December 20, 2022

If You’re Investing Based on the Fed, You’re Missing the Point of Value Investing

The financial media, observers and traders are focused almost exclusively on the path of the Fed’s interest rate tightening policy. How much will they raise rates at the next meeting? How about the meeting after that? Then what? What is the terminal rate (the highest rate of the cycle)? When will the Fed start reducing rates?

Closely related is the debate over whether these guessed-upon policy moves will produce a recession. And, if so, when will it arrive? How deep will it be? And, when will the recession end?

One of the most ridiculous arguments we’ve heard follows this line of thinking: The Fed is raising rates too fast, which is really bad for stocks. This path will drive the economy into a recession and crush corporate earnings. But, it will also lead to weaker inflation and soon enough the Fed will be cutting rates which will be great for stocks. So, raising rates too fast is actually good, so buy stocks aggressively now.

We don’t even know where to start in critiquing this legitimate-sounding but obviously flawed circular logic.

At the end of November, investors were cheering the possibility that the Fed would be slowing its pace of rate hikes to 50 basis points per meeting and that inflation statistics will increasingly show weakening price pressure. The consensus got both parts right. But the market slid nevertheless. So far this month, the S&P 500 is down over 6%.

The best investing is based on individual stocks and their company-specific merits. How well is this company being run? Does it have a product or service that addresses a real customer need? Can its balance sheet support its future? How much free cash flow does the company generate? How much does the leadership care about shareholders? Is the stock priced at a discount to allow for an unknown future?

Value investors follow the approach that the market is there to serve you, not to guide you¹. Let the market guide your investing, and you will essentially be captive to the narrative of the day. Value investors, on the other hand, want to buy at bargain prices – so if the stocks of interesting companies go down due to narrative-of-the-day selling, the market is serving your interests. Buy the stocks at the macro-driven discounts.

1. Paraphrasing a quote from Warren Buffett, chairman of Berkshire Hathaway.

Share prices in the table reflect Monday (December 19) closing prices. Please note that prices in the discussion below are based on mid-day December 19 prices.

Note to new subscribers: You can find additional color on our thesis, recent earnings reports and other news on recommended companies in prior editions of the Cabot Undervalued Stocks Advisor, particularly the monthly edition, on the Cabot website.

Send questions and comments to Bruce@CabotWealth.com.

Today’s Portfolio Changes
None.

Last Week’s Portfolio Changes
None.

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 fell 4% for the week and have 39% upside to our 66 price target. The valuation is attractive at 9.4x EV/EBITDA and 13.4x earnings per share. The 3.2% 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 worry 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, pay a generous dividend (recently raised 8%) and sizeable share buybacks.

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

Comcast shares fell 5% for the past week and have about 22% upside to our 42 price target. The shares offer an attractive 3.1% dividend yield. BUY

Dow Inc. (DOW) is the world’s largest producer of ethylene and polyethylene, the most widely used plastics. Investors undervalue Dow’s hefty cash flows and sturdy balance sheet largely due to its uninspiring secular growth traits, its cyclicality and concern that management will squander its resources. The shares are driven by: 1) commodity plastics prices, which are often correlated with oil prices and global growth, along with competitors’ production volumes; 2) volume sold, largely driven by global economic conditions, and 3) ongoing efficiency improvements (a never-ending quest of all commodity companies). Recent concerns about a recession have sent Dow shares to well-below our estimate of their fair value, even as the company’s long-term prospects and ability to maintain its dividend are attractive. Dow shares are a recommended Buy in our sister publication the Cabot Turnaround Letter.

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

Dow shares slipped 3% in the past week and have 21% upside to our 60 price target (same as in the Cabot Turnaround Letter). The quarterly dividend appears readily sustainable and provides an appealing 5.6% yield. The shares trade at a modest 6.5x EV/EBITDA multiple and 11.3x EPS on recession-minded 2023 estimates. BUY

State Street Corporation (STT) – State Street is the world’s largest custodian bank, with $38 trillion in assets under custody/administration. About 56% of its revenues are produced from custody, client reporting, electronic trading and full enterprise solutions services for investment managers. The balance is produced from investment management fees on ETFs, foreign exchange fees, securities financing fees and net interest income. The industry has combined into four dominant firms due to economies of scale. State Street’s shares are out of favor and unchanged since 2007 due to concerns over its anemic growth and steady pricing pressure from competitors. However, we see State Street as a solid, well-capitalized franchise that provides critical services, with a slow-growth but steady revenue and earnings stream. Our interest in STT shares is that we can buy them at an attractive valuation. We also find the dividend yield appealing.

State Street said it would allow more institutional investors to cast their own votes in proxy elections for companies held in its index ETFs. This step follows pressure against companies like State Street, Vanguard and Blackrock, which collectively hold as much as $20 trillion in index products, who appear to hold too much power when it comes to voting on company directors, executive pay and other proxy ballot initiatives. These three managers are usually among the largest shareholders of most S&P 500 companies, often with a collective 20% stake or more. The debate came to the fore as firms like Blackrock began pressuring companies to follow tighter ESG mandates – which fomented controversy about both the ESG mandates and the rights of shareholders over index managers.

State Street shares fell 2% in the past week and have about 20% upside to our 94 price target. The company’s dividend (3.2% yield) is well-supported and backed by management’s strong commitment. 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.

Congress passed the Fiscal Year 2023 National Defense Authorization Act, which increases federal defense spending by 8% over last year’s authorization. The bill has yet to be signed by the president. A small but important part of Allison’s business is making transmissions and related components for military vehicles including tanks, motorized artillery/mortar pieces, armored personnel carriers and others. These vehicles are proving their worth in land wars like the one in Ukraine and will likely see more demand from the new spending program. Allison also recently announced a new $51 million contract to support the Abrams battle tank.

ALSN shares were flat in the past week and have 13% upside to our 48 price target. The stock pays a respectable and sustainable 2.0% dividend yield. BUY

Arcos Dorados (ARCO), which is Spanish for “golden arches,” is the world’s largest independent McDonald’s franchisee. Based in stable Uruguay and listed on the NYSE, the company produces about 72% of its revenues in Brazil, Mexico, Argentina and Chile. At our recommendation date, the shares were depressed as investors worried about the pandemic, political/social unrest, inflation and currency devaluations. However, the company has a solid brand, high recurring demand, impressive leadership (including founder/chairman who owns a 38% stake) and successful experience in navigating local conditions, along with a solid balance sheet and free cash flow.

Macro issues have a sizeable impact on the shares’ trading, including local inflation and the Brazilian currency. Since early 2020, the currency has generally stabilized in the 1.00 real = $0.20 range – a remarkably favorable trait given the sharp declines in other currencies around the world. Recent weakness in the U.S. dollar has not affected the US/Brazilian real exchange rate. As the company reports in U.S. dollars, any strength in the local currency would help ARCO shares.

Arco said it will announce fourth-quarter earnings and hold its annual investor day on February 2, 2023, at 7:30 a.m. Eastern Standard Time.

ARCO shares rose 7% this past week and have 8% upside to our 8.50 price target. The shares are re-approaching their post-pandemic high. 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 fell 2% in the past week and have about 31% upside to our 14 price target Based on management’s estimated dividend for 2023, the shares offer a generous 7.1% yield. 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.

Moody’s raised its credit rating for Barrick’s senior unsecured debt to A3 from Baa1 with a stable outlook. While the upgrade will have a minimal effect on Barrick, it is a useful acknowledgment of the company’s strong financial condition.

Over the past week, commodity gold rose 1% to $1,801/ounce. Despite all the volatility, the gold price is essentially unchanged year to date. The 10-year Treasury yield ticked up to 3.58%. While investors had anticipated the “end-game” in which Treasuries peak at a roughly 5.0% yield (to roughly match or exceed the anticipated inflation rate in a year or so), recent comments from Fed Chair Powell along with resilient labor demand may mean that rates peak above 5%. Similarly, we are seeing a few commentaries suggesting that the 2% inflation target isn’t sacrosanct, but that 3% or possibly even 4% inflation would be tolerable. If this tolerance takes hold, and the economy slows, the Fed’s inflation-fighting resolve may weaken, and gold prices should rise. Investing in gold-related equities is a long-term decision – investors shouldn’t allow near-term weakness to deter their resolve.

The U.S. Dollar Index, another driver of gold prices (the dollar and gold usually move in opposite directions), was down fractionally, to 104.64.

Barrick shares slipped 1% in the past week and have about 63% upside to our 27 price target. Our resolve with Barrick shares remains undaunted through the recent sell-off. 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 in the first quarter 2022, likely burdening it with new and permanent debt.

Retail sales fell 0.6% in November, worse than expectations for a 0.3% decline. The number is not adjusted for inflation. On the other hand, jobless claims continued to decline. We find these statistics to be only of moderate use in determining the fate of a company like Big Lots, as the company’s results are affected much more by the management’s merchandising and pricing initiatives. Generally, these stats help us understand the “season” we are in (are consumers in a spending “winter,” for example, when times are tight, or is it a spending “summer” when dollars are flowing free and easy) rather than what the weather is like in a specific town. Right now, it feels a little like autumn – neither a harsh nor easy season.

Big Lots shares remain high-risk due to the permanent debt balance and the likelihood of a suspension of the dividend.

Big Lots shares fell 9% this past week and have 63% upside to our revised 25 price target. The shares offer a 7.8% dividend yield, although, as noted, investors should not rely on this dividend being sustained.

We reiterate our view that Big Lots shareholders who are not willing or able to sustain further losses in the shares should sell now. There is no reasonably definable floor to a stock like Big Lots when fundamentals and valuation are ignored while investors reduce their risk exposure. 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.

Citi and Revlon lenders (mostly hedge funds) reached an agreement regarding $894 million that Citi erroneously paid to the lenders more than two years ago. Understandably, the lenders wanted to keep all of the funds, but in the end more than 75% of the mistaken payouts will be returned to the bank. Citi CEO Jane Fraser called the embarrassing blunder a “massive, unforced error.” Exact terms of the settlement haven’t been made public.

Goldman Sachs’ massive layoff of thousands of its employees may ease the path for Citi to do the same, as capital markets activity slows compared to the now-ending boom years.

Citi reported that its credit card charge-off rate was 1.33% in November, compared to 1.32% in October. Its credit card delinquency rate was 0.98%, up from 0.90%. Citi has one of the industry’s largest credit card portfolios – so its card metrics indicate both its own future losses and the condition of consumers in general. We would view the uptick in credit costs as small and reasonable, recognizing that they will also likely continue to increase, albeit slowly.

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, remained essentially unchanged at a negative 71 basis points (100 basis points in one percentage point), as both 10-year yields and 90-day yields were largely unchanged. This spread is nearly the widest since at least the early 1980s. Our interpretation is that investors are assuming that the Fed rate hikes and other macro drivers will drag down inflation to sub-5% or so in a year. Given that the inflation metrics are flattening out or declining, this assumption may be perfectly reasonable.

Citi shares trade at 55% of tangible book value and 6.5x estimated 2023 earnings. The remarkably low valuations assume an unrealistically dim future for Citi.

Citi shares fell 4% in the past week and have about 93% upside to our 85 price target. Citigroup investors enjoy a 4.6% dividend yield. We anticipate that the bank is done with share buybacks until there is more clarity on the economic and capital market outlook, which could readily be a year or more away. 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 were flat in the past week and have about 26% upside to our 14 price target. At the current price and based on estimated 2022 results, the shares offer a 12% free cash flow yield (free cash flow divided by market cap). This is a sizeable discount to what the company is worth. 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 fell 2% in the past week and have about 33% 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 8.3x estimated 2023 results, still among the lowest valuations in the consumer staples group and below other brewing companies. BUY

Organon & Company (OGN), a spin-off from Merck, specializes in patented women’s healthcare products and biosimilars, and also has a portfolio of mostly off-patent treatments. It may eventually divest its Established Brands segment. The management and board appear capable as they work to boost internal growth augmented by modest-sized acquisitions. The company produces robust free cash flow, has modestly elevated debt and pays a reasonable dividend.

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

OGN shares fell 1% in the past week and have about 69% upside to our 46 price target (using the same target as the Cabot Turnaround Letter). The shares offer an attractive 4.1% dividend yield. 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 8% in the past week and have about 86% upside to our 75 price target. Our price target looks optimistic in light of the broad market sell-off, but we will keep it for now, even as it may take longer for the shares to reach it. BUY

*Note: DOW price is based on April 1, 2019 closing price following spin-off from DWDP.

Buy – This stock is worth buying.
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.
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