock has been overvalued for several years and has likely started the process of rerating to a lower valuation.
- In this article, I review my bearish sentiment from 3.5 years ago and also share an updated analysis.
- I estimate what sort of returns I expect from McCormick over the next four years.
Introduction
In this article, I will use an earnings-based analysis to estimate what sort of returns I expect McCormick ( MKC ) stock to produce over the next four years for investors. I last covered McCormick about 3.5 years ago, and in my article " McCormick: A 10-Year, Full-Cycle Analysis ", I rated McCormick stock a "Sell", based on valuation. It was the only sell rating for McCormick published on Seeking Alpha that year. Here is how the stock has performed relative to the S&P 500 ( SPY ) since that article was published on 9/26/19.
I estimated a 10-Year CAGR for MKC of about +0.61% back in 2019, and the stock is right around that expected range of return. I share this data to hopefully add some credibility to my valuation process since typically I don't spend a lot of time in articles sharing stories about the business beyond their historical earnings trends. In this article, I will use a similar form of analysis I used back in 2019, only this time I will focus on 4-year return estimates instead of 10-year CAGRs. My hope is that framing the valuation as 4-year expected returns will be more immediate (four years instead of 10 years) and clearer (a total return instead of a CAGR estimate) for readers.
This article will be part of a new series I'm writing about the ability to roughly predict stock returns using valuations for steady-earning businesses over the medium term of four years. I often receive feedback on my articles that stock valuations of the sort I share on Seeking Alpha are not useful for predicting or improving one's returns. These critiques come in a couple of variations. One of them states that investors should just buy the stocks of quality businesses whenever they find them regardless of price. Another, the flip-side of this thought process, is that stocks shouldn't be sold based on valuation because that is "market timing" and it cannot be done successfully on a consistent basis. I strongly disagree with both critiques, so I will be systematically tracking the results of my 4-year return estimates for dozens of stocks like McCormick in an effort to hopefully demonstrate the usefulness of earnings-based valuations. (More on this experiment later in the article.)
Valuation
The first thing I check with almost every stock before I start the valuation process is the business's historical earnings cyclicality. I generally require at least one recession as part of the data so I can see how earnings performed during that recession. Because 2020's recession was so unusual, I place most of the weight on the 2008/9 recession when examining the historical earnings cyclicality. This can also help me assess the long-term earnings trend, which I require to generally be growing over time. (I don't have any interest in buying the stock of shrinking businesses or turnaround stocks.)
Since 2005 McCormick had never experienced a negative EPS growth year until last year, when EPS fell -17%. Even considering the recent decline, a -17% decline is only moderately cyclical so there is no problem using an earnings-based analysis with McCormick as long as we take into account last year's decline.
Next, I need to select the historical time frame I want to use in order to estimate the earnings growth rate going forward. I will use a time frame from 2015 to 2023's expected earnings. This is a long enough time period to smooth out irregularities but close enough to the present day to reflect the business's current state of affairs.
Because I'm going to use EPS in order to estimate earnings, I also check for any share buybacks that occurred over this period, because those will inflate the EPS growth rate by lowering the share count. (A rising share count, however, will already be incorporated in the EPS figure, so I won't make adjustments if the share count has risen.)
Overall, McCormick has issued more shares during this period than they have bought back, so we won't have to make adjustments for buybacks and the valuation process will be pretty straightforward.
Above, I have another FAST Graph from the time period 2015 through 2023. I have annotated it with the data I will use for my 10-year collected earnings projections. Note that I am pulling forward 2023's expected EPS rate of $2.57 per share, which, at the current stock price translates to a P/E ratio of about 28.93, an earnings yield of +3.36%. The earnings growth rate from 2015 through 2023, has been about +4.76%. You'll notice that because I didn't have to make any adjustments for buybacks and because there weren't many negative EPS years, my estimate is very close to FAST Graphs +4.80% earnings growth calculation. All-in-all, this is a pretty straightforward analysis.
The way I think about this is, if I bought MKC's whole business for $100 with an earnings yield of +3.36%, it would earn $3.62 the first year ($3.36 plus 4.76% growth), and that $3.62 would grow at a rate of +4.76% each year, for 10 years total.
Below is a table that shows the expected cumulative collected earnings on $100 over 10 years.
Year | Earnings for Year | Cumulative Earnings |
1 | $3.62 | $3.62 |
2 | $3.79 | $7.41 |
3 | $3.97 | $11.39 |
4 | $4.16 | $15.55 |
5 | $4.36 | $19.91 |
6 | $4.57 | $24.48 |
7 | $4.79 | $29.27 |
8 | $5.01 | $34.28 |
9 | $5.25 | $39.53 |
10 | $5.50 | $45.03 |
Total | $45.03 | $100 + $45.03 = $145.03 |
So, if you bought MKC at the current valuation for $100 and collected all the earnings for yourself you would have started with $100 and ended 10 years later with $145.03. This is a compound annual growth rate of about +3.79%.
Next, what I will do is take that long-term average earnings CAGR of +3.79% and figure out what that works out to after four years' time, since our goal is to estimate the returns over that time period. When I do that, it works out to a basic total return of +16.04%. So, over the next four years, if we disregard market sentiment and assume it stays the same, treating MKC more like a private business, we could expect our total return in collected earnings after four years to be valued at about +16.04% if we assume the earnings trend will continue for 10-years total.
This return is the absolute return expectation if we assume that market sentiment for the stock is similar to what it is right now. But I think it's also worth comparing this expected 4-year total return to alternative investments. The two alternatives I will compare it to are the SPDR S&P 500 Trust ETF ( SPY ) and the iShares Treasury Floating Rate Bond ETF ( TFLO ), which is what I'm currently using as my cash equivalent for investment money. The reason we compare to alternatives is to see if there are better simple alternatives that don't require a lot of skill to analyze, which basically anyone could own instead of the individual stock.
Using a similar method that I used with MKC's earnings, I also track about half of the S&P 500 ( SP500 ) stocks using this method, which represents about 2/3rds of the S&P 500 weighting. If I use that group of stocks to estimate their 4-year expected returns, I get an absolute expected total return for the index of about +27.48%. And, I generally expect TFLO, or short-term treasuries, to yield about 4% per year over this time, or to produce a 17.00% total return in four years. Let's see what sort of return MKC is likely to produce compared to these alternatives given these estimates.
4-Year No Mean Reversion | 4-year total return expectation | 4-year return expectation minus SPY's +27.48% | 4-year return expectation minus TFLO +17.00% |
MKC | +16.04% | -11.44% | -0.96% |
Overall, if sentiment remains the same for MKC and the wider market, MKC should be expected to have returns a little less than the wider market (16.04% vs. +27.48%), but not a lot less.
It's always good to start with steady sentiment as a base for a valuation, but I've found that over the longer-term (and four years is starting to get into the "longer-term") stock earnings valuations tend to revert toward a mean of about a +7.00% 10-year earnings CAGR. (For a stock with the same earnings growth expectations as MKC of +4.76%, we would expect an average P/E ratio of about 13.46 to be the "normal" P/E the market would be likely to pay.)
With a Generic 7% 10-year Mean Reversion Assumption | 4-year total return expectation | 4-year return expectation minus SPY's +13.62% | 4-year return expectation minus TFLO's +17.00% |
MKC | -36.27% | -49.88% | -53.27% |
Okay, this is where things get interesting. For comparison, if the S&P 500 index were to revert to a 7.00% CAGR expectation over four years it would produce a +13.62% total return based on my estimates. TFLO's returns would be expected to remain about the same as before with a +17% return. If MKC's business earnings produce an average return valuation by the market, it is likely to return about -36.27% over the next four years on a total return basis. This is -49.88% (or -4,988 basis points) of difference between the S&P 500's +13.62% expected 4-year return. That is a very big difference in expected returns. Additionally, the relative returns compared to TFLO are even worse, with a -53.27% (or -5,327 basis point) spread.
This implies that over the medium term on a relative basis, MKC is significantly overvalued compared to the S&P 500 and even more overvalued compared to the likely returns from a cash equivalent, if market sentiment reverts to something close to its historical mean at some point during the next four years.
Ratings & Explanations
Assuming my estimates are reasonably close, there are several ways to interpret these results. The things we don't know, even if the earnings return estimates end up being fairly accurate, are what sort of mood the market will be in and how the wider economic conditions might influence the returns in four years. If we are in a deep recession at that particular time, then we would naturally expect the earnings to be lower, while if we are in some sort of economic boom, we would expect them to be higher. So, using relative returns is a way to somewhat control for macroeconomics. If we are in a recession, then it's likely SPY will perform poorly as well, so the difference between those returns is what we care about if we want to control for macro conditions.
Using mean reversion, on the other hand, helps to account for how people feel about certain stocks at certain times and what sort of returns investors are willing to accept. In this case, MKC and SPY have a significant difference between the two of them, and SPY is expected to perform better.
Different investors might have different assumptions and expectations about sentiment and macro conditions will be, so that's why I first provided the expectation without assuming mean reversion. That said, I do generally assume that after a period of four years, the chances are good that mean reversion will take place for most stocks, so, personally, I care about the mean reversion estimates the most. Additionally, I aim for a 4-year mean reversion expected return that is about 75% before I buy a stock based on earnings valuations. If I write about a stock (and earnings are not expected to drop because of a near-term recession) and it has a 75% 4-year return expectation, I will buy it, and those stocks will earn a "Strong Buy" rating from me.
Because I know I'm aiming for higher returns than many other market participants, I will rate stocks a "Buy" if the 4-year mean reversion total returns are 25% (2,500 basis points) higher than both SPY and TFLO, because these will likely be above market average returns and above cash average returns.
If the 4-year mean reversion returns are within 25% (+/- 2,500 basis points) of SPY, then I would consider that stock a "Hold." I don't consider any of my estimates superbly precise. They are meant to work as a rough guide, where we can take action if they reach extremes. So, within this range, I don't have a strong opinion about the stock one way or the other.
If the 4-year mean reversion returns are likely to underperform SPY or TFLO, i.e., cash, by -25% (-2,500 basis points) or more, then that stock would get a "Sell" rating from me.
And, finally, if a stock is likely to underperform both SPY and TFLO by more than -25% or (-2,500 basis points) over the course of four years then the stock would be a "Strong Sell."
I use -25% as the threshold because it's enough of a difference that a person could sell a stock, pay a full 20% long-term capital gains tax on the sale, and still come out ahead. If a person is dealing with a bigger tax bill than 20%, then they should do the math and figure out what that level is and use that as a guide for their selling threshold.
At today's price, McCormick stock is expected to perform significantly worse than both the S&P 500 and US treasuries if the market sentiment gets closer to its historical mean. Because it is expected to underperform both alternatives by more than -2,500 basis points, I am rating this stock a "Strong Sell", as per my guidelines.
Conclusion And Final Thoughts
I have a couple of additional thoughts about this stock. I have noticed a trend in recent years of stocks with low but consistent earnings growth, like utilities, being priced by the market with huge premiums. For many years, if an investor wanted to own a consistent business that had the ability to pass on inflation to customers, because bond yields were so low, it might have made sense for these investors to pay a little bit of a premium for the inflation protection a utility, or a business like McCormick, could offer them. However, two problems have arisen for stocks like these. The first is that their valuations got astronomically high so they were unlikely to provide good returns for long-term investors. We've seen that already start to happen during the past 3-4 years. The second is likely more troubling, and that is now there is an alternative in short-term treasuries that yield 4-5% with no duration risk. The combination of high valuation and a viable alternative that is safe and yields something at least close to the inflation rate likely means that over time the appeal of overpaying for consistent earners will come down over the next several years. And if the stock prices of these stocks start to really come down, I wouldn't be surprised if there is eventually a rush to the exits as investors who thought they held a 'safe' business, but who overpaid, are confronted with -20%, -30% or -40% stock declines.
The one factor balancing some of this out is persistent inflation. It might be the case that if services inflation is stickier than many expect and McCormick is able to raise prices, that the nominal declines in stock price might not materialize. We've already had in between 15% and 20% inflation since my last article on McCormick, so we see some of this happening already. The stock price is flat, but the purchasing power of the stock is down about -20%, an invisible loss. Perhaps this goes on for another four years and we have another 20% worth of inflation. The stock price might hold steady, but just like holders of duration bonds, the owner will have suffered a lot of lost purchasing power.
At any rate, I don't find McCormick stock, at its current valuation more attractive than TFLO, so, I continue to rate this stock a "Strong Sell" until the valuation improves.
For further details see:
Where Will McCormick Stock Be In 4 Years?