Archer-Daniels-Midland (NYSE:ADM) has soared in recent years as inflation has driven up commodity prices, although the shares have returned -12% so far in 2023. Even with the declines for the YTD, ADM has returned a total of 9.6% over the past 12 months, as compared to -6% for the S&P 500 (SPY).
ADM’s share price has also benefited from the broad rotation from growth to value over the past year. The iShares S&P 500 Growth ETF (IVW) has returned a total of -15.2% over the past 12 months, as compared to +3.4% for the iShares S&P 500 Value ETF (IVE).
The correspondence between ADM’s share price and the 10-Year Treasury yield is even stronger than I anticipated. Coming out of the COVID-driven lows of early 2020, ADM rose with the broader market. Bond yields started to rise in mid-to-late 2020 and went from lows of about 0.5% in early August of 2020 to over 4% in the 4th quarter of 2022. Given that the market views ADM as an inflation hedge, the declines in ADM for the YTD, as inflation has begun to moderate, makes sense.
ADM’s earnings have risen rapidly in recent years, as one would expect given the inflationary environment. Earnings are expected to fall in the coming years. The consensus outlook for EPS growth over the next 3 to 5 years is -5.1% per year.
I last wrote about ADM on August 11, 2022, at which time I upgraded the shares from a hold to a buy. In the 6+ months since this post, ADM has modestly outperformed the S&P 500. At the time of this analysis, the Wall Street consensus rating on ADM was a buy, with a 12-month consensus price target that corresponded to an expected total return of 13.6%. The most recent earnings, for Q2 of 2022, were very strong and EPS exceeded the consensus expected level by 25%. The forward P/E was 12.3, in the mid-to-low range of values over the trailing 5 years. The market-implied outlook, a probabilistic price forecast that represents the consensus outlook from the options market, was slightly bullish until early 2023, with expected volatility of 31% (annualized). As a rule of thumb for a buy rating, I want to see an expected 12-month total return that is at least ½ the expected volatility. The expected return from the Wall Street consensus fell slightly short of this threshold. I concluded the post by noting that “I don’t expect large gains, but I like the inflation-offsetting aspects of owning ADM.”
Given the slightly positive overall outlook, I noted that selling covered calls against ADM looked attractive. At that time, it was possible to sell at-the-money call options (strike price of $85) expiring on January 20, 2023 which provided 7.2% in income over the next 5.3 months (from the date I was writing the analysis to January 20th).
For readers who are unfamiliar with the market-implied outlook, a brief explanation is needed. The price of an option on a stock reflects the market’s consensus estimate of the probability that the stock price will rise above (call option) or fall below (put option) a specific level (the option strike price) between now and when the option expires . By analyzing the prices of call and put options at a range of strike prices, all with the same expiration date, it is possible to calculate the probable price forecast that reconciles the option prices. This is the market-implied outlook and represents the consensus view among buyers and sellers of options. For a deeper discussion than is provided here and in the previous link, I recommend this outstanding monograph published by the CFA Institute.
I have calculated updated market-implied outlooks for ADM and I have compared these with the current Wall Street consensus outlook in revisiting my rating.
Wall Street Consensus Outlook for ADM
Seeking Alpha calculates the Wall Street consensus outlook for ADM by aggregating the views of 16 analysts who have published ratings and price targets within the last 90 days. The consensus rating is a buy, as it has been for all of the past 3 years (a period over which the annualized total return for ADM is 26.2% per year). The consensus 12-month price target is 22.5% above the current share price, for an expected total return of 24.7% over the next year.
Of the 16 analysts included in this calculation, 6 have a rating of “strong buy” on ADM, 2 have a “buy” rating, 7 assign a “hold” rating and 1 has a “sell” rating.
Market-Implied Outlook for ADM
I have calculated the market-implied outlook for ADM for the 3.6-month period from now until June 16, 2023 and for the 10.8-month period from now until January 19, 2024, using the prices of call and put options that expire on these dates. I selected these specific expiration dates to provide a view to the middle of 2023 and through the entire year.
The standard presentation of the market-implied outlook is a probability distribution of price return, with probability on the vertical axis and return on the horizontal.
The outlook to June 16th has the peak probability outcome at a return of +1%, but the most significant feature of the distribution is the asymmetry in probabilities due to the shape of the distribution. The probabilities of positive returns tend to be higher than those for negative returns of the same magnitude. Compare, for example, the probability of having a +5% return to the probability of having a -5% return. The expected volatility calculated from this distribution is 25.2% (annualized), slightly higher than the 24% implied volatility that ETrade calculates for the options expiring on June 16th. The expected volatility back in August was 31%.
To make it easier to compare the relative probabilities of positive and negative returns, I rotate the negative return side of the distribution about the vertical axis (see chart below).
This view shows that the tilt in probabilities to favor positive returns is consistent across a wide range of the most-probable outcomes (the solid blue line is well above the dashed red line over the left ⅔ of the chart above). This is a bullish market-implied outlook to the middle of 2023.
Theory indicates that the market-implied outlook is expected to have a negative bias because investors, in aggregate, are risk averse and thus tend to pay more than fair value for downside protection. There is no way to measure the magnitude of this bias, or whether it is even present, however. The expectation of a negative bias reinforces the bullish interpretation of this outlook.
The market-implied outlook for the 10.8-month period from now until January 19, 2024 is also bullish, with a clear tilt in probabilities to favor positive returns. The expected volatility calculated from this distribution is 26.7% (annualized).
Given the uncertainties surrounding forecasting the trajectory of inflation and the sensitivity of ADM’s earnings, some investors may want to consider selling covered calls to manage this risk. At the time that I pulled the options quotes for this analysis, ADM was trading at $81.39 and the bid price (the price the market will pay) for a call option with a strike of $82.50, expiring on January 19, 2024, was $8.30. Buying the shares and selling this call option provides an option premium income yield of 10.2% ($8.30 / $82.39) in addition to expected dividend yield of 1.7%, for a total yield of 11.9% over the next 10.8 months. For context, ADM’s annualized return over the past 10 years is 11.4% per year.
ADM has performed extremely well over the past several years, boosted by inflation surging to multi-decade highs in addition to a market shift to favor value stocks relative to growth over the past year. While management certainly deserves credit for some of the earnings performance, there is no question that the macro environment has been extremely helpful. Going forward, inflation is slowing, and the prevailing view is that earnings are entering an extended decline. The Wall Street consensus rating continues to be a buy and the consensus 12-month price target corresponds to an expected total return of 24.7% over the next year, in line with the 26.2% annualized return over the past 3 years. The market-implied outlook for ADM is bullish to the middle of 2023 and into the beginning of 2024, with expected volatility in the range of 25%-27%. Taking the Wall Street consensus price target at face value, the expected total return is close to the expected volatility, suggesting a very favorable risk-return balance. The rapidity of the sell-off in ADM since the beginning of 2023 suggests some caution because the market could sour on ADM very quickly if inflation abates more rapidly than expected. Overall, however, the positive outlook from the Wall Street consensus and from the market-implied outlook support a continued favorable view on ADM. I am maintaining a buy rating on ADM.