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Turnaround Letter
Out-of-Favor Stocks with Real Value

January 2019

It is useful (if also humbling) to review how our prior year’s forecast turned out.

In this issue, we take a look back - and a look forward - as we assess our moves.

Cabot Turnaround Letter 119

In This Issue:

2019 Outlook

Bankruptcy Review

Favorite Stocks for 2019


Buy: Civeo

News Notes



In a reversal from last year, stock markets were broadly weak in 2018. With only a few days remaining in the year, the S&P500 index has returned –5.9%. Overseas, the MSCI index is down 18% year-to-date. Emerging market stocks, as measured by the MSCI EM index, have also declined 18%, led by Chinese-related shares which are down nearly 25%.

In U.S. dollar terms, every developed and emerging country tracked by MSCI, except Qatar, has seen their markets decline this year. Local market returns, with the notable exceptions of Brazil, Russia, India and Qatar, were similarly negative as well. Driven by the sharp fall off in oil prices, returns in the Energy (-18%) and Materials (-16%) sectors led the market’s decline, while gains in Utilities (+3%) and Health Care (+4%) provided hiding places. The newly-configured Communications Services sector, which includes Facebook (-24%), Alphabet (-1%) and AT&T (-28%), lost over 13% of its value. In a fascinating study by data firm FactSet, S&P500 stocks with the lowest percentage of “Buy” ratings at the start of the year were the top 2018 performers, while those with the highest ratings were the worst performers.

This was a reversal from 2017, when the exact opposite occurred. Growth stocks lost only 3%, outperforming value stocks which fell by nearly 10%. Large cap stocks, with a -6% return, held their value better than small-cap stocks which declined by 12%. Rising interest rates pressured bond returns, as the broadly-followed Barclays Aggregate index, which includes a wide range of government and corporate bonds, dropped 0.5%, while high yield bonds lost about 3.0% on average. It is useful (if also humbling) to review how our prior year’s forecast turned out. We were right about continued earnings growth as well as the surge in volatility making the market bumpier in 2018. However, our estimate that the S&P500 would return 6% proved to be optimistic, and our IN THIS ISSUE call for value to outperform growth missed the mark. As we anticipated, large-cap outperformed small-cap, and bond returns were mediocre at best. For 2019, we see more volatility as investors assess a wide range of risks, including slowing economies, tightening liquidity, high debt levels and political volatility.

Given this, we disagree with the widely-held narrative that a possibly deep recession is just around the corner. (We are mindful of the admonition from the late Nobel prize winning economist Paul Samuelson that “the market has predicted nine of the past five recessions.”) We think domestic economic growth will slow from its torrid 4.2% pace earlier this year, but we don’t expect a stall-out. The Fed will likely make only one or possibly no interest rate hikes, while inflation will likely stay at or slightly above a 2% rate. While investors are likely to remain wary of risk, we think 2019 could be a decent year for the S&P 500. With perhaps 4% earnings growth, a modest P/E expansion and the 2% yield, we see a 7% total return.

We see value stocks rebounding relative to growth stocks, with small cap recovering to outperform large cap stocks. Emerging market stocks should do better due to their cheapness. Bonds will likely have a better year in 2019, although we think high yield bonds will struggle as spreads widen due to higher economic risks and rising defaults. All of this said, this is a good time to re-emphasize one of our most basic investing beliefs: You should not try to time the market. Rather, you should put as much money into stocks as you are comfortable with and stay the course.

If you try to time the market, you risk getting “whipsawed” -- bailing out just before the market rebounds and getting back in again just before it peaks.


[vc_row][vc_column][vc_column_text]For the full year, bankruptcy activity slowed in 2018, but it picked up in the fourth quarter. Moreover, conditions in the debt markets suggest that the pace of bankruptcy filings could increase significantly in 2019. In 2018 (through December 20) we saw 58 publicly traded companies with total assets of $52 billion file for bankruptcy. The oil & gas sector produced the most Chapter 11 filings – 13 – again in 2018. Most of these were companies still feeling the effects of the substantial drop in oil prices back in 2014 and 2015, but a few were probably victims of the sharp decline in the price of oil over the last few months. Retail, which always features prominently in the roster of bankruptcies, was not far behind with ten filings (including two supermarket chains). The largest filer of the year was iHeart Media (which used to be called Clear Channel Communications), a radio broadcasting and billboard company, and it was fol-lowed by Sears, the retail chain.

Public Bankruptcies 2009 to 2018 The pace of bankruptcy activity picked up considerably over the last three months of the year. Since October 1, we have seen 20 bankruptcy filings by public companies with about $19 billion in assets. Seven of the 20 filers were in the oil & gas sector. If the filing pace in the fourth quarter continues through 2019, we will see about 80 filings with more than $75 billion in assets, which would rank as one of the more active bankruptcy years since 2009. In fact, we expect to see the pace of bankruptcy filings pick up even more as we go into 2019. As we have discussed before, a huge amount of lower quality bond and bank debt – approximately $1.7 trillion principal amount – comes due over the next five years. Until recently, the debt markets were very forgiving, suggesting that much of the debt could be re-financed fairly easily. However, the recent market volatility has spooked not only the equity markets, but the debt markets as well. As a result, high yield debt issuance dwindled to almost nothing in November and December. Moreover, high yield bond investors are now realizing that the relatively low interest yields they have been receiving do not adequately compensate them for the risk of future defaults. Unless the debt markets return to the blissful, carefree ways of the last few years – which we think unlikely – many of the debt issues coming due in 2019 will not get refinanced and will end up defaulting. Should the Federal Re-serve raise interest rates further or the economy soften, defaults and bankruptcies will pile up even faster. That said, while we do foresee an increase in bankruptcies in the coming year, we do not expect to see a sharp spike up in defaults like the one we experienced in 2008-09 (which was fol-lowed by an almost equally sharp decline in defaults in 2009-10). Rather, we expect the growth in bankruptcies to be more gradual and probably extend over several years. If we are correct, this will create a very favorable environment for turn-around and distressed securities investors for a number of years to come.[/vc_column_text][/vc_column][/vc_row]


[vc_row][vc_column][vc_column_text]As we do at each year-end, we are selecting our “Top Five” stocks from our list of recommendations for the upcoming year. We’re generally reluctant to narrow our list of recommendations to just a handful, as we like all of our recommended stocks, otherwise they wouldn’t be on the list. Also, we always recommend holding a well-diversified group of turnaround stocks because individual turn-around stocks can be risky. However, these five stocks appear poised for the sharpest gains in the coming year. Some have been badly beaten up in the market downturn, while others have a turnaround underway which remains unrecognized by most investors. Some years, our top picks have produced stellar returns. Four of our 2017 picks produced an average return of 43%. The fifth pick, NIHD, was a dud, but went on to gain nearly 1,000% in 2018. This past year’s selections did not fare so well (at least so far). All five fell in value, some sharply, like GE and WFT. In a few weeks, our Top Five for 2019 list will be published on our website and may receive some press coverage. As a loyal subscriber, it’s only fair that you see the list first:

ADIENT (ADNT) – The world’s largest maker of car seating is exposed to many of investors’ current fears: domestic and Chinese auto industry downturns, tariffs and a slowing U.S. economy. On top of these, it has self-inflicted operating issues, elevated debt and a suspend-ed dividend. As a result its shares have fallen 79% this past year. Given the highly negative sentiment, even a modest lifting of the macro issues would be favorable to the shares. The company’s competitive positioning is strong, and we don’t expect demand for new autos to collapse. Adient’s internal problems are fixable, with a well-matched new CEO focused clearly on making needed changes.

GENERAL ELECTRIC (GE) – Following the company’s jaw-dropping fall from the pinnacle of Corporate America, GE is a chastened company determined to work its way back from the brink. Its highly-capable new CEO is rapidly taking remedial action. The company has filed to spin off its healthcare unit, and it is divesting many of its other operations and ownership stakes, including Baker Hughes. In addition, GE has announced a split-up of its struggling Power unit, replaced another board member and is replacing its long time independent auditor. While there are still many uncertainties and risks ahead, the company appears to be finally moving in the right direction. Its heavily sold stock appears to reflect all but a worst-case scenario.

JANUS HENDERSON (JHG) – Shares of this $378 billion (assets under management) in-vestment manager have been weighed down by concerns over asset outflows from weak mutual fund performance combined with clients’ growing preference for ETFs, of which Janus offers very few. Its 2017 merger of equals didn’t go as smoothly as expected. However, Dick Weil, who led Janus’ prior turnaround, is now the sole CEO, and we believe he will bring improvements to the combined company. Most compelling is Janus’ valuation, at a very modest 6.8x earnings and 3.7x EBITDA. The company is generating considerable free cash flow and the balance sheet is strong. Moreover, the 7.4% dividend yield looks sustainable.

MIDSTATES PETROLEUM (MPO) – This small-cap oil and gas producer recently emerged from bankruptcy and now has a nearly debt-free balance sheet. Its board members collectively represent over 38% of the company shares. The tight-fisted new leadership has pared spending to the point where it is approaching break-even free cash flow. The company’s hedges offer it some protection from the recent drop in oil prices. As a potential buyer of oil fields, low oil prices should reduce what Midstates might pay for future acquisitions. Currently trading at 2x EBITDA, Midstates looks poised for a strong rebound in the coming year.

NEWELL BRANDS (NWL) – This collection of well-known consumer brands is undergoing a complete overhaul. Under the capable watch of activist investor Starboard Value, which has overseen impressive changes at companies like Darden Restaurants and Advance Auto Parts, Newell is divesting 35% of its operations over the next year or so while it improves the mar-gins and cash flow from the remaining businesses. Cash proceeds are already paying down part of its $9.6 billion in debt and will eventually fund the repurchase of up to 40% of its shares, while management plans to maintain its healthy dividend. With its turnaround well underway, we think Newell shares should perform well in 2019.


Purchase Recommendation: Civeo Corporation


Background: Civeo builds, owns and operates housing for energy and mining workers in locations too remote for conventional accommodations. The company was spun off from Oil States International in May 2014. Civeo currently owns 30 lodges and villages comprising nearly 32,000 rooms. About 64% of revenues are generated in Canada near oil sands and LNG projects. Another 26% comes from locations near metallurgical coal mines in Australia, with the remaining 10% sourced from the United States. Its customers are generally major multi-national companies that provide strong contracts that reduce Civeo’s risks.

We previously recommended CVEO as a Buy in our July 2017 Turnaround Letter at 2.05, and recommended its Sale in our July 2018 issue at 4.36 for a 113% gain.

Investors have been quick to penalize Civeo ever since its highly disappointing IPO in 2014 at the peak of oil prices. The shares fell 82% that year after posting sharply declining results, exacerbated by management’s controversial decision to not convert into a real estate investment trust (REIT). Improved profits, Civeo’s sensible Noralta and Lake Charles acquisitions earlier in 2018 and some flexibility from its lenders drove a sharp rebound earlier this year leading to our sell recommendation. However, the recent drop in oil prices along with some operating issues and highly risk-averse investor sentiment (probably coupled with year-end tax loss selling) have pushed CVEO shares down (again) to near-record lows.

Analysis: While weak oil prices do not help Civeo’s outlook, its business is more durable than it might appear. Many of its customers have made long-term commitments to large scale projects for extracting hydrocarbons and minerals. These projects are less-sensitive to short-term commodity price volatility. Civeo’s Canadian operations serve massive oil sands facilities along with natural gas-related pipelines and export facilities. Conditions in Australia are improving as prices for metallurgical coal stay close to $200/ton. Even in the U.S. where oil production can be turned off more quickly, the company has relocated much of its mobile accommodations fleet to the more attractive Permian and Mid-Continental regions.

Civeo is well-positioned to benefit from a recovery in oil prices as well as stability in natural gas and coal prices. With many of its costs fixed, incremental increases in room demand translate into higher profits. Civeo’s assets remain competitive and relevant, reflected in its receiving commitments for new rooms for Canadian LNG operations, its rising occupancy rates in Australia and higher revenues in the United States.

The company is very focused on fixing its recent operating problems, and many other things are going in the right direction. Civeo remains on track to achieve the targeted C$10 million in annualized savings from the Noralta acquisition while maintaining overall tight cost controls. Confidence from its lenders has given the company more flexibility to fund capital outlays related to its recent contract wins. Civeo continues to generate positive cash flow from its operations.

While Civeo shares offer considerable upside potential, they are not without risk. Its financial results and share price remain vulnerable to volatile and unpredictable commodity prices as well as global economic conditions – all magnified by elevated debt levels on its balance sheet. However, we believe that the return potential of Civeo shares, particularly given the currently deep negative sentiment, more than outweighs these risks. We recommend the PURCHASE of shares of Civeo (CVEO) up to 2.

NEWS Notes

NII Holdings is increasingly likely to be acquired. We think the selling price could be significantly higher than the current stock price, and so we are raising our rating to BUY with a 7 limit. Weatherford continues to struggle with weak oil prices and its complicated turnaround. Given the risks posed by its very high debt load, we are reducing our rating to HOLD. Blue Apron will likely turn EBITDA positive next year but at a lower level than we estimated due to revenue declines. On the other hand, a new alliance with Weight Watchers looks promising. We still like the stock, but are reducing our BUY limit to 2. Bristow’s operating outlook has darkened with the lower oil prices while its recent acquisition now appears to be unfavorable. We are reducing our rating to HOLD.


The tables below and on the next page show the performance of all of our currently active recommendations, plus recently closed out recommendations.