I have yet to write a public article about Cigna (NYSE:CI), but I did buy the stock about a year ago when I suggested it was “buy” for members of my investing service, The Cyclical Investor’s Club, on 3/1/21. Since then, in absolute terms, it has performed pretty much in line with expectations, and I honestly haven’t paid a whole lot of attention to it.
While the ride has been a bit choppier, Cigna’s returns have equaled those of the S&P 500, and produced results more or less in line with their earnings growth over this period.
In this article, I will make the case that in the current late-cycle environment, Cigna stock would be a solid addition to most investors’ portfolios because of its steady earnings growth and relatively defensive nature. It has little exposure to rising energy costs or a broad tech sell-off, which could send the major market indices down even farther from here.
A Consideration Before Analyzing Cigna
There are a lot of well-established valuation techniques investors frequently use, and many of them can be traced back to a particularly successful investor or a broad school of academic thought. Most investors adopt one or more of these schools of thought or they mimic investors that have had success in the past. I am a little different because I create my own valuation techniques and strategies (I now use four unique strategies in combination at the portfolio level). While many of my techniques have drawn on lessons from historical investors like Lynch, Fisher, Buffett, or Dalio, they are not exactly the same. For that reason, I tend to care about and watch for different things than most investors do, and I tend to use my own set of rules and guidelines that are specific to my strategies.
One of those guidelines is that I typically don’t buy the stocks of businesses that have recently taken part in big M&A. (I roughly define “big” as more than 20% of the acquirer’s market cap.) Usually, I wait about three years before I consider buying a stock after it has had big M&A, but sometimes if the price looks really attractive and I have extra cash I’ll buy a little sooner than that. There are many reasons why I have this M&A rule. The first reason is pretty simple, usually, the purchasing company overpays for the company they are buying and it takes a few years to see whether it was a good deal or not and for the stock price to respond appropriately (usually after things have been written down). The second reason is that often big acquisitions are made precisely because management is responding to competitive pressures, so there is often increased disruption risk with a business that feels it needs to make a transformative purchase. And the third reason is that it can throw off some of my valuation metrics, so it makes it harder for me to value the stock quickly (and I like to be able to value quickly because it gives me an edge).
Cigna made a very big acquisition of Express Scripts in 2018. However, I had been following Express Scripts at the time and it looked like Cigna paid a reasonable price for it. Usually, however, if I’m looking at a stock that has previously closed a big purchase, I’m rarely familiar enough with the acquiree’s valuation at the time to judge whether it made sense or not. In this case, since I was at least somewhat familiar with it, I bought Cigna’s stock a little sooner than my typical 3-year waiting period requires when I bought Cigna last year. Now, however, the full three years are up, so Cigna fully passes this initial test and waiting period, and I feel more comfortable writing about it publicly. One can see, though, that Cigna’s performance since they closed that deal, while okay in absolute terms, has only returned about 1/3rd of the S&P 500’s returns.
With this issue addressed, let’s now get into the basic valuation process for Cigna today.
As part of the analysis, I calculate what I consider to be the two main drivers of future total returns: Market Sentiment returns and Business returns. I then combine those expected returns together in the form of a 10-year CAGR expectation and use that to value the stock.
Before I begin this analysis, I always check the business’s long-term earnings patterns in order to ensure that the business is a proper fit for this sort of analysis. If the historical earnings 1) don’t have a long enough history 2) are erratic in nature, or 3) are too cyclical, then I either avoid analyzing the stock altogether or I use a different type of analysis that is more appropriate.
Cigna has a full 20-year earnings history on FAST Graphs and for most of the years in this period, EPS has grown at 11-12% on average and analysts expect similar levels of growth to continue for the next three years. Out of these 20 years, there have been three official recessions, during the 2001/2 recession Cigna’s earnings growth fell for two years for a total of about -24%, during the 2008 recession earnings growth fell -14%, and there was one mid-cycle earnings growth decline in 2016 of a modest -6%. I would describe this overall earnings cyclicality as low-to-moderate in nature. Because its earnings history is not particularly cyclical and earnings have shown solid growth, Cigna meets all of the basic requirements for the Full-Cycle Analysis I’m about to share.
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. Since we have had a recent recession (albeit an unusual one), I’m starting this cycle in fiscal year 2014 and running it through 2022’s estimates.
Cigna’s average P/E from 2014 to the present has been about 13.82 (the blue bar circled in gold on the FAST Graph). Using 2022’s forward earnings estimates of $22.49 (also circled in gold), Cigna has a current P/E of 10.84. If that 10.84 P/E were to revert to the average P/E of 13.82 over the course of the next 10 years and everything else was held the same, Cigna’s price would rise and it would produce a 10-Year CAGR of +2.43%. 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 +9.20%. The way I like to think about this is, if I bought the company’s whole business right now for $100, I would earn $9.20 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 EPS growth rate since 2014, 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).
Because Cigna issued a bunch of shares for the Express Scripts purchase, I am going to use the buybacks before the purchase, and also after the purchase, excluding the shares that were issued for the purchase. This should produce a more conservative earnings growth rate assumption.
From 2014 to late 2018 they bought back about 9.32% of shares outstanding.
And over the past three years or so they repurchased another ~16% of the company’s shares outstanding. So, overall I estimate they’ve bought back about 27% of the company since 2014 and I will adjust for the reduction of shares in my earnings growth estimates. I will also adjust for the one year when there was a -6% decline in EPS growth during this period.
After doing that, I calculate an annual earnings growth rate of about +10.73%. That is more conservative than FAST Graph’s +13.69% number during this time, but it is right in line with analysts’ future expectations and also Cigna’s most recent performance, so it strikes me as a reasonable earnings growth estimate.
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 Cigna’s whole business for $100, it would pay me back $9.20 plus +10.73% growth the first year, and that amount would grow at +10.73% 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 $265.14 (including the original $100). When I plug that growth into a CAGR calculator, that translates to a +10.24% 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 Cigna, it will produce a +2.43% CAGR. If the earnings yield and growth are similar to the last cycle, the company should produce somewhere around a +10.24% 10-year CAGR. If we put the two together, we get an expected 10-year, full-cycle CAGR of +12.67% 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. That makes Cigna a “Buy” at today’s price. (I take small, 1% weighted positions when using this strategy. And reserve the option to add an additional 1% weighted position at a later date if the price drops dramatically.)
An Additional Consideration: Recession P/E
The second consideration with Cigna has to do with downcycles and Cigna stock’s likely decline during a recession. Since I have judged we are currently late in the economic cycle, I prefer to not hold stocks that are likely to fall dramatically during recessions, and I have sold most of the stocks in my portfolio that have a history of deep price or earnings declines during recessions (with a few exceptions).
The question of how Cigna’s stock will perform during the next recession is a difficult one to answer because the last “real” recession was in 2008/9, quite some time ago and it was under very different circumstances than those we have today. Below is a FAST Graph with some added annotations from me. It states the monthly low recession P/Es for the last three recessions for Cigna.
Cigna’s current forward P/E is about 10.84. During the Great Recession that P/E went as low as 2.54. Part of the reason for that went beyond the recession itself because there was a belief among many that President Obama and a Democratic Congress would effectively nationalize health insurance. So, I think the next recession will be truly different in that regard and I wouldn’t expect the P/E to fall that low again. During the 2001/2 recession, the P/E bottomed at double that number, around 5.4, and in 2020 it bottomed at 8.19, considerably higher. I have decided to use that 8.19 P/E as a recession expectation for the next recession because I think Cigna is positioned much better for a potential recession this time around than it was in previous recessions. That number might be a little optimistic on my part, and Cigna could certainly fall farther than that, but I think if you buy the stock with a 10 P/E or less, even if the stock falls more during a recession, it will bounce back in a timely manner so there won’t be much to really worry about.
The above chart shows Cigna’s historical price drawdowns. If I just saw this and nothing else I would think that Cigna was in a particularly cyclical industry. But if we look at Cigna’s earnings drawdowns, they aren’t nearly as steep, only about -24% in 2001, -14% in 2008/9, and -6% in 2016. In contrast, the price dropped over -75% in the 2001 and 2008 recessions. I would not expect a price decline that steep during the next recession, but if it were to happen, I would add to my position. Basically, I want investors to understand what is possible in terms of a drawdown here even though I think the odds of it happening are small, and to be prepared to make one more purchase if the stock ends up down, say, -60% or so off its highs.
Overall, I think given the nature of where things stand right now with supply chain issues, rising interest rates, deglobalization, high energy prices, and a withdrawal of fiscal stimulus from the government, healthcare overall will be viewed as a defensive sector during the next downturn.
If an investor thinks a recession is on the horizon and would like to buy at a P/E closer to the recession P/E, I typically like for stocks during downturns (which we are likely going into soon) to be within 20% of the recession P/E. For example, if the recession P/E is 10, then I wouldn’t buy until the current P/E was under 12. If you think the 8.19 recession P/E is reasonable to use, then you would be looking at a buy price a little lower than today’s, at around $230 per share. Since I bought my position a year ago when we were far away from a recession, this was not a consideration I used at the time. With a business this solid, I would probably go ahead and use the higher P/E, and then plan to buy more, as I mentioned earlier if the stock fell -60% off its highs. That would put a second deep buy price at about $109 per share.
I think overall, taking a small position in Cigna right now makes sense. If we don’t have a recession anytime soon, the stock is poised to produce very good returns over the long term. And if we do have economic troubles, they seem unlikely to impact Cigna as much as other businesses. Political threats seem very unlikely any time soon, and the stock is trading at a very reasonable valuation both in absolute and relative terms. If we do have a bad recession, and the price drops a lot, this is a position that could be added to, or simply held through the downturn since it will likely come out the other side just fine.