Honeywell (HON) - Get Report recently posted a strong earnings report, causing the stock to pop a couple of percentage points on an earnings beat and raised annual guidance. This upward momentum continues the trend that shares have been on all year. Honeywell shares are up nearly 32% year-to-date. The company is outperforming its large cap peers, solidifying itself as the best-in-breed name in the industrial space. Looking at the stock's chart and the company's operational performance results, it's very difficult to find anything to critique. But, as the share price creeps higher, valuation becomes a concern. Right now it appears that Honeywell is priced for near perfection and conservative investors should be wary of the stock's elevated multiples.
After its recent run-up, Honeywell shares are trading at multiples well above the stock's long-term averages. The company's average trailing twelve-month price-to-earnings multiple over the 20 years is approximately 16.5x. Over the last 10 years, Honeywell's average backwards looking multiple is approximately 16x. And, over the last 5 years, the stock's average ttm P/E ratio is 17.05x. All of these figures are significantly below the 21.5x multiple that the market has placed on shares today.
Honeywell shares do have a habit of rising up to similar highs prior to previous recessions. During the dot-com boom at the turn of the millennia, Honeywell shares sky rocketed. That's when the market placed a near-30x premium on them, marking the highest valuation that they've seen at any point during the last 20 years. Yet, when the dot-com boom went bust, Honeywell suffered alongside the rest of the market. It's share price was cut in half and its P/E multiple fell to just 11x.
Over the next decade, the stock recovered (as most blue chips tend to do), with valuations hovering in the 15x to 20x range. In 2007, the premium associated with Honeywell shares increased from 16x to 19x. We all know how 2008/2009 played out. It wasn't long before Honeywell saw its share cut in half again. At the trough of the Great Recession, Honeywell shares traded for just 7x earnings.
Not only does the stock's current valuation represent a stark premium relative to historical averages, it also coincides with a more recent resistance level that Honeywell shares have bumped up against 3 other times during the last 2 years. In each case, the stock failed to break through and ultimately sold off to varying degrees.
In January of 2018, Honeywell topped out at $153/share and a 21.3x multiple before experiencing a 10.5% pullback to the $137 range where the stock's premium was 18.3x. Then, the stock rallied, climbing up to nearly $160/share and a 20.5x multiple in September of 2018 before falling 17.5% to the $124 area during the Christmas Eve sell-off last year where the stock's multiple was less than 16x. Since then, we've seen the stock rally to the $175 area where it sits today with a 21x+ multiple.
Using The Past To Try To Reduce Risk
So, what does all of this backwards looking data mean? Is the stock poised for another double digit sell-off? Without a working crystal ball, I have to give the cliché answer: only time will tell.
While it's certainly true that the past cannot be used to accurately predict the future, I think it can be helpful when analyzing risk. It can be said that elevated multiples like the ones applied to Honeywell today reduce the margin of safety that shares offer investor. In an efficient market, a reduced margin of safety typically results in increased downside risk (especially if operations slow down, resulting in multiple contraction).
It also means that prospects for future returns are reduced, even if the company continues to perform well due to the likelihood that the share price will consolidate while the fundamentals catch back up. For instance, right now analysts expect to see Honeywell produce 10% EPS growth in 2020 and 2021. If the current consensus 2021 EPS estimate of $9.80 holds true, Honeywell will still be trading with a 17.7x multiple come December of 2021. This figure is still well above historical averages, showing how overvaluation can put pressure on share price appreciation during strong periods of prosperity.
It is true that the market is often irrational for extended periods of time and therefore, it's impossible to predict when (or even if) Honeywell's current elevated valuation premium will come back to haunt shareholders. Personally, I'm long the stock and I have no inclination to sell my shares because I believe that a best-in-breed name like Honeywell should be owned and not traded. However, I'm also not temped to increase my exposure to the stock by chasing the recent rally because of the relatively lofty multiples. Even when buying the bluest of blue chips, valuation should not be ignored.
Nicholas Ward is long HON.