April 18, 2023

On Time

Each investor operates within their own time horizon. Day traders’ time horizon is the 4 p.m. ET market close, or shorter. Some traders focus on the calendar week, while most hedge fund traders have a month-end time horizon. Mutual funds focus on a quarterly or at most annual time horizon. Financial commentators have their own time horizons, as well. Bombastic TV or live-streaming pundits usually focus on very short horizons – “what has the stock done for me lately” is their mantra. The definition of “lately” can change but usually means “the past few weeks” or “since it stopped going up.”

We estimate that 85% of the dollars invested in the stock market operate on a time horizon of no more than six to nine months. This means that there is less competition for stocks that might take some time to work. Warren Buffett has generated immense success with his favorite time horizon of “forever.” We’re not quite “forever” holders but we clearly emphasize a long-term horizon as well. This allows us to capture profits by having a different time horizon than everyone else. The trendy buzzword for this approach is called “time arbitrage.”

One example is when a company reports a dismal quarter that misses analysts’ estimates. Usually this leads to a sell-off by short-term investors. But long-term investors can buy that exact same security on the exact same news as it produces a lower entry price. As long as the underlying long-term thesis remains in place, short-term bad news becomes long-term good news.

Efficient market hypothesis theorists say that it is impossible to beat the market because the market is all-knowing and that all information (obtained legally or otherwise) is already embedded into every stock price. For short-term investors, this is probably true – because most investors focus on gathering short-term information. With relatively few investors focusing on a horizon of a year or more, this “market” is much less efficient. Academics don’t always recognize or accept this flaw in the theory.

However, examples of this flaw in action abound. The recent inflating and collapsing of a large number of mega-cap tech stocks is a prime example. These companies were reporting comforting short-term (revenue-related) news, which helped drive up their share prices. That the same companies were benefitting from a time-limited pandemic demand surge while simultaneously reporting ominous long-term news (ever-larger losses that had to be funded by generous and free capital) was deemed to be irrelevant.

Eventually, the long term arrived: The near-term demand surge collapsed and capital became scarce, leading to the sharp sell-off in the shares. Same stocks, same long-term fundamentals, very different outcomes depending on one’s time horizon.

Buying when everyone else is selling … paying attention to long-term fundamentals … ignoring short-term noise. Maybe this trendy and impressive-sounding phrase “time arbitrage” is just a newer and fancier name for old-fashioned value investing.

Share prices in the table and discussed below reflect Friday, April 14 closing prices.

Scheduling note: With the arrival of spring vacation for our kids, we will be on a lighter publication schedule. We’ll continue to monitor all of the holdings and provide any Alerts if necessary.

Note to new subscribers: You can find additional color on past earnings reports and other news on recommended companies in prior editions and weekly updates of the Cabot Undervalued Stocks Advisor on the Cabot website.

Send questions and comments to Bruce@CabotWealth.com.

Today’s Portfolio Changes
None.

Last Week’s Portfolio Changes
None.

Upcoming Earnings Reports

Tuesday, April 25: Sensata Technologies (ST)

Wednesday, April 27: Allison Transmission (ALSN), Comcast (CMCSA)

Tuesday, May 2: Molson Coors Beverage Company (TAP)

Wednesday, May 3: Barrick Gold (GOLD)

Thursday, May 4: Gates Industrial (GTES)

GROWTH/INCOME PORTFOLIO

Cisco Systems (CSCO) is facing revenue pressure as customers migrate to the cloud and thus need less of Cisco’s equipment and one-stop-shop services. Cisco’s prospects are starting to improve under a relatively new CEO, who is shifting Cisco toward a software and subscription model and is rolling out new products, helped by its strong reputation and entrenched position within its customers’ infrastructure. The company is highly profitable, generates vast cash flow (which it returns to shareholders through dividends and buybacks) and has a very strong balance sheet.

There was no significant company-specific news in the past week.

CSCO shares slipped 2% in the week and have 31% upside to our 66 price target. The valuation is attractive at 9.5x EV/EBITDA and 13.4x earnings per share. The 3.1% dividend yield adds to the appeal of this stock. BUY

Comcast Corporation (CMCSA) – With $120 billion in revenues, Comcast is one of the world’s largest media and entertainment companies. Its properties include Comcast cable television, NBCUniversal (movie studios, theme parks, NBC, Telemundo and Peacock), and Sky media. The Roberts family holds a near-controlling stake in Comcast. Comcast shares have tumbled due to worries about cyclical and secular declines in advertising revenues and a secular decline in cable subscriptions as consumers shift toward streaming services, as well as rising programming costs and incremental competitive pressure as phone companies upgrade their fiber networks.

However, Comcast is a well-run, solidly profitable and stable company that will likely continue to successfully fend off intense competition while increasing its revenues and profits, as it has for decades. The company generates immense free cash flow which is more than enough to support its reasonable debt level, generous dividend and sizeable share buybacks.

There was no significant company-specific news in the past week.

Comcast shares rose 1% in the past week and have 10% upside to our 42 price target. The shares offer an attractive 3.0% dividend yield. BUY

BUY LOW OPPORTUNITIES PORTFOLIO

Allison Transmission Holdings, Inc. (ALSN) – Allison Transmission is a midcap manufacturer of vehicle transmissions. While many investors view this company as a low-margin producer of car and light truck transmissions that is destined for obscurity in an electric vehicle world, Allison actually produces no car or light truck transmissions. Rather, it focuses on the school bus and Class 6-8 heavy-duty truck categories, where it holds an 80% market share. Its EBITDA margin is sharply higher than its competitors and on-par with many specialty manufacturers. And, it is a leading producer and innovator in electric axles which all electric trucks will require. The company generates considerable free cash flow and has a low-debt balance sheet. Its capable leadership team keeps its shareholders in mind, as the company has reduced its share count by 38% in the past five years.

There was no significant company-specific news in the past week.

ALSN shares rose 7% in the past week, have 17% upside to our 54 price target and offer a 2.0% dividend yield. BUY

Aviva, plc (AVVIY), based in London, is a major European company specializing in life insurance, savings and investment management products. Amanda Blanc, hired as CEO in July 2020, is revitalizing Aviva’s core U.K., Ireland and Canada operations following her divestiture of other global businesses. The company now has excess capital which it is returning to shareholders as likely hefty dividends following a sizeable share repurchase program. We expect that activist investor Cevian Capital, which holds a 5.2% stake, will keep pressuring the company to maintain shareholder-friendly actions.

There was no significant company-specific news in the past week.

Aviva shares rose 1% this past week and have 33% upside to our 14 price target. Based on management’s guidance for the 2023 dividend, the shares offer a generous 7.8% yield. On a combined basis, the dividend and buyback provide more than a 10% return to shareholders. BUY

Barrick Gold (GOLD), based in Toronto, is one of the world’s largest and highest-quality gold mining companies. About 50% of its production comes from North America, with the balance from Africa/Middle East (32%) and Latin America/Asia Pacific (18%). Barrick will continue to improve its operating performance (led by its highly capable CEO), generate strong free cash flow at current gold prices, and return much of that free cash flow to investors while making minor but sensible acquisitions. Also, Barrick shares offer optionality – if the unusual economic and fiscal conditions drive up the price of gold, Barrick’s shares will rise with it. Given their attractive valuation, the shares don’t need this second (optionality) point to work – it offers extra upside. Barrick’s balance sheet has nearly zero debt net of cash. Major risks include the possibility of a decline in gold prices, production problems at its mines, a major acquisition and/or an expropriation of one or more of its mines.

Barrick released preliminary first-quarter gold and copper volumes. The company also said that it remains on track to meet its 2023 production goals. Hitting its targets is important for Barrick to maintain its credibility.

Over the past week, commodity gold settled at $2,016/ounce after touching $2,060 mid-week last week. Gold prices can be impressively volatile and have risen 25% since troughing late last year at $1,730. The recent surge is likely due to a growing popularity of the view that the Fed’s rate hike campaign is approaching its limit even as inflation remains well above the 2% Fed target.

This past week, the 10-year Treasury yield ticked higher to 3.54%. The U.S. Dollar Index (the dollar and gold usually move in opposite directions) edged fractionally lower to 101.66.

Investors and commentators offer a wide range of outlooks for the economy, interest rates and inflation. We have our views but hold these as more of a general framework than a high-conviction posture. Investing in gold-related equities is a long-term decision – investors shouldn’t allow near-term weakness to deter their resolve.

Barrick shares were flat in the past week and have 37% upside to our 27 price target. BUY

Big Lots (BIG) – Big Lots is a discount general merchandise retailer based in Columbus, Ohio, with 1,431 stores across 47 states. Its stores offer an assortment of furniture, hard and soft home goods, apparel, electronics, food and consumables as well as seasonal merchandise. Our initial case for Big Lots rested with its loyal and growing base of 22 million rewards members, its appeal to bargain-seeking customers, the relatively stable (albeit low) cash operating profit margin, its positive free cash flow, debt-free balance sheet and low share valuation. Our thesis was deeply rattled by the company’s surprisingly large inventory glut, now resolved, but which leaves the company with a hefty and permanent $300 million debt burden.

Big Lots shares remain high-risk due to the new debt balance, weak fundamentals and the possibility of a suspension or reduction of the dividend. Sentiment in the shares is very weak – investors unwilling or unable to sustain further losses in the shares should sell now, as sentiment could weaken further and drive the shares lower.

Regarding the dividend, Big Lots now has every incentive to eliminate it. Investors clearly are not convinced that it will be maintained, given the company’s likely weak profits for at least the current fiscal year. And, eliminating the $35 million in cash payouts would help the company retire its $300 million debt as well as ease future seasonal borrowings.

There was no significant company-specific news in the past week.

Big Lots shares slipped 2% this past week and have 138% upside to our revised 25 price target. The shares offer an 11.4% dividend yield, although, as noted, investors should not rely on this dividend being sustained. We continue to hold onto Big Lots’ shares as we believe the company will ultimately rebuild about half of its prior earnings base. The shares’ highly discounted valuation provides a reasonable valuation cushion, even as investor sentiment continues to push the shares lower. HOLD

Citigroup (C) – Citi 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.

This past week, the yield spread between the 90-day T-bill and the 10-year Treasury bond, which approximates the drivers behind Citi’s net interest margin, widened to negative-153 basis points (100 basis points in one percentage point). Interest rates ticked up about 5 basis points at both maturities.

Many commentators use the spread between the 2-year Treasury and the 10-year Treasury as an indicator of “inversion” of the yield curve. To us, the 2-year Treasury is too far out on the maturity curve to accurately reflect the cost of short-term money, so we use a much better measure of short-term money – the 90-day T-bill.

Citigroup reported a good first quarter, with adjusted earnings of $1.86/share falling 1% from a year ago but 11% above the $1.67 consensus estimate. Return on assets of 0.76% improved incrementally from 0.74% a year ago. Return on equity of 9.5% also improved incrementally from 9.0% a year ago. These return metrics are improving but still well below a 1.0% ROA and 12% ROE that we would consider reasonable targets. Guidance for 2023 was unchanged.

Revenues rose 12% due to higher interest rates, as fee income slipped 3%. The net interest margin of 2.41% improved from 2.05% a year ago and 2.39% in the prior quarter. Citi is having to boost the interest rate it pays on deposits to retain this funding source. The average rate paid in the first quarter was 2.72%, up from 0.33% a year ago. In the year-ago period, the 0.33% rate was about 50 basis points below the 90-day T-bill rate, while today the deposit interest rate is about 233 basis points below the T-bill rate. This incremental spread, plus the higher spread on non-interest-bearing checking deposits, is helping boost Citi’s net interest margin despite the inverted yield curve.

Non-interest expenses rose only 1% and remained controlled, particularly for a bank undergoing an aggressive overhaul. Citi’s efficiency ratio (operating expenses as a percent of total revenues) improved to 62% from 69% a year ago. Credit losses increased incrementally from the prior quarter but remained low. The bank boosted its reserves for losses to a hefty 2.65% of total loans, and the bank appears to be satisfied with this size.

Capital strength increased, with the CET1 ratio rising to 13.4% compared to 11.4% a year ago and 13.0% in the prior quarter. The bank did not repurchase any shares during the quarter. Data on the securities portfolio were not reported – we will get this from the 10Q which has yet to be filed. Deposits fell only 3% from the prior quarter and were unchanged from a year ago.

Citi shares remain attractive as they trade at 59% of tangible book value of $84.21 and offer a sustainable 4.1% dividend yield.

Citi shares jumped 8% in the past week and have 71% upside to our 85 price target. Citigroup investors enjoy a 4.1% dividend yield.

When comparing Citi shares with a U.S. 10-year Treasury bond, Citi offers a higher yield and considerably more upside potential (about 71% according to our work vs. 0% for the Treasury bond). Clearly, the Citi share price and dividend payout carry considerably more risk than the Treasury bond, but at the current valuation Citi shares would seem to have a remarkably better risk/return trade-off. BUY

Gates Industrial Corp, plc (GTES) – Gates is a specialized producer of industrial drive belts and tubing. While this niche might sound unimpressive, Gates has become a leading global manufacturer by producing premium and innovative products. Its customers depend on heavy-duty vehicles, robots, production and warehouse machines and other equipment to operate without fail, so the belts and hydraulic tubing that power these must be exceptionally reliable. Few buyers would balk at a reasonable price premium on a small-priced part from Gates if it means their million-dollar equipment keeps running. Even in automobiles, which comprise roughly 43% of its revenues, Gates’ belts are nearly industry standard for their reliability and value. Helping provide revenue stability, over 60% of its sales are for replacements. Gates is well-positioned to prosper in an electric vehicle world, as its average content per EV, which require water pumps and other thermal management components for the battery and inverters, is likely to be considerably higher than its average content per gas-powered vehicle.

The company produces wide EBITDA margins, has a reasonable debt balance and generates considerable free cash flow. The management is high-quality. In 2014, private equity firm Blackstone acquired Gates and significantly improved its product line-up and quality, operating efficiency, culture and financial performance. Gates completed its IPO in 2018, with Blackstone retaining a 63% stake today.

There was no significant company-specific news in the past week.

GTES shares rose 4% in the past week and have 20% upside to our 16 price target. BUY

Molson Coors Beverage Company (TAP) is one of the world’s largest beverage companies, producing the highly recognized Coors, Molson, Miller and Blue Moon brands as well as numerous local, craft and specialty beers. About two-thirds of its revenues come from the United States, where it holds a 24% market share. Investors worry about Molson Coors’ lack of revenue growth due to its relatively limited offerings of fast-growing hard seltzers and other trendier beverages. Our thesis for this company is straightforward – a reasonably stable company whose shares sell at an overly discounted price. Its revenues are resilient, it produces generous cash flow and is reducing its debt. A new CEO is helping improve its operating efficiency and expand carefully into more growthier products. The company recently re-instated its dividend.

There was no significant company-specific news in the past week.

TAP shares rose 8% in the past week and have 22% upside to our 69 price target. The stock remains cheap, particularly on an EV/EBITDA basis, or enterprise value/cash operating profits, where it trades at 9.0x estimated 2023 results, still among the lowest valuations in the consumer staples group and below other brewing companies. BUY

Sensata Technologies (ST) is a $3.8 billion (revenues) producer of nearly 47,000 highly engineered sensors used by automotive (60% of revenues), heavy vehicle, industrial and aerospace customers. About two-thirds of its revenues are generated outside of the United States, with China producing about 21%. Investors undervalue Sensata’s durable franchise. Its sensors are typically critical components that generally produce high profit margins. As the sensors’ reliability is vital to safety and performance, customers are reluctant to switch to another supplier that may have lower prices but also lower or unproven quality. Sensata has an arguably under-leveraged balance sheet and generates healthy free cash flow. The relatively new CEO will likely continue to expand the company’s growth potential through acquisitions. Electric vehicles are an opportunity as they expand Sensata’s reachable market.

There was no significant company-specific news in the past week.

ST shares rose 3% in the past week and have 58% upside to our 75 price target. Our price target looks optimistic in light of the broad market sell-off and worries over a possible recession (which would slow demand in its automotive and other end-markets), but we will keep it for now, even as it may take longer for the shares to reach it. BUY

Strong Buy – This stock offers an unusually favorable risk/reward trade-off, often one that has been rated as a Buy yet the market has sold aggressively for temporary reasons. We recommend adding to existing positions.
Buy – This stock is worth buying.
Hold – The shares are worth keeping but the risk/return trade-off is not favorable enough for more buying nor unfavorable enough to warrant selling.
Sell – This stock is approaching or has reached our price target, its value has become permanently impaired or changes in its risk or other traits warrant a sale.

Note for stock table: For stocks rated Sell, the current price is the sell date price.

Current price is yesterday’s mid-day price.
CSCO: Estimates are for fiscal years ending in July of 2023 and 2024