Cognizant: Patiently Waiting For A Growth Turnaround

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Introduction

There is a scene in the movie “Star Wars: The Empire Strikes Back” when Han Solo, while being chased by Imperial forces, prepares to fly into an asteroid field. The droid C3PO, alarmed by this decision, informs Solo “Sir, the possibility of successfully navigating an asteroid field is approximately 3,720 to 1″ to which Solo replies “Never tell me the odds” and continues into the field.

When it comes to investing, I’m no Han Solo. I want to have at least a rough approximation of what the odds of success are with every investment I make. In fact, one of the reasons I have an unconcentrated portfolio (at least with regard to initial positions) is so that I can estimate what my success or failure rate is over time. In order to reduce the chances that the results of a strategy are the result of luck, the more data points one has, the better. As a rule of thumb, I like to have around 30 data points, spread out over time, to help convince me that luck was likely not the primary cause of an aggregate outcome. What I’m really after are strategies that are repeatable over time, that I can have some confidence that 3-5 years into the future a certain percentage of my ideas will produce above average results. In other words: Tell me the odds.

I’ve only written one previous Seeking Alpha article on Cognizant Technology Solutions (NASDAQ:CTSH) titled “Cognizant: A 10-Year Full-Cycle Analysis” back in September of 2019, soon after I bought the stock. I still hold the stock today. Here is how it has performed compared to the S&P 500 (SPY) since that article.

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CTSH Total Return Price data by YCharts

Overall, it has been a rocky road for Cognizant stock. While returns are positive, and decent, at around 20%, they aren’t great and have lagged the S&P 500 during certain periods, including right now.

There are three basic categories that an investment can fall into over time: an outperformer, an underperformer, or a loser. Cognizant, so far, is an underperformer. Which is a stock that has produced positive returns, but not done as well as the index. Basically, it’s in the middle of being a clear winner or loser. In this article, I’m going to share some general thoughts about my investing strategy and how I think about stocks like Cognizant in my portfolio. I’ll also share what my expectations for Cognizant stock are, and the metrics that I track and care about when considering whether to keep holding the stock or to sell it and cut it loose.

The Full-Cycle Earnings Strategy

In my marketplace service, The Cyclical Investor’s Club, I use a mix of 5 different investing strategies to create a well-diversified stock portfolio with the goal of achieving 15-20% annual total returns over the long-term. The most-used of those strategies is what I call the Full-Cycle Earnings strategy. That is the strategy and analytical approach I used to buy Cognizant back in 2019. At the time, the Full-Cycle Earnings strategy was only about 6 months old, so, I didn’t have much real-world data on how it would perform. Now I have a lot more data, which is worth reviewing.

Since I started using this approach, I’ve fully realized 32 positions, with an average holding period just under one year. That’s shorter than I would normally expect the average holding period to be, which is generally somewhere between 3-5 years, but because of the crazy-fast market recovery in 2020 and early 2021, I ended up taking profits earlier than I would normally expect with many stocks. The average total return for these realized positions was +74.10% compared to the S&P 500’s total return over the same time periods of +42.31%. In this case, the relative returns compared to the index are more important than the absolute returns because as I said, I would normally expect this process to take an average of 3 years to play out instead of 1 year. So, I do not expect long-term returns of the strategy to be over +70% per year! But we can see there was dramatic outperformance even on a relative basis, using a pretty good sample size of 32 positions.

Here is how they broke down by the three basic categories I shared earlier:

  • Outperformers: 23 positions, about 72%
  • Underperformers: 5 positions, about 16%
  • Losers: 4 positions, about 12%

Overall, these are excellent results for the realized portion of the strategy. Now let’s include the positions I currently hold that have not been realized as well. In total, I am currently holding 39 Full-Cycle Earnings stocks. The average holding period with these is roughly 2 years. The approximate total return is +32.58% compared to SPY’s +26.61% if purchased on the same date. So, still some modest outperformance here, but not quite as dramatic as the already realized positions. Here is how these unrealized holdings break down into the three performance categories:

  • Outperformers: 21 positions, about 54%
  • Underperformers: 8 positions, about 21%
  • Losers: 10 positions, about 25%

Importantly, I’m still holding many of these because I expect them to do better over time, whereas the realized positions I had judged that the future was not as bright as the past. So, my expectation is that the performance of the current holdings will improve as time goes on. Still, we have another 39 positions, that are net outperforms on average.

Now let’s combine these two data sets together, and see what sort of relative outcomes we might reasonably expect from the strategy. There are 71 total data points.

  • Outperformers: 44 positions, about 62%
  • Underperformers: 13 positions, about 18%
  • Losers: 14 positions, about 20%
  • Positive Return Likelihood: ~80%
  • Negative Return Likelihood: ~20%

As I noted above, I expect the returns of the current holdings to improve over time, but as it stands right now, using a very big sample size of 71 individual positions, the strategy is likely to produce positive returns about 80% of the time, and is likely to outperform the S&P 500 about 63% of the time, with the aggregate relative returns also outperforming the index, if the past 3 years are any indication of the future.

Because I use an unconcentrated approach with 71 data points to examine, this is useful information regarding the effectiveness of the strategy. If I only had 5 to 10 data points, it would be much less informative.

I bring all this up, because this informs how I think about my Cognizant investment and what to do with it going forward. Currently it’s an underperformer, and I’m still holding the stock after almost 3 years. The way I typically think about Full-Cycle Earnings investments is that usually I expect to see outperformance within about 2 to 3 years if we don’t have a recession during that time period. If we do have a recession and it affects the business in question, then I might not expect good returns until we get into the 3-5 year range. That’s why, generally speaking, I am always willing to hold any stock I buy for 5 years unless I see signs in a handful of metrics I monitor that my thesis is failing, and then I will sell no matter where my returns happen to stand at the time. I think with Cognizant it could be a fairly murky picture over the next couple of years, and so I thought it might be worth simply sharing how I am thinking about it.

After I buy a stock I think is a good value, I usually keep holding it unless I have a good reason to sell it. Here are some of the reasons I would consider selling my Cognizant position. The most common reason I sell Full-Cycle Earnings stocks is because the stock price has increased so much that the forward earnings are likely to be too low to meet my investment goals. Usually this means I expect a long-term CAGR of 4% or less from the stock. However, there are times when the long-term CAGR expectations fall below that level, not because of price appreciation, but instead because earnings and earnings expectations have declined. My valuation method, which I’ll share later in the article, takes into account both of these possibilities.

Other reasons that I might sell a Full-Cycle Earnings stock is if the cumulative 3-year revenue turns negative, when we are not in a recession. If the wider economy is doing okay, and a business is experiencing a medium-term revenue decline, that’s almost always a sell trigger for me. Also, it’s worth noting that if revenue is struggling a little bit and the company decides to do significant M&A (usually to cover up the revenue trend either by buying some other company or doing some sort of spin-off) that can be a sign that it’s time to sell as well. But, I generally cut businesses slack on revenue trends if we are going into a recession. If they have a rough year, and then the next year we hit a recession, I try not to hold that against them too much. It’s really only when the rest of the economy is doing okay, and the business has declining revenues, I take clear action to sell.

An additional reason to sell is if I judge we are late in the economic cycle (as we are right now) and the stock has a history of very deep price declines. I sold a lot of stocks back in January of this year because they were likely to have their stock prices fall deeply during a down cycle. I don’t always sell every stock that has a history of deep price declines, but it can be a reason sometimes.

And lastly, even if we are in a bear market and/or a recession, and I don’t necessarily feel compelled to sell a stock based on its own merits, if I were to run out of cash in my portfolio during a downturn, and a higher quality business came up for sale at very good price, I would be willing to sell the more marginal business, and trade up to something higher quality that I have a better likelihood to hold for a longer period of time. So far, I’ve always had enough cash to buy whatever I wanted during declines, but it’s possible there will be a time when I run out and choose to upgrade some stocks in my portfolio if some really high quality businesses are particularly cheap.

So, as I examine Cognizant, which has been an underperformer for me the past few years, these are the basic considerations for whether I might want to sell or not, that I’m thinking about.

With that, let’s get on with the analysis.

My Valuation Method

The valuation method I use for Cognizant first checks to see how cyclical earnings have been historically. Once it is determined that earnings aren’t too cyclical, then I use a combination of earnings, earnings growth, and P/E mean reversion to estimate future returns based on previous earnings growth and sentiment patterns. I take those expectations and apply them 10 years into the future, and then convert the results into an expected CAGR percentage. If the expected return is really good, I will buy the stock, and if it’s really low, I will often sell a stock. In this article, I will take readers through each step of this process.

Importantly, once it is established that a business has a long history of relatively stable and predictable earnings growth, it doesn’t really matter to me what the business does. If it consistently makes more money over the course of each economic cycle, that’s what I care about.

Cognizant historical earnings

FAST Graphs

Cognizant’s historical earnings are represented by the dark green shaded area in the FAST Graph above. As you can see, up until 2018, every single year was positive. That is what I categorize as a secular growth stock (at least up until that point). Then in 2019 they experienced their first year of EPS growth decline, which amounted to about -13%, followed by another year of -14%, before EPS started growing again in 2021. This combined decline of about -30% for 2019 and 2020 is below the -50% decline I require to categorize the business as a “Deep Cyclical”, which would disqualify it as stock using the Full-Cycle Earnings strategy. Since, even after the two years of declines, CTSH still wasn’t super-cyclical, while I no longer consider it a secular growth stock, it still fits into the parameters I have established for the Full-Cycle Earnings strategy, so we can carry on with the analysis.

Market Sentiment Return Expectations

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. For this, I’m using a period that runs from 2015-2022.

Cognizant average P/E ratio

FAST Graphs

Cognizant’s average P/E from 2015 to the present has been about 18.71 (the blue number circled in gold near the bottom of the FAST Graph). Using 2022’s forward earnings estimates of $4.55 (also circled in gold), CTSH has a current P/E of 15.33. If that 15.33 P/E were to revert to the average P/E of 18.71 over the course of the next 10 years and everything else was held the same, CTSH’s price would rise and it would produce a 10-Year CAGR of +2.01%. That’s the annual return we can expect from sentiment mean reversion if it takes ten years to revert. If it takes less time to revert, the return would be higher.

Business Earnings Expectations

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 (which is an inverted P/E ratio, so, the Earnings/Price ratio). The current earnings yield is about +6.52%. The way I like to think about this is, if I bought the company’s whole business right now for $100, I would earn $6.52 per year on my investment if earnings remained the same for the next 10 years.

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 historical EPS growth rate, 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).

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CTSH Shares Outstanding data by YCharts

Cognizant has bought back about 15% of the company since this point in 2015. I’ll make adjustments for this, along with adjustments for their two years of declining EPS growth in 2019 and 2020. After doing that, I get an EPS growth estimate for CTSH of +4.84%. This is a conservative estimate, and significantly lower than FAST Graphs +7.63% listed growth rate over this period. It is also much more conservative than analysts’ expected forward earnings growth rate of 9-10% over the next few years as well. But, I think the more conservative estimate reflects the uncertainty of Cognizant’s ability to resume its previous earnings growth trend. Sure, they are putting together two decent years of growth in a row (which is great), but this is during a time when we had tremendous government stimulus and economic growth. It’s much harder to know where this earnings growth rate eventually settles at over the medium and long-term. When I bought Cognizant in 2019, 2020 EPS was expected to be $4.32 per share and ended up being $3.42, and 2021’s was expected to $4.72 per share and it ended up being $4.12. So, we can see that analysts aren’t always right on their forward projections and it’s best to be cautious.

When I bought CTSH, it was trading at a price so low that it had only briefly traded at those levels one other time the previous 5 years. If I hadn’t been conservative in my initial analysis, I would likely be underwater with this investment right now instead of simply underperforming. So, it pays to be conservative sometimes.

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 CTSH’s whole business for $100, it would pay me back $6.52 plus +4.84% growth the first year, and that amount would grow at +4.84% per year for 10 years after that. 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 $185.48 (including the original $100). When I plug that growth into a CAGR calculator, that translates to a +6.37% 10-year CAGR estimate for the expected business earnings returns.

10-Year, Full-Cycle CAGR Estimate

Potential future returns can come from two main places: market sentiment returns or business earnings returns. If we assume that market sentiment reverts to the mean from the last cycle over the next 10 years for CTSH, it will produce a +2.01% CAGR. If the earnings yield and growth are similar to the last cycle, the company should produce somewhere around a +6.37% 10-year CAGR. If we put the two together, we get an expected 10-year, full-cycle CAGR of +8.38% 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. An +8.38% CAGR expectation makes Cognizant stock a “Hold” at today’s price, and almost right in the middle of what I would consider the fair value range.

If you are looking for a price to consider buying Cognizant stock should we have a market sell-off, my buy price for the stock is currently $55.27 per share, roughly -20% lower than where it trades today. This assumes earnings estimates don’t dramatically change in the meantime.

What would make me sell Cognizant stock?

In this section I’m going to run through some of the scenarios that might prompt me to sell my Cognizant stock. The first, is that it becomes overvalued. Assuming nothing changes with the current earnings outlook, if the stock were to rise above $95 per share, it would definitely come under review as a potential sell. Chances are, though, if the price were to rise that high, it’s likely the earnings would have surprised to the upside, so, in reality, it would probably take a higher price to get me to sell the stock for valuation reasons. Right now, though, if the stock rose to over $95 tomorrow, then my expected long-term CAGR would fall below 4%, and I usually take profits when that happens.

Another, perhaps more likely scenario, is that Cognizant’s revenue trend turns negative at some point in the future. I like to use the 3-year revenue trend as my primary guide, because sometimes a tough year of comps can follow a good year, or there can be one-time issues that impact a business from time to time, that don’t really say much about the general direction of the business. As long as we aren’t in a recession, though, the 3-year trend can be very revealing for the business and usually it cuts through most of the actions (besides M&A) that a company can take to try to hide their lack of earnings growth.

Chart
CTSH Revenue (TTM) data by YCharts

Currently the 3-year revenue trend is actually quite good, and as long as this stays positive, I will likely keep holding the stock and give management time to make whatever adjustments they need to make to keep the business growing (which is exactly what I’ve been doing the past three years).

The last potential reason I would sell the stock is if we have a recession and I run out of cash to buy high quality cheap stocks, and I think I’ve found a better business selling at a valuation it is unlikely to sell for unless we are in a recession. In this case I might “trade up” in quality under the right conditions. Right now I am holding about 1/3 cash in my portfolio, so it would likely take at least an average depth recession and bear market for me to get all that cash to work. And even after that, I probably have a few other stocks I would sell that aren’t quite as high quality as Cognizant I would sell first if I needed to raise funds. So, while it’s not impossible I might sell this stock to trade up during a recession, it’s unlikely.

There is always the case that something else weird happens that would cause me to sell, but they are very rare (things like accounting issues, M&A I don’t like, or delistings, etc). The most likely outcome is that I simply keep holding this stock, and if it does as analysts expect and grows earnings 10% per year from here, I should do reasonably well with it. It’s even possible I could get into the low end of my 15-20% annual return goal, still.

Conclusion

Cognizant is a business with a very good track record, which hit a rough patch in 2019 and 2020, and has now (perhaps) turned the corner back to steady earnings growth again. Right now, using conservative estimates, the stock is trading around what I would consider fair value. If the price were to fall to $55.27 and earnings expectations were the same, it would become a buy. If the price were to rise above $95 per share under the same conditions, it would become a sell.

The key metric I am watching to determine whether to sell my holding or not is the 3-year revenue trend. Right now, it looks just fine. But if it were to go negative when economy was not in a recession, that would be a signal for me to sell. What could make that decision harder is if we have a recession next year, which is my base case right now. If that happens, it will be difficult to tell, either from earnings or from revenue trends, what Cognizant’s medium-term prospects will be. Chances are, I would at least hold onto the stock until we were out of the recession for a year in order to see if the business was recovering in a timely manner before I passed judgment. If that recession scenario were to play out, then I will have held Cognizant stock for roughly 5 years, which is plenty of time, even with a recession or two, to judge how my initial thesis played out.

Until then, I patiently wait.

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