October 19, 2022

A Flatline Market?

So far, earnings season is showing that investor expectations have become overly negative. Results from banks indicate that consumer activity remains healthy even as domestic economic growth stalls. Several of our recommended companies are industrials (Dow, Gates Industrial, Allison Transmission) along with Cisco Systems which is essentially “industrial tech,” so we are very curious as to their outlooks for the non-consumer segment of the economy. Expectations have slid sharply, so most of the reported results will probably be positive surprises.

The market appears to be digesting the primary macro risks of rising interest rates and slowing/reversing earnings growth relatively well. And, these factors can be easily quantified: the value of Company X based on, say, 5% interest rates and earnings of $2.00/share in a year or two, can be reasonably estimated, although opinions will of course vary.

But, there is almost no way to quantify the risks of a financial accident like what almost happened in the obscure world of British pension plans, when or if China makes a military grab for Taiwan or if Putin is defenestrated, or some other previously small risk emerges into a major reality. There is just no way to measure the immediate and downstream effects of these kinds of known unknowns and unknown unknowns, to borrow a phrase from a former U.S. Defense Secretary.

One possible outcome is … nothing. That things play out mostly as expected over the next few years, with some small issues arising but otherwise no major surprises from the economy, inflation, geopolitics, domestic politics, financial surprises or anything else. In this kind of market, stocks might grind higher, with episodic jumps and dips, but could essentially go nowhere for five years. In such a world, stock-picking would reign over indexing and other strategies that have been successful in the past decade.

Right now, with macro issues swirling like Hurricane Ian, this flat-market scenario seems to have almost no chance of occurring. But, it’s worth considering. Especially when apparently no one seems to be thinking it is even a possibility.

Share prices in the table reflect Tuesday’s (October 18) closing prices. Please note that prices in the discussion below are based on mid-day October 18 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
Merck (MRK) – Moving from Hold to Sell

Upcoming Earnings Reports
Dow (DOW) – Thursday, October 20
Sensata Technologies (ST) – Tuesday, October 25
Allison Transmission Holdings (ALSN) – Wednesday, October 26
Molson Coors Beverage Company (TAP) – Tuesday, November 1
Barrick Gold (GOLD) – Thursday, November 3
Organon & Company (OGN) – Thursday, November 3
Gates Industrial Corp (GTES) – Friday, November 4
Aviva plc (AVVIY) – Wednesday, November 9
Arcos Dorados (ARCO) – Thursday, November 10
Cisco Systems (CSCO) – Wednesday, November 16
Big Lots (BIG) – Thursday, December 1

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 are rebounding with the market but remain well below what we believe to be their intrinsic value. Cisco holds a key role in the basic plumbing of technology systems. Near-term revenues and profits may be sloppy, but on a secular basis, the company’s positioning seems at worst stable. Given its ability to adapt, it will likely return to revenue and earnings growth albeit not at the rocket-like pace of newer tech companies riding some emerging trend. Cisco is essentially a dull company that grinds forward.

The shares rose 6% in the past week and have 57% upside to our 66 price target. The valuation is attractive at 8.2x EV/EBITDA and 11.9x earnings. BUY

Dow Inc. (DOW) merged with DuPont to create DowDuPont, then split into three companies in 2019 based on product type. The new 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). We see Dow as having more years of strong profits before capacity increases signal a cyclical peak, and expect the company to continue its strong dividend, reduce its pension and debt obligations, repurchase shares slowly and restrain its capital spending. Dow shares are a recommended Buy in our sister publication the Cabot Turnaround Letter.

Dow reports third-quarter earnings on Thursday, October 20, with the consensus estimate of $1.08/share.

Dow shares rose 4% in the past week and have 31% upside to our newly adjusted 60 price target (same as in the Cabot Turnaround Letter). The quarterly dividend appears readily sustainable and provides an appealing 6.1% yield. The shares trade at a low 5.6x EV/EBITDA multiple and 9.0x EPS on recession-like 2023 estimates. BUY

Merck (MRK) is working aggressively to replace profits likely to be lost when Keytruda, a blockbuster oncology treatment (about 30% of revenues) faces generic competition in late 2028, and when its Januvia diabetes treatment likely sees generic competition soon, and also is exposed to government price controls. The company’s new CEO is accelerating Merck’s acquisition program. Merck is highly profitable and has a solid balance sheet. It spun off its Organon business in June 2021 and we think it will divest its animal health segment sometime in the next five years.

As Merck shares traded up near their all-time high and “close enough” to our 99 price target, we moved the shares from Hold to Sell. While there certainly could be upside in the stock from here, and there is nothing wrong with the company, its strategy, financial condition or outlook, we would rather devote our attention to stocks that are more deeply undervalued, particularly in this market. SELL

State Street Corporation (STT) – Based in Boston, 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 back-, middle- and front-office services including custody, client reporting, electronic trading and full enterprise solutions 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 reported a good quarter, with adjusted earnings of $1.82/share falling 9% from a year ago but beating the consensus estimate by about 3%. Revenues fell 1% but were essentially in line with estimates. Expenses were flat, so the pre-tax margin slipped to 29.1% from 29.9% a year ago. The bank said it would repurchase about $1 billion of its shares in the fourth quarter – nearly 5% of shares outstanding and a savvy purchase as the stock is considerably undervalued.

Services related to asset management are the core of State Street’s business, and as most of these revenues are directly linked to the value of stock and bond markets, services revenues fell 8%. Within services, however, strong foreign currency services (+14%) helped offset lower asset-driven fees.

The bank appears to be gaining new fee-based clients as well as seeing net inflows into its ETFs. Part of what drives the State Street story is that it needs to maintain or incrementally increase its market share and, on this count, it seems to be doing reasonably well, earning perhaps a B+ grade for the quarter.

Essentially fully offsetting lower services revenues was a 36% surge in net interest income. Net interest income was about 22% of total revenues in the quarter. Rising interest rates drove the increase. We will hopefully get more color on the conference call regarding how sustainable this level of net interest income is.

Expenses were flat compared to a year ago, although, excluding the favorable effect of the strong dollar, expenses rose 4%. Part of the increase was due to higher marketing expenses, the return of business travel, higher wages and headcount. As the bank faces steady pricing headwinds, tight expense control is crucial to its long-term health. We would give the bank a B grade for this quarter on expenses.

As lending is a tiny component of its business, and as it lends to highly credit-worthy clients, its credit losses are essentially zero.

The buyback is supported by State Street’s excess capital position. With its 13.2% capital ratio (using the overly complex CET1 metric), the bank is well above its 11-12% target range.

State Street shares rose 3% in the past week and have about 51% upside to our 94 price target. The company’s dividend (4.0% 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 35% 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. Another indicator of its advanced capabilities: Allison was selected to help design the U.S. Army’s next-generation electric-powered vehicle. 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.

Earnings estimates fell sharply (about 12%) as analysts begin to factor in the impact of the recession. Slow economic activity would likely reduce the demand for new trucks and buses that are major drivers of sales for Allison products.

Allison shares rose 4% in the past week and have 30% upside to our 48 price target. The stock pays a respectable and sustainable 2.3% 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. The shares are depressed as investors worry 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. As the company reports in U.S. dollars, any strength in the local currency would help ARCO shares.

The results of the upcoming October 30 presidential election run-off will likely drive the broad Brazilian stock market and thus Arco’s shares.

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

ARCO shares rose 2% this past week and have 15% upside to our 8.50 price target. 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.

Sentiment toward Aviva shares has improved as the U.K. government’s recently launched and ill-fated fiscal plan was reversed. We look forward to an update on Aviva’s capital position and outlook when it reports interim results in early November.

Based on management’s estimated dividend for 2023 (which remains credible but is subject to a smaller increase than the current guidance for a 48% boost), the shares offer a generous 9.1% yield. Based on this year’s actual dividend, the shares offer an attractive 6.1% dividend yield.

Aviva shares rose 10% in the past week. The shares have about 54% upside to our 14 price target. 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 new and highly capable CEO), generate strong free cash flow at current gold prices, and return much of that free cash flow to investors while making minor but sensible acquisitions. Also, Barrick shares offer optionality – if the unusual economic and fiscal conditions drive up the price of gold, Barrick’s shares will rise with it. Given their attractive valuation, the shares don’t need this second (optionality) point to work – it offers extra upside. Barrick’s balance sheet has nearly zero debt net of cash. Major risks include the possibility of a decline in gold prices, production problems at its mines, a major acquisition and/or an expropriation of one or more of its mines.

Barrick reported third-quarter unit sales and production results. Gold sales totaled 1.0 million ounces of gold and 120 million pounds of copper. The company said that incremental high-grade gold volumes from the Nevada Gold Mines were pushed back to the fourth quarter, but added that the company will reach its full-year production guidance. The company reports full results on November 3.

Over the past week, commodity gold fell about 1% to $1,659/ounce. The 10-year Treasury yield rose to essentially 4.0%. Investors are starting to anticipate the “end-game” when Treasuries will peak at a roughly 4.5% to 5.0% yield to roughly match or slightly exceed the anticipated inflation rate in a year or so. If this scenario pans out, gold and equity prices in general should rise.

The U.S. Dollar Index, another driver of gold prices (the dollar and gold usually move in opposite directions), slipped modestly to 112.11.

Any wavering by the Fed in its now-strident rate hike campaign would also likely result in gold rebounding sharply. Until this happens, gold will probably remain out of favor. Investing in gold-related equities is a long-term decision – investors shouldn’t allow near-term weakness to deter their resolve.

Barrick shares slipped 2% in the past week and have about 83% 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 dismal first-quarter results although second-quarter results, while dismal, were better than the market’s dour consensus. The company needs to offload its still-bloated inventory at sharp discounts while also now loading the company with what is probably permanent debt.

We are retaining our HOLD rating for now: investor expectations are sufficiently depressed to provide some downside cushion, while management should be able to extract itself from the worst of the inventory problem over the next few quarters. Nevertheless, the Big Lots investment is now high-risk due to the new debt balance, the lost value from the inventory glut and the likelihood of a suspension of the dividend.

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

Big Lots shares slipped 1% this past week. 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.

The stock has 100% upside to our $35 price target. The shares offer a 6.9% 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.

Citi reported adjusted earnings of $1.50/share, down 39% from a year ago and about 3% above the consensus estimate. Revenue excluding divestitures fell 1% and were fractionally below the consensus estimate. Overall, a reasonable quarter for Citigroup with a moderately encouraging outlook as the bank maintained its full-year revenue and expense guidance. Its major divestitures (Mexico consumer and Asia consumer) are on track. The Citigroup turnaround remains a slog, measured in years rather than quarters, but appears likely to be successful. Citi shares offer a 4.7% dividend yield and considerable upside potential (>100%) for patient investors. The valuation, at a discounted 54% of tangible book value, compared to well over 100% for its major peers, supports our upside case.

Revenues were boosted by net interest income which rose 18% from a year ago. This was driven mostly by a shift to more interest-earning assets, as the spread between the yield on its earning assets and the cost of its deposits and other funds widened by only 0.07 percentage points.

Institutional Client Group (ICG) services revenues rose 33%, but this was more than offset by weaker ICG equity market, institutional banking and corporate lending fees. Personal banking revenues, which includes credit cards, rose 10% although this was partly offset by lower wealth management revenues due to the weak stock and bond markets.

Expenses rose by 7% excluding the effect of divested businesses, as the bank continues to spend more to turn around its operations and invest for future growth and incurs some cost inflation. These more than offset productivity and other tailwinds. Credit costs remain remarkably subdued, and Citi added to its already-generous credit reserves.

Like most banks, Citi is seeing cheap deposits trickle out (down 3%). The average loan balance fell 2%. Capital remains robust at 12.2%, above the 12% new requirement starting this coming January 1. The bank is tweaking its risk-weighted asset mix to reduce the amount of capital it requires. The return on tangible capital of 7.5% continues to be sub-par and declined from 11.0% a year ago. Tangible book value per share rose a modest 2% from a year ago, but this pace includes reductions due to the generous dividend.

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, slide back to 0.20%. For now, it appears that this spread is driven by the 10-year yield, as the short-term yield is anchored around a 70-basis-point (100 basis points = 1 percentage point) premium to the Fed Funds rate.

The current spread is still near the low end of its range over the past 40 years, with a 2.00 percentage point spread being a rough average. If spreads were to return to a 2-point spread, bank profits would likely surge, assuming that other sources of profits including credit quality remained unchanged.

Citi shares trade at 54% of tangible book value and 6.4x estimated 2023 earnings. The remarkably low valuations assume an unrealistically dim future for Citi.

Citi shares rose 9% in the past week and have about 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 jumped 10% in the past week and have about 31% upside to our 14 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 rose 4% in the past week and have about 39% 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 8.4x estimated 2022 results, still among the lowest valuations in the consumer staples group and below other brewing companies. The 3.1% dividend yield only adds to the appeal. BUY

Organon & Company (OGN) was recently spun off from Merck. It specializes in patented women’s healthcare products and biosimilars, and also has a portfolio of mostly off-patent treatments. Organon will produce better internal growth with some boost through smart yet modest-sized acquisitions. It may eventually divest its Established Brands segment. The management and board appear capable, the company produces robust free cash flow, has modestly elevated debt and will pay a reasonable dividend. Investors have ignored the company, but we believe that Organon will produce at least stable and large free cash flows with a reasonable potential for growth. At our initial recommendation, the stock traded at a highly attractive 4x earnings.

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

OGN shares rose 5% in the past week. Investors have basically given up on OGN shares.

The shares have about 87% upside to our 46 price target (using the same target as the Cabot Turnaround Letter). The shares continue to trade at a remarkably low valuation while offering an attractive 4.6% 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.

Overall, the Sensata investment remains sharply underwater as its revenue growth is challenged by new economic cycle pressures on top of the post-pandemic supply chain issues. The company is well-positioned for the post-recession, electric vehicle environment, but investors will have to wait for that to arrive. The shares are still worth holding onto given their now-low valuation and ability to financially endure the downturn.

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

ST shares recovered 7% in the past week and have about 84% 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

Disclosure:The chief analyst of the Cabot Undervalued Stocks Advisor personally holds shares of every recommended security, except for “New Buy” recommendations. The chief analyst may purchase or sell recommended securities but not before the fourth day after any changes in recommendation ratings has been emailed to subscribers. “New Buy” recommendations will be purchased by the chief analyst as soon as practical following the fourth day after the newsletter issue has been emailed to subscribe

*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