Stocks I Bought On The Dip: Align Technology (NASDAQ:ALGN)
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 it with the public, because I simply didn't like the way it 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 the end of March, I purchased 33 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 34 stocks, 19 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, 18 stocks remain that I plan to write public articles about over the coming weeks. So far, in addition to Comcast, I have now covered Hologic (HOLX), FLIR Systems (FLIR), Sysco Corporation (SYY), Tractor Supply (TSCO), and Microchip Technology (MCHP) 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 Align Technology (ALGN), and it's one I've done quite well with since purchasing on 3/19/20.
What I'm going to do in this article is to take everyone through my valuation process. It's the same process I use for almost all stocks that have low-to-moderate earnings cyclicality, and it is the process that helped me identify the value in Align Technology during the sell-off.
Step 1: Determine the Cyclicality of Earnings
On the F.A.S.T. Graph above, the adjusted operating earnings for Align Technology is represented by the shaded dark green area. ALGN didn't become consistently profitable until 2007, about a year before the peak of the last economic cycle. Since then, it has only had one year of negative EPS growth, which was in 2008 when EPS declined -32%. I place a green circle on that year in the graph. That is the expected decline from peak earnings I will base my forward expectations on. It's worth noting that right now, during this recession, EPS is expected to decline -47% from last year. While this is deeper than the last recession, right now, analysts expect a very quick recovery in 2021 compared to the last recession. Personally, I don't place much value in what analysts think about the next two years because I don't think we really know what will happen. But I do think that if I expect a -32% decline as we experienced during the last recession, and we build-in a substantial margin of safety when it comes to our forward return expectations, then we can likely do a reasonably good job estimating a good buy price for the stock that offers an adequate risk/reward even if don't know exactly what the immediate future holds. The good part about approaching the uncertainty over recession earnings in this way is that often when sharp stock price declines occur (as they did in March) we have very limited knowledge about how far earnings might decline over the next year. But we have very clear knowledge about how far they fell during previous declines and we have that knowledge before a decline occurs. While no two earnings declines are exactly the same, often they are similar, and using the past a guideline can usually get us in the right ballpark.
With moderately cyclical businesses like this one, fairly traditional valuation systems using P/E ratios and earnings growth estimates work reasonably well to predict future returns as long as we try our best to account for that modest earnings cyclicality, so the full-cycle approach using traditional methods is what I used for Align Technology (if earnings had been more cyclical, I would have used a different method of valuing the stock).
Step 2: Full-Cycle Analysis
Next, I'm going to run what I call a "Full-Cycle Analysis," which is the same analysis I performed that flagged Align Technology as a buy in March. As part of the analysis, I calculate what I consider to be the two main drivers of future total returns: Market Sentiment returns and Business returns.
In order to estimate what sort of returns we might expect over the next 10 years, let's begin by examining what return we could expect 10 years from now if the P/E multiple were to revert to its mean from the previous economic cycle. I start the previous cycle around the end of 2007, a little before the last cyclical peak.
As I write this, ALGN's blended P/E on the FAST Graph is 50.58, while its normal P/E this past cycle has been 35.65. The reason the blended P/E ratio is so high is because blended P/Es look forward a quarter or two and combine those estimates with current earnings, so this blended P/E is assuming that earnings will indeed be lower over the next couple of quarters which raises the P/E ratio because the "E" is reduced. Using forward or blended P/Es is fine for low-to-moderately cyclical stocks during non-recessionary periods, but during recessions, for moderate-to-highly cyclical stocks forward or blended P/Es can give the wrong feedback and they can make these stocks look expensive when they aren't. Align has moderately cyclical earnings. For that reason, I like to use peak forward earnings. These are the earnings analysts were expecting for the remainder of the year back in February before the recession. And if we create a P/E from peak earnings expectations using today's price, we get a peak earnings P/E of about 35.83, which is only a little bit above its long-term average full-cycle P/E since the end of 2007.
If, over the course of the next 10 years, ALGN's P/E were to revert to its normal 35.65 level from its current 35.83 level and everything else was held equal, it would produce a 10-year CAGR of about -0.05%. So, on a full-cycle basis, it is trading right around its average market sentiment. (My minimum threshold for purchasing a stock during the current recessionary downturn is a +1.00% expected 10-year CAGR from sentiment mean reversion. When I bought ALGN it had a P/E ratio of 19.59, which would have produced a 10-year sentiment mean reversion CAGR expectation of about +6.17%, well above my minimum threshold.)
Step 3: Current and Historical Earnings Patterns
We previously examined what would happen if market sentiment reverted to the mean. This is entirely determined by the mood of the market and is quite often disconnected, or only loosely connected, to the performance of the actual business. In this section, we will examine the actual earnings of the business. The goal here is simple: We want to know how much money we would earn (expressed in the form of a CAGR %) over the course of 10 years if we bought the business at today's prices and kept all of the earnings for ourselves.
There are two main components of this: the first is the earnings yield, and the second is the rate at which the earnings can be expected to grow. Let's start with the earnings yield. Even using peak earnings, the current earnings yield is quite low at about +2.78%. The way I like to think about this is, if I bought the company's whole business right now for $100, I would earn $2.78 per year on my investment if earnings remained the same for the next 10 years. (Back in March, when I bought the stock, this number was about $5.10, so you can see the dramatic difference it makes buying at a lower price in terms of the expected return on investment one gets.)
The next step is to estimate the company's earnings growth during this time period. I do that by figuring out at what rate earnings grew during the last cycle and applying that rate to the next 10 years. This involves calculating the EPS growth rate since 2007, taking into account each year's EPS growth or decline, and then backing out any share buybacks that occurred over that time period (because reducing shares will increase the EPS due to fewer shares).
Let's start by looking at how much shares were reduced since 2007.
Shares outstanding have actually risen over the course of this cycle, so I won't make any adjustments here. It's good to see they have essentially remained flat since about 2013, so if we hold the stock long-term our ownership stake will not be diluted over time. Even when I take into account Align's negative EPS year, I get an expected 10-year earnings growth rate of +23.48%, which is an extremely high growth rate. It's so high, in fact, that when I see estimated growth rates over +20%, I assume that it's unlikely they will be sustainable at that high of a rate for a full decade to come. It is very hard to maintain a growth rate that high for decades at a time. There will almost always be some sort of competitive pressures that arise or limits to a business's addressable market that come into play over the course of a decade. For that reason, whenever I see a growth rate above +20%, I always round it down to 20% for the sake of my estimates and as a way to build in a margin of safety. So for Align Technologies, I use a 20% earnings growth rate for my estimates.
Next, I'll apply that growth rate to current earnings, looking forward 10 years in order to get a final 10-year CAGR estimate. The way I think about this is, if I bought ALGN's whole business for $100, it would pay me back $2.78 plus 20% growth the first year, and that amount would grow at +20.00% per year for 10 years. I want to know how much money I would have in total at the end of 10 years on my $100 investment, which I calculate to be about $186.58. When I plug that growth into a CAGR calculator, that translates to a +6.44% 10-year CAGR estimate for the expected earnings returns.
10-Year, Full-Cycle CAGR Estimate
Potential future returns can come from two main places: market sentiment returns or earnings returns. If we assume that market sentiment reverts to the mean from the last cycle over the next 10 years for ALGN, it will produce a -0.05% CAGR. If the earnings yield and growth are similar to the last cycle, the company should produce somewhere around a +6.44% 10-year CAGR. If we put the two together, we get an expected 10-year, full-cycle CAGR of +6.39% at today's price.
My Buy/Sell/Hold range for this category of stocks is: above a 12% CAGR is a Buy, below a 4% expected CAGR is a Sell, and in between 4% and 12% is a Hold. Right now, ALGN is in the "Hold" category. Assuming earnings don't make new highs, ALGN would cross the sell threshold around $290 per share, and that that point I would develop an exit strategy for the position, perhaps putting in a trailing stop. But I plan to hold until we at least rise above that price.
Conclusion
One of the more interesting things about this purchase is that I consider it a value purchase at the time I bought it. It's a great example of how value investors can find growth without a lot of speculation. Align has had a long history of actual earnings, it has gone through at least one major recession, and it briefly traded below a 20 P/E ratio during the current recession. But, because it's not a software company or an electric car manufacturer, and it lacked a well-known brand name it was mostly ignored by growth investors. While there weren't a lot of stocks that combined a good earnings history, growth, and value during this downturn, there were a few. They all seemed to be lesser-known companies (though not exactly small) in unsexy businesses. Perhaps that's something to keep in mind in the event of a market double-dip.
Speaking of a double-dip, should we have one, my buy price for Align is about $135.00. If the stock price drops below that, I think it offers a good risk-reward over the long-term.
If you have found my strategies interesting, useful, or profitable, consider supporting my continued research by joining the Cyclical Investor's Club. It's only $29/month, and it's where I share my latest research and exclusive small-and-midcap ideas. Two-week trials are free.
Disclosure: I am/we are long ALGN, BRK.B, CMCSA, FLIR, SYY, TSCO, HOLX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Gloss