Cabot Turnaround Letter Issue: December 27, 2023

Top Five Stocks for 2024

At the end of each year, the Cabot Turnaround Letter looks through its portfolio of recommended stocks to select the “Top Five” for the coming year. We are reluctant to select only five, as we like all of our 39 current recommendations (otherwise they wouldn’t be on the roster). However, these five stocks have what we believe are the most favorable combinations of risk/reward and timeliness. As always, we encourage investors to hold a diversified portfolio of turnaround stocks, as individual names can carry high risk.

In previous years, our picks have often produced strong returns. For 2021, the average return was 115%. Our 2022 picks returned an average of +4% while the S&P 500 generated a -19% loss^[1].

Our 2023 crop was significantly less productive and could readily be termed a whiff. Our big winner, Goodyear Tire & Rubber (GT), gained 44%, helped by its low initial share valuation and some robust support by activist investor Elliott Management. However, our selection of Duluth Holdings (-6%), Nokia (-28%), Vodafone (-14%) and ZimVie (-34% during our holding period) paled when compared to the 24% increase in the S&P 500. Even compared to the 12% return of the equal-weighted S&P 500 index, which weights all stocks at 0.2% each (or , our selection was dismal. Investing in turnaround stocks is a high-risk venture, and the 2023 names fully reflect that fact. The common theme among the losers was continued deterioration in their fundamentals, which more than offset their ostensibly cheap share prices.

This year’s Top Five list emphasizes companies with deep fundamental turnarounds underway. Goodyear Tire (GT) is a repeat selection as we believe the changes have only started. Advance Auto Parts (AAP), Kohl’s (KSS), Kopin (KOPN) and Newell Brands (NWL) all feature new leadership that are undertaking root-and-branch overhauls of their respective companies even as their share prices remain highly out of favor.

We anticipate that our list will receive media coverage in the near future, as it usually does. However, as a loyal subscriber, it is only fair that you see it first.

Advance Auto Parts (AAP) – One of the four major auto parts retailers, Advance Auto continues to struggle as its aggressive decades-long acquisition spree overstretched its ability to operate efficiently. A turnaround effort under the prior CEO fell well short of its promise, followed by a slashed dividend, both of which helped drive the share price down 65% from its 2015 peak. With the shares trading at an embarrassingly low price and valuation, a refreshed board finally took aggressive action earlier this year. We believe that the company finally has the right CEO, Shane O’Kelly, the former head of HD Supply, in place to tackle the job. HD Supply is Home Depot’s industrial products distribution subsidiary, providing a vast array of over 100,000 products through more than 100 distribution centers across North America. The skills required to efficiently and effectively oversee HD Supply translate well to Advance Auto. Augmenting his team, O’Kelly brought in a former senior finance executive from retailer Lowe’s as the new CFO.

The new leadership team is undertaking a comprehensive operational and strategic review of Advance Auto. While we await significant details, the initial steps, including a planned divestiture of Worldpac and the Canadian business, along with a $150 million cost-cutting program, are highly encouraging. The company’s debt is elevated but its interest rates are mostly fixed and there are no major maturities until 2026. Free cash flow is positive. With the shares trading at a depressed multiple of depressed earnings, we believe Advance Auto makes for a promising turnaround investment.

Goodyear Tire & Rubber Company (GT) – Our initial thesis for an investment in Goodyear was for an opportunistic purchase of an average company whose shares had fallen sharply out of favor. Since then, activist investor Elliott Management has taken a 10% stake with the goal of pressing the board to revitalize Goodyear. As a result of the subsequent strategic review, the company will replace its long-running CEO, divest as many as three businesses and streamline its remaining operations to double the profit margin to 10%. Demand for new and replacement tires should continue to be relatively stable, while pricing will likely remain strong enough to offset rising input costs. Goodyear has excessive debt, but a key priority for the improved free cash flow is to sharply reduce this burden. One intangible is the Goodyear name – one of the world’s most widely recognized and respected consumer brands. All-in, this turnaround offers significant promise for shareholders.

Kohl’s Corporation (KSS) – Investors see Kohl’s as a broken company left behind by time, trends and technology, further pressured by bloated inventory, a possible recession, and rising labor and goods costs. Its chronic underperformance has led to repeated takeover attempts and activist investor campaigns to address its broad range of operational and leadership shortcomings. Major positive changes, however, are underway, led by a refreshed board and new CEO (Tom Kingsbury). Kingsbury is a proven operator whose mandate and expertise is to restore rigor and discipline to the company’s operational performance. The company’s profits and free cash flow, while weakened, are resilient. The debt burden is reasonable but is being trimmed further. Management has committed to maintaining the $0.50/share quarterly dividend, which provides a highly attractive 7.2% yield. While the turnaround carries risks and won’t happen overnight, the deeply undervalued shares, down 65% from their 2018 peak and trading at a low 3.9x EBITDA, provide a margin of safety.

Kopin Corporation (KOPN) – This small company is developing high-performance optical display technologies, including headsets and other applications, for military, enterprise, industrial and consumer products. Since its launch in 1992, Kopin had been run as a money-losing research hobby of its brilliant founder. The labs generated fascinating prototypes but these had minimum commercial value, so the company was chronically in need of fresh cash infusions. Following a pandemic surge due to hype around augmented reality and other potential uses for headsets, Kopin’s shares collapsed over 90%. Recognizing the company’s peril, the founder took the exceptionally rare and equally savvy move of completely stepping away from the company. This has radically changed Kopin’s trajectory. A new and capable outside CEO, with deep experience in technology and defense companies, is reorienting Kopin to become a profitable and growing business. Research efforts are now focused on only the most commercially promising products while savings from eliminating wasteful spending are being redirected toward productive business purposes. Impressively, the company completed a large and likely final round of raising fresh equity – yielding enough cash to carry it until it can become free cash flow positive in early 2024. Kopin has zero debt. While the risks are high, so is the potential reward.

Newell Brands (NWL) – This consumer products company has struggled, literally for decades, with weak strategic direction, epitomized by its over-reaching and over-priced $16 billion acquisition of Jarden in 2016. Leadership has been weak at best, and issues with its accounting practices have led to an indictment of the company and a former CEO. The subsequent CEO took a top-down approach to fixing Newell but was forced out due to ineffective reigning-in of the company’s product and expense sprawl while not addressing Newell’s elevated debt burden. Reflecting the financial, operational, strategic and leadership disarray, the company’s shares have slid 84% from their 2017 peak and nearly touched their 2009 financial crisis lows. However, activist and other shareholder pressure are leading to changes in Newell’s board and top management. Chris Peterson, the new CEO, is taking the right approach: dealing with the most basic ground-level issues plaguing Newell. These include too many products, weak junior and mid-level management, weak accountability, ineffective culture, overly complex organizational structure, and weak free cash flow. This turnaround is complicated and will not happen overnight. But, the company appears to finally be on the right track, with some encouraging early progress. The shares discount almost no improvement, so as the turnaround advances, so should the shares, which remain significantly undervalued relative to their post-turnaround potential. 1. Returns are price-only and are based on periods from the prior year-end to the letter-of-record pricing date. Prices for 2023 returns, for example, are based on the period from December 23, 2022, to December 22, 2023.

Disclosure Note: The chief analyst personally owns shares of all Cabot Turnaround Letter recommended stocks, including the stocks mentioned in this article.

Stock Market Review and 2024 Outlook

We said it in last year’s Outlook, and it clearly applies again this year, “The investing world has certainly changed from a year ago.” However, the direction is the opposite: this year, the market rebounded sharply from its sell-off last year. Last year’s worries about rising interest rates have evaporated as inflation appears to be tamed and as the Fed is widely expected to cut rates at least three times next year. The recession continues to be another six months away, although economic activity has slowed. The growing number of hot wars, including Ukraine and Israel-Hamas, have become “non-issues” in their impact on the U.S. stock market, despite the awful consequences that all wars bring.

This year, the S&P 500 returned an impressive 25.9%, nearly unwinding last year’s sell-off. The tech-heavy Nasdaq Composite rebounded 45.5%, a welcome response to last year’s negative 33% return. The Dow Jones Industrial Average returned 15.3%, better than the long-term average of about 10%.

Since year-end 2019, just prior to the pandemic, markets have produced buoyant returns. The four-year annualized rates of return for the broad-based S&P 500 (+12%),Nasdaq Composite (+15%) and the more-like-the-broad-economy Dow Jones Industrial Average (+9%) have washed away the world-is-ending panic we all felt in March 2020.

Within the S&P 500, the Magnificent Seven tech stocks (AMZN, MSFT, AAPL, GOOG, META, NVDA and TSLA) went on moonshots. NVDA’s share price more than tripled during the year, while META nearly tripled, and the other five each returned at least 50%. This collection of winners, with a combined weight of nearly 30% of the index, contributed 64% of the index’s total return.

Growth stocks (+43%) trounced value stocks (+11%) once again. Large-cap stocks, driven by the Mag Seven, rose 26%, leaving small-cap stocks (+17%) in the rearview mirror despite a 13% year-end rally in small caps.

Returns among the sectors reflected their holdings of the Mag Seven. The strongest sector (Technology, +54% gain), features Microsoft, Apple and Nvidia, which comprise over half of the sector’s weight. Next, the Communications Services sector (+51%), was powered by Meta Platforms and Alphabet, given their combined weighting of nearly half of the sector. Amazon and Tesla comprise a little under half of the Consumer Discretionary sector, helping push this group to a +39% return this year. The next-best sector, Industrials, bereft of Mag Seven stocks, returned a more humbling +15%.

Elevated starting valuations and rising interest rates weighed on the Utilities sector, which slid -11%. The balance of the sectors produced returns between +10% and -5%.

Outside of the United States, returns were similar to the equal-weighted S&P 500, reflecting their lack of stocks like the Mag Seven. The MSCI EAFE index of developed country markets gained +12% (local return), buoyed by the +24% return in Japan and healthy increases in most other countries. A notable exception was the -20% decline in Hong Kong, as this market is increasingly under the sway of the mainland Chinese market. Reflecting the muted change in the U.S. dollar during the year, the EAFE index rose +14% in U.S. dollar terms.

Emerging market returns were modest at +4% in both local and dollar terms. Returns in China (-15%) were dismal for the second year running, while India (+18%) reflected that country’s improved economic prospects. Frontier markets produced a 10% gain in local terms, but this bland average hid spicy returns in countries like Nigeria (+38%) and sour returns (-37%) in Kenya.

Fixed-income returns were healthy, buoyed by falling interest rates. Investment-grade corporate bonds returned +8% but which only partly offset last year’s depressing -15% loss. Nevertheless, the merits of the 60/40 strategy were boosted by both bond and stock buckets this year. High-yield bond returns of +12% more than offset last year’s -10% loss. Commodity prices were mixed: gold rose +13% to approach all-time highs, while oil eased -8% as hefty U.S. output more than offset cuts from OPEC+. Copper prices rose +2% while wheat and corn fell -21% and -29%, respectively. Due to supply issues, prices surged for frozen concentrated orange juice (+76%) and cocoa (+68%).

Let’s review our results from last year’s Outlook, keeping in mind two of our favorite quotes about forecasts. The first, spoken by the linguistically creative baseball legend Yogi Berra, is that “predictions are difficult, especially about the future.” The second, from Warren Buffett, is that “… the only use for stock forecasters is to make fortune tellers look good.”

We certainly helped the fortune-teller industry with our prediction for a flat S&P 500 return for 2023. Our view that earnings growth would be modest was spot-on (actual growth is likely to be about 1%) but we whiffed horribly with our view that the 16.6x earnings multiple would stay flat (it increased to 21x). Providing a modest amount of solace: the economy remained healthy, as we expected. We underestimated the size of interest rate hikes at 50-75 basis points (actual was 100) but our contrarian view that the Fed would not cut rates in 2023 proved right. Similarly, our expectation for single-digit bond market returns was in the right neighborhood.

Turning to our outlook for 2024, we see a typical year for the markets, with a 10% return for the S&P 500. The Mag Seven stocks could continue to surge, but we anticipate flat/modest gains at best for this elite group as their lofty AI-inspired valuations won’t likely be adequately supported by their ground-level fundamentals. Their pale returns should allow gains by the remaining 495 stocks to shine. We expect bonds to produce modest single-digit returns. On the economy, we see 3% growth, supported by productivity and other sources of strength, with only modest but stubborn 3% headline inflation.

From a strategic perspective, we see little change in the current trajectory of our “Two Easts” view. Washington D.C. (in the eastern U.S.) will continue to heavily influence social and economic policy, especially since 2024 is an election year. Also, Washington’s role is increasingly intermixing with the behavior of the other east, the “Far East,” as China and Russia along with Iran in the Middle East play a leading role in the new Cold War that seems to be spawning hot wars. As we wrote last year, the world is “crossing from a relatively peaceful era to a war era” and that, “In the long sweep of history, unfortunately, war and aggression, not peace, has been the norm.” We see no change in this sad trajectory.

All-in, the pace of change across markets, the country and the world will continue to accelerate. One constant, however, is human nature. It never changes. While sometimes this constancy produces dark problems, it also has markedly and consistently improved the world and the daily lives of billions of people. As a contrarian investor, we also know that the constancy of human nature produces a reliable crop of out-of-favor stocks with real value. We repeat our closing comments from last year, in which “… consumers, companies and countries – amazing sources of ingenuity and resolve – work their magic to adapt to whatever curve balls are thrown at them. Our optimism is undaunted.” Onward to 2024.

High-Yield Bonds: Review and 2024 Outlook

Public company bankruptcies surged in 2023, reflecting a combination of tighter capital market conditions and broken business models. Ninety-three companies filed for bankruptcy compared to 34 last year. The aggregate asset total more than doubled to $65 billion. As with last year, we excluded from our roster the Chapter 15 filings of companies with insignificant U.S. operations, including Evergrande Group ($267 billion in assets) and Sunac China Holdings Ltd ($148 billion). More foreign companies are taking advantage of the U.S. bankruptcy system, but these distort the underlying picture in our domestic market.

We remind readers that we also exclude financial companies due to their elevated asset totals. A notable financial bankruptcy excluded from this year’s tally this year was SVB Financial Group, as were the failures of First Republic Bank and Signature Bank whose businesses were placed under FDIC control, and Silvergate Capital which liquidated its operations.

The largest bankruptcy was filed by WeWork, the one-time trendsetter that collapsed due to a structurally flawed business model. Well-known retailers like RiteAid, Bed Bath & Beyond and Party City also succumbed. Mallinckrodt’s failure (its second in three years) was widely expected but Yellow Corporation’s announced liquidation was a surprise – its operations may still be salvaged due to their valuable trucking industry assets.

Looking ahead, we anticipate a steady flow of new bankruptcies due to continued pressure on weak, over-levered companies. Capital markets remain restrictive, but it takes time for these kinds of companies to fail. Creditors are in the “amend and pretend” stage – amending their agreements to relax debt terms while pretending that the company’s profits will improve. Structurally unprofitable Wayfair remains an enduring example of this phenomenon. Also, the resilience of the U.S. economy continues to provide a tailwind.

Eventually, however, higher interest expenses will begin to overwhelm unprofitable companies and creditors will grow weary of the amend and pretend game, leading to a higher number of bankruptcies. Also, the previously voracious appetite among institutional and retail investors for income-producing assets has faded – which will increasingly dampen lenders’ enthusiasm and capacity to refinance unserviceable debts.

Today, conditions in the high-yield bond market remain roughly neutral (neither favorable nor unfavorable). Yields at 7.7% appear reasonably attractive. However, the embedded 3.4 percentage point premium to Treasuries provides only modest protection from defaults, which could readily rise to 3 to 4 percentage points in an economic downturn. And, this premium is below the 5.0% midpoint of the past 25 years and close to the 3.0% spread that marked the low since the global financial crisis. Spreads could certainly expand from here: several times this century the spread reached 7.5 percentage points, with the peak spread hitting a massive 20 points in the depths of the global financial crisis.

The credit markets have changed immensely in the past decade. The rise of private credit (cousin of private equity) has siphoned away much of what previously would have been financed with traded bonds. This trend has changed the composition of public high-yield bonds such that comparisons of default rates with prior cycles may be less useful. One change is that credits that are funded by today’s high-yield bonds tend to be, in aggregate, higher credit quality. This would imply a lower default rate.

All-in, high-yield bonds in general have moderate attractiveness but are not obviously mis-priced. Our preference is to wait until market conditions turn grim. This produces the highly attractive opportunities that not only generate impressive profits but also, counterintuitively, carry the lowest risk due to the heavily discounted prices.

RECOMMENDATIONS

Purchase Recommendation: Mohawk Industries (MHK)

Mohawk Industries (MHK) 160 S. Industrial Blvd Calhoun Georgia 30701 www.ir.mohawkind.com

Symbol MHK Market Cap $8.7 billion Category Large Cap Business Flooring Mfg Revenues (2023e) $11.1 Billion Earnings (2023e) $580 Million 12/22/23 Price $103.11 52-Week Range: $76.02-130.63 Dividend Yield: 0% Price target: $165

Background:
Mohawk Industries is a major global producer of flooring including carpets, tiles, laminates and vinyl. Based in northwest Georgia, near Atlanta, the company was founded in 1902 in upstate New York. The company grew both by organic expansion and mergers and completed its initial public offering in 1992 at the split-adjusted equivalent of $4.45/share. Since then, Mohawk has made over 40 acquisitions which expanded its product offering and geographic scope. Today, the company generates over $11 billion in revenues from sales in 170 countries, grouped into three segments: Global Ceramics (38% of sales), Flooring North America (35%) and Flooring Rest of the World (27%). Mohawk has production facilities in 19 countries.

The company’s shares have tumbled 55% from their cyclical peak in 2021 and now trade unchanged from their 2007 price. The pandemic-driven surge in residential demand is fading, while commercial demand is softening from slowing economic growth in much of the world along with reduced office demand as workers embrace remote work. To fill under-utilized factories, many flooring manufacturers are turning to profit-eroding discounting. Also, until recently, raw material and energy prices were surging, adding pressure to already-tight margins. Mohawk has taken $1.6 billion in goodwill write-offs since 2021 to reflect the weak conditions.

Analysis:
Profitably investing in a cyclical company like Mohawk requires favorable answers to three basic questions: can the company survive until the upturn, what will industry conditions be like in the upturn, and does the current share price offer an attractive-enough entry point. We believe Mohawk favorably addresses all three.

First, Mohawk is highly likely to endure until the upturn. It is a well-managed company, capably led by CEO Jeff Lorberbaum for over 22 years. Lorberbaum’s 15% ownership stake, partly gained by Mohawk’s acquisition of Aladdin Mills in 1994, which his parents founded in 1957, creates strong alignment with all shareholders to maintain durable business fundamentals with a long-term time horizon. The company has been a capable integrator of its 40+ acquisitions, which have helped produce a geographically diversified company with cost and distribution advantages over its many competitors. It sells to both residential and commercial end-users for new construction as well as remodeling purposes, further expanding its reach and tamping down its cyclicality. The company regularly upgrades its asset base, adjusts its cost structure, trims or closes facilities that become uneconomic, and remains relevant by adding products that are growing in demand. Mohawk is following this recipe in the current weakening environment.

Mohawk has the financial strength to readily survive a downturn. Despite lower profits relative to the 2021 peak, the company continues to generate healthy net income of over $500 million. EBITDA will likely be above $1.4 billion, and we project free cash flow of close to $600 million this year. For 2024, our assumptions are for roughly a repeat of 2023, even as consensus estimates are for a better year.

The balance sheet is investment-grade and carries a modest $2.6 billion in debt – less than 2x adjusted EBITDA. Of this, about $900 million matures in 2024 and carries a 5.87% interest rate. We anticipate that the company will have no difficulties refinancing this at roughly the same interest rate. The next major maturity is $529 million due in 2027. Overall, even if the downcycle deepens, Mohawk has the financial capacity to stay afloat without risking its survival.

We see the post-downturn industry as being at least the same size as the pre-downturn industry. Inexorable global growth, along with rising global incomes that provide a general tailwind as developing countries broadly upgrade their building stock, support our view. Mohawk’s end-customer industries – new residential and commercial construction, as well as remodels/renovations – will be key components of the world’s economy for a long time. The company’s products are highly relevant and well-positioned to fully participate in the recovery. And, many weaker competitors’ outdated factories will likely fall away, allowing at a minimum for Mohawk to maintain its market share. We see little reason to believe that the post-downturn industry profit structure will change significantly.

Mohawk’s shares provide an attractive entry point. Not only are they trading near long-time lows, but more important, the share valuation is low on key metrics. On current earnings, the shares trade at a 6.1x multiple – nearly at the lowest level in the past two decades. Our price target is based on an 8x EV/EBITDA multiple, comparable to the mid-point for the shares over the past two decades.

On an EV/sales basis, which avoids much of the cyclicality that complicates the use of earnings multiples, the shares similarly trade near long-time lows. On estimated 2024 results, the shares trade at a 0.8x multiple – among the lowest in the past 20 years outside of the global financial crisis and the trough of the pandemic period. For perspective, Mohawk shares traded at a 2.25x multiple at their 2018 peak, and a 1.5x multiple at their 2021 peak. If we use a modest 1.25x multiple, roughly the 20-year average, the shares would be worth $173 each.

Mohawk shares are not risk-free. Major risks include an economic downturn that could be deeper and longer-lasting than anticipated and feature simultaneous weakness across all geographies and segments. Competition is aggressive and could turn to heavy price discounts. General execution, currency changes and other risks could impair the shares’ value. Impatient investors could readily push the shares lower.

All-in, Mohawk shares are trading at an attractive entry point for long-term investors. While past performance is no guarantee of future returns, the opportunity looks comparable to our years-ago recommendation of Mohawk shares: our March 2019 recommendation generated a +51% profit.

We recommend the purchase of Mohawk Industries (MHK) shares with a $165 price target.

Performance

The following tables show the performance of all our currently active recommendations, plus recently closed out recommendations.

Large Cap¹ (over $10 billion) Current Recommendations

Mid Cap¹ ($1 billion - $10 billion) Current Recommendations

Small Cap¹ (under $1 billion) Current Recommendations

Most Recent Closed-Out Recommendations

Notes to ratings:
1. Based on market capitalization on the Recommendation date.
2. Total return includes price changes and dividends, with adjustments as necessary for stock splits and mergers.
* Indicates mid-month change in Recommendation rating. For Sells, price and returns are as-of the Sell date.
** BNRE return includes spin-off value of BAM shares.
*** GE total return includes spin-off value of GEHC shares at January 6, 2023 closing price to reflect our sale.

The next Cabot Turnaround Letter will be published on January 31, 2024.