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Value Investor
Wealth Building Opportunites for the Active Value Investor

Cabot Undervalued Stocks Advisor Weekly Update

If you want to build a buy-and-hold portfolio of attractive takeover targets, look no further than undervalued small- and mid-cap growth stocks. Presuming normal stock market action, you’ll reap the benefits associated with owning growth stocks, and you’ll periodically reap the additional exciting benefit of owning takeover stocks.

The Key to Building a Portfolio of Potential Takeover Stocks

Did you know that undervalued growth stocks can be ideal takeover targets? I love takeover stocks! I love the thrill of watching the market open and seeing a stock gap up 20% because a bigger company has announced its intention to buy a smaller company.

In August 1994, after two weeks of negotiations, American Home Products agreed to buy American Cyanamid at a share price that was 60% higher than the price at which American Cyanamid had been trading prior to the buyout offer. Somewhere in my basement, in boxes of memorabilia, is the printout of my computer screen showing the huge jump in the share price on the morning of the initial buyout offer. I even remember the name of a client who had the biggest position in the stock—it was Renae.

In the 22 months since I began writing Cabot Undervalued Stocks Advisor, we’ve had four takeover stocks in the portfolios: Axiall, Chemtura, Harman International and SanDisk. We could get lucky again, literally tomorrow, because I’m still using the same stock-selection strategy that I used for those four recent takeover stocks.

Let’s shrink this idea down to Molly’s Sewing Business, to make it really understandable. Molly is the CEO and she does business with button shops, thread shops, fabric shops, sewing machine shops and more. In this scenario, Molly’s Sewing Business represents the large-cap stock that’s looking to make a buyout offer, and the button shop represents the small-cap stock that becomes the takeover target.

Molly’s business is doing well, and she has extra money in the bank that’s not set aside for any particular expense, plus she has a large credit line. She knows that if she buys a small company, it could lower her supply costs, possibly expand her customer base, and possibly increase her annual profits. So she looks at all her suppliers and asks herself:

  • “Are any of these companies earning attractive profits?” The profit will transfer directly to Molly’s bank account, so that’s a strong consideration.
  • “Are these profits steady or growing annually?” It sure would be a bonus to receive growing profits in addition to receiving access to the small company’s valuable product mix and customer base!
  • “How much debt has the company accumulated, that I’ll have to repay if I buy the company?” Obviously, less debt is better than more debt.
  • “If I buy this company, can I make the products more costly to my competitors?” Hmmm, maybe she can get an edge on her competition at Greta’s Dressmaker Shop and at Elena’s Fabric Emporium.
  • “Can I buy this company for a fair-to-low price?” Molly noticed that fabric shops have been selling for 20 times annual earnings, but that button shops are selling at only 15 times earnings.

Molly decides to make a buyout offer for Belinda’s Button Shop, which has growing annual profits, very little debt, sells product to Molly’s competition, and costs a lot less than Elena’s Fabric Emporium.

How does this takeover scenario translate to merger & acquisition activity in your investment portfolio? Well, we’re already buying undervalued companies with rising profits and low debt levels, so we can check off that box. Therefore, the most important subsequent consideration is the size of the company. The smaller the company, the less expensive it will be to acquire.

If you own stock in Adobe Systems (market cap $75 billion), it’s going to be hard for a company to come up with enough cash & financing to make a takeover offer. Perhaps Microsoft (market cap $561 billion) or Alphabet (market cap $321 billion) could afford to buy Adobe, but the bigger the takeover target, the fewer the number of companies that can afford to buy it.

Now think about Cavium (market cap $4.2 billion), KLX (market cap $2.4 billion) and Alexion Pharmaceuticals (market cap $30.7 billion). Many medium and large-sized companies can afford to buy Cavium, KLX and other similar small companies. Even though Alexion is a good-sized mid-cap stock, there are many large players in the pharmaceutical industry that could make a buyout offer, including Bristol-Myers Squibb (market cap $95.7 billion), Pfizer (market cap $199 billion) and Merck ($172 billion).

So if you want to build a buy-and-hold portfolio of attractive takeover targets, look no further than undervalued small- and mid-cap growth stocks. Presuming normal stock market action, you’ll reap the benefits associated with owning growth stocks, and you’ll periodically reap the additional exciting benefit of owning takeover stocks.

Special Trader Alert: Royal Caribbean Cruises (RCL) typically announces an annual dividend increase of 20%–50% during September, with the ex-dividend date following within two weeks. The price chart is bullish; earnings estimates have been recently rising, along with analyst upgrades from Citigroup and Morgan Stanley; and the long-term debt ratio has been dropping. These factors combine to present a near-term capital gain opportunity. I’m not going to report back on the stock, so follow your personal trading patterns if this opportunity is attractive to you.

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Portfolio Notes

Make sure to review the Special Bulletins from August 24 and 25 in which I mentioned news, rating changes and/or price action on Dollar Tree (DLTR), GameStop (GME) and KLX (KLXI).

Buy-Rated Stocks Most Likely* to Rise More than 5% Near-Term:

Alexion Pharmaceuticals (ALXN)
Apple (AAPL)
Blackstone Group (BX)
Boise Cascade (BCC)
Commercial Metals (CMC)
Molina Healthcare (MOH)

*I can review price charts and make an educated determination about what’s likely to occur, but I will sometimes be wrong. I cannot control the stock market, I can only guide you through it.

Today’s Portfolio Changes: None

Last Week’s Portfolio Changes:

Ameriprise Financial (AMP) moves from Hold to Buy.
Andeavor (ANDV) moves from Buy to Strong Buy.

Updates on Growth Portfolio Stocks

Apple (AAPL – yield 1.5%) manufacturers the iPhone, iPad and Mac. Apple begins its 2018 fiscal year in October, for which earnings estimates have been rising since January. At this point, EPS are expected to grow 20.3% in fiscal 2018, while the P/E is just 14.7. Apple hasn’t had a year of strong earnings growth since fiscal 2015, so Wall Street is likely to pay close attention to the stock’s capital gain potential in the coming year.

The interesting thing about AAPL is that people become so smitten with the aura of the company and its products that they can’t see the forest for the trees when it comes to the share price. Pull up a five-year price chart and look at what the share price did in each of these fiscal years (September year-end):

2013: EPS fell, share price fell
2014: EPS rose, share price rose
2015: EPS rose, share price rose
2016: EPS fell, share price fell
2017: EPS rose, share price rose
2018: EPS expected to rise, share price rising

You’ll also notice that the share price turns around a few months in advance of the next fiscal year’s EPS trend, the pivotal point happening in July or August, like clockwork. Yet each time that the share price goes through a stagnant or falling time period, investors act confused, shaking their fist at Wall Street and complaining to anybody who will listen to them.

News flash: With Apple, the share price always correlates to the earnings trend. This is one of the easiest, most predictable opportunities in the stock market. Take advantage of it! The stock will probably climb through next summer, at which point it will then be fueled by fiscal 2019 expectations. Buy AAPL now. Strong Buy.

Bank of America (BAC – yield 2.0%) is an undervalued large-cap growth stock. Changes in bank regulations, lower tax rates and a surge in interest rates—which all benefit banks’ net income—have not yet been factored into earnings estimates. Investors should therefore expect rising earnings estimates throughout the banking industry over the next several years. BAC has traded between 22 and 25.5 all year. I expect BAC to rise past 25.5 in the near future. Strong Buy.

Cavium (CAVM) is an undervalued, aggressive growth stock in the semiconductor industry. CAVM presents a large capital gain opportunity for investors who are willing to hold the stock without staring at the daily price fluctuations. There’s currently 20% upside as CAVM travels back to 74, where it traded in May. Barring a bearish stock market, CAVM could exceed 74 later this year. Buy.

KLX Inc. (KLXI) is a small-cap stock in the aerospace and energy services industries. KLX will give a presentation at the Gabelli & Company 23rd Annual Aerospace & Defense Conference on September 7. KLX reported a good second-quarter last week (see the August 24 Special Bulletin). Revised estimates project the company’s EPS to grow 192% and 26.1% in 2018 and 2019 (January year-end). Shockingly, the corresponding P/Es are just 15.2 and 12.1.

KLXI has traded between 46.5 and 53 for over four months, and it’s currently sitting at the bottom of that range. That means both traders and longer-term growth investors can probably earn attractive capital gains by buying at the current price. There’s 12% upside within the trading range. Once the stock breaks past 53, it could begin a sustainable run-up. Strong Buy.

Martin Marietta Materials (MLM – yield 0.9%) increased its quarterly dividend last week from $0.42 to $0.44 per share. Analysts expect EPS to increase by 18.9% and 30.5% in 2017 and 2018. MLM is overvalued based on 2017 numbers, but undervalued based on 2018 numbers.

The stock is down recently. Is there a corporate or industry problem? No. Stocks in the construction aggregate industry are having a big price pullback, including my three favorites, MLM, Vulcan Materials (VMC) and Eagle Materials (EXP). The construction aggregate industry is projected to have strong demand in the coming years, based on municipal and federal projects that are already approved and in the pipeline. The stock is not yet ready to rebound. There’s about 22% upside as MLM retraces its May peak at 240, where the stock will still be undervalued. Buy.

PulteGroup (PHM – yield 1.4%) is a U.S. homebuilder, and a very undervalued aggressive growth stock. PHM has been slowly ratcheting upward since breaking out from a long-term trading range in July. Buy PHM now. Strong Buy.

Quanta Services (PWR) provides specialized infrastructure and network services to the electric power, oil and natural gas industries. This undervalued aggressive growth stock was featured in the August issue of Cabot Undervalued Stocks Advisor. I expect PWR to rise to 38.5, where it traded in February, then rest again before climbing further. There’s 25% upside to my fair-value price target of 44. Buy PWR now. Strong Buy.

Vertex Pharmaceuticals (VRTX) is an undervalued, aggressive growth biotech company that corners the market in treatments for cystic fibrosis (CF). Last week, Vertex received Priority Review designation from the FDA for a new CF drug application, thus shortening the review process by about four months to an action date of February 28, 2018. VRTX is fully valued based on 2017 EPS, but distinctly undervalued based on 2018 earnings projections. VRTX pulled back after a rapid run-up in July, and now appears to be retracing recent highs. Buy VRTX now. Buy.

Vulcan Materials (VMC – yield 0.9%) is a supplier of construction aggregates, asphalt and concrete. Last week, Vulcan announced a friendly buyout of Vancouver-based Polaris Materials Corporation, which serves the California market. Analysts expect EPS to increase by 19.2% and 44.6% in 2017 and 2018. VMC is overvalued based on 2017 numbers, but undervalued based on 2018 numbers.

The stock is down recently. Is there a corporate or industry problem? No. Stocks in the construction aggregate industry are having a big price pullback, but the industry is projected to have strong demand in the coming years, based on municipal and federal projects that are already approved and in the pipeline. The stock is not yet ready to rebound. There’s 18% upside as VMC retraces its June peak at 134, where it will still be undervalued. Buy.

XL Group (XL – yield 2.1%) is an insurer and reinsurer, and a very undervalued mid-cap aggressive growth stock. The stock had a big run-up earlier this year, followed by a price correction, followed by the fear surrounding Hurricane Harvey’s impact on the company’s bottom line. Scoop up XL while it’s cheap, because I believe this low price will be quite temporary. Strong Buy.

Updates on Growth & Income Portfolio Stocks

Ameriprise Financial (AMP – yield 2.4%) offers insurance products and asset management to retail and institutional clients. AMP pulled back from its August high, and seems to be resting in preparation for another run up to 148. The stock will be fairly valued at 160. Buy.

BP plc (BP – yield 6.9%) is a European integrated oil company and a very undervalued aggressive growth stock. There’s 27% upside, plus dividends, as BP eventually retraces price resistance at 44, where BP traded in 2014. Buy BP now. Strong Buy.

Blackstone Group LP (BX – variable large payouts) – BX could appeal to traders, dividend investors and long-term growth investors. There’s 17% upside as the stock retraces long-term upside price resistance at 37. This is an excellent stock for a buy-and-hold portfolio. Buy BX now. Strong Buy.

Commercial Metals Company (CMC – yield 2.7%) is a recycler and manufacturer of steel and metal products, including rebar and fence posts. There’s 33% upside, plus dividends, as CMC retraces its December 2016 high around 24, at which point the stock will still be extremely undervalued. Buy CMC now. Strong Buy.

ExxonMobil (XOM – yield 4.0%) is the largest U.S. integrated oil company. The company is experiencing very aggressive earnings growth in 2017. Share prices of integrated oil companies have been weak recently, and are tentatively on the mend. There’s 18% upside, plus dividends, as XOM retraces its highs from July and December 2016 at 91. Strong Buy.

GameStop (GME – yield 7.8%) is a retailer of games, collectibles and technology; with additional ventures in the entertainment field. Please refer to the Special Bulletin from August 25 for news on the company’s good second-quarter results. Here are a few more positive facts:

  • In November 2016, CEO Paul Raines reiterated the company’s intent to continue increasing dividends and share repurchases.
  • GameStop increases the dividend payout annually in the first quarter.
  • The company repurchased 26.1% of its common stock in the five years ending January 2017.
  • With a 7.8% dividend yield, investors are being paid it wait for the stock market to embrace GameStop’s multi-year process of diversifying its product areas away from a dependence upon physical game revenue.
  • The long-term debt to capitalization ratio is relatively low at 26%, which means that debt payments are not harming the company’s business operations or outlook.
  • GameStop could easily be a takeover target. GME is a small-cap stock with a market capitalization of $2.0 billion. Any medium-to-large entertainment or technology company that wanted to access GameStop’s global distribution network or its cash flow could make an offer to buy the company.

As a reminder, companies that are “in trouble” do not waste cash on dividends and share repurchases. I won’t be giving GME a Buy recommendation until the price chart turns bullish. However, dividend investors should buy now. Hold.

Invesco (IVZ – yield 3.5%) is an asset management company. The company is in the news because it might buy Guggenheim Partners’ ETF business for $1 billion. However, the deal will not necessarily be accretive to earnings in the near-term, so I don’t expect a dramatic change in the share price. Traders should note that there’s 10% upside, plus dividends, to the stock’s recent high at 36.5, where I might sell due to fair valuation. Hold.

Johnson Controls (JCI – yield 2.6%) is an undervalued, large-cap growth & income stock. There’s 13% upside, plus dividends, as the stock retraces its July high at 44, where it will still be undervalued. Buy JCI now. Strong Buy.

Weyerhaeuser (WY – yield 3.9%) is one of the largest U.S. manufacturers of wood and cellulose fiber products. Weyerhaeuser was featured in the August issue of Cabot Undervalued Stocks Advisor. The company is experiencing aggressive multi-year earnings growth, and the stock is undervalued. There’s 10% upside, plus dividends, to the top of its recent trading range at 35. I expect additional capital gains thereafter. Strong Buy.

Updates on Buy Low Opportunities Portfolio Stocks

Alexion Pharmaceuticals (ALXN) is a biopharmaceutical company that researches and manufactures treatments of severe and rare health disorders. Last week, Soliris received approval by the European Commission to treat patients with refractory generalized myasthenia gravis (gMG). This aggressive growth stock is undervalued based on its 2018 valuation. Alexion was featured in the August issue of Cabot Undervalued Stocks Advisor. ALXN embarked on a new run on August 28. Buy ALXN now. My intention is to hold the stock until it reaches upside price resistance at 160 or 190, depending on momentum among pharmaceutical stocks. Buy.

Andeavor (ANDV – yield 2.4%) is the new name for Tesoro (TSO) as of August 1. It’s an undervalued aggressive growth stock. Gasoline prices are spiking due to Hurricane Harvey and its affect on near-term refining activity. ANDV is therefore rising due to expectations of increased profit margins. If the stock breaks past 102, we could see a sustained near-term run-up to 112, where the stock traded in 2015. I might then keep ANDV for longer-term gains. Strong Buy.

Boise Cascade (BCC) is a wood products and building materials company. BCC has traded between 28 and 32 for three months. There’s 10% upside within the trading range, and about 30% upside if BCC rises to the upper 30s later this year. Buy this micro-cap aggressive growth stock now. Strong Buy.

Chipotle Mexican Grill (CMG) is an undervalued aggressive growth stock. Despite the difficulty with the share price, the company’s annual profits are rising rapidly. Therefore, I have confidence that the share price will eventually right itself. I’m waiting for a more stable price chart before giving the stock a Buy recommendation. If we get a near-term rebound, CMG could rise to 350, then pull back a bit before continuing upward. Hold.

Dollar Tree (DLTR) reported a much better-than-expected second quarter last week (read the August 24 Special Bulletin). Raymond James then changed its recommendation on the stock from Market Perform to Strong Buy, and Jim Cramer reminded investors that Dollar Tree successfully competes against on pricing. (The latter is a no-brainer: people who spend $1 per product are usually cash-strapped. They do not order discretionary products online!) For the first time since early March, analysts have meaningfully raised their full-year earnings expectations for the company. At this point, EPS are expected to grow 22.2% and 11.3% in 2018 and 2019 (January year-end). These are great numbers for a food or discount retailer, and much better than the two-year growth projections at Wal-Mart (WMT), Target (TGT), Dollar General (DG) and Sprouts Farmer’s Market (SFM). As a matter of fact, Target’s profits are expected to decline in both years! Despite the rosy earnings outlook, I consider DLTR to be overvalued based on 2019 numbers, although clearly the retail group commands a higher P/E than I’m comfortable with.

During the first half of Dollar Tree’s 2018 fiscal year, the long-term debt-to-capitalization ratio has dropped from 62% to 49%. The higher debt ratio came in conjunction with the July 2015 purchase of Family Dollar Stores, and the company is now paying down the debt at an unusually fast pace.

Consider any pullback a buying opportunity. There’s a little price resistance at 83, and more at 90. The best-case scenario is that DLTR could rise 20% to the upper 90s in the coming 12 months, where it last traded in August 2016. Buy.

Goldman Sachs Group (GS – yield 1.3%) is a fairly-valued large-cap investment back. Changes in bank regulations, lower tax rates and a potential surge in interest rates could each prompt rising earnings estimates. There’s 13% upside, plus dividends, to my 250 price target. Buy.

Legg Mason (LM – yield 3.0%) is a U.S.-based global asset management and financial services company with $750 billion in assets under management (AUM). There’s about 10% upside as the stock retraces its high of 41.5 in July; and about 17% upside, plus dividends, to long-term price resistance at 44. Strong Buy.

Mattel (MAT – yield 3.6%) Profits are expected to fall in 2017, then rise about 27.5% in 2018. I’m going to hold the stock for the rebound that will likely take place under the new CEO. MAT remains undervalued, but it’s not out of the woods yet. When the price chart becomes more bullish, I will give the stock a Buy recommendation. Hold.

Molina Healthcare (MOH) is a managed healthcare operator. Molina is being run by experienced company and board executives during a search for a permanent CEO. I believe the share price on MOH is now completely out of the woods, and ready to begin marching back to its all-time high in the low 80s, from the summer of 2015. In the short-term, there’s 16% upside as MOH retraces its July high at 72. My longer-term price target is 80, giving new investors a potential 29% capital gain. Strong Buy.

Schnitzer Steel Industries (SCHN – yield 2.9%) is one of the largest U.S. scrap metal recycling companies, and a manufacturer of steel products that are used in nonresidential construction. The company also owns over 50 stores that sell used auto parts. This micro-cap stock offers aggressive earnings growth, moderate debt levels, enough cash flow to fund a hefty dividend and a very strong CEO at the helm, all of which could attract M&A interest. SCHN has a more bullish price chart than just about any other steel stock. We could see an immediate breakout past 26.5. My price target is 29, where the stock traded in December 2016. Hold.

Total (TOT – approx. 4.3%) is an integrated oil & gas company based in France, and a greatly undervalued stock. Analysts raised their 2018 EPS estimates for Total in light of the pending acquisition of Maersk Oil.Click here to read a bullish August 25 review of TOT by Zacks. Earnings are now expected to grow 19.5% in 2018. TOT could reach a maximum of 54 in the short-term, and will then likely have another pullback before climbing to three-year price resistance in the low 60s, delivering 19% capital gain potential plus dividends. Buy TOT now. Strong Buy.

Universal Electronics (UEIC) is a manufacturer and cutting-edge world leader of wireless remote control products, software and audio-video accessories for the smart home, with a strong pipeline of new products. The company also offers energy management and control products through a recent acquisition. Universal Electronics will be meeting with Wall Street analysts at three industry conferences in September. There are only about four analysts currently covering this undervalued micro-cap stock. If even one more analyst picks up coverage after meeting with the CEO and CFO in September, that would expand the stock’s investing audience, potentially enhancing the share price.

Wall Street expects earnings per share (EPS) to grow at a compound annual rate of 17% per year in 2017 and 2018. The company has just $12.6 million outstanding in long-term debt, adding to its attraction to potential buyers. The share price fell after the recent earnings report for no substantial reason, and now appears to be stabilizing. There’s 26% upside to the July high around 72, at which point the stock will still be undervalued. Buy.