Thank you for subscribing to the Cabot Turnaround Letter. We hope you enjoy reading the July 2022 issue.
As we approach the mid-point of the calendar year, we provide our traditional mid-year update for the stock market and high-yield bond market. Our commentary on stocks reviews what sectors worked (only one), what sectors and stocks stood out as the weakest, how the value vs. growth shift has played out so far, and what helped developed markets outside the United States limit the depth of their selloffs. We also discuss the state of two key drivers of future stock market performance, the role of the two “Easts,” and offer some advice on what not to do in this market, as well as a suggestion about what value investors might want to do.
Our call last year to avoid high-yield bonds, cousins of sorts to turnaround stocks, was spot-on. We walk through the effects of inflation on the two components of high bond yield prices, provide some historical perspective on yield spreads, and describe how only two of the three ingredients for a bankruptcy cycle are in place. We also suggest that while high-yield bonds are more attractive today than a year ago, it is still a time to be selective.
Our feature recommendation this month is ESAB Corporation (ESAB). This high-quality company was recently spun off from Colfax Corporation and checks nearly all of our boxes for an appealing turnaround stock, yet it is being overlooked as investors migrate to familiar stocks.
We note our recent ratings change of Marathon Oil (MRO) from Buy to a Sell.
Cabot Turnaround Letter Issue: June 29, 2022
Mid-Year Stock Update: Time to Selectively Buy Bargains
As we approach the midpoint of 2022, the S&P 500 has produced a sharp 17% year-to-date loss. This is among the worst first-half results on record. Our original estimate for a full-year return of 5% is looking exceptionally optimistic.
Every sector except Energy produced a loss, including the Utility sector (-2%), which couldn’t overcome the drag of rising interest rates. Across sectors, returns diverged: Healthcare stocks, led by major pharmaceuticals, fell only 8%, while Communications stocks fell 26%. The Communications sector is home to Meta Platforms, née Facebook (-49%) and Netflix (-68%). Shares of Netflix were the weakest in the S&P 500 and have plummeted 73% from their all-time high set last November – erasing $226 billion of market cap. Technology sector stocks fell 23%, as stalwarts like Apple (-20%) and Microsoft (-20%) weren’t immune to the sell-off. For investors holding large positions in Energy stocks (+32% return), the year has been sunnier, led by a 98% rebound in the debt-laden but now Berkshire Hathaway favorite Occidental Petroleum (OXY). OXY’s return was more than double the S&P 500’s second-best stock, ExxonMobil (+42%). Outside of the Energy sector, only 78 stocks produced positive returns.
Value stocks fell 11%, buoyed by the group’s sizable exposure to the Energy sector and lack of meaningful exposure to over-priced mega-cap tech stocks. Growth stocks tumbled 25% as rising interest rates, a slowing economy and tighter capital market conditions pressured these companies’ stretched valuations.
Small-cap stocks fell 21%, a bit worse than large-cap stocks. Developed market stocks slumped 20% in dollar terms – not much different from the U.S. markets – but in local terms, which removes the effect of this year’s strong dollar, developed market stocks fell only 14%. While the lack of mega-cap hyper-growth tech stocks weighed on developed market relative returns in recent years, it clearly helped limit the depth of the current sell-off. Emerging market local returns were in line with developed market local returns, but this masked some large differences: gains in the Czech Republic (+13%) were blended with large losses in Poland (-27%) and Hungary (-32%). A rebound in Chinese shares led to a respectable 11% decline year-to-date in that market.
As stock prices have tumbled, the market’s valuation has compressed. The S&P 500 currently trades at a 15.8x multiple of the consensus year-ahead earnings estimate. This multiple is below the 10-year average of about 17x earnings and roughly in line with its average over many decades.
With the market’s struggles, the initial public offering window remains closed. So far this year, only $4.2 billion has been raised through IPOs, with nearly 20% coming from the debut of Bausch & Lomb. Other speculative securities markets have shriveled, as well, as it appears that rampant enthusiasm is being slowly wrung out of the market.
What do we see for the rest of 2022? Let’s look at two primary drivers of the market: earnings growth and interest rates.
Earnings growth remains supportive. The consensus estimate calls for 2022 earnings growth of 10%, with only a modest tapering to 9% next year. While analysts have trimmed their estimates for second-quarter S&P 500 earnings growth to a 4% pace, they haven’t noticeably reduced their full-year estimates. We will no doubt learn more about what companies expect for the rest of the year in the upcoming conference calls following second-quarter earnings reports.
The broad economy, which provides the foundation for corporate earnings, appears to be at least stable. Yet, the outlook remains highly uncertain, even around second-quarter GDP growth which is the most easily estimated given that we have two months of data already. The consensus second-quarter growth rate is around 1.9%, but the Atlanta Federal Reserve Bank’s GDPNow forecast calls for a 0% growth rate. Estimates for the full year and for 2023 are equally divergent, a far cry from the year-ago consensus for continued strong growth. Inflation is eroding consumers’ ability and willingness to spend, while higher interest rates are weighing on debt-funded spending on capital goods ranging from new homes to new business start-ups. Yet there are other factors that can’t be easily estimated which could nevertheless bolster growth, hence the lack of clarity.
The already challenging forecasting task is further complicated by the thick fog of inflation which must be accurately measured so that real (inflation-adjusted) economic activity can be properly separated from nominal (actual) activity. Regardless of what GDP numbers are reported, they represent only a rough estimate of the real economy and as such should be taken with a sizeable dose of salt.
The most we can say about the economy is that we think there is little chance of a deep recession over the next few years, but a recession of some type seems likely. We place little credibility on any economic forecast, even our own, and are reminded that Warren Buffett’s comment, “the only value of stock forecasters is to make fortune tellers look good,” can equally be applied to economic forecasters.
The other driver of stock prices – interest rates – seems to be on a permanently higher plane as a return to zero interest rates is highly unlikely. The Fed’s fight to tame inflation ends and possibly reverses the trend over the past 40 years when rates steadily fall and thus remove a secular tailwind behind stocks. If inflation remains elevated at an 8-9% rate, there is little chance for the 10-year Treasury yield to remain at the current 3.2%. Historically, this yield floats around the inflation rate plus/minus two percentage points. The market is not pricing in a 6-7% Treasury yield. All-in, given earnings growth that is probably topped out and interest rates that are unlikely to come down, we see little chance that the market returns to its record high anytime soon.
We also see further downside in stocks if earnings growth stalls or reverses alongside continued increases in interest rates. We see elevated risk from a financial accident – that some investment fund somewhere will fail and send credit shockwaves across all markets. A repeat of the Lehman Brothers failure seems unlikely, however, as most financial institutions have much stronger capital levels and risk controls, which should serve to limit financial contagion.
Our view that the market will continue to be heavily influenced by the two “Easts” – the Near East (fiscal, monetary and regulatory/legal from Washington, D.C.) and the Far East (China) – remains intact. The new wildcard of Russia’s invasion of Ukraine was a surprise and is poised to tragically grind along, taking a heavy toll measured both in human terms and economic terms while also threatening the planet’s 75-year geopolitical structure.
For investors in general, the burn-down of former high-flying stocks is not necessarily an invitation to buy them. Some companies have zero value regardless of their prior trading history. Any stock can lose 100% of its value – it doesn’t matter if it was purchased at $200/share or $2.00/share.
It is also not a good time to attempt to time the market’s bottom. Nobody picked the market top, and nobody will pick the bottom, either. Own as much in stocks as you can while still sleeping well at night, and focus on company-specific valuations and fundamentals.
For value investors in particular, this is a time to selectively begin to buy with their large cash reserves after having found relatively little to buy over the past few years. This isn’t market timing – it’s staying with a discipline that says if there isn’t much in the way of good bargains to buy, then don’t buy much. And when there are more stocks worth buying, then buy more. There is more to buy today.
Mid-Year High-Yield Bond Review: More Attractive, But Investors Should Be Patient
We’ll be the first to admit that we are not high-yield bond market savants. But we are keen observers of high-yield bond prices and the risk/return trade-offs for these cousins of turnaround stocks. So, when at the end of 2021 high-yield bonds were priced for perfection and were paired with near-perfect conditions (booming economy, rock-bottom interest rates, dearth of bankruptcies, investors’ voracious appetite for income-producing assets), there was only one reasonable call to make: down.
And so, our description of these securities as “Highly Unappealing” in the December 29, 2021 edition of the Cabot Turnaround Letter proved to be spot on. We saw “very limited prospects for generating profits from high yield securities” and that “rising interest rates combined with a tapering of economic growth” meant “high-yield bonds look poised to enter the unfavorable part of the credit cycle with very limited current appeal.”
Almost from the start of the year, conditions deteriorated from near-perfection. Driven by rising inflation, capital is no longer “cheap and easy” but “expensive and scarce.” Responding to the changes, high-yield bond prices dropped 13% this year – a six-month loss rarely seen in this asset class. Triple-C-rated bonds, which sit deeper in junk territory, have lost more than 15%.
Bond prices, of course, move in the opposite direction from their yields. Yields are driven by the risk-free interest rate plus the yield premium, or spread, that high-yield bonds offer as compensation for their elevated risks. This year, both components jumped higher, which dragged down bond prices.
Treasury bond yields across most maturities are about 2 percentage points higher than at year-end. Spreads have widened as investors worry about the deleterious effect that tighter access to capital and a slowing economy have on default rates. The high-yield spread widened to 538 basis points (100 basis points = 1 percentage point) from only 310 at year-end. Combined, yields on high-yield bonds are now almost 4 percentage points higher, at about 8.4%, compared to their year-end yield of about 4.5%.
For perspective on high-yield bond spreads, we look to history: last year’s 310 basis point spread was nearly a 25-year low, and today’s spread is more in line with its historical average in normal economic conditions. Spreads widened to 870 basis points in the depths of the pandemic and nearly 2,000 basis points when Lehman Brothers collapsed in late 2008.
With lower prices and better yields, how attractive are high-yield bonds today? Our approach to turnaround investing – finding stocks at the bargain end while avoiding those at the premium end – applies to high-yield bonds. In brief, we see high-yield bonds as in between the two ends: having more balanced appeal – not embarrassingly attractive nor embarrassingly unattractive. Investors are now compensated more fairly for both the risk-free component of bonds in general (based on the 3.2% Treasury yield) and for the potential for defaults (the 538 basis point spread).
We expect a rising number and dollar amount of defaults. Last year’s near-perfect conditions led to a near-record low in defaults (see nearby table), and this trend has continued through mid-year 2022. And excluding Chapter 15 defaults, which allow foreign companies to protect any U.S. assets but can inflate domestic default totals, this year would be approaching the near-zero rate that investors had priced into bonds last year.
Currently, two of the three ingredients for a bankruptcy cycle – rising interest rates and tightening access to capital – are now in place. With an uncertain economic outlook, the third ingredient – a stalling/shrinking economy – is only starting to be baked into bond prices.
One new tailwind that could restrain default rates is inflation. All else being equal, inflation allows companies to raise their prices, making it easier for them to service their debts.
All-in, high-yield bonds are more attractive than six months ago, and offer some appeal given their higher yields that more fairly compensate investors for normal default risk. We continue to encourage patience – nibble on some bonds today but be selective. While bond funds and other institutional investors are compelled by their mandates to buy high-yield bonds in all conditions, the private investor has the option to wait until conditions are highly favorable.
Purchase Recommendation: ESAB Corporation (ESAB)
ESAB Corporation (ESAB)
ESAB produces specialty industrial and commercial welding and cutting equipment, accessories and supplies, as well as equipment to control the flow of high-pressure gases. Based in Bethesda, Maryland, the company was founded in Sweden by engineer Oscar Kjellberg in 1904 following his pioneering welding innovation. ESAB’s unusual name is derived from its original name Elektriska Svetsnings-Aktiebolaget. The business was acquired by British engineering company Charter International in 1994, which in turn was acquired by Colfax Corporation, the highly regarded American company, in 2012. In April 2022, ESAB was spun off from Colfax as an independent company, with Colfax (now named Enovis Corporation) retaining a 10% stake.
ESAB is a global company. It is the market share leader in Europe, the Middle East, South America, Australia, India and China. Emerging markets account for over half of its sales. In North America, it holds the number three market share, behind Lincoln Electric and Illinois Tool Works.
After an encouraging 25% surge following their debut on April 5, ESAB shares have slipped back to near their opening day price. While much of the sell-off is likely due to the weak stock market, some is likely due to rising concerns over the global economic outlook, as the company’s revenues are affected by the pace of industrial and automotive production, oil and gas projects, and construction activity. Also, the shares may have weakened due to technical issues including different ownership constituencies that go with many spin-offs. Importantly, ESAB carries liabilities related to asbestos which can be an automatic disqualifier for many investors.
In a volatile market where many investors are fleeing to familiar names, newly-public ESAB shares appear to be getting overlooked.
ESAB shares check nearly all of our boxes. First, the company has a strong leadership team with a credible plan that is likely to succeed. At the top, the chairman is Mitchell Rales, a co-founder of Colfax (1995) and Danaher Corporation (1983), two industrial companies that are legendary for their success and focus on quality. Several other former Colfax board members serve on ESAB’s board along with two new outsiders. ESAB’s CEO, Shyam Kambeyanda, has led the company since 2016 and was instrumental in turning around the then-struggling company after its acquisition. The CFO and most of the rest of the leadership team came over from pre-spin ESAB, providing strong continuity and an easy transition.
One of the hallmarks of the leadership team at Colfax and now ESAB is their “business excellence” philosophy. The EBX system is a set of values, processes and tools that have been developed and enhanced over decades, helping drive steady improvements in margins, quality, capital efficiency, safety and innovation. Under this leadership team and the EBX system, ESAB has become a highly competitive company, with high customer loyalty and strong brands.
A core component of the EBX system is the disciplined acquisition of companies that bring needed capabilities while also helping to expand margins and efficiency. In recent years, ESAB has added robotic and automation solutions, specialty alloys and digital/internet-empowered capabilities, augmenting its in-house research and development processes that are keeping the company in a technological leadership position and provide access to faster-growing and promising new revenues.
ESAB checks the boxes for steady revenue growth and strong profits. Sales have grown at a 6.2% pace over the past five years, while the profit margin has expanded by 3 percentage points to an attractive 17.9% last year. Helping bolster its results are the recurring and profitable revenues from consumables which generate about 69% of sales. Free cash flow is robust – management guidance is for $210 million this year, equal to about 85% of earnings and headed toward the company’s goal of 100%. Its balance sheet carries a moderately elevated but readily manageable $1.2 billion in debt, or about 2.9x EBITDA, which funded a payment to its former parent. ESAB anticipates initiating a modest dividend in the near future.
We readily acknowledge some concern regarding the company’s asbestos liabilities. While ESAB no longer owns the operations which produced the liabilities, nor did it manufacture any asbestos products (the asbestos-containing components were purchased from vendors), it remains the holder of the liabilities. Our concerns are partly assuaged by insurance and other assets that fully offset the booked liabilities, by the fact that the majority of claims are dismissed for no payment, and by other factors that appear to cap the company’s maximum burn.
ESAB’s shares trade at a modest 9.4x estimated 2022 EBITDA. This undervalues its worthy franchise. The nearly 20% discount to peer Lincoln Electric (LECO) and 38% discount to Illinois Tool Works (ITW) seems overly punitive.
Recent results were encouraging. First-quarter sales grew 18% while adjusted EBITDA grew 16%, as price increases and new product introductions helped expand ESAB’s margins. Management reiterated their full-year sales and profit guidance despite the impact of their exit from Russia.
Overall, overlooked ESAB shares offer highly attractive long-term appeal.
We recommend the purchase of ESAB Corporation (ESAB) shares with a 68 price target.
Ratings and Price Target Changes
On Friday, June 3, we moved our rating on Marathon Oil (MRO) from Buy to Sell. We were reluctant to sell Marathon, as the company’s cash generating power remains incredibly strong. The shares are not expensive but are no longer the bargain they once were. Oil prices remain elevated toward the high end of reasonable. Even though Russian oil may be cut off, we are well aware of the ability and perhaps the newfound willingness of the Saudi government to open its oil taps just a bit.
The bane of being a contrarian and a value investor is that we sometimes sell too early. But we also recall the admonition of Nathan Rothschild, the incredibly wealthy financier from a few centuries ago, who, when asked how he got so rich, he replied, “I always sell too soon.”
We are a captive of our rating system, which is basically binary – either Buy or Sell. But this call is not a “sell it all today” call—rather a recommendation to start trimming out. From a tactical perspective, investors holding MRO shares may want to initially reduce any outsized positions, then gradually chip away at the remaining balance over perhaps the next few weeks. We see nothing wrong with keeping a stub position for an extended period. This would capture much of the strong profit on the shares but also allow some participation should the shares continue to ride higher.
From our initial recommendation in September 2021, the MRO investment produced a 166% total return.
Disclosure: The chief analyst of the Cabot Turnaround Letter personally holds shares of every company on the Current Recommendations List. The chief analyst may purchase securities discussed in the “Purchase Recommendation” section or sell securities discussed in the “Sell Recommendation” section but not before the fourth day after the recommendation has been emailed to subscribers. However, the chief analyst may currently hold and may purchase or sell securities mentioned in other parts of the Cabot Turnaround Letter at any time.
The following tables show the performance of all our currently active recommendations and recently closed out recommendations.
Large Cap1 (over $10 billion) Current Recommendations
|General Electric||GE||Jul 2007||304.96||67.08||-54||0.5%||Buy (160)|
|Shell plc||SHEL||Jan 2015||69.95||50.91||+6||3.8%||Buy (60)|
|Nokia Corporation||NOK||Mar 2015||8.02||4.81||-28||0%||Buy (12)|
|Credit Suisse Group AG||CS||Jun 2017||14.48||5.95||-52||1.7%||Buy (24)|
|Toshiba Corporation||TOSYY||Nov 2017||14.49||21.21||+55||3.0%||Buy (28)|
|Holcim Ltd.||HCMLY||Apr 2018||10.92||9.12||+3||4.8%||Buy (16)|
|Newell Brands||NWL||Jun 2018||24.78||20.03||-4||4.6%||Buy (39)|
|Vodafone Group plc||VOD||Dec 2018||21.24||15.66||-9||6.6%||Buy (32)|
|Kraft Heinz||KHC||Jun 2019||28.68||38.40||+52||4.2%||Buy (45)|
|Molson Coors||TAP||Jul 2019||54.96||55.77||+8||2.7%||Buy (69)|
|Berkshire Hathaway||BRK/B||Apr 2020||183.18||278.28||+52||0%||HOLD|
|Wells Fargo & Company||WFC||Jun 2020||27.22||40.76||+55||2.5%||Buy (64)|
|Western Digital Corporation||WDC||Oct 2020||38.47||47.07||+22||0.0%||Buy (78)|
|Elanco Animal Health||ELAN||Apr 2021||27.85||20.61||-26||0%||Buy (44)|
|Walgreens Boots Alliance||WBA||Aug 2021||46.53||41.65||-6||4.6%||Buy (70)|
Mid Cap1 ($1 billion – $10 billion) Current Recommendations
|Mattel||MAT||May 2015||28.43||23.5||-5||0%||Buy (38)|
|Conduent||CNDT||Feb 2017||14.96||4.46||-70||0%||Buy (9)|
|Adient plc||ADNT||Oct 2018||39.77||33.17||-16||0%||Buy (55)|
|Lamb Weston Holdings||LW||May 2020||61.36||71.91||+21||1.4%||Buy (85)|
|Xerox Holdings||XRX||Dec 2020||21.91||15.79||-21||6%||Buy (33)|
|Ironwood Pharmaceuticals||IRWD||Jan 2021||12.02||11.3||-6||0.0%||Buy (19)|
|Viatris||VTRS||Feb 2021||17.43||10.96||-34||4%||Buy (26)|
|Organon & Co.||OGN||Jul 2021||30.19||35.86||+22||3.1%||Buy (46)|
|Marathon Oil||MRO||Sep 2021||12.01||31.68*||+166*||0.9%||SELL*|
|TreeHouse Foods||THS||Oct 2021||39.43||40.6||+3||0.0%||Buy (60)|
|Kaman Corporation||KAMN||Nov 2021||37.41||31.43||-14||2.5%||Buy (57)|
|The Western Union Co.||WU||Dec 2021||16.4||16.69||+6||6%||Buy (25)|
|BAM Reinsurance Ptnrs||BAMR||Jan 2022||61.32||45.66||-25||1.2%||Buy (93)|
|Polaris, Inc.||PII||Feb 2022||105.78||107.57||+3||2.4%||Buy (160)|
|Goodyear Tire & Rubber Co.||GT||Mar 2022||16.01||11.68||-27||0.0%||Buy (24.50)|
|M/I Homes||MHO||May 2022||44.28||40.01||-10||0.0%||Buy (67)|
|Janus Henderson Group||JHG||Jun 2022||27.17||25.62||-6||6.1%||Buy (41)|
|ESAB Corporation||ESAB||Jul 2022||45.64||45.64||na||0.0%||Buy (68)|
Small Cap1 (under $1 billion) Current Recommendations
|Gannett Company||GCI||Aug 2017||16.99||3.12||+4||0%||Buy (9)|
|Duluth Holdings||DLTH||Feb 2020||8.68||10.81||+25||0%||Buy (20)|
|Dril-Quip||DRQ||May 2021||28.28||24.35||-14||0%||Buy (44)|
|ZimVie||ZIMV||Apr 2022||23.00||16.18||-30||0%||Buy (32)|
Most Recent Closed-Out Recommendations
|Trinity Industries||TRN||Large||Sep 2019||17.47||*Mar 2021||32.35||+92|
|Valero Energy||VLO||Large||Nov 2020||41.97||*Apr 2021||79.03||+93|
|Volkswagen AG||VWAGY||Large||May 2017||15.91||*Apr 2021||42.33||+182|
|Mohawk Industries||MHK||Large||Mar 2019||138.60||*June 2021||209.49||+51|
|Jeld-Wen Holdings||JELD||Mid||Nov 2018||16.20||*Jul 2021||27.45||+69|
|Biogen||BIIB||Large||Aug 2019||241.51||*Jul 2021||395.85||+64|
|BorgWarner||BWA||Mid||Aug 2016||33.18||*Jul 2021||53.11||+70|
|The Mosaic Company||MOS||Large||Sep 2015||40.55||*Jul 2021||35.92||-4|
|Oaktree Specialty Lending||OCSL||Small||Oct 2015||4.91||*Sept 2021||7.09||+69|
|Albertsons||ACI||Mid||Aug 2020||14.95||*Sept 2021||28.56||+94|
|Meredith Corporation||MDP||Mid||Jan 2020||33.01||*Nov 2021||58.30||+78|
|Signet Jewelers Limited||SIG||Small||Oct 2019||17.47||*Dec 2021||104.62||+505|
|General Motors||GM||Large||May 2011||32.09||*Dec 2021||62.19||+122|
|GCP Applied Technologies||GCP||Mid||Jul 2020||17.96||*Jan 2022||31.82||+77|
|Baker Hughes Company||BKR||Mid||Sep 2020||14.53||*April 2022||33.65||+140|
|Vistra Corporation||VST||Mid||Jun-21||16.68||* May 2022||25.35||+56|
|Altria Group||MO||Large||Mar-21||43.80||*June 2022||51.09||+27|
Notes to ratings:
- Based on market capitalization on the Recommendation date.
- Price target in parentheses.
- Total return includes price changes and dividends, with adjustments as necessary for stock splits and mergers.
- SP - Given the unusually high risk, we consider these shares to be speculative.
- *Indicates mid-month change in Recommendation rating. For Sells, price and returns are as-of the Sell date.
The next Cabot Turnaround Letter will be published on July 27, 2022.
About the Analyst
Bruce Kaser has more than 25 years of value investing experience in managing institutional portfolios, mutual funds and private client accounts. He has led two 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).