Illinois Tool Works stock has been a steady compounder for over a decade. The share price is up ten-fold from the 2009 bottom, handily beating the S&P 500’s return over the same period. More recently, ITW has more than doubled from its 2020 low at $116 to $258 as of this writing. The obvious conclusion is that a long-term investor could hardly make a mistake buying this company’s shares.
On the other hand, while sales have been rising, albeit slowly, free cash flows have stagnated. FCF stands for the actual money a company makes after deducting capital expenditures, which are otherwise not reflected in the income statement. In the case of Illinois Tool Works, the free cash flow figure has been gravitating around $2.5B for over five years now. In other words, the company’s valuation has been growing solely because of multiple expansion rather than actual business growth.
An appropriate word to describe this kind of situation is ‘unsustainable’. At its current market cap of $78B, ITW trades at a P/FCF of 31, which is quite expensive for a no-growth business. But what we think should worry investors even more is the Elliott Wave pattern shown below.
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Valuation doesn’t matter until it does. The moment it usually starts to matter is when the price reaches the end of the positive phase of the market cycle. The weekly chart of Illinois Tool Works reveals a complete five-wave impulse, labelled I-II-III-IV-V. Wave II unfolded during the 2008-9 crisis and was a sharp a-b-c zigzag. Wave III, whose five sub-waves are also visible, was a wonder to behold.
Wave IV, obeying the guideline of alternation between the corrective waves within an impulse, was a sideways retracement in the shape of an expanding flat. Its wave ‘c’ coincided with the Covid-19 panic of March, 2020. The surge from $116 must then be the fifth and final wave of the sequence. It looks like a textbook ending diagonal pattern, marked 1-2-3-4-5. Unlike in a regular impulse, here waves 1 and 4 overlap.
Ralph N. Elliott himself observed that ending diagonals are often followed by a ‘swift and sharp’ reversal. A strong bearish RSI divergence between waves III and V reinforces the negative outlook. If this analysis is correct, we can expect a three-wave correction to drag Illinois Tool Works stock back to the support near $130 a share. Currently at $258, that would be a ~50% decline in the company’s valuation. Something most investors wouldn’t like to experience firsthand.
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