Did our definition of the word cyclical go haywire? Are all companies now growth companies set to make their numbers no matter what -- and if they don't, then they go up anyway?
As I examine the quarters reported so far, the big surprise of the quarter is that a downside surprise doesn't yield a selloff. It's an astonishing thing. You could be right about how bad a quarter you might have just seen and then be shocked to see the stock defy revenue and earnings per share gravity and go higher.
Consider this: Deere (DE) , Dow (DOW) , Caterpillar (CAT) , PPG Industries (PPG) , Illinois Tool Works (ITW) , CSX Corp (CSX) and Union Pacific (UNP) all reported quarters that in a vacuum I would have said should have sent their stocks lower, perhaps sharply lower. They all had misses of sorts and all required estimates to come down.
In the old days, when I used to be able sell short stocks, often my goal would be to approximate which companies, come reporting time would miss quarters and cut forecasts. All of these big cyclical companies qualify for those negatives. Therefore, after their earnings were reported, analysts should cut numbers and the stocks should fall. As someone who liked to short, I knew I would pretty much have a guaranteed opportunity to make some money if a company's report hit that criteria.
Not this time.
Why is that? After studying pretty much every single cyclical quarter of any size, I think I have gleaned enough to make some judgments.
First, lots of research is run from the top down, meaning that Wall Street firms establish a worldview of global growth and then try to peg companies' performances into that worldview. It is hard to imagine a more gloomy worldview than we have now, other than during the Great Recession. Whether it be the endless trauma of Brexit or the trade with China or the uncertainty over our election, there's a genuine belief that things are worse than they've been. If that's the case, then aggregate numbers are too high. If aggregate numbers are too high, which are the ones that are going to produce the shortfalls? Why, it's the cyclicals of course.
So, numbers get cut beforehand. Nobody was looking for anything good from Caterpillar. That's why back in August, with Caterpillar's stock at $120, Goldman Sachs downgraded Caterpillar from buy to hold and took its price target $156 to $130. The downgrade seemed in sync more with a slowing worldwide economy than anything Caterpillar specific. Then on October 18, with the stock at $132, Morgan Stanley downgraded Caterpillar from buy to hold and cuts its price target from $150 to $145 a share. This time? Worries about peak construction and energy markets.
So when Caterpillar reported last week, even as it was a clear miss on top and bottom lines with a forecast cut, the stock first fell 6% in pre-market trading, flailing at about $130, and then it rallied almost back to even. By the end of the week it stood at $139, a remarkable turn. There were several reasons why it occurred but perhaps the most important had to do with these pre-reporting downgrades. They sowed the seeds of their own failure to help.
Close observers of last week might say, wait, the stock of McDonald's (MCD) caught a key downgrade, too, and yet when it missed forecasts the stock got obliterated. The answer to that conundrum is the second reason why these cyclical stocks aren't going down: They have finally gotten so cheap versus their safety compadres that they can resist downside surprises while the senior growth stocks can't afford them. I was as stunned about the strength of Caterpillar as I was the weakness in McDonald's in wake of these reports. These stocks are especially cheap when you consider the commitments they have all made to boosting their dividends regularly and buying back shares. I was bowled over when I heard Caterpillar refer to itself as a dividend aristocrat until I looked at its consistent dividend bumps and realized it was deserving.
The third reason why these stocks are performing counterintuitively? Managements turned out to be far more savvy than anyone, including the analysts, thought they might be about the outlook and their numbers. Here PPG, the coatings company, maybe the most instructive of the quarter. I am so used to seeing numbers cut in a downturn for a company that makes paint for a host of industrial uses, everything from planes, to boats to cars and buildings.
But how about if you are CEO Michael McGarry and you see it coming? How about if you are able to throttle back on costs quickly and efficiently and dodge the shortfalls? That's exactly what happened here. In fact, not only was the quarter not nearly as bad as I expected, but McGarry called the auto business out as a reason for the upside. That's a reminder that managements learned more from the Great Recession that we think. We are used to them being blindsided. The only blindsiding here was to the shorts.
Fourth, these companies have decided to change their stripes to the point that you have to recognize they just aren't the same and they don't deserve the same low valuations.
Illinois Tool Works was supposed to miss badly. It didn't do so well the last few quarters. The auto business had been keeping them back. On this quarter's call, I heard enough about non-auto businesses to realize that the company was simply not going to sit there and take a licking any longer. There was margin improvement pretty much everywhere. Plus, the weakness in the world isn't all bad here. Raw material cash pressures eased. And the company saw some strength in Europe.
The best examples of raw improvement came from the rails, notably Union Pacific and CSX. I keep thinking about what Jim Foote, the CEO of CSX, told us the other night on Mad Money. The rails in this country, perhaps because first they had no competition and then only competition from trucks for lighter goods, simply weren't run that well. It wasn't like a utility was suddenly going to use a trucking company to send coal or a steel company to send cable and wire via Ford 150s.
They owned the markets.
However, in the last few decades as our nation shifted toward more value-added, smaller form-factor parts, trucks did start taking share. Trains went from 100% of all transportation to 8% over a multi-year decline.
But in comes a new group of railroad professionals who have decided to re-look at everything and take business back that had been lost to trucks by focusing on being on time and convenient. Funny thing: when you do that you need fewer people, too. Efficiency breeds higher earnings per share. That's why, even as the revenue went down, the earnings didn't fall as fast, and the stocks caught bids before you would have expected and ended up rallying.
I know Deere has confounded people with the strength of its stock, but it, too, has something going for it that people aren't understanding. When the Chinese decided to shift their big soy orders to Brazil, the farmers there, flush with cash, bought lots of Deere equipment. At the same time our government came through with a Market Facilitation Program which gave our farmers money to buy Deere equipment, too. There would not have been a similar Brazilian program if we had won all the soy orders, so Deere double dipped into success.
The fifth and final reason why these stocks aren't going down? It's possible, just possible, that things might be getting better around the world for some companies. With the exception of Dow, this is not the perception of these companies. But if you think that the trade war may have hit its zenith and Brexit could actually be resolved -- it took the Europeans forever to resolve Greece, but they did in the end -- then could there be a better place to be than these stocks?
I don't think so.
These are five solid reasons why these stocks have failed to go down. Maybe five solid reasons why they are still buys.
