Several weeks ago Deere & Company (NYSE:DE) was down 3.34% on a Friday, closing at $89.13. A downgrade from JP Morgan was the driver, with an assist from Goldman Sachs, which included Deere in a list recommending the purchase of puts based on seasonal patterns. The share price has since bobbed back up.
Ben Graham suggested the use of 5 or 7 year average EPS as a way of smoothing out the business cycle. This seems quaint in a market where last quarter’s earnings and guidance govern prices. However, it’s still a valid point of view, and particularly useful for cyclical stocks.
My current version of this technique includes the use of projected earnings for the current year, and a method of weighting previous years so that the distant past is reduced in importance. In addition, and this is important in today’s market environment, current share counts are projected to give effect to buybacks. Here’s how I did the math:
Please consider that this analysis includes 2009, so we have two troughs based on the idea that 2015 will be a low point. Also, in 2009 an average 429 million shares were outstanding, compared to an actual count of 339.5 million at the end of the most recent quarter. The computation method employed here compensates for the reduced share count.
The multiple of 15x here was suggested by Graham. As a practical matter, high quality non-cyclical companies are trading at around 22x on this metric. I used 15x as Deere is definitely cyclical, driven not only by the general business cycle but also by agriculture which has its own rhythms.
If it takes two years for Deere to reach this target, the investor will receive 15% annualized share price appreciation, as well as the dividend, currently yielding 2.6%.
If it takes four years, and with the company buying back 3% of shares per year, price appreciation would be 10% annually, not too shabby, and you could add the dividend.
The downside risk here is very manageable. Warren Buffett is an owner, and added to his positions, according to the 13F-HR filed for the first quarter. I conjecture that Deere meets Buffett’s rule #1, as well as #2.
Strategy and Tactics
Goldman Sachs notes that Deere is prone to seasonal declines during the summer, and suggests buying puts. As Buffett says, selling puts won’t get you in at the bottom. Neither will buying them.
Consulting a Ned Davis Seasonality chart, available from my Schwab account, Deere has a distinct tendency to underperform in June and July.
The market is very fairly valued, and the S&P 500 is making new highs. Taking all of this together, there will possibly be better entry points available.
I’ve been holding and trading around a normal size position since June of 2013, with fine profits. Following the JPM downgrade, I added a vertical call spread, long DE Dec 2015 82.5 calls and short Dec 87.5 calls. If the price is below $87.5 at expiration, I will be the proud owner of additional shares, well below my estimate of fair value. If not, I will have a profit on the spread.
Deere is suitable for Dividend Growth or buy, hold and monitor investors. Accumulate while monitoring would make sense here.
A Philosophical Digression
These are uncertain times, and none of us can foresee the future. However, it is likely that seedtime and harvest will continue into the indefinite future, and that Deere will continue as a major provider of agricultural machinery on a global basis.
Technically the correct way to value a company is discounted cash flow, looking out for decades. But doing the math on it is an exercise in futility, since future interest rates and cost of equity capital are impossible to foresee. We can only assume that the future will be consistent with trends that are visible from the past. Certainly something as basic as farming would be subject to those assumptions.
Under this line of thinking, the expected global glut of corn in 2015 isn’t that important. Deere expects to show a profit, and to generate free cash. The company pulled through the financial crisis of 2008/2009 with flying colors. The key to this investment is patience and a long-term view.