This Stock May Be a Buy on This Big Dip

Over the past year-plus, I’ve been pounding the table on why investors should stay away from shares of industrial conglomerate 3M Company (NYSE:MMM). See here and here. The constant theme of those bearish calls? Slowing growth is converging on a rich valuation, and that dynamic almost always results in share price erosion.

That’s exactly what has happened to 3M stock. Over the past several quarters, as global economic expansion has slowed, 3M’s revenue growth rates have likewise slowed. Additionally, margins have compressed. Subsequently, the rich valuation in shares unraveled. Since March of last year, the equity has shed more than 25%.

But the dynamic supporting the 3M stock price today is very different compared to the past-year plus timeframe.

During that period, a premium value on MMM contradicted its slowing growth trend.

Now, though, 3M isn’t richly valued. It’s actually undervalued relative to its historical norm.

At the same time, growth rates have already come down, and could actually improve over the next several quarters.

In other words, previous overhang has cleared.

Now, you have accelerating growth converging on a depressed valuation. Ultimately, that dynamic should spark a nice rally in MMM stock over the next several quarters.

Therefore, I think it’s time to get bullish on 3M stock as it should fly higher into the year’s end.

Why 3M Stock Has Been Killed Recently
In early 2018, 3M was firing on all cylinders.

The global economy had steadily and significantly recovered from a late-2015/early-2016 slowdown, during which 3M’s local currency revenue-growth rates hit the flatline. In 2017, 3M’s growth rates bounced back up to 5%. By mid-2018, local currency revenue-growth rates had climbed to 5.6%.

At the same time, healthy revenue growth was driving strong opex leverage. Also, margins were consistently expanding by 20 to 100 basis points every quarter. This combination was driving robust profit growth, and investors were bullish that the good times would last forever. As such, they bought up MMM stock, regardless of valuation. Eventually, the forward multiple on the stock rose to above 22, versus a five-year average-forward multiple of 20.

Then, the global economy started to cool. 3M’s local currency revenue-growth rates slipped from a 5.6% high in the second quarter of 2018 to -1.1% last quarter. Operating margins went from 100 basis points on expansion in Q2 2018 to 160 basis points of compression last quarter. Profit growth went away. The whole growth story collapsed on itself.

And as that growth story collapsed, the 3M stock price dropped substantially. That’s because before the slowdown, the markets priced shares for big growth to continue for much longer.

Again, it’s the theme I mentioned earlier: MMM stock struggled due to a rich valuation contrasting against a slowing growth narrative.

Why 3M Stock Could Rebound
The bull thesis on MMM stock rests on the idea that the dynamic underlying shares have completely reversed. That is, we moved from an unjustified premium valuation to an overly discounted undervaluation.

This argument breaks down into two parts. First, growth should accelerate from here. Two, once it does, MMM stock will fly higher, since the valuation today is relatively discounted.

On the first part, it does look like 3M’s growth rates will improve from Q1’s depressed base. Over the past several years, local currency organic-revenue growth has hovered in the 0% to 5% range. Extremes on either side of that range have proven unsustainable. When the growth rate has topped 5% (as it did in mid-2018), it quickly retreated. Similarly, when the growth rate dropped into negative territory (as it did in late 2015), it quickly rebounded.

Right now, 3M’s organic growth rate is in negative territory. History says it should bounce back. So do the fundamentals, since the trade headwinds which are weighing on growth should become increasingly less intense over time as the U.S. and China get closer to a deal. Low rates should also help stimulate global economic growth. Consequently, 3M’s growth trajectory should accelerate higher from here over the next several quarters.

With respect to valuation, 3M stock is no longer richly valued. A year ago, its forward-earnings multiple was pushing north of 22. Today, it trades at 18-times forward earnings. The five-year average valuation is 20-times forward earnings. Thus, MMM has gone from 10% overvalued relative to its historical norm to 10% undervalued.

Given that we have a fundamental reversal, it’s logical to likewise expect a flipped result.

Bottom Line on MMM Stock
I’ve been bearish on 3M stock for a long time. But I think that bear thesis has run its course. And with shares down 25% since March of last year, the bull thesis is starting to look compelling.

Over the next few quarters, growth trends should improve. As they do, those improvements will converge on a relatively discounted valuation, sparking a robust recovery.

— Luke Lango

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Source: Investor Place