December 28, 2022

Investing in a Bear Market

For most people, investing during a bear market is a frustrating experience. Share prices keep going down, profitable positions erode in value, new purchases become money-losers. Short upward bursts in market sentiment bring hope for a new bull market, but these fade quickly. The temptation is to sell everything and wait for better times.

But this isn’t the only way to look at bear markets. And it may not be the right way. Rather than seeing bear markets as a time to sell, active investors can invert this thinking to see bear markets as a time to buy. With credit to one of the most successful long-term investors, Warren Buffett (and our apologies for modifying his tale to fit this article), we describe this contrarian way of thinking with an analogy:

Every day, a salesman stops by your house to buy or sell $1 bills. These of course are worth exactly $1.00 each.

• Usually, he sells them for somewhere between 95 cents and $1.10.
  
• If he is in an exuberant mood, he prices them at $1.40. This isn’t the time to join in and buy – it’s the time to sell.
  
• But, when he is in a bad mood, he prices them at 60 cents. It wouldn’t make any sense to sell your dollars to him just because the price went down. This is the time to buy.

Stock markets have a strong resemblance to this story. Using Buffett’s analogy, the stock market is currently in a foul mood as interest rates keep rising, the outlook for earnings is weakening, a recession appears to be looming and the world in general seems to have a growing list of ever-worsening problems. Shares are being marked down, just like the dollar bills in the story.

As an active investor, you can use this mindset to generate above-average long-term profits. A key is to remember that you are buying pieces of ownership of real companies, not pieces of paper or ticker symbols. The bear market is doing you a service by marking down the price of that ownership.

An important part of this mindset is to avoid the trader’s mentality which looks to identify and then buy heavily “at the bottom” of the market. It is essentially impossible to do either of these successfully. Most likely, investors buy at what seems like the bottom, only to see stock prices slide further, leading to frustration and exits that lock in losses.

Related to this is the importance of not waiting until there are clear signs that the market has bottomed to begin buying. By that time, the market is probably rebounding sharply. Most investors either wait too long to get back into the market or avoid getting back in entirely. Both mistakes can be devastating to one’s portfolio.

Investing successfully during a bear market requires some patience and discipline. Remember that you are not buying to make a quick trading profit. You are buying ownership of enduring companies to generate long-term profits. Think like a business owner – someone who is buying the entire company and can’t sell for 2-3 years or longer.

Looked at from a different perspective, you are planting seeds in the winter that will flourish in the spring. The seeds won’t grow the day you plant them. They will look like they are doing nothing for a long time. Have the patience to wait. The season will turn.

What kind of companies to buy? Focus on enduring companies that are highly likely to survive the economic challenges. Accept that their revenues and profits may slip temporarily but will likely more than fully recover. Traits of these companies include:

1. Quality business model – The business has enduring value backed by enduring profits. Their products and services have been highly relevant for years and will continue to be highly relevant. Ideally, the company has a strong position in markets without excessive competition. These companies also have generated significant profits in each year over the past decade or so and are highly likely to remain profitable well into the future. You are not looking for trendy tech companies that blossomed during the pandemic but whose revenues are now collapsing and won’t likely ever produce respectable earnings.

2. Sturdy balance sheet and positive cash flow – During bear markets and weak economic conditions, excessive debt burdens can become unwieldy. Interest costs may increase and capital markets may be unwilling to provide credit on reasonable terms. Focus on companies that could readily continue to service their debts even if profits and cash flow slump 20-40%.

3. Capable and shareholder-friendly management – The leadership, including the CEO, CFO and board, have proven their ability to effectively manage the company, to think clearly, to lead effectively and to produce worthwhile results for shareholders.

4. Meaningfully undervalued shares – Focus on stocks that are undervalued relative to their long-term prospects using a reasonably conservative outlook. This means a price/earnings multiple or EV/EBITDA multiple that is below their long-term averages and probably well below the market’s current multiple.

HOW TO THINK ABOUT CASH

Popular financial media, observers and many advisors suggest that investors should always be “100% invested” in stocks. This advice implies that cash has no value, as it is side-lined money that will miss out on future gains in the stock market. For passive investors, this may be good advice worth following.

But for active investors, this approach ignores the value of having cash reserves. What is that value?

1. Accepting that holding cash is OK frees the investor from the imperative to buy overvalued stocks, particularly in a raging bull market. It makes it OK to wait for better prices.

2. It allows investors to deploy cash when valuations are more acceptable. A fully invested portfolio has no cash to deploy, so to buy low, one must sell something else low.

The TINA mindset (that “There Is No Alternative”) of the last bull market cycle implied that investors had no choice, due to near-zero interest rates on cash, to own anything other than overpriced stocks or other “risk” assets. The current bear market shows that this was a false choice. Cash is never trash.

How much cash is the right amount? Many active managers find that holding between 10% and 30% of investable assets in cash is a workable range over the long term. During most market conditions, a narrow range of perhaps 15% to 25% is common. The low, 10% cash position would be reserved for extremely under-valued markets, while the 30% cash position might make sense during extremely over-valued conditions. Extremes on either end might be sensible for only a few months of every decade.

THE PROCESS FOR INVESTING IN A BEAR MARKET

1) Have your “Buy” list ready. Prepare your list of companies that you want to own if the share price becomes attractive. Use the checklist above to create and refine your list. Share prices are falling, so you likely have time to build a list of 15-20 companies that you want to own for the long-term but whose share prices remain too high. Preparing your list now allows you to wait for the price to fall to attractive levels.

2) Be patient. Bear markets can last longer and grind down further than you may think. Avoid the temptation to think that every market rebound indicates that the bottom is in.

3) Nibble, don’t chomp. When share prices for your selected companies start to look attractive, make small purchases (perhaps a quarter of your full position size). The share price may continue to decline, allowing you to add more to your position. The alternative, buying a full position right away, can mean watching your position slide in value, which boosts the temptation to sell before it deteriorates even more.

4) Dollar cost averaging is an effective pacing technique. Buying a set dollar amount of attractive stocks can provide valuable discipline for pacing your purchases. As the shares go down in price, you will be able to buy more shares for each given dollar amount. One example: Buy a tenth of the targeted position size every month for 10 consecutive months. Grit your teeth and keep to your buying schedule. You may very well lose money on every purchase, at least for a while. But over time, these cringe-worthy purchases could readily become the best performing holdings in your portfolio.

5) Focus on the share prices of your selected companies, not the overall market direction or sentiment. Avoid the noise.

6) Remember: You are investing cash that didn’t go down in value, so you are already ahead of the game. You are taking advantage of other people’s negative sentiment and forced-sale problems.

7) Prune your holdings of unworthy companies. Selling stocks during a bear market usually means selling at low prices, but this can be a good time to exit if a company meets any of these descriptions:

• Its shares remain significantly overvalued. In bear markets, share prices for even exceptional companies can tumble, and valuations that once seemed justifiable may no longer be. Bear markets eventually take down overvalued stocks.
  
• The company’s fundamentals are not likely to improve. If your company is struggling to remain relevant to its customers, hasn’t yet produced a profit and carries excessive debt, it may be a bad business with little ability to endure. Share prices of these companies may be on their way to zero.

Investing during bear markets may seem counterintuitive, but it is the basis for many of the largest long-term gains. By thinking like a long-term owner of solid companies with enduring value, and buying when the price is sensible, active investors can let bear markets serve them through discounted prices. Value can be enduring, even as the share price fluctuates. Just ask the dollar bill salesman.

Warren Buffett said it best: “Price is what you pay, value is what you get.”

Share prices in the table reflect Friday (December 23) closing prices. Please note that prices in the discussion below are also based on closing December 23 prices.

Please note that the regular publishing day for the Cabot Undervalued Stocks Advisor has been moved to Tuesday. This week, the publishing day has been pushed back one day, to Wednesday, due to the Christmas holiday. Next week, the publishing day will also be pushed back one day, to Wednesday, due to the New Year’s holiday. Our regular Tuesday publishing day will resume on January 10, 2023.

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

Arcos Dorados (ARCO) – Moving the shares from Buy to Hold.

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 1% 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 as 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 rose 2% for the past week and have 20% 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 send 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 lifted 2% in the past week and have 18% upside to our 60 price target (same as in The Cabot Turnaround Letter). The quarterly dividend appears readily sustainable and provides an appealing 5.5% yield. The shares trade at a modest 6.5x EV/EBITDA multiple and 11.6x 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.

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

State Street shares were flat in the past week and have 21% upside to our 94 price target. The company’s dividend (3.3% 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.

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

ALSN shares were flat in the past week and have 14% 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 US dollar has not affected the US/Brazilian real exchange rate. As the company reports in US dollars, any strength in the local currency would help ARCO shares.

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

ARCO shares rose 10% this past week and have 2% upside to our 8.50 price target. The shares are re-approaching their post-pandemic high. With limited upside to our price target, we are moving the shares to a Hold. HOLD

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 UK, 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 were flat in the past week and have 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.

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

Over the past week, commodity gold held steady at $1,804/ounce. Despite all the volatility, the gold price is essentially unchanged year-to-date. The 10-year Treasury yield jumped to 3.75%, in a move that was attributed to the Japanese central bank’s decision to ease off of its program to keep interest rates at or near zero.

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 Jerome 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 US Dollar Index, another driver of gold prices (the dollar and gold usually move in opposite directions), was down fractionally, to 104.36.

Barrick shares rose 3% in the past week and have 55% 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.

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

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

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.

Big Lots shares fell 8% this past week and have 72% upside to our revised 25 price target. The shares offer an 8.2% dividend yield, although, as noted, investors should not rely on this dividend being sustained. 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.

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

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, narrowed to negative-57 basis points (100 basis points in one percentage point) due primarily to the jump in 10-year yields. This spread remains 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 6.6x estimated 2023 earnings. The remarkably low valuations assume an unrealistically dim future for Citi.

Citi shares were flat in the past week and have 92% 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 rose 1% in the past week and have 25% 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 straight-forward – 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 1% in the past week and have 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 rose 2% in the past week and have 65% upside to our 46 price target (using the same target as the Cabot Turnaround Letter). The shares offer an attractive 4.0% 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 safely 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 fell 3% in the past week and have 89% 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