Honeywell (NASDAQ:HON) shares saw a substantial rally at the end of 2020, but YTD the total return for the diversified technology and manufacturing company is only 5.1% compared to 19.4% for the broader US equity market. Over the past three months the stock has fallen 4.8% while the US equity market as a whole has returned 3.2%.
The start of the recent decline for HON generally corresponds to its Q2 earnings report on July 23, when the company beat the expected EPS by a small margin (reported EPS of $2.02 vs. expected EPS of $1.94). The current share price is 5.8% below the YTD high close on Aug. 11 and investors will be closely watching its Q3 earnings report on Friday, Oct. 22 to see if it will provide any impetus for the share price.
Source: Investing.com
The path ahead for HON seems clear, as the firm becomes more focused on software, as well as an effort in quantum computing. This is important for earnings growth potential and also in shaping investor perception that the stock can support a higher multiple. We have seen this trend across a range of more traditional industrial manufacturers (General Motors (NYSE:GM) and Ford (NYSE:F) building out EVs and autonomous vehicles, for example).
Honeywell is also building out capabilities in renewable energy products and services. This area has advantages for both earnings growth and capitalizing on investor interest in clean energy. Honeywell already runs a major business line in building management systems, which is a key element in making building more energy efficient.
With a forward P/E of 24 and a forward dividend yield of 1.8%, the stock looks quite expensive by historical standards, but relatively cheap when considered relative to tech firms. As HON derives more revenue from software and computer technology, not to mention clean energy, there is room for a higher multiple.
The question for investors, of course, is timing. The market is waiting for more evidence that the company can deliver on its vision, as evidenced by the relative stagnation in the share price vs. the broader market for the YTD. The expected near-term earnings growth is low (4%), but the longer-term outlook is much better (3-5 year expected EPS growth of 12% per year).
Along with looking at fundamentals, I rely on two forms of consensus outlooks when analyzing a stock. The first is the well-known Wall Street analyst consensus. The second is the market-implied outlook, which is a probabilistic forecast of the share price representing the consensus view of buyers and sellers of options.
The price of an option reflects the market’s consensus on the probability that the price of the underlying stock will rise above (call option) or fall below (put option) a specific level (the strike price) between now and when the option expires. By analysing prices of put and call options at a range of strikes, and a common expiration date, it is possible to calculate a probabilistic outlook for the share price that best reconciles all of the options prices. This is the market-implied outlook. For more information on this approach, including links to the relevant financial literature, see this overview.
Wall Street Consensus Outlook for HON
ETrade calculates the Wall Street consensus using the views of 9 ranked analysts who have published ratings and price targets within the past 90 days. The consensus rating is bullish and the consensus 12-month price target is 8.6% above the current share price. The dispersion among the price targets is unusually low (relative to other stocks I have examined). Higher agreement between the analysts tends to add confidence in the predictive value of the consensus price target.
Source: ETrade
Investing.com constructs the Wall Street consensus outlook from ratings and price targets of 26 analysts. The consensus rating is bullish and the consensus 12-month price target is 10.2% above the current share price.
Source: Investing.com
The Wall Street consensus outlooks calculated by ETrade and Investing.com are both bullish, with expected 12-month total returns (including the current forward dividend yield) of 10.4% and 12%, respectively. Whether or not this is attractive depends on the expected risk level, which is calculated in the next section.
Market-Implied Outlook for HON
I have analyzed call and put options on HON at a range of strike prices, all expiring on Jan. 21, 2022, to calculate the market-implied outlook for HON for the next 3.1 months (from now until the expiration date). I have also generated the 8-month market implied outlook from options expiring on June 17, 2022.
The standard presentation of the market-implied outlook is in the form of a probability distribution of price return, with probability on the vertical axis and return on the horizontal.
Source: Author’s calculations using options quotes from ETrade
The market-implied outlook to Jan. 21, 2022 is generally symmetric, although the maximum probabilities are clearly tilted to favor positive returns (a bullish indicator). The peak probability corresponds to a price return of +2.6%. The distribution is somewhat negatively skewed. The probability of having a return of -20% over this period is about twice as high as having a return of +20%, for example. The annualized volatility calculated from this distribution is 22%, which is low for an individual stock.
To make it easier to directly compare the probabilities of positive and negative returns of the same magnitude, I rotate the negative return side of the distribution about the vertical axis (see chart below).
Source: Author’s calculations using options quotes from ETrade. The negative return side of the distribution has been rotated about the vertical axis.
From this view, it is evidence that the probabilities of positive returns are consistently higher than for positive returns of the same scale, for a wide range of the most-probable returns. This is a bullish outlook for HON.
Theory suggests that the market-implied outlook is expected to have a negative bias because investors, in aggregate, are risk averse and, as a result, are willing to pay more than fair value for put options. In addition, dividend-paying stocks tend to have a negative tilt in the market-implied outlook because the dividends reduce the potential price appreciation. Considering both of these factors makes the market-implied outlook appear even more bullish.
Looking out to the middle of 2022, the 8-month period from now until June 17, 2022, the market implied outlook is generally neutral but still looks slightly bullish when the risk aversion bias is considered. The annualized volatility derived from this distribution is 24%.
Source: Author’s calculations using options quotes from ETrade. The negative return side of the distribution has been rotated about the vertical axis.
The market-implied outlook for HON is bullish, with the strength of the bullish signal becoming somewhat muted by the middle of next year. It is common for the market-implied outlook to express a diminishing directional signal for longer time periods, for which there is simply less confidence in the outlook. The expected volatility, 22% to 24%, is on the low end for individual stocks.
Summary
The outlook for HON is generally bullish, as the firm ramps up higher-margin business lines in software, computing, and clean energy. The Wall Street consensus outlook is bullish, with expected 12-month total return of 10.4% (ETrade) to 12% (Investing.com).
While this is not an especially high level of expected gain, the risk level for HON is quite low, with expected volatility in the range of 22% to 24%.
As a rule of thumb for a buy, I look for an expected 12-month return that is at least half the expected (annualized volatility). HON is right about at the cutoff. The market-implied outlook to early 2022 is bullish, shifting to slightly bullish at mid-year. My overall rating for HON is bullish.