Preparing for a Change in Market Leadership
It’s quite common that a year’s top-performing stocks and industries can fade after the new year arrives as investors shift money into industries that have been long-ignored. “Buy low” doesn’t just refer to stock market corrections and random stocks that have fallen precipitous amounts. “Buy low” can also refer to unrecognized industry-wide opportunities. During the last 18 months or so, I pounded the table on banking, semiconductor, homebuilder and energy stocks. A lot of people thought I was nuts, but these opportunities were obvious to me because there were aggressive earnings growth and low P/Es on the horizon throughout those industries. Eventually, high quality undervalued stocks become recognized by the market, and the buying frenzy begins. That’s what I anticipate in 2018 among oilfield service and property/casualty and reinsurance stocks.
In my opinion, the most financially healthy, undervalued and ridiculously ignored industry in U.S. stocks markets is oilfield services. I added Schlumberger (SLB) to the Cabot Undervalued Stocks Advisor portfolios in October, and I’m adding Baker Hughes, a GE Co. (BHGE) today. (For the record, I would not buy Weatherford (WFT), due to ongoing net losses, or Halliburton (HAL), due to a slightly high debt ratio.)
I’ll be doing additional portfolio shuffling between now and February, and will almost certainly add another property/casualty and reinsurance stock. Industry stocks have been held down due to prospects of increased excise taxes for Bermuda-based companies within new income tax legislation. That negative news is offset by news that the reinsurance industry is entering a long-overdue phase of price increases that will exponentially enhance net income. Various analysts are expecting average insurance rate increases anywhere between 2% and 7%, which can lead to consensus estimates rising approximately 8% to 30% beyond the current earnings per share (EPS) projections. Yet the market is not talking about this boost in industry profitability, and the stocks currently have huge disparities between earnings growth rates and valuation.
As we near February, I’ll consider selling stocks where the share prices have suffered and did not subsequently begin to rebound in January.
Mid-Cap Banks
There’s bipartisan support in the U.S. Senate to change SIFI rules–regulations that apply to systemically important financial institutions—as they apply to banks with less than $250 billion in assets. The stock market has not factored in potential SIFI changes, largely due to its familiarity with the slow wheels of change in Washington D.C., partisan bickering and 2018 mid-term elections supposedly causing decision-making paralysis. What these expectations don’t take into account is that there’s a new end game in Washington D.C., causing a push for reform (just look at the suddenly-rapid changes and/or improvements in the tax code and in international trade). There are also lots of newly-nominated and appointed heads of agencies who will presumably want to make their marks by taking action, including at the Securities and Exchange Commission, the Federal Open Market Committee, the U.S. Commodity Futures Trading Commission and the Office of the Comptroller of the Currency.
Think about it: if you acquired a new job as head of a policy-making entity, would you run everything business-as-usual or would you seek to make changes, improvements and innovations? Between leadership changes, bipartisan influence and a political administration that’s stressing the need to get rid of two regulations for each new regulation, I think the long list of proposed SIFI rule changes is going to see some serious action.
The Cabot Undervalued Stocks Advisor portfolios are going to be overweighted in banks and financials if I add any mid-cap banks right now. Sigh. I feel like I’m visiting a bakery while on a diet … or any food store, for that matter. I love food! But with regard to banks, you might want to go shopping, so here are my favorite mid-cap banks: BB&T (BBT), Bank of the Ozarks (OZRK), Independent Bank Group (IBTX) and KeyCorp (KEY). If I were managing a mutual fund, I’d buy all four of them!
Wishing you blessed religious holidays and peace for your families!
Send questions and comments to crista@cabotwealth.com.
Portfolio Notes
Buy-Rated Stocks Most Likely* to Rise More Than 5% Near-Term:
Alexion Pharmaceuticals (ALXN)
Alphabet (GOOGL)
Apple (AAPL)
Nucor (NUE)
*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:
Baker Hughes, a GE Co. (BHGE) joins the Buy Low Opportunities Portfolio as a Strong Buy.
Southwest Airlines (LUV) moves from Hold to Buy.
Vertex Pharmaceuticals (VRTX) moves from Hold to Strong Buy.
Last Week’s Portfolio Changes:
Nucor (NUE) moved from Strong Buy to Buy.
Updates on Growth Portfolio Stocks
Alphabet Cl. A (GOOGL) is the world’s largest internet company. Revenue is derived from Google’s online ads, with the balance coming from the sale of apps, digital content, services, licensing and hardware. Alphabet was featured in the December 5 issue of Cabot Undervalued Stocks Advisor. GOOGL is an undervalued, large-cap aggressive growth stock. EPS are expected to grow 28.6% and 18.8% in 2018 and 2019. I expect the current run-up to continue. Buy GOOGL now, and buy more on dips. Strong Buy.
Apple (AAPL – yield 1.4%) manufactures a wide range of popular communication and music devices. The company is expected to grow EPS by 24.4% in fiscal 2018 (September year-end), and the P/E is 15.2, presenting an attractive growth and value scenario. Earnings estimates have been rising all year. The price chart is bullish. AAPL rose past price resistance at 176 yesterday. Buy AAPL now and buy more on dips. Strong Buy.
Bank of America (BAC – yield 1.6%) is expected to see EPS grow 18.7% in 2018, with a P/E of 13.4. Over the course of the next several years, all of the following phenomena can serve to push earnings estimates higher: lower income tax rates, higher interest rates, deregulation and a growing U.S. economy. The price chart remains bullish. I expect additional capital gains from BAC in 2018. Strong Buy.
KLX Inc. (KLXI) is a small-cap stock in the aerospace and energy services industries. EPS are expected to grow 26.3% in fiscal 2019 (January year-end), with a P/E of 15.5. KLXI shot upward in early December, in reaction to its recent report, paused briefly, then began another ascent. I anticipate additional capital gains in the coming year. Expect volatility. Strong Buy.
Martin Marietta Materials (MLM – yield 0.8%) is a supplier of crushed stone, sand, gravel, cement, concrete and asphalt. MLM is Morningstar’s top pick for U.S. infrastructure. This mid-cap company is expected to achieve EPS growth of 29.0% and 20.3% in 2018 and 2019, with corresponding P/Es of 23.4 and 19.4. There’s 16% upside as MLM retraces its May 2017 peak at 240, where the stock will still be undervalued. Strong Buy.
Quanta Services (PWR) provides specialized infrastructure and network services to the electric power, oil and natural gas industries. EPS are expected to grow 25% in 2018 with a P/E of 15.4. PWR rose above long-term price resistance this month, then dipped down to tentative price support at 37.5. I expect additional near-term capital gains. Buy PWR now. Strong Buy.
Southwest Airlines (LUV – yield 0.7%) CEO Gary Kelly said last week that Southwest would use savings from proposed cuts in the corporate income tax rate to fund new airplanes, add jobs (at Southwest and/or Boeing), benefit employees and repurchase stock. Southwest is expected to see EPS grow 25.5% in 2018, with a P/E of 14.4. This month, LUV retraced its July high near 64, then kept rising. Since the price chart indicates near-term upside, I’m moving LUV from Hold to Buy. Still, a pullback towards 60 would be perfectly normal, and a good buying opportunity. I expect additional capital gains in 2018. Buy.
Vertex Pharmaceuticals (VRTX) is a biotech company that corners the market in treatments for cystic fibrosis (CF). EPS are expected to grow 55% in 2018, with a P/E of 49.8. VRTX had a huge 2017 run-up through July, and has since languished. My sense is that the stock’s preparing to rise, so I’m moving VRTX from Hold to Strong Buy. There’s about 13% upside as VRTX retraces 166. At that time, clues in the earnings outlook, the price chart and the broader market will hint at whether VRTX could begin reaching new highs again thereafter. Strong Buy.
Vulcan Materials (VMC – yield 0.8%) is a supplier of construction aggregates, asphalt and concrete. EPS are expected to grow 38.1% in 2018 with a P/E of 29.3. VMC has traded between 112 and 135 since November 2016. I expect the stock to eventually break out of that trading range. Buy.
XL Group (XL – yield 2.5%) is an insurer and reinsurer, and an undervalued mid-cap stock. After taking a loss in 2017 due to natural disasters, XL is expected to earn $3.71 per share in 2018. The corresponding P/E is low at 9.8. Subsequent to a huge run-up in the first half of 2017, on July 20 I wrote, “I’m changing my recommendation from Strong Buy to Buy because [XL] will probably need to rest soon.” Then hurricane season struck … and earthquakes and a typhoon! XL fell back toward 36, where it began the year. Bargain hunters could earn a 31% capital gain as XL travels back toward 47 in 2018. Buy.
Updates on Growth & Income Portfolio Stocks
BP plc (BP – yield 5.8%) is a European integrated oil company. BP is expected to have another leap in profit in 2018, with EPS growing 37.8%. The corresponding P/E is 16.2. Despite being undervalued and having aggressive earnings growth, I’ll probably sell BP as it approaches 42, where it last traded in 2014. That’s because when stocks retrace highs from several years ago, they almost always stop rising when they hit that price, and then languish for an extended period of time. Hold.
Blackstone Group LP (BX – yield 7.4*) is an alternative asset manager, and an undervalued growth & income stock. BX had a big run-up in the second quarter of 2017, and is most recently trading between 31 and 34.5. In the coming three to 12 months, I expect BX to retrace 37, where it last traded in early 2015, giving new investors a potential 17% capital gain. Buy BX now. Strong Buy.
*The payout varies each quarter, with the total of the last four announced payouts yielding 7.4%.
Commercial Metals Company (CMC – yield 2.3%) is a recycler and manufacturer of steel and metal products, including rebar and fence posts. CMC is expected to see EPS grow 77.5% and 30.2% in 2018 and 2019 (August year-end). The corresponding P/Es are very low at 16.4 and 12.6. The stock is rising toward price resistance at 22, with additional resistance at 24, where it last traded in December 2016. CMC offers new investors a potential 15% capital gain. Strong Buy.
GameStop (GME – yield 8.1%) is a retailer of games, collectibles and technology; with additional ventures in the entertainment field. The share price has improved since November, but continues to be subject to tax-loss selling until the new year. GME is a good choice for income investors and patient growth investors who like to buy bargains. Buy.
The Interpublic Group (IPG – yield 3.5%) is a large conglomerate of advertising, marketing, communications and public relations companies serving all global markets. Interpublic was featured in the December 5 issue of Cabot Undervalued Stocks Advisor. IPG is a slightly undervalued growth & income stock with an attractive rising annual dividend.
IPG rose to an all-time high of 25.25 in July, then fell precipitously as full-year 2017 revenue and profit estimates were lowered to reflect very modest growth. The stock appears to have begun its rebound. There’s 23% capital gain potential as IPG wanders back to its July high. At that point, I would expect the stock to get stuck. But for now, there’s lots of room to make money. Strong Buy.
Johnson Controls (JCI – yield 2.8%) is a multi-industry, large-cap growth & income stock. This month, the company increased the quarterly dividend from $0.25 to $0.26 and added $1 billion to the share repurchase authorization (which has $200 million remaining from the previous authorization). The stock is overvalued based on 2018 EPS (September year-end), yet undervalued based on subsequent years’ stronger earnings growth projections. I will likely sell near price resistance at 40 in the coming months. Hold.
Morgan Stanley (MS – yield 1.9%) is a major U.S. investment bank and wealth manager, and an undervalued growth & income stock. The price chart is bullish. I expect MS to rise toward my fair-value price target of 58 during the next two to six months. Hold.
Schlumberger (SLB – yield 3.1%) is a premier oilfield equipment and services company with a global footprint. SLB is an undervalued aggressive growth stock. Consensus EPS estimates point toward 28.9% 48.3% and 38.1% EPS growth in 2017 through 2019. Those are incredible growth rates, rarely seen in large-cap stocks. The 2018 P/E is 28.5. Oilfield service stocks did not participate in the 2017 energy stock rally, which was led by integrated oil, E&P and refining/marketing companies. It’s quite normal that the performance of oilfield service stocks lags those industries when their sectors are at the sweet spot in the economic cycle. The earnings growth prospects and valuations at SLB and Baker Hughes (BHGE) are outstanding. I expect oilfield service stocks to have a tremendous year in 2018. There’s 34% upside plus dividends as SLB eventually retraces its December 2016 high near 86. Strong Buy.
WestRock Company (WRK – yield 2.7%) is a major player in the global packaging and container industry. Last week, WestRock announced the pending acquisition of corrugated packaging company Plymouth Packaging, thereby expanding WestRock’s containerboard market share via Plymouth’s customer base, and also producing post-merger cost synergies. WRK is a mid-cap growth and income stock. After a slow-growth year in 2017, WestRock is expected to see EPS grow 40.1% in 2018 (September year-end), with a P/E of 17.2. The stock rose to a new all-time high this month. I expect additional capital gains in 2018. Strong Buy.
Weyerhaeuser (WY – yield 3.4%) operates in the areas of timberland, wood products, real estate, energy and natural resources. WY shares are overvalued based on slowing 2018 EPS growth. The stock rose to new all-time highs in November, and has since traded between 35 and 36. We could see new highs again quite soon. Hold.
Updates on Buy Low Opportunities Portfolio Stocks
Baker Hughes a GE Co. (BHGE – yield 2.3%) joins the Buy Low Opportunities Portfolio today as a Strong Buy. Baker Hughes offers products, services and digital solutions to the international oil and gas community.
In May 2016, after 18 months of tension and negotiations, Baker Hughes’ planned merger with Halliburton (HAL) fell apart. Subsequently, General Electric (GE) announced its intention to buy Baker Hughes, planning to merge Baker Hughes with GE’s own oil and gas equipment and services operations. The deal successfully closed in July 2017. GE now owns 62.5% of the new company.
Despite incredibly attractive earnings growth and valuations, oilfield service companies did not participate in the 2017 bull market. To a certain extent, that was predictable, because oilfield service stocks typically lag exploration and production stocks and refining and marketing stocks when the energy sector ramps up.
The price charts of oilfield service companies have been dismal, yet recently stable. Tax-loss selling is almost over. This is the best time of year to go shopping for bargain stocks among great companies that have been ignored by investors. The pendulum always swings—we’re seeing it in politics and we saw it with the market’s mood toward financial and energy companies in recent years after exaggerated downturns.
I absolutely love BHGE, and I think investors are going to earn outsized capital gains on the stock in 2018. I also think that progress with the share price will be almost immediate, barring, of course, an unexpected market downturn. (I do expect a stock market correction-and-rebound in 2018, but it’s not here yet, and I’m not going to panic and sell everything when it happens.)
BHGE is a large-cap stock. Institutions own 93% of the shares, which is no surprise because this multi-faceted stock could easily fit into growth portfolios, value portfolios and growth & income portfolios.
It’s quite common that stocks flounder in the wake of big corporate events that can take months or years to unfold, such as M&A activity or recoveries from serious problems. Examples include the Kraft-Heinz merger, the BP oil spill, and the Adobe revenue model transition. (Believe it or not, people were worried about Adobe! That cracks me up.) You know who’s not worried about Baker Hughes’ future? Wall Street analysts. Check out their earnings per share (EPS) estimates:
You might be looking at the earnings growth in the chart and thinking, “that’s nice,” but let me assure you that it’s rare to find a large-cap stock with such aggressive earnings growth projections!
Here’s some more good news: the company’s long-term debt-to-capitalization ratio is incredibly low. There’s some disparity in the reporting, with MarketWatch citing an 18% ratio and Charles Schwab citing a 7% ratio, but either way, both of those numbers are quite attractive. And by the way, the debt ratio has remained below 20% for at least five years, since I began keeping records on the company.
When companies can easily handle their debt obligations, they usually have extra cash with which to invest in operations or reward shareholders. In November, Baker Hughes’ management announced their intention to repurchase $3 billion of stock, or 8% of outstanding shares, including shares owned by GE. (I’m relatively certain that GE will welcome the influx of cash to shore up their ailing finances!) The company also pays an attractive dividend, yielding 2.3%. (The most recent dividend increase took place in November.)
How high can BHGE climb? It’s hard to say, so let’s take it one step at a time. There’s some short-term upside resistance at 37, where the stock traded in September, so that’s my first price target, giving new investors a potential 20% capital gain. I’m likely to continue holding the stock at that point. Buy BHGE today. Strong Buy.
Alexion Pharmaceuticals (ALXN) is a biopharmaceutical company that researches and manufactures treatments of severe and rare health disorders. In recent days, Morgan Stanley lowered its price target on ALXN to 150, and Baird raised its rating on ALXN to Outperform. Alexion was featured in the December 5 issue of Cabot Undervalued Stocks Advisor. ALXN is an undervalued aggressive growth stock. Analysts are expecting another year of aggressive earnings growth in 2018, with EPS growing 25.5%. The 2018 P/E is just 16.4. The 2017 drop in the share price was significant, and the turnaround seems to have begun. There’s a 36% capital gain opportunity as the stock rebounds to its April 2016 high at 160. Buy ALXN now. Strong Buy.
Boise Cascade (BCC – yield 0.7%) is one of the largest producers of engineered wood products (EWP) and plywood in North America and a leading U.S. wholesale distributor of building products. BCC is a fairly-valued small-cap growth stock. The stock has been on an uptrend since late August, and could reach a maximum of 43—where it previously reached an all-time high in February 2015—before the run-up comes to a halt. Hold.
Chipotle Mexican Grill (CMG) is a growing-yet-beleaguered restaurant chain. Consensus estimates point toward EPS growth of 40.3% in 2018, with a P/E of 33.3, and continued aggressive earnings growth in subsequent years. There’s short-term upside price resistance at 330 and 350. As long as the profit outlook and valuation remain attractive, I will hold the stock for the prospect of future capital gains. Hold.
Delek US Holdings (DK – yield 1.9%) is a diversified downstream energy company, with businesses that include petroleum refining, transportation, marketing, renewables (producing biodiesel fuel) and asphalt operations. DK is an undervalued small-cap stock. Consensus earnings estimates have been rising for the past four weeks, now reflecting 196% EPS growth in 2018, with a P/E of 20. DK emerged from a year-long trading range in early November and quickly rose to two-year price resistance at 32. It would be a bullish sign if DK continued to trade between 32 and 33 for another month or so, gathering the strength for another run-up. Strong Buy.
Legg Mason (LM – yield 2.7%) is a U.S.-based global asset management and financial services company. LM is an undervalued growth stock. Earnings estimates have been rising since mid-October. LM appears ready to climb to 44, where it last traded in October 2015, and where I will likely sell. Hold.
Mattel (MAT) shares are way down for the year. My suggestion is that investors hold MAT for either a takeover offer or a corporate and share price rebound in 2018. Hold.
Nucor (NUE – yield 2.4%) is a low-cost producer of a diversified portfolio of iron and steel products, and an undervalued mid-cap growth stock. Consensus estimates point toward 20.5% EPS growth in 2018, with a P/E of 13.7. I expect NUE to rest when it reaches its December 2016 high of 65, before gathering enough momentum to continue its run-up. Buy.
Total (TOT – approx. 4.0%) This French integrated oil & gas stock is fairly valued in relation to 2018 EPS growth expectations. TOT is recently trading between 54 and 57. I expect the stock to rise to the low 60s, where it last traded in July 2014, and where I will likely sell. Hold.
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. UEIC is an undervalued micro-cap stock, forecasted to achieve aggressive 2018 EPS growth. UEIC rose on huge volume on December 15—always a bullish sign. There’s 50% upside as UEIC retraces its July high around 72, where the stock will still be undervalued. Expect volatility. Risk-tolerant investors should buy now, and cautious investors should wait until January to consider the stock. Strong Buy.
