March 21, 2023

Match the Pot

Last Thursday evening, I was a guest at a friend’s regular poker game. It seemed friendly enough – the regulars were average players (like myself), pleasant to spend time with (no jerks), and the evening included a tasty dinner. Also, favorably to me as the newbie, the stakes were modest.

The games were straightforward: 5-card draw, 7-card stud high-low, while a few others included a small field of common cards similar to Texas Hold’em. Betting was reasonable, with limits on both the size and number of raises. So far, so good.

Yet, after a while, one of the players introduced a twist: match the pot. If you stayed in a hand until the end, and then lost, you had to match the pot. This is dangerous for two reasons. First, you don’t have a chance of winning back your contribution in that hand. You have to wait until the next hand, with a totally different set of cards and odds, such that your chances of winning your generous contribution back are random. Second, the size of the contribution (the loss) was perhaps 30x a typical bet. This size totally overwhelms the risk/return trade-off.

My strategy for “match the pot” games was this: Stay in as long as needed to ensure one of two outcomes: either gaining a lock on a win, or not. The only way to make the risk worthwhile was to have a sure thing. My cards would have to be better than everyone else’s, better than what they had showing combined with the best possible hole cards. Otherwise, I risked taking a huge hit to my capital.

I folded some very promising match-the-pot hands in the next-to-last betting rounds. Yes, I possibly gave up modest winnings on those hands, but I never lost a 30x hand either. In case you’re wondering: My evening’s winnings produced a very respectable 50% ROI on my initial buy-in.

This story brings me to the bank stocks. Everyone has read about the Credit Suisse takeover by UBS, problems and failures of other banks, calls for full deposit guarantees, the Fed’s upcoming rate decision and other complex matters.

What I am more focused on is the downside of investing in banks. Like “match the pot,” by waiting instead of buying, I may very likely be missing out on some winnings. The typical regional bank stock has tumbled around 25% in the past week or so, as measured by the SPDR S&P Regional Bank ETF (KRE). A full recovery would produce a 33% gain. But more likely, bank investors will haircut the upside such that a likely rebound potential is probably only 15-20%. Major banks like JPMorgan and Bank of America have even less rebound potential.

Why only 15-20%? Bank managers fearing deposit run-offs will almost certainly raise the interest rates they pay on deposits. This will pressure their net interest margin, likely for at least the rest of the year if not on an ongoing basis.

And, banks’ capital ratios have been impaired by the losses in their bond holdings, meaning that regulators could easily pressure some banks to cut their dividends, halt share buybacks and possibly raise new capital. Many banks (most/all?) have sizeable holdings of long-term mortgage and other bonds which may be worth only 80% of their prior value. Currently, the losses embedded in these bonds are hidden by their accounting treatment – they are assumed to be “held to maturity” so they are recorded on the balance sheet at close to par value. But removing the dollar amount of the losses from the bank’s capital might reduce that capital by 15-40%. That is a hole that regulators would want filled.

One related risk is that regulators could require all bonds to be marked to market, with all changes to their value (or at least the losses) flowing through the income statement and into the capital ratio. As the tide of favorable accounting treatment flows out, a lot of naked banks would be exposed.

And most bank valuations aren’t cheap yet and embed little/no dividend cuts or capital raises, leaving little margin for safety.

So, buying bank stocks aggressively here is a bit like “match the pot.” If you lose, you could take a sizeable hit to your capital, all for the hope of a modest win.

Our view on Citigroup (C) is to keep it. The valuation is low at 56% of tangible book value. Also, Citi’s unrealized losses in its bond portfolio are a modest 17% or so of its CET1 capital. Citi’s capital ratio is plenty high at 13.0%. So, a 17% hit would pull the ratio down to 10.8% or so – lower than before but not an urgent problem. We also think Citi has relatively limited deposit-run risk given its size and role as a systemically important bank.

Share prices in the table reflect Monday, March 20 closing prices. Please note that prices in the discussion below are based on mid-day March 20 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
Comcast Corp. (CMCSA) – Moving shares from HOLD to BUY

Last Week’s Portfolio Changes
None.

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 rose 5% for the week and have 30% upside to our 66 price target. The valuation is attractive at 9.5x EV/EBITDA and 13.5x 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 3% in the past week and have 15% upside to our 42 price target. The shares offer an attractive 3.2% dividend yield. Given the decline in the shares, we are restoring our Buy rating. BUY

BUY LOW OPPORTUNITIES PORTFOLIO

Allison Transmission Holdings, Inc. (ALSN) – Allison Transmission is a mid-cap 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 2% in the past week, have 25% 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.

Last week, 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 are being dragged down as worries increase over the stability of the financial system. We believe that Aviva will weather the current storm. Its bond losses flow through the income statement and so are already factored explicitly into the bank’s capital level – which currently is more than adequate. Also, unlike a bank, Aviva isn’t vulnerable to a run on its deposits. Theoretically, its customers could cash out of their insurance policies, but this is highly unlikely and would probably result in enough of a refund discount that Aviva could benefit from the capital outflow.

Aviva shares fell 3% this past week and have 40% upside to our 14 price target. Based on management’s guidance for the 2023 dividend, the shares offer a generous 7.9% 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 another 3% to $1,970/ounce and briefly hit $2,013/ounce as investors searched for safe alternatives to bank deposits and worried about another global financial crisis. The current stress on the financial system is likely to slow, if not pause, the Fed’s rate hike campaign, which would support gold prices. The March 14 CPI report was less of an event than advertised as inflation remained elevated but not accelerating in an alarming way.

For the record, our view is that the Fed will announce a 25-basis point hike but accompany the boost with stern talk on both sides of the issue: It must continue to fight inflation but also acknowledge the heightened risk that rising rates pose to the financial system and the economy.

The 10-year Treasury yield ticked lower to 3.47% after an exceptionally rare 50+ basis point slide last week.

The U.S. Dollar Index (the dollar and gold usually move in opposite directions) ticked down to 103.40, likely due to incrementally lower odds of a “higher for longer” Fed interest rate policy.

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 8% in the past week and have 47% 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, weak fundamentals and the possibility of a suspension or reduction of the dividend. Sentiment in the shares is 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. And, eliminating the $35 million in cash payouts would help the company retire its $300 million debt as well as ease future seasonal borrowings.

Big Lots recently refinanced the bulk of its debts, so we think it is highly unlikely that these credit lines could be revoked. However, the current financial market stress may reduce Big Lots’ access to future funding. Given its cyclical and currently unprofitable business, this adds yet another pressure on the company and weighs on our patience.

Big Lots shares fell 9% this past week and have 101% upside to our revised 25 price target. The shares offer a 9.7% 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, narrowed to negative-105 basis points (100 basis points in one percentage point).

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 in our opening commentary, we are retaining our view to keep Citi shares.

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 rose 2% 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 U.S. 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 lineup 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 21% 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 2% in the past week and have 35% 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 8.5x 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 1% in the past week and have 61% 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