Cabot Stock of the Month Issue: October 12, 2023

Market Review

Investors weren’t surprised by the Federal Reserve’s decision to hold rates steady, but they also didn’t react by ramping up their stock purchases—too much uncertainty what with the election rhetoric heating up and the turmoil in Congress, after Kevin McCarthy was unceremoniously ousted as Speaker. And now, we have the war in Israel.

It’s no wonder we are seeing market volatility, although the markets have perked up a bit in the last week.

The economy continues to lope along. Job growth remains strong, as does manufacturing.

Real estate—surprising to most of us in that business—is better than we expected, considering that the precipitous rise in interest rates was predicted to “doom” the business. It certainly has kept inventory low (how can you expect a seller to trade in his 2.5% mortgage rate for an 8% rate?), and prices—though not rising as fast as last year—are still pretty heady.

Economists are predicting that home sales will fall 10-12% this year, while prices continue to rise 3-5%.

The leaders in the markets right now are growth stocks, with large caps gaining 26.72% year-to-date, midcaps, 9.57%, and small caps, 2.75%.

Sector-wise, Communication Services (up 40.93%), Technology (35.88%), and Consumer Discretionary (24.48%) are the winners so far in 2023 and Utilities (-17.99%), Consumer Staples (-10.49%) and Real Estate (-7.93%) are trailing the pack.

Here at Cabot, we’re happy to see the recent momentum in the markets, but still remain cautious.

Judicious stock picking remains our focus, looking for companies with good fundamentals, trading at reasonable prices—like the company I’m recommending to you today!

Feature Recommendation - Gates Industrial Corp, plc (GTES): A Solid Buy in a Growing Industry

Bruce Kaser, Chief Analyst of Cabot Value Investor and Cabot Turnaround Letter, is an expert in choosing companies with strong fundamentals that are undervalued. And this month, I asked him to look over his portfolio to give us some of his very favorite stocks. And Gates Industrial Corp, plc (GTES) is at the top of his list.

Here’s what Bruce had to say about Gates: “Gates is a specialized producer of industrial drive belts and tubing. While this niche might sound unimpressive, Gates has become a leading global manufacturer by producing premium and innovative products. Its customers depend on heavy-duty vehicles, robots, production and warehouse machines and other equipment to operate without fail, so the belts and hydraulic tubing that power these must be exceptionally reliable.

“Few buyers would balk at a reasonable price premium on a small-priced part from Gates if it means their million-dollar equipment keeps running. Even in automobiles, which comprise roughly 43% of its revenues, Gates’ belts are nearly industry-standard for their reliability and value. Helping provide revenue stability, over 60% of its sales are for replacements.

“Gates is well-positioned to prosper in an electric vehicle world, as its average content per EV, which require water pumps and other thermal management components for the battery and inverters, is likely to be considerably higher than its average content per gas-powered vehicle.

“The company produces wide EBITDA margins, has a reasonable debt balance, and generates considerable free cash flow. The management is high-quality. Gates’ shares currently trade at a modest 7.3x EV/EBITDA and 9.5x per share earnings.

“Based in Denver, Colorado, Gates was founded in 1911. In 2014, private equity firm Blackstone acquired Gates. Gates was poorly run by its prior owners, but during its Blackstone ownership, the company improved its product lineup and quality, operating efficiency, culture, and financial performance. Gates completed its IPO in 2018. Following several sell-downs, Blackstone has a 43% stake today.

“The management and board are high quality, which helps it follow a disciplined operating and capital allocation strategy. Gates’ debt balance has been reduced to a reasonable level, with considerable support from robust free cash flow.

“Gates shares fell 1% this past week and have 38% upside to our 16 price target. BUY”

The company is well-diversified in the end placement of its products, as you can see from the following graphic.

Gates’ products are segmented into two categories, Power Transmission ($2.2 billion in revenues) and Fluid Power ($1.4 billion), and primarily serve off-highway sectors, including construction and agriculture.

In 2022, Gates saw its revenues rise by 2.3%, but gained more strength in the last quarter of the year, with sales growing by 9.5%. EPS for the fourth quarter rose to $0.30, up from $0.21 in the prior year.

Thus far, in 2023, the trend has continued. Second-quarter EPS was $0.23, compared to $0.19 in the prior year, and sales were a record for the quarter, up 3.3%, to $936.3 million.

For the year, the company expects its core revenue to grow in a range of 1% to 5% and its adjusted earnings per Share is forecast between $1.13 and $1.23.

Analysts predict third-quarter EPS will be $0.31 on revenues of $879.08 million.

The company’s shares are trading at a P/E ratio of 14.38, considerably less than its industry average of 17.17, leaving Gates with plenty of room to grow!

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About the Analyst: Bruce Kaser, Chief Analyst of Cabot Value Investor and Cabot Turnaround Letter

Bruce Kaser has more than 25 years of value investing experience in managing institutional portfolios, mutual funds, and private client accounts. He has led three successful investment platform turnarounds, co-founded an investment management firm, and was principal of a $3 billion (AUM) employee-owned investment management company.

Previously, Bruce led the event-driven small/midcap strategy for Ironwood Investment Management and was Senior Portfolio Manager with RBC Global Asset Management, where he co-managed the $1 billion value/core equity platform for over a decade. He earned his MBA degree in finance and international business from the University of Chicago and earned a Bachelor of Science in finance, with honors, from Miami University (Ohio).

Nancy: In a recent issue of the Cabot Turnaround Letter, you discussed investing in “out-of-favor” stocks, which is part of what you look for in your newsletter. Would you please share with my subscribers some of the criteria you review when researching such stocks, and what your key parameters are when deciding if the stock is a good “turnaround” candidate?

Bruce: We look for stocks that have significantly underperformed the broad market and their more successful peers. “Significantly” is a subjective term, but one example might be a stock that has been flat, or worse, for five or 10 years while the stock market has gained 50-100% or more.

From this list of out-of-favor stocks, we look for underlying companies that have fixable problems with a clear reason why those problems will be fixed. Perhaps the prior management was motivated by prestige or empire-building, or maybe just was not up to the task, leaving the company with problems that a new, capable, shareholder-mindful leadership team could reverse. A turnaround could also include a cyclical company at the bottom of its cycle, but which has the balance sheet and cost structure to survive until the upturn. We also find turnaround opportunities in spin-offs and IPOs that have fallen out of favor but have solid, well-managed businesses that the market is ignoring for temporary reasons.

In addition to good management, we want the company to have a reasonably strong balance sheet and positive free cash flow. These can provide it with the financial durability to survive until its profits recover.

Nancy: Earnings season is coming soon, and I know that you take those numbers very seriously. I also understand that you are a long-term investor, so what sort of weight do you think an investor should put on quarterly earnings?

Bruce: Quarterly earnings are the primary report cards for all companies, so we rely heavily on these updates. But unlike traders and momentum investors that focus on whether a company beat or missed its estimates, we focus mostly on the “why” and other indicators of whether the turnaround is moving in the right direction. Turnarounds don’t happen in a straight line, so our companies may report awful near-term earnings yet are making important progress that short-term investors don’t care about.

Nancy: In general, how long of a period do you allow your turnaround stocks to actually turn around before you move on?

Bruce: Some turnarounds take longer than others. We’ve had turnarounds work in as little as six months, others have taken as many as five or more years. In general, we start getting worried if a turnaround isn’t making much progress after a year or two, and our typical targeted holding period is about 2-3 years.

Nancy: You recently wrote about the frequent misunderstanding surrounding retail stocks. They do tend to be very volatile, falling in and out of favor rapidly, often due to large institutional holdings that tend to enter and leave certain stocks frequently. You have a few retailers in your Turnaround portfolio. Will you elaborate on why they attracted you—what makes them different?

Bruce: The broad market is worried that consumers will lose their appetite for buying apparel due to the resumption of student loan payments and a weakening economy. As such, investors have discarded many of these stocks to the point where the share prices have become sharply undervalued even if a difficult retail environment actually arrives. We found several retailers with strong and perhaps unique niches, good leadership and healthy balance sheets. One of the retailers we discussed in our most recent letter, Chico’s FAS (CHS), agreed to be acquired by a private equity firm for a 65% premium only days after our article was published, suggesting that we are onto something.

Nancy: In the “old” days (when I first got into the investing arena!), tech companies were scary, disruptive, and not for the faint-of-heart investor. In today’s world, we have stalwart techs such as Cisco (in your Cabot Value Investor portfolio), Intel, Microsoft, IBM, etc. In your opinion, what characteristics can an investor look for when investing in technology companies, to help predict whether they are a fly-by-night business or if they have staying power?

Bruce: Tech stocks are notoriously difficult for value/contrarian investors because once these companies lose their competitive lead, they very rarely regain it. We have found that staying power is reflected by a history of moderate but steady revenue growth, wide gross margins and a solid franchise in a necessary product or service. We also have found that strong free cash flow including stock option expenses indicates that the company has staying power. We find it almost humorous that many investors talk about a company’s huge free cash flow, but ignore the fact that all of that free cash flow comes from the use of stock options.

Nancy: What are the 3-5 most critical challenges to price appreciation in the stocks in your portfolio right now?

Bruce: Turnarounds can be vulnerable to recessions, so the market’s worries about an economic slowdown, regardless of when and how deep, are weighing on some of our holdings. Many of our holdings are very early in their turnarounds, so investors avoid these stocks, especially as they become risk-averse as the calendar year-end approaches. And, not every turnaround works, so a few of our companies are struggling more than we anticipated, which of course keeps the pressure on their share prices.

Portfolio Updates

Tom Hutchinson, Chief Analyst of Cabot Dividend Investor and Cabot Income Advisor, updated his view on Qualcomm Inc. (QCOM), saying, “The chipmaker stock continues to struggle through this year. It has returned just 3% YTD while the technology sector is up over 30% over the same period. The sector is being driven by stocks with exposure to AI that are benefiting right now. It’s a little soon for Qualcomm. The company is highly dependent on smartphones. And sales have been falling as the 5G cycle comes to an end and the global economy is sputtering. But smartphone sales may have bottomed out and QCOM could benefit mightily and move fast when things turn around. BUY.”

Qualcomm hasn’t lost its appeal with Wall Street, as the stock’s average brokerage recommendation is 1.72, on a scale of 1 to 5 (Strong Buy to Strong Sell). There are currently 23 analyst recommendations, with 15 rating the stock Strong Buy and one is Buy. And 73 hedge funds currently own the stock. I see no reason to disagree. Continue to Buy.

Devon Energy (DVN) beat analysts’ earnings projections, posting EPS of $1.18 per share versus the estimate of $1.17 per share. And analysts have been boosting EPS estimates for the past month or so, based on rising oil prices, and the expectation that the company will raise its dividend payout and continue repurchasing shares. I remain a believer. Hold.

Bruce Kaser also updated his report on Citigroup (C), commenting, “Citi CEO Jane Fraser is essentially taking off the gloves to institute a much more aggressive restructuring than earlier anticipated. Her pace is accelerating, and the number of layoffs and strategic changes will likely rise considerably. She has been CEO since March 2021. Our view is that she is becoming (rightfully) impatient with Citi’s bloated culture and wants to move bigger and faster. We’re good with this. We see her motivation as driven partly by her performance-oriented personality and partly by perhaps a sense of urgency that if she doesn’t get better results in the near/mid-term then she will be replaced.

Citi shares fell 1% in the past week and have over 100% upside to our 85 price target. The shares remain attractive as they trade at 47% of tangible book value of $85.34. The recently raised $0.53 quarterly dividend looks sustainable and offers investors a 5.2% yield. BUY.”

In more news, Citi is continuing to simplify its operations and has agreed to sell its China unit to HSBC Bank China.

Investor interest in the shares is picking up. Edgar Wachenheim III’s Greenhaven Associates bought an additional 2.2 million shares of Citigroup, bringing his total ownership up to 13.1 million shares. He commented, “We estimate that 30%-35% of Citi’s profits come from its ‘payments’ business (which it calls Treasury and Trade Solutions). This is a very good service business that generates fee income and deposits—and Citi is a leader in payments and enjoys an excellent reputation for quality.”

Patient Capital Opportunity Equity Strategy has also been adding Citi shares, saying, “We’ve recently been adding to Citigroup Inc. After perennially disappointing for decades, even the most bullish financial investors aren’t interested (a good thing in our view!). CEO Jane Fraser is making all the right moves: exiting underperforming consumer businesses, investing to improve the tech and operating infrastructure, returning capital to shareholders. These actions should result in improving returns on equity. We should start to see serious cost improvements in late 2024 accompanied by improving returns on equity. The stock trades at ~$46, 55% of its $85 tangible book value. The company is confident it can reach 11-12% return on tangible common equity by 2025 when its tangible book should be greater than $100. If it reaches its return target, as we believe, Citi should trade back to tangible book, implying a more than double over the next couple years. Meanwhile, you collect the dividend, which is currently a better yield than long-term treasuries.”

I concur, and am changing my rating back to Buy.

No news on Curaleaf (CURLF). The stock had a nice bounce last month, but has retreated somewhat since. The long-term potential is enticing, so if you currently own the shares, Hold, but if you don’t, the shares are a Speculative Buy.

Tyler Laundon, Chief Analyst for Cabot Early Opportunities and Cabot Small-Cap Confidential, reported on TransMedics Group (TMDX), saying “There’s been no news since the Morgan Stanley Healthcare Conference (three transportation contracts with transplant centers disclosed, a good start). As I’ve been saying this is now a “show me” story as investors await details on how the business model and financial profile will adjust once the aviation business is off and flying. HOLD THREE QUARTERS”

I agree. Continue to Hold.

Tom Hutchinson also updated Brookfield Infrastructure Partners (BIP), noting, “The tough times for safe stocks continue. Despite strong operational performance in a period of shrinking earnings for most companies, BIP continues to make new 52-week lows as investors fear interest rates will limit growth potential. The price hasn’t been this low since the pandemic bear market more than three years ago. But earnings have been solid and growing with remarkably resilient revenues ahead of a likely slowing economy. It’s a historically strong market performer, selling at multiyear lows with a safe 5.2% yield. (This security generates a K-1 form at tax time). BUY.”

Brookfield currently yields 5.46%, a dividend that has increased for 14 years. The shares are attracting Wall Street’s money, with analysts predicting a target stock price some 40% above its current trading level.

Brookfield will announce earnings on November 1, 2023. Current estimates are EPS of $0.20 on $2.44 billion in revenues. Buy.

Bruce Kaser commented on NOV, Inc (NOV), “This high-quality, mid-cap company, formerly named National Oilwell Varco, builds drilling rigs and produces a wide range of gear, aftermarket parts and related services for efficiently drilling and completing wells, producing oil and natural gas, constructing wind towers and kitting drillships. About 64% of its revenues are generated outside of the United States. Its emphasis on proprietary technologies makes it a leader in both hardware, software and digital innovations, while strong economies of scale in manufacturing and distribution as well as research and development further boost its competitive edge. The company’s large installed base helps stabilize its revenues through recurring sales of replacement parts and related services.

“We see the consensus view as overly pessimistic, given the company’s strong position in an industry with improving conditions, backed by capable company leadership and a conservative balance sheet. BUY.”

The company will announce earnings on October 27, 2023. Current estimates are for EPS of $0.34 on $2.13 billion in revenues. Buy.

Carl Delfeld, Chief Analyst of Cabot Explorer, updated his view on International Business Machines (IBM), reporting, “International Business Machines shares held steady as IBM CEO Arvind Krishna said it was a misconception that increases in productivity from artificial intelligence must lead to job losses. Big Blue is making a transition from IT infrastructure to cloud computing, AI, and quantum computing. Buy a Half.”

Most analysts see artificial intelligence as the key to IBM’s next run, anticipating a contribution of $1 billion in consulting revenue in 2024 and $2 billion in 2025. I think they’re right. Buy.

Mike Cintolo, Chief Analyst of Cabot Growth Stocks and Cabot Top Ten Trader, says this about Noble (NE): “NE is another example of ‘the company is not the stock,’ as oil prices are still north of $80 despite a recent dip, the demand for offshore rigs is set to outpace supply next year and Noble’s earnings, free cash flow and shareholder returns (2.5% current yield, but should be raised as business improves) are all almost sure to increase in a big way in the quarters ahead. Despite that, the stock has stagnated and this week, broken through some support, which had us selling one-third of our position in a special bulletin on Wednesday. Now, overall, the chart isn’t a horror show, with shares ‘only’ 13% off their highs and the relative performance (RP) line even closer to new high ground; thus, we’re OK giving our remaining shares a little more rope, seeing if the dip morphs into a shakeout. But we do have a relatively tight leash in place, so we won’t ride NE down the chute in case the trend in oil stocks is truly cracking. SOLD ONE THIRD, HOLDING THE REST.”

I’m not arguing with Mike about this one. Sell 1/3; hold the rest.

Our newest recommendation, IonQ (IONQ), announced an expanded relationship with the Air Force Research Lab (AFRL) to deploy two barium-based trapped ion quantum computing systems for quantum networking research and application development.

This is a year after the company agreed to provide AFRL access to the company’s trapped ion systems. And it further supports the increased federal government activity with quantum computing, following 2018 creation of the National Quantum Initiative (NQI), a broad, interagency program promoting quantum research and development.

The stock has retreated in the recent market pullback. Continue to Buy.

Portfolio

*Aggressive (A), Moderate (M), Conservative (C)

ETF Strategies

Currently, Adaptive Alpha Opportunities ETF (AGOX), Communication Services Select Sector SPDR Fund (XLC), First Trust Water ETF (FIW), iShares US Energy (IYE), and Vanguard Dividend Appreciation Index Fund (VIG) are showing positive returns.

This month, I’m taking the iShares Russell Top 200 ETF (IWL) off our watch list and adding it to our portfolio.

The index measures the performance of the largest capitalization sector of the U.S. equity market, as defined by Russell. The fund generally will invest at least 80% of its assets in the component securities of its index and in investments that have economic characteristics that are substantially identical to the component securities of its index and may invest up to 20% of its assets in certain futures, options and swap contracts, cash and cash equivalents.

5 Star
Average Risk
Large Cap Blend

Our Watch List has three names remaining:

O’s Russell Smallcap Qlty Divd ETF (OUSM)
GX U.S. Infrastructure Development ETF (PAVE)
Vanguard Small Cap Growth Index Fund (VBK)

Technology is Boosting the Industrial Machinery Industry

The Specialty Industrial Machinery industry in the United States has a market cap of almost $700 billion, total revenue of $330.89 billion and a weighted average P/E ratio of 17.17.

Statista.com forecasts that the industry will grow at a CAGR (compound annual growth rate) of 3.17% through 2028. Much of the growth is predicted to arise in the agriculture industry (a big portion of Gates’ product line), due to the need for advanced technology, such as artificial intelligence, robotics, and the Internet of Things (IoT), which will reduce costs and improve efficiency and productivity.

The specialty industrial machinery industry has many applications, including:

• Heavy equipment
• Hardware
• Industrial process
• Machine
• Machine tool
• Tool
• Industrial machines
• Agricultural equipment
• Assembly line
• Industrial robot
• Oil refinery
• Packaging and labeling
• Paper mill
• Sawmill
• Smelter
• Water wheel

Consequently, the industry is very fragmented, with 10 companies accounting for a significant portion of revenues. That may imply a pickup in the M&A atmosphere, once the economy strengthens. We’re seeing some activity already, with 430 M&A deals announced in the industry in the first quarter of this year, worth a total value of $5.6 billion.

Analysts expect the industry’s earnings to grow by 13% annually over the next few years.

This is one of those sectors that will be boosted by economic strength. I don’t expect it to be a barn-burner until we see more stability in rates, but it’s a good time to pick up an undervalued company in an undervalued industry. This is a moderate risk buy.

Portfolio

*Aggressive (A), Moderate (M), Conservative (C)
**Purchase price reflects a 3-for-1 stock split

The next Cabot Money Club Stock of the Month issue will be published on November 9, 2023.