Cabot Turnaround Letter Issue: July 26, 2023

Mid-Year 2023 Stock Market Update

Surprising nearly all investors and market followers, the stock market has surged 19.2% this year (year-to-date¹ S&P 500 total return). If stock prices can be boiled down to two drivers – earnings and interest rates – both have been supportive.

A remarkably enduring economic and jobs cycle has bolstered confidence in company earnings. After strong growth during the pandemic years, earnings this year are likely to remain steady, at a level nearly 34% higher than in 2019, rather than experience a decline like many had anticipated. Next year, earnings are expected to resume growing at a healthy 12% clip. All-in, investors are confident that earnings growth is healthy.

And the steady weakening of actual and expected inflation has calmed worries about the possibility of ever-higher interest rates. While the 10-year U.S. Treasury yield of 3.8% is sharply higher than the 1.5% yield at the start of 2022, this increase was discounted by last year’s stock market sell-off. Yields so far this year are essentially unchanged since last December.

It’s no secret that the gains in the S&P 500 have been concentrated in the seven largest stocks, all of which are technology stocks. The so-called Magnificent Seven have returned, on average, a remarkable 91% this year, and are responsible for roughly 80% of the index’s return. The contribution of the “Other 493” has been only 20%. This is arguably the most concentrated production of returns on record. The Magnificent Seven comprise an elevated 28% of the S&P 500 index weight. One could make a legitimate case that the S&P 500 is now a concentrated growth fund rather than a diversified core fund.

Looking at the index performance from another perspective: The Equal-Weighted S&P 500 (each name is weighted equally, rather than by market capitalization) has generated only a 7% return, while the Dow Jones Industrial Average has returned 7.5%. Generally, the three indices track each other relatively closely.

With the surge in mega-cap tech stocks, growth stock returns (+31%) have been sharply stronger than value stock returns (+8%). Without any comparable source of gains, small-cap stocks (+12%) haven’t been able to keep up with their larger brethren.

Returns elsewhere have been reasonably strong. Developed country stocks, as measured by the EAFE index, have gained 9% in local currencies. Emerging market stocks have returned a more modest but respectable 7%. While returns have been generally consistent across developed countries with the exception of Hong Kong (-8%), there has been a wide spread among emerging market countries. Returns in China (-2%), the Gulf Coast countries (3%) and Turkey (-12%) have paled in comparison to those of Korea (+22%) and Eastern Europe (+18%).

Fixed-income returns have recovered from a weak 2022. Investment-grade bonds have gained 4%, while high-yield bonds have returned 7%, with speculative CCC-rated bonds rebounding with a 12% return. Despite the Fed’s rate increase campaign, 10-year Treasury yields are essentially unchanged from year-end, at 3.84%.

Key commodity prices are also essentially unchanged this year: West Texas Intermediate crude oil is down only 4% to $77/barrel, gold has increased 8% to $1,964/ounce, and copper is flat at $3.82/pound. Cocoa (+31%) and live cattle (20%) have been notable winners while wheat (-12%) has been a laggard.

Compared to our Year-End 2022 Outlook for 2023, we are on track on nearly all metrics (earnings growth, economic growth, interest rates, bond market returns) except the one that perhaps matters the most: stock returns. Our expectation for a flat S&P 500 is currently looking exceptionally wide of the mark. The surge in the Magnificent Seven stocks caught us by surprise, although we did capture some of the gains through our recommendation of Meta Platforms (META) in January. Perhaps we should have extrapolated our enthusiasm for Meta Platforms to stocks in general.

What do we see for the remaining five months of 2023? Momentum and enthusiasm for artificial intelligence (AI) could continue to propel the Magnificent Seven ever higher. But with their valuations, averaging 49x expected earnings, fully reflecting that momentum and enthusiasm, any disappointments would rattle their share prices. Artificial intelligence may be world-changing in a decade, but it won’t repeal the law of gravity. The overall economy looks resilient, but any similar disappointments would weigh on prices of the “Other 493.” If we could re-set our market outlook, we would say that stocks are flat from here to year-end. We’ll leave unchanged our other forecast metrics.

In terms of valuations, the S&P 500 currently trades at 21x estimated 2023 earnings and 18.5x estimated 2024 earnings. In an environment of 5% short-term interest rates, these multiples strike us as elevated but not towering. But clearly, value is to be found outside of the Magnificent Seven and the other enthusiastically bid-up growth stocks.

We remain steadfast in our view that the “Two Easts” remain a major source of risk. The Near East (the Federal Reserve and the federal government overall) may be fading in short-term stature: The Fed is nearly finished with its rate hike campaign and the generous fiscal stimulus has peaked. Over time, however, the Near East’s influence will remain large, including the effects of annual interest payments on the Federal debt that will cross $700 billion this year (and will reach $1 trillion in a few years), budget deficits of at least 5% of GDP as far as the eye can see, the resumption of student loan payments, rising anti-trust and other regulations, and next year’s presidential election. We see little relenting of the growing influence of the “Far East” (China) across the economic, political and military environment, nor the war in Eastern Europe.

As always, we remain optimistic about American companies, the U.S. economy and our society. The future is rarely a straight line up, but rather one that zigs and zags as it moves in the right general direction. We see a continued vibrant future even if at times the visibility can be murky.

Note: Returns are total returns through July 21, 2023.

Mid-Year High-Yield Bond Review: Still “Not Unfair Enough”

At year-end, we wrote that 2022’s decline in high-yield bond prices made these securities incrementally more interesting. Our view was that market conditions were roughly neutral (neither favorable nor unfavorable), as the bonds’ yield of about 8.7% better compensated investors for rising default rates and other risks. Today, conditions haven’t changed much, so our view is unchanged. Professional investors who focus exclusively on bonds may be satisfied with the marginally favorable risk/return trade-offs in the high-yield segment, much like a professional blackjack player may be satisfied with a tiny edge over the house. But for everyone else, the edge on high-yield bonds isn’t high enough yet for more than nibbling on selected credits.

One measure of “unfairness” or “edge” is the spread on high-yield bonds compared to the likely default rate. The average high-yield bond today offers a 390-basis point higher yield (100 basis points equals 1 percentage point), or spread, over risk-free Treasury bonds. The default rate on high-yield bonds is expected to be around 3.5% this year and 4.0% next year. Investors are therefore likely to be fairly but not excessively or unfairly compensated for these default rates relative to Treasuries. We are looking for an environment with excessive compensation.

Let’s add some historical context to these numbers. Today’s 390-basis point spread is about where it was just prior to the pandemic. In the priced-for-perfection market like year-end 2021, spreads fell to 310 basis points, or 3.1%. This compares to periods of moderate stress like late 2011, mid-2016 and early 2022, when spreads jumped to 8-10%. For the market to be “unfair enough” in the right direction, we want spreads to at least be in this 8-10% range. In an ideal environment, like during the global financial crisis, spreads expanded to over 20%. Subsequent high-yield bond returns were stunningly generous.

Similarly, default rates appear to be around historical averages. During the perfection markets of just a few years ago, the default rate was less than 1.0%. Cheap and easy money combined with a booming economic rebound to produce conditions such that even the weakest of credits could survive. During the past 20 years, high-yield default rates averaged 3.6%. Scrubbing out the few years with elevated defaults like 2009 (5.3% rate), the typical year features a default rate of about 2%.

The primary question today for high-yield bond investors: What will the default rate be during the next five years or so? Will defaults be at a “typical” 2% pace, or the average of around 4%, or elevated like in 2009? If the default rate remains low, high-yield bonds would provide incrementally attractive returns. If the rate upshifts to 5%, not so much.

While the consensus default rate estimate points to a 4% pace, a worse outcome is possible but a better one seems unlikely. The past 20 years have featured a secular decline in interest rates, easy credit terms and surging flows of capital into riskier bonds. These have provided a tailwind that supported more and more marginal companies. With the reversal of these tailwinds, much of the burgeoning supply of zombie companies may eventually succumb to bankruptcy. Bondholders eventually will tire of efforts to provide “extend and pretend” financing, like that recently received by Carvana (CVNA), a company whose business model is perhaps inherently unprofitable. Stalling or reversing economic growth will likely accelerate creditors’ feelings of exhaustion.

Our bankruptcy statistics, shown nearby, indicate that 2023 is pacing above last year. Notably, these numbers exclude the major bank failures (including three of the four largest in U.S. banking history). Currently, two of the three ingredients for a bankruptcy cycle – rising/higher interest rates and tightening access to capital – are now in place. The third ingredient, a stalling/shrinking economy, seems to be delayed, at least.

So, all-in, we see high-yield bonds priced for a “fair game” and wait patiently for the game to be tilted in a much more favorable “unfair” direction. That time will come, but it is not here yet.

RECOMMENDATIONS

Purchase Recommendation: Kopin Corporation (KOPN)

Kopin Corporation 125 North Drive Westborough, MA 01581 www.kopin.com

Symbol KOPN Market Cap $227 million Category Small Cap Business Optical Technology Revenues (FY2023e) $44 million Earnings (FY2023e) Break-even 7/21/23 Price $2.03 52-Week Range: 0.94-2.50 Dividend Yield: 0% Price target: $5.00

Background: Founded in 1984, Westborough, Massachusetts-based Kopin is a small company that focuses on developing high-performance optical display technologies, including headsets and other applications, for military, enterprise, industrial and consumer products.

Other than the dot-com bubble in 1999, and a hype cycle in 2021 when meme investors drove Kopin shares to over $13 based on ill-founded hopes for its augmented reality (AR) and virtual reality (VR) potential, the shares have had a moribund history since the 1992 IPO. The problem: The company was essentially a research hobby for the brilliant scientist and founder, John C.C. Fan.

Prior to creating Kopin, Fan, 79, was a leader at the Electronic Materials Group at MIT’s Lincoln Laboratory, a U.S. Department of Defense-funded research center focused on advanced technologies. Fan earned a Ph.D. in applied physics from Harvard University and holds over 70 patents. While clearly having standout intellectual capabilities, Fan appeared to have little interest in creating a sustainable business. As a shareholder and as the president, CEO and chairman, Fan had essentially total control.

The result was the creation of a milieu of impressive-sounding technologies but few commercially viable products. Not surprisingly, Kopin generated an almost uninterrupted stream of operating losses since its founding. To fund its losses, the company routinely raised new equity by selling shares. Kopin’s share count grew 10-fold since the mid-1990s.

With its chronic losses, intensive dilution and near-zero chance of any commercial success, it is no wonder that investors have ignored Kopin’s shares.

Analysis:

Seismic changes are underway at Kopin that look poised to radically change this company’s trajectory. Most important, the founder and chairman recently voluntarily stepped away from the business and is no longer an employee or the chairman (he remains a director). Instead, he is devoting his energy to Lightning Silicon Technologies, a recently spun-off segment that remains 20% owned by Kopin. A new and impressive outsider was hired in September 2022 to lead the company as CEO and president. James Brewington, a long-time outside director, was selected as the new chairman in May 2023. The board has hired respected executive recruiting firm Egon Zehnder to help develop a board succession plan, indicating that the board may be refreshed at next year’s board elections.

The new president/CEO, Michael Murray, is a well-chosen executive as he brings strong entrepreneurial, technical, operations and turnaround capabilities to Kopin. Murray previously led a successful turnaround of the cyber business for Ultra Electronics Group, a major British defense and security company. Before Ultra, he gained valuable experience at early-stage cyber companies following more than a decade of senior executive and operations leadership at Analog Devices. Analog is an exceptionally well-managed semiconductor company – no doubt Murray will be applying much of the Analog processes to Kopin. Along the way, he earned an MBA from MIT.

His top strategic priority for Kopin is to exit 2023 at cash flow break-even and generate an operating profit in the first quarter of 2024. To achieve these goals, Murray is investing in new equipment, increasing employee and process efficiency, hiring capable new talent in key operations, and improving quality, which should allow Kopin to produce more with fewer resources. Additionally, research projects must now meet high hurdles for likely commercial success and for returns on investment.

The quality initiatives have a critical side benefit. Creating a reputation for meeting production and quality targets will provide the pedigree necessary for Kopin to compete for more and higher-value defense and commercial contracts. Kopin is already making progress with winning new contracts – this pedigree could help provide it with immense new opportunities.

Helping boost profits: Kopin’s recent spin-off of 80% of Lightning Silicon Technologies. This transaction removes as much as $9 million of unproductive operating expenses from Kopin’s books even as the company retains all intellectual property rights and a partial royalty stream.

Kopin is focusing its R&D on microdisplays, a $2 billion market that is expected to reach $6 billion by 2028. These displays overlay digital information onto the analog world. While weapons applications are the key end-market, other uses in the medical, industrial, consumer and automotive industries could also be significant. Helping its commercialization efforts, Kopin has a long-established customer base with Tier 1 global companies like Collins Aerospace, General Dynamics, Lockheed Margin, 3M and Google. The company has over 200 patents issued or pending, providing a solid in-house intellectual base for all of the critical technologies.

Murray aims to boost revenues and profits by not only commercializing the company’s technologies and boosting its operating efficiency, but also by moving up the value chain. Most of its products are sold as components with low prices and low margins. But, shifting into assemblies and systems could boost per-product prices by as much as 10-fold and margins to as high as 50%.

To provide a solid financial footing, Kopin raised $22 million in a highly dilutive equity offering earlier this year. Given the company’s new focus on profits and free cash flow, it very well could be the last. In addition to funding near-term losses and equipment upgrades, the capital provides Kopin with enough balance sheet strength to be eligible to bid for attractive new contracts. Two side benefits: one, the new capital helps keep Kopin shares as members of various stock indices. And two, Fan’s ownership is now diluted down to a 5% stake, providing the other shareholders with a controlling vote. Kopin continues to be a debt-free company.

Kopin’s shares have doubled from the $1 floor earlier this year. Yet, the company is getting essentially no credit from investors for its complete overhaul, despite the clear and sharp upgrade in its leadership, its redirected strategy and the sizable market opportunity. Traditional valuation metrics are not relevant given the company’s insignificant revenues and lack of profits. Even the 4.4x price/sale ratio is meaningless in the context of its current position and future opportunities. The risks of an investment in Kopin shares are high, as a failed turnaround could mean a sharp and potentially total loss to investors. But, if Kopin executes well, the upside is immense and likely much higher than our admittedly arbitrary $5.00 price target.

We recommend the purchase of Kopin Corporation (KOPN) shares with a $5 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 August 30, 2023.