March 14, 2023

Everything Everywhere All at Once

Last night at Hollywood’s Academy Awards, the movie Everything Everywhere All at Once won the award for best picture, long considered the top prize of the event. It also won six other coveted Oscars. The movie, ostensibly, is a science fiction film about alternative realities and an everyday laundromat owner.

For investors, the movie is immediately elevated to mandatory viewing – the title applies directly to what is going on in “this here” in “this now” in today’s capital markets.

After years of scarce bank collapses, three sizeable banks have collapsed since last Thursday. SVB Financial Corp (SIVB) was the second-largest bank collapse in U.S. history, and Signature Bank (SBNY) and Silvergate Capital (SI) were by no means minor banks. Investors worry that First Republic Bank (FRC) is next and so are fleeing its shares, which fell by 68% through mid-day trading on Monday. Shares of other banks are tumbling, including well-capitalized, diversified and well-managed banks like US Bancorp (USB), whose shares have slid 22% in a week. Shares of recommended bank Citigroup (C) have dropped a relatively modest 12%, perhaps owing to its already deep discounted valuation.

Bond prices, seemingly certain to grind lower as the Fed presses its inflation fight, have rebounded sharply: Everyone everywhere all at once is swapping their presumably dodgy bank deposits into rock-solid U.S. Treasury debt. Further boosting bonds are speculators who are now convinced that the Fed will slow or pause its rate hike campaign to provide capital markets and the real economy some time to adjust.

But, perhaps, as the movie quote says, “The universe is so much bigger than you realize.” When interest rates are dragged from zero-for-a-decade to 5% in a very short time, a financial accident is essentially inevitable. We wonder which undercapitalized or inattentive bank is next. Or, it might be an insurance company, hedge fund or other financial vehicle caught short from the surge in interest rates.

Logically, but oddly, the broad stock market seems fine with the bank stock meltdown, as it strongly implies (as noted earlier) lower interest rates for everyone, everywhere.

Maybe we should re-watch “Alice in Wonderland” next.

Share prices in the table reflect Monday, March 13 closing prices. Please note that prices in the discussion below are based on mid-day March 13 prices.

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
Organon (OGN) – Moving from Buy to Sell

Upcoming earnings reports
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 35% upside to our 66 price target. The valuation is attractive at 9.2x EV/EBITDA and 13.0x 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 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 fell 4% in the past week and have 17% upside to our 42 price target. The shares offer an attractive 3.2% dividend yield. HOLD

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 fell 8% in the past week. The shares have 21% upside to our 54 price target and offer a 2.1% 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.

Aviva reported strong second-half 2022 results, with earnings of £0.41/share, which was sharply higher than the consensus £0.22. Full-year 2022 underlying operating earnings of £2.2 billion rose 24% from a year ago, helped by healthy revenues and lower costs. Underwriting profits remain strong although the company is watching incrementally elevated losses in its U.K. property and casualty business. The company’s capital, as measured by its wonky Solvency II Shareholder Cover Ratio, is sturdy at 212% despite sizeable share buybacks and dividends. Aviva continues to make impressive progress as it winds down its overhaul and shifts into steadier growth.

Aviva declared the balance of the year’s dividend, bringing the full-year total to £0.31/share, equal to about $0.75/ADR. Reflecting its strong capital position, for 2023 the management incrementally raised its dividend expectations to at least £0.326/share, or about $0.78/ADR and announced a new £300 million buyback, or about 2.4% of Aviva’s market cap. These returns of capital are expected to be covered by cash flows, leaving the firm well-capitalized in the currently turbulent market.

Aviva shares fell 4% this past week and have 35% upside to our 14 price target. Based on management’s guidance for the 2023 dividend, the shares offer a generous 7.6% 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.

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

Over the past week, commodity gold jumped 3% to $1,915/ounce as investors add gold-related assets in a flight to safety. The 10-year Treasury yield tumbled to 3.48%, down nearly half a percentage point, in the past week. This degree of volatility is exceptionally rare. Depending on what Tuesday’s CPI report shows, the bond market may see even more volatility – in either direction.

The U.S. Dollar Index (the dollar and gold usually move in opposite directions) ticked down to 103.58, likely pushed by lower interest rates.

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 rose 4% in the past week and have 60% 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 in the first quarter 2022, likely burdening it with new and permanent debt.

Big Lots shares remain high-risk due to the new debt balance and the possibility of a suspension or reduction of the dividend.

On March 2, Big Lots reported a respectable quarter, with an adjusted loss of $(0.28)/share, compared to a $1.75 profit a year ago and estimates for a loss of $(0.66). Revenues fell 11%, with same-store sales falling 13%, but these results were in-line with estimates. Adjusted EBITDA of $39 million fell about 65% from a year ago but was more than double the $15 million estimate. On the positive side, the inventory glut appears to be fully worked down, while the gross margin narrowed by only about 1 percentage point and expenses were controlled. Big Lots maintained its $0.30/share quarterly dividend. On the negative side, the company has a new and permanent debt burden of about $300 million, produced by the inventory mistake.

Big Lots continues to have a loyal customer base and should fully recover operationally although we believe it will ramp up its spending on inventory management tech. Cost improvements should make 2023 a much better year than 2022, although full profit restoration may take a few more years. The company generates enough free cash flow to endure. At 2.5x our depressed but expected post-recovery earnings, the shares provide considerable upside potential, even as the downside risks have been trimmed.

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

Big Lots shares fell 7% this past week and have 87% upside to our revised 25 price target. The shares offer a 9.0% 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.

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 significantly to negative-131 basis points from negative-89 basis points (100 basis points in one percentage point). The crisp decline in short-term yields drove the expansion.

Until inflation relents to a 2% pace for perhaps six months, we see little chance for the Fed to declare “mission accomplished.” The recent CPI and other reports suggest that the six-month clock hasn’t yet started.

As noted earlier, the next CPI report will be released on March 14 at 8:30 a.m. Eastern time, after this letter is submitted for publication.

The shift in sentiment toward higher-for-longer interest rates has at least momentarily reversed. If the CPI report shows enduring elevated inflation, the Fed and investors will likely have a more complicated environment to navigate.

As noted in our opening note, Citi’s shares are being hit in the bank run contagion. Currently, we do not believe the bank is vulnerable to a run on its deposits. The bank’s capital position and liquidity are strong, even with a hit from lower bond prices. One likely issue for Citi is that it will need to boost the interest rates it pays on deposits to prevent a slow drainage of deposits – this will exert some pressure on its net interest margin.

Citi shares trade at 56% of tangible book value and 7.8x estimated 2023 earnings. The remarkably low valuations assume an unrealistically dim future for Citi.

Citi shares fell 12% in the past week and have 86% upside to our 85 price target. Citigroup investors enjoy a 4.5% dividend yield.

When comparing Citi shares with a US 10-year Treasury bond, Citi offers a higher yield and considerably more upside potential (about 86% 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 fell 5% in the past week and have 18% 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 reinstated its dividend.

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

TAP shares fell 1% in the past week and have 32% 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 8.6x 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 fell 7% in the past week and have 57% 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

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