Cabot Stock of the Month Issue: October 13, 2022

The market roller coaster continued this past month, with inflation worries and rising interest rates leading the charge.

I believe this volatility will continue at least until the first quarter of next year. Consequently, I’m moving the portfolio in a more conservative direction at the moment.

Having said that, however, economic indicators continue to be positive. Motor vehicle sales are still strong, with 13.5 million units sold last month, better than expected. The ADP employment report also exceeded forecasts, with 208,000 new jobs coming online. And the unemployment rate fell to 3.5% from 3.7% the prior month.

Market Overview

The market roller coaster continued this past month, with inflation worries and rising interest rates leading the charge.

I believe this volatility will continue at least until the first quarter of next year. Consequently, I’m moving the portfolio in a more conservative direction at the moment.

Having said that, however, economic indicators continue to be positive. Motor vehicle sales are still strong, with 13.5 million units sold last month, better than expected. The ADP employment report also exceeded forecasts, with 208,000 new jobs coming online. And the unemployment rate fell to 3.5% from 3.7% the prior month.

As you can see from the chart below, home prices have continued to abate, down 0.4% last month. Economists are forecasting that they will continue to slightly decline over the next few months.

However, sales of homes are still pretty strong. And according to Realtor.com, housing inventory is increasing, up 26.9% over last year, so prices should continue to moderate.

Most economists expect the Federal Reserve to raise rates again next month to try to ward off creeping inflation. That uncertainty lends itself to market volatility.

Here at Cabot, we are being defensive and cautious, but searching for bargains for the long term.

Featured Recommendation
Inflation, the war in Ukraine, and recession fears have disrupted banking stocks, taking them down to 2021 prices. Stocks in the Financial Services sector have declined 20.45% so far in 2022.

Invesco KBW Bank ETF (KBWB)

And while I don’t expect any near-term upside moves, I think it’s time to consider entering the Financials while prices are so low. I’m going to begin with a name familiar to all—a mega money center bank that is beginning to recover from some fairly bad decisions during the 2007-2009 economic malady.

Citigroup Inc. (C): Undervalued, Underappreciated, and Poised to Benefit from Rising Rates

Citigroup Inc. (C) is a diversified financial services holding company, operating in North America, Latin America, Asia, Europe, the Middle East, and Africa. The company operates in two segments, Global Consumer Banking (GCB) and Institutional Clients Group (ICG), providing traditional banking services to retail customers and wholesale banking products and services to corporate, institutional, public sector, and high-net-worth clients. Founded in 1812, the company now includes more than 2,300 branches around the world. And as you can see from the following chart, it is the third largest U.S. bank.

Source: www.Bankrate.com

As I was looking for undervalued financial stocks, I naturally consulted Bruce Kaser, Chief Investment Analyst of Cabot Undervalued Stocks Advisor and Cabot Turnaround Letter.

Here are Bruce’s comments in his original recommendation of Citigroup:

“Citigroup (C) is one of the world’s largest banks, with over $2.4 trillion in assets. The bank’s weak compliance and risk-management culture led to Citi’s disastrous and humiliating experience in the 2009 global financial crisis, which required an enormous government bailout. The successor CEO, Michael Corbat, navigated the bank through the post-crisis period to a position of reasonable stability. Unfinished, though, is the project to restore Citi to a highly profitable banking company, which is the task of new CEO Jane Fraser.

“With the exceptional volatility in financial markets, investors worry that a Lehman-like crisis, perhaps triggered by a collapse of Swiss-based Credit Suisse, will threaten Citi’s financial stability. Our view is that it is quite reasonable to expect some type of financial accident, but that major banks, including Citi, have tamped down their risk and bolstered their capital to such a large extent over the past decade that they are highly unlikely to suffer a cataclysmic collapse in such a situation.

“This past week, the yield spread between the 90-day T-bill and the 10-year Treasury note, which approximates the drivers behind Citi’s net interest margin, narrowed back to 0.27% after spiking last week. The current spread is still near the low end of its range over the past 40 years, with a 2.00 percentage point spread being a rough average. If spreads were to return to a two-point spread, bank profits would likely surge, assuming that other sources of profits including credit quality remained unchanged.

“The remarkably low valuations assume an unrealistically dim future for Citi. Citi shares have about 92% upside to our 85 price target. Citigroup investors enjoy a healthy dividend yield and perhaps another 3% or more in annual accretion from the bank’s share repurchase program once it reaches its new target capital ratio, and if a slowing/stalling economy doesn’t meaningfully increase its credit costs.”

And in his most recent update, Bruce further commented on the stock’s low valuation:

“Citigroup is considered to be by far the weakest of the major banks. However, at 6.0x earnings and 50% of tangible book value, the shares’ valuation is less than half that of its peers—a discount that we view as highly excessive. Notably, the stock trades near its pandemic March 2020 low. Investors worry that Citi will suffer significantly higher credit losses and narrower interest margins and that it could be crippled in a possible financial market seize-up like what happened in the global financial crisis. Our view is that the new CEO, Jane Fraser, is taking the right steps to rebuild the bank’s profitability. Its overall risk position is much lower than perhaps any time in the past 25 years, and it carries plenty of extra capital. We like the (4.8%) dividend which pays investors to wait for the turnaround.”

Citigroup has a huge institutional and investment banking presence, but it also has an enviable consumer banking business, and as interest rates rise, that chunk of business should help pad the bank’s top and bottom lines.

And as Bruce mentioned, its CEO, Jane Fraser, has been putting her mark on the company. She is increasing the company’s core strengths, moving the company toward a more service-oriented strategy, while getting rid of underperforming international banking properties, such as in Mexico.

This transition is attracting some big investors, like Warren Buffett, who bought about $2.5 billion in Citigroup stock last June. Additionally, value investor Edgar Wachenheim III’s Greenhaven Associates recently increased his stake in the stock by more than 10%.

For the second quarter, Citi’s revenue was $19.6 billion, higher than last year’s $17.8 billion, yet earnings growth has still not caught up, due to higher credit costs and restructuring expenses.

Right now, the 22 analysts with 12-month price targets for Citigroup are forecasting a median target of 56.18, with a high estimate of 83.00 and a low estimate of 44.00.

Earnings are due on October 14, with analysts forecasting EPS of $1.48 on revenues of $18.38 billion, down about 27% and up 7%, respectively, from last year.

The stock is heavily discounted, trading at a P/E ratio of 5.21. And when you add in the healthy dividend yield of 4.8%, the shares look very appealing to me. Buy

About the Analyst: Bruce Kaser, Cabot Undervalued Stocks Advisor 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, he 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).

Both Value and Growth Stocks are down for the year, but undervalued companies have not suffered as much as growth. And with the markets continuing to be very volatile, I want to err on the side of caution and look for very undervalued stocks to add to our portfolio at this time.

Consequently, I asked Bruce to give us his take on the markets, and particularly his forecasts for the Value universe. Here’s our interview:

Nancy: Bruce, your portfolio is divided into two categories: Growth & Income Portfolio and Buy Low Opportunities Portfolio. Would you please expand on those definitions for my subscribers, and tell us what criteria, specifically, you are looking for in choosing stocks in each of these categories?

Bruce: Growth & Income Portfolio stocks are generally higher-quality, larger-cap companies that have fallen out of favor and now trade at overly discounted valuations. They usually have some combination of attractive earnings growth and an above-average dividend yield. Risks tend to be relatively moderate, with reasonable debt levels and modest share valuations.

Buy Low Opportunities Portfolio stocks include a wide range of value opportunities. These stocks carry higher risks than our Growth & Income stocks, yet also offer more potential upside. This group may include stocks across the quality and market cap spectrum, including those with relatively high levels of debt and a less-clear earnings outlook. The stocks may not pay a dividend. In all cases, the shares will trade at meaningful discounts to our estimate of fair value.

Nancy: I know you’ll agree that 2022 has been very challenging for both Growth and Value investors, although Value stocks have not lost as much as Growth stocks, on average. Do you foresee that continuing to be the trend for the rest of the year? And why?

Bruce: In many ways, Value stocks can be defined simply as “not Growth stocks.” Unlike too many Growth stocks, which have no earnings yet trade at elevated revenue multiples, Value stocks usually have healthy earnings yet trade at low multiples on those earnings. Also, the Energy sector is included in the Value camp. This group will likely continue to produce strong earnings, yet the shares still trade at very low multiples of those earnings. Many energy stocks offer impressive dividend yields which should support their share prices even as interest rates increase and economic growth flattens out. So, yes, all-in, Value stocks will likely outperform Growth stocks the rest of this year.

Nancy: Many pundits agree that the U.S. will likely see a recession in 2023. How have you set up your current and future portfolio to weather such an event?

Bruce: We focus on finding companies that are out of favor yet have real value and often catalysts to unlock that value. We are certainly aware of the broad macro-economic risks but specifically avoid making investments based on forecasting economic trends, as this type of investing tends to have a low success rate. Rather, we look for stocks that are meaningfully undervalued. This can mean buying stocks that go against the prevailing macroeconomic narrative, yet that is where many bargains can be found.

Nancy: Energy stocks are, so far in 2022, the only positive sector. Do you see them still outperforming for the rest of the year? If so, why?

Bruce: Tight global energy supplies plus the recent OPEC plans for further production cuts provide considerable support to oil prices. Natural gas prices will likely remain elevated due to the cut-off of natural gas from Russia. In this environment, energy stocks should be able to hold their value reasonably well. And they trade at generally low valuations and can in many cases offer very attractive dividend yields.

Nancy: With inflation running rampant, what sectors do you see as providing your subscribers with the best price protection over the next six months?

Bruce: To answer the question directly, we think it will be difficult for any stock to make much headway until we can see an end to the Fed’s rate hikes and its quantitative tightening policies. If pressed, I’d say shares of companies in the energy sector would be best positioned to hold their value.

But to answer it in a different way, the future is impossible to predict, so efforts to select investments that might do well in the short term based solely on an assumption of a weak stock market are unlikely to work very well. Stocks that currently are perceived as the safest today, like Apple (AAPL), may actually be the riskiest if their fundamentals can’t continue to support their elevated safe-haven valuations. Our view is that buying solid companies at prices well below their underlying value is the best strategy over longer time horizons.

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

Bruce: Clearly, rising interest rates and the risk that near-term earnings could slide are major impediments to higher prices for our recommended stocks. Many of our companies continue to struggle with supply chain problems in their operations and in their customers’ operations, and several have too much inventory that they need to offload at respectable prices. All these are true for a lot of other stocks, as well. Unlike most companies, many of ours suffer from poor decisions made by prior leadership, but now have the opportunity under new leadership to bring self-help driven recoveries in their earnings that might overcome the effects of the unfavorable macro environment.

Portfolio Updates

GitLab (GTLB)’s CFO Brian Robins recently noted that the company’s sales cycle has accelerated, due to customers adopting its streamlining software. Researcher Forrester says this could lead to an increase of 407% in the company’s ROI. Gartner also says the transition to single-delivery platforms like GitLab’s is boosting demand for the company’s products. There’s plenty more room for growth, as GTLB has just 1% share in a $40 billion market. Shares have been hit by the market’s volatility, making them even more discounted. I’m switching my recommendation back to Buy.

Watch for earnings from M/I Homes (MHO), due on October 26. Analysts are predicting EPS of $4.05 on revenues of $1.05B. The company continues to increase its backlog, has kept its debt reasonable, and should continue to thrive—albeit at a less accelerating level—through this period of economic uncertainty. Buy

QUALCOMM Incorporated (QCOM) is winning again in the courts, for the second time recently. Apple’s appeal re: its patent infringement case against QCOM was refused a hearing by the U.S. Supreme Court.

Qualcomm continues to diversify its product line, making chips for connected cars, Internet of Things (IoT) devices, drones, and VR/AR headsets. And it’s beginning to pay off. Just last week, the company forecasted growing automotive revenue of more than $4 billion in 2026 and $9 billion in 2031, up from previous estimates of $3.5 billion and $8 billion respectively. For this year, QCOM expects revenue from that sector to rise 33% this year.

Automotive revenue, which the company started disclosing in 2020, represents a small but growing piece of the overall revenue, at 3.2% for the quarter ended June 26, compared with 56.2% for handsets. Qualcomm in July reported revenue of $10.9 billion for the quarter ended June 26, up 35.7% from the prior-year period. Its net income totaled $3.73 billion for the quarter, up 84% from the prior-year period.

The shares of QCOM were knocked around again when the U.S. Department of Commerce said it would restrict exports of some semiconductors to China.

Tom Hutchinson, Chief Analyst of Cabot Dividend Investor, and our contributor for this stock recommendation, just updated his comments on QCOM, saying: “After a strong summer rally, QCOM has hit the skids again. It got hit as technology sold off again amid fears of higher rates and continuing inflation. Then it took another hit as semiconductor stocks sold off on recession worries. Even though QCOM is performing well individually on an operational basis, it just can’t overcome a market that is souring on the sector. The selling is overdone as earnings continue to be strong and the stock already sells at a cheap valuation. It can move higher fast and make up for lost time when the going gets good again.”

I agree. Buy

Shares of MP Materials Corp. (MP) have been under pressure as economic uncertainty has softened EV sales. A Canaccord analyst reduced the price target on shares of MP Materials to 40 from 47, based on the price of rare earth element neodymium-praseodymium dropping.

Chief Analyst Carl Delfeld from Cabot Explorer has moved MP to a Hold. Here is his reasoning: “MP Materials (MP) shares dipped from 31 to 28 as the company’s market value gets closer to $5 billion and its shares trade at 25 times forward earnings, which is about half of where the metric sat a year ago. I recently moved this stock to a hold primarily because rare earth concentrate prices have pulled back sharply, which is not good for business. This stock is a way to play clean tech, defense, semiconductors, and other advanced and emerging technologies through some of their basic inputs.” I agree. Hold.

Mike Cintolo, Chief Analyst of Cabot Growth Investor and Cabot Top Ten Trader, sold his position in our newest recommendation, Devon Energy (DVN), saying, “We leapt out of the remainder of our position in Devon Energy last week, and we don’t regret the thinking—the market was, of course, in freefall, and DVN (and most peers) sliced its 200-day line for the first time in many months, something that’s usually a reliable sell indicator (especially this year). However, at least for now, that move looks like a shakeout, with oil stocks rebounding nicely while oil prices do the same. Because we’ve gotten some questions, yes, if you still own some, you can hold onto your remaining DVN, but we’d also still have a stop in place—it and most other oil names are still so-so on the weekly chart (potential multi-month tops after huge runs). Still, we’re intrigued by the bounce in the group.”

Devon’s shares have rebounded nicely. I’m going to keep a Buy on the stock. But I think Mike’s recommendation for setting a stop-loss is a great idea. I’d put the stop at 20%.

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

ETF Strategies

Our ETF portfolio has suffered from the continuing market volatility. Right now, only iShares US Energy (IYE) and AGFiQ US Market Neutral Anti-Beta fund (BTAL) are in positive territory for the month.

Remember that this portfolio is for the long term, so we won’t be making many radical changes to it each month. However, having said that, due to the market’s high volatility, let’s be a little defensive here and move everything but those two ETFs to a Hold; these two are still Buys.

However, if you are just starting with us, it’s ok to add positions in the following ETFs:

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

Once we see a definite change in the market’s direction, I will continue to add new ETF positions to our portfolio.

These are the definitions I am using for Risk Preference:

As a conservative investor, you are less willing to accept market swings and significant changes in the value of your portfolio in the short- or long-term. Capital preservation is your primary goal, and you may plan on using the principal from your investments in the near-term, preferably as a steady income stream. The average level of return you expect to see is 5%-10%, annually.

As a moderate investor, you seek longer-term investment gains. You are comfortable with some swings in your portfolio’s performance, but generally seek to invest in more conservative stocks that build wealth over a substantial period of time. The average level of return you expect to see is 10%-25% annually.

As an aggressive investor, you primarily seek capital appreciation and are open to more risk. Swings in the market, whether short term or long term do not impact your investment decisions and you have confidence that volatility is necessary to achieve the high return-on-investment you are looking for. You typically expect a 25%+ return, annually, though you do not need your principal investment immediately.

I hope you all saw my Alert on suggested portfolio recommendations, using stocks and ETFs from our portfolios. If not, you can find itright here.

I’ll be adding to those portfolio recommendations once I see a return to normal volatility in the markets.

The Digital Transformation Is Changing the Face of Banking

The environment for financial companies is almost always changing, and today, most of that transformation is coming from the demand for digital banking from millennials and Gen Z’ers is transforming how the entire banking industry operates.

But it’s not just those generations, as reported by Insider Intelligence, noting, “Mobile banking has become the go-to method for users to make deposits, account transfers, and monitor their spendings and earnings—and a key differentiator for banking leaders. Nearly 80% of our survey respondents who have used mobile banking say it is the primary way they access their bank account.”

I had to be dragged kicking and screaming to participate in this revolution, but I finally conceded, and now do most of my banking digitally and online. It’s just too convenient and time-saving to ignore!

And, fortunately, our newest recommendation, Citigroup (C), is at the forefront of that movement. In 2021, the bank was named the “World’s Best Digital Bank” by Global Finance. In May, it was named “Bank of the Year in Asia-Pacific” by The Asset Magazine, and in August, Global Finance named it “Best Corporate/Institutional Digital Bank in 16 Latin American Countries.”

Citi released these statistics, and although they are a few years old, they certainly show the rapid adoption of mobile banking:

But the company isn’t just relying on the growth in digital banking for its rebound. As you can see from the following charts from Citi’s recent investor presentation, the bank has a solid plan to efficiently grow its revenues and reduce its costs.

With its shares trading at such a low valuation, and considering the healthy dividend, I’m willing to take a bet on this bank.

The next Cabot Money Club Stock of the Month issue will be published on November 10, 2022.