Reduced Recession Risk
I’ve been writing about earnings “bust” bear market and recession risk for about two years now on Seeking Alpha. Over that time, the earnings bust occurred for most businesses that had experienced a “boom” from the pandemic, stimulus money, and supply chain issues that followed, but the economy hasn’t gone into recession, yet. Two of the three big remaining catalysts for a recession have been diminished recently, while one will persist into next year. The one recession catalyst that will remain with us for some time is the repayment of student loans, which only started two months ago. We have seen credit card debt and delinquencies rise since then, so there will be continued economic restrictions from student loan repayment as time goes on, but the other two recession catalysts have been diminished. The first of those is gasoline and fuel prices, which have dropped significantly, and are immediately felt by consumers. The second occurred this past month with interest rates falling significantly.
The 10-year US treasury yield has fallen nearly -20% in two months and currently stands near 4%. Even though the Federal Reserve did not move short-term rates, any time long-term rates fall this much it gives borrowers a chance to refinance or to be able to make a purchase they previously could not afford to make for big-ticket items. Additionally, it gives a little relief to those borrowers who may be right on the edge of delinquency and default. In short, even if rates eventually come back up, this sort of move gives the Fed more time to adjust, and it reduces the immediate risk of deep recession.
This is important for a somewhat economically sensitive stock like Interpublic Group (NYSE:IPG) which also carries some debt. While I don’t think IPG is out of the woods, and while I don’t think a recession is completely off the table, the odds of a near-term deep recession have decreased. This means the biggest risks associated with an advertising and marketing business like IPG have been mitigated, and we can examine the valuation of the stock in light of this reduced cyclical risk.
Historical Earnings Cyclicality
The first thing I always check when analyzing a stock is what the historical earnings pattern has been. Earnings cyclicality is the main thing I check for, but I also look for other patterns like stagnation, unusual rises or declines, or erratic fluctuations that can’t be easily explained. If I determine the historical earnings are cyclical, then I usually don’t use earnings to value the stock because they can be too unpredictable and can often send the wrong signals regarding valuation. Also, if earnings are very erratic I sometimes immediately put the stock in the “too hard pile” if I don’t think historical earnings are a reasonably good guide for the future.
IPG suffered a -57% EPS decline in 2009, a -5% decline in the weak economic year of 2012, and a -10% decline in 2020. So, they have a history of their earnings being economically sensitive if the economy is struggling or in recession, and the -57% decline in 2009 was quite significant. However, their earnings more than fully recovered immediately after the years in which the declines occurred, and if an investor had held through those downturns they would have done fine as long as they didn’t pay too much for the stock. So, I think as long as investors understand that these earnings declines will happen and are prepared for them, the worst outcomes can be avoided. And as long as we take these declines into account when estimating earnings growth I don’t think IPG is too cyclical to use my typical “full cycle” valuation approach, which focuses on earnings and earnings growth.
Interpublic Group’s Current Valuation
The most basic way I perform a valuation for a moderately cyclical stock like IPG is to calculate how much in earnings I would likely collect over a 10-year period if I owned the business and kept all the earnings for myself. I convert that amount of collected earnings into a CAGR percentage and use that percentage to decide whether or not the valuation is attractive. I do this by using a combination of earnings yield and earnings growth expectations. I typically base my earnings growth expectations on what the growth rate has been over the previous economic cycle. In this case, I’m going to begin with the historical earnings growth since 2015, so we include the down year in 2020.