2023-10-27 14:57:41 ET
Summary
- Having a consistent and rational investing process is extremely important.
- During Align Technology stock's previous downturn in 2020, I was able to buy the stock at a good price and take profits well before the current downturn.
- The recent drop in Align's stock price was due to the end of a stimulus boom, leading to a more rational pricing of future earnings.
- I share the price I would be willing to buy Align stock again.
Introduction
When it comes to writing about stock investing, I view my primary job as that of a teacher of applied investing. This means that while I certainly have developed my own investing theories, and I think they are important, what is more important is the actual application of those strategies and techniques in the real world. That's why I only write "Buy" rated articles on stocks I have actually purchased myself. I've never understood independent stock analysts who continuously put out buy ratings on stocks they aren't actually willing to buy for their own portfolios. I first bought Align Technology ( ALGN ) stock on 3/19/20 in my own portfolio and my Investing Group, The Cyclical Investor's Club, and wrote about it a couple of months later publicly on 5/31/20 in my article " Stocks I Bought On The Dip: Align Technology ". In that article, I shared the process that I used to buy Align stock at the price I did. A few months later, after the stock price had doubled since I had purchased it when the medium-term returns looking 2-5 years forward no longer looked attractive, I took profits for about a 108% gain. Soon after I sold, I wrote an article titled " My Process For Taking Profits in Align Technologies " where I explained my reasoning and method for selling the stock. Here is how the stock has performed since that article compared to the S&P 500 ( SPY ):
In the first year after I sold, the stock price rose about 150%. Now the stock price is down about -34% from when I sold three years ago. Just about anyone who bought the stock between then and now and didn't sell yet is currently underwater.
I sold this stock based purely on the valuation and future earnings expectations compared to the price. Often when I do this I have commenters on my articles claim I am a "market timer" and that "market timing doesn't work". But as we see above, I was just applying my valuation process. I wasn't trying to time the top of the stock price when I sold (or, the bottom, when I purchased it). I don't think there was any way I could have predicted the stock would have risen an additional 150% after my 108% gain. The market can be irrational both on the upside, as well as the downside and I don't believe there is any way to predict those short-term moves consistently, so I stick with my process which primarily focuses on fundamentals and historical trends over time. In this article, I will share the process I'm currently using to decide when to potentially purchase the stock again.
Why did Align's stock price fall?
Align stock recently fell about -25% in a single day after reporting earnings. As noted on Seeking Alpha's newswire: "Align posted Q3 adjusted earnings per share of $2.14, which missed estimates by 12 cents. Revenue rose 7.9% Y/Y to $960.2M, but came in short of consensus by $34.57M." So, a relatively small miss on earnings and basically 8% revenue growth (about the same as most high-quality S&P 500 companies this quarter) caused the stock price to go full Tom Petty and free fall. Why?
The above FAST Graph shows where Align's P/E ratio was one day before they reported earnings. We can see that the P/E ratio was about 30, which is expensive when one considers that this year they were only expected to have 8% earnings growth. Align went on to miss those expectations. Over the next couple of years, earnings were expected to grow about 15% per year on average, but I would expect those estimates to come down in the coming days and weeks after the report.
What likely has happened here is that a combination of suppressed demand from 2020 and massive amounts of US stimulus money in 2021 led many people to seek teeth alignment in 2021 when ALGN experienced a massive 114% surge in earnings growth. And this rationally makes sense. Tooth alignment is often a discretionary purchase, at least at the margins. It can also be pretty expensive. So, if the government puts out a one-time stimulus, spending that money on one's teeth or one's kids' teeth makes a lot of sense since that is a one-time purchase also. I know my daughter got braces earlier this year (Align's products were not an option for her, but I would have used them if they were.), and it was much easier to pay $6,000 for braces after the good economic year in 2021, in part, thanks to stimulus money like child tax credits than it would have been pre-pandemic.
So, we had a stimulus boom in 2021, which we had for many companies, and that boom was followed by a 'bust' that is still going on. (I've written a lot about this phenomenon beginning in January 2022). Align's stock price peaked around a 75 P/E ratio. At that valuation, the market was pricing Align's business as if the boom would go on forever. It wasn't rational to do so. Align's stock price is simply pricing in a more rational outcome regarding future earnings, and that is why it has fallen so much.
When I'll Start Buying Again
Let's begin by framing where the market and economy currently stand. I think we are in a period of what I have termed "Fragile Stagflation". This is a period where stagflation is the norm (due to demographics and deglobalization), but occasional shocks to the system like energy price spikes, higher interest rates, and reversal of stimulus like the repaying of student loans, cause periodic slowdowns and recessions. Align stock has officially come down off the highs of "boom" and has had a "bust", but I don't believe it is priced for a recession or significant economic slowdown yet. While I don't know the precise timing of when one of these slowdowns will happen, I do think right now is a time of elevated risk, and I prefer to buy Align during a slowdown or recession rather than before one. That's what I did in March 2020 and it worked out well.
There may be investors who are not concerned about a recession or who do not want to be labeled "market timers". For those folks, I will share some quick buy prices depending on what your future earnings growth estimates are for the business, based on a $8.36 EPS expectation for this year.
10-year Average Earnings Growth Rate | Buy Price |
15% | $174 |
10% | $130 |
5% | $98 |
If EPS estimates come down for this year, then these buy prices would go lower, obviously. But, for those who are not concerned with a recession, you can use the above prices as a guide.
I do want to be prepared for an economic downturn. And the way I do that is to first try to avoid buying near the peak of an economic expansion or too soon on the way down. Since Align stock is now down about -74% off its highs, I think I've done that successfully. The second thing I want to do is to examine history to see how the market has treated the stock in past economic contractions and recessions. For Align, I have chosen to go all the way back to 2008. Even though it was a particularly bad recession, and we might not experience another one that bad this time around, since we are coming directly off a stimulus "bust" the combination of boom/bust and recession, could be just as bad as 2008 for the stock price.
I call this metric the "Recession P/E", and what it does is to go back to the previous recession and create a P/E ratio by using the lowest price the stock experienced during that time and the peak earnings before the recession.
Back during the recession of 2008/9 Align's stock price bottomed at $4.88 per share and earnings peaked at $0.47 in 2007. When I create a P/E using those numbers I get 10.38. This 10.38 recession P/E is the most pessimistic (yet realistic) metric based on history, and I just want to get somewhat within the range of that metric when buying the stock. I want to give myself at least a 20% chance of actually having my buy price hit in a recession so I don't want to be unrealistically pessimistic and miss the opportunity entirely. So, what I have done in this case is be willing to buy if the current recession P/E gets within 30% of the 10.38 2008 recession P/E, which is a current recession P/E of 13.49.
Normally, I would just use whatever the peak earnings were for a stock combined with the current price to determine the current recession P/E, but because Align had such a "boom" in 2021, I am going to control for that a little bit. Going into 2020 Align had been growing EPS at about 20%. So I am going to take 2019 EPS of $5.90 per share and grow that at 20% for two years, and I'm also going to add on another 15% for inflation from all the extra money in the economy that isn't going away. When I do that, I get peak 2022 "COVID adjusted" earnings of $9.77 (instead of the actual $11.22). It's the $9.77 combined with the current price I will use to determine the current recession P/E (I also make a small adjustment for net debt or cash, which will improve ALGN's buy price a bit). I have their current price at $191.54 as I write this and I get a current recession P/E of about 19.60. In order for 19.60 to get down to our buying level of 13.49 P/E, we need the stock price to fall about -29% further to $135.91.
As long as I think the recession risk remains high, this $135.91 buy price is where I will be looking to buy the stock.
Conclusion
In order to get better than average stock market returns over the long-term investors need to learn how to value the business by making reasonable estimates about the future. I have found that about 80% of the time history is the best guide to the future. Because I am aiming for high returns, and because I'm pretty cautious about the macro backdrop, I have a pretty low buy price. I've tried to provide some additional guidelines for investors who might not share my caution regarding the macro. I sometimes get criticized for my low buy prices, but I've shown in the past with Align stock that they do hit. I'll be ready to buy if they hit again.
For further details see:
Why Align Technology Stock Fell, And When I'll Start Buying