In Theory, Macro Translates Directly to Micro. In Practice? Not So Much.
As a practitioner in the investing world, I find theoretical debates to be sometimes interesting but usually not highly applicable to my work. This mirrors a favorite saying of mine, attributable to Albert Einstein: “In theory, theory and practice are the same. In practice, they are not.”
Debates about the chances of a recession dominate the financial media. But these debates remain highly theoretical – there is plenty of evidence to support all sides of the argument. And, the future is unknown and unknowable, so until reality arrives, typically one day at a time, there will be no proving of any answer.
Last week we wrote about the stability of earnings estimates for many of our Recommended stocks. This stability would appear to be surprising as the broad stock market is increasingly pricing in a recession, which would likely drag down the earnings of most companies. Many of our Recommended stocks, including Dow (DOW), Big Lots (BIG) and Citigroup (C), have highly cyclical earnings.
This past week, in advance of second-quarter earnings reports, analysts have begun to trim ever so slightly their 2022 and 2023 earnings estimates for several of our Recommended stocks. This new-found cautiousness would seem reasonable as economic growth has clearly slowed. However, the current economic cycle is very different from prior cycles and will likely remain unique – particularly as the jobs market and consumer spending seem to be robust. As such, its applicability to any specific company’s revenues and profits is murky, at best. We’ll have to wait for the company’s actual reports to know for sure.
Share prices in the table reflect Tuesday (July 12) closing prices. Please note that prices in the discussion below are based on mid-day July 12 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
None
Upcoming earnings reports
Friday, July 15: Citigroup (C)
Thursday, July 21: Dow (DOW)
Tuesday, July 26: The Coca-Cola Company (KO)
Tuesday, July 26: Sensata Technologies (ST)
Thursday, July 28: Merck (MRK)
Friday, July 29: Allison Transmission Holdings (ALSN)
Friday, July 29: MolsonCoors Beverage Company (TAP)
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.
While Cisco shares’ round-trip from our initial recommendation at 41.32 to 64 and back to 41 or so is frustrating, this is not the time to sell the stock. The fundamentals remain reasonably stable and likely to tick back upward, and profits seem likely to improve, as well. The shares will likely come back to life as earnings reports show favorable growth and profit trends, so investors will need some patience. If we have a recession in global tech spending, Cisco would likely feel the downturn but not as severely as other technology companies due to the mission-critical nature of its products and services.
There was no significant company-specific news in the past week.
The valuation is attractive at 8.6x EV/EBITDA and 12.9x earnings, the shares pay a sustainable 3.5% dividend yield, the balance sheet is very strong, and Cisco holds a key role in the basic plumbing of technology systems even if its growth rate is only modest. We are keeping our Buy rating.
CSCO shares rose 3% in the past week and have 52% upside to our 66 price target. BUY
The Coca-Cola Company (KO) is best-known for its iconic soft drinks yet nearly 40% of its revenues come from non-soda beverages across the non-alcoholic spectrum. Its global distribution system reaches nearly every human on the planet. Coca-Cola’s longer-term picture looks bright, but the shares remain undervalued due to concerns over the pandemic, the secular trend away from sugary sodas, and a tax dispute which could cost as much as $12 billion (likely worst-case scenario). The relatively new CEO James Quincey (2017) is reinvigorating the company by narrowing its oversized brand portfolio, boosting its innovation and improving its efficiency, as well as improving its health and environmental image. Coca-Cola’s balance sheet is sturdy, and its growth investing, debt service and dividend are well-covered by free cash flow.
Competitor PepsiCo reported 9% organic (net of acquisitions, divestitures and currency changes) revenue growth in its North American beverage unit, helped by higher pricing. However, the Pepsi unit reported adjusted profits that fell 3% as commodity, labor, transportation and other costs rose, and partly due to the divestiture of sizeable juice operations. While the results points to similar revenue strength at Coca-Cola, which reports on July 26, pre-market, Coke’s operating structure and global product mix differ enough from those of Pepsi’s North American segment that the read-through on Coke’s revenues and profits is murky but generally positive.
KO shares were flat in the past week and have 9% upside to our 69 price target. Coca-Cola’s fundamentals remain sturdy with respectable revenue, profit and free cash flow growth. Management continues to focus on execution in its core business while generally avoiding any major non-core commitments. HOLD
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/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.
Industry conditions are healthy, but investor worries about a global recession are pressuring Dow’s shares. The primary concern: slowing demand could weigh on pricing – which is the primary driver of Dow’s exceptionally strong earnings. Tight supplies and high energy inputs have driven up the prices that Dow’s products command, but as demand weakens, pricing could slip. Fortunately, global prices are being propped up by Europe’s very high local natural gas prices (due to falling imports from Russia).
Dow’s volumes would decline, but this is a lesser concern as volumes tend to change moderately even in slowdowns. And, Dow’s volumes are supported by its status as one of the world’s lowest-cost producers, helped by relatively cheap domestic natural gas prices.
Dow took great advantage of its recent high-profit period to improve its balance sheet and upgrade its operations. Even in a slowdown, we see the company sustaining its dividends, backed by what will likely be still-sizeable free cash flow.
There was no significant company-specific news in the past week.
Dow shares rose 1% in the past week as investors continue to worry about the outlook for the U.S. and global economy. Estimates for 2022 and 2023 earnings ticked fractionally lower this past week. We will get considerably more color on the post-earnings conference call.
The shares have 53% upside to our 78 price target and offer an attractive 5.5% dividend yield. BUY
Merck (MRK) shares are undervalued as investors worry about Keytruda, a blockbuster oncology treatment (about 30% of revenues) which faces generic competition in late 2028. Also, its Januvia diabetes treatment may see generic competition next year, and like all pharmaceuticals it is at-risk from possible government price controls. Yet, Keytruda is an impressive franchise that is growing at a 20% rate and will produce solid cash flow for nearly seven more years, providing the company with considerable time to replace the potential revenue loss. Merck’s new CEO, previously the CFO, is accelerating Merck’s acquisition program, which adds return potential and risks to the story. The company 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.
Merck is reported to be finalizing an acquisition of Seagen (SGEN), a biotech company. Seagen’s therapies focus on attacking just the cancer itself, which increases the effectiveness of the treatment in fighting the cancer while reducing the side-effects. This field offers promising potential, but the acquisition would be large, at around $40 billion deal, and expensive at about 20x revenues. Seagen, previously called Seattle Genetics, is not profitable.
Merck shares rose 1% in the past week and have about 6% upside to our 99 price target. The company has a strong commitment to its dividend (2.9% yield) which it backs up with generous free cash flow, although its shift to a more acquisition-driven strategy will slow the pace of dividend increases. While the shares have pulled back, we are retaining our Hold rating as rising interest rates reduce the upside potential value of its shares. HOLD
Buy Low Opportunities Portfolio
Allison Transmission Holdings, Inc. (ALSN) – Allison Transmission is a midcap ($6.4 billion market cap) manufacturer of vehicle transmissions. 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. However, Allison produces no car and light truck transmissions, instead 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.
Allison shares rose 1% in the past week and have 26% upside to our 48 price target. The stock pays an attractive and sustainable 2.2% dividend yield to help compensate for the wait. 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, as well as political/social unrest, inflation and currency devaluations. However, the company has a solid brand and high recurring demand and is well-positioned to benefit as local economies reopen. The leadership looks highly capable, led by the founder/chairman who owns a 38% stake, and has the experience to successfully navigate the complex local conditions. Debt is reasonable relative to post-recovery earnings, and the company is currently producing positive free cash flow.
Macro issues, including issues in Brazil related to its economic conditions (in particular, inflation, running at a 11.3% rate), currency and the chances that a socialist might win this year’s Brazilian presidential elections, will continue to move ARCO shares.
There was no significant company-specific news in the past week.
ARCO shares were flat in the past week and have 33% 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 was hired as the new CEO in July 2020 to revitalize Aviva’s laggard prospects. She divested operations around the world to re-focus the company on its core geographic markets (U.K., Ireland, Canada), and is improving Aviva’s product competitiveness, rebuilding its financial strength and trimming its bloated costs. Aviva’s dividend has been reduced to a more predictable and sustainable level with a modest upward trajectory. Excess cash balances are being directed toward debt reduction and potentially sizeable special dividends and share repurchases.
Much of our interest in Aviva is based on its plans for returning its excess capital to shareholders, including share repurchases and dividends. These distributions could be substantial. We also look for incremental shareholder-friendly pressure from highly regarded European activist investor Cevian Capital, which holds a 5.2% stake.
There was no significant company-specific news in the past week. Please note that the ticker symbol for the ADS has reverted back to “AVVIY.”
Aviva shares fell 1% in the past week and have about 45% upside to our 14 price target. Based on management’s estimated dividend for 2023 (which we believe is highly credible), the shares produce a generous 8.6% yield. Based on this year’s actual dividend, the shares offer an attractive 5.8% dividend yield. 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.
There was no significant company-specific news in the past week.
Over the past week, commodity gold fell 2% to $1,728/ounce. The 10-year Treasury yield rose to 2.93% as investors worried incrementally less about a recession. The next CPI release is July 13, pre-market.
The U.S. Dollar Index, another driver of gold prices (the dollar and gold usually move in opposite directions), rose another 1% to 107.92. The surging dollar is nearly at parity with the Euro and approaching a 24-year high vs the Japanese Yen and a 37-year high vs the British Pound. The U.S. Dollar remains about in the middle of its long-term range vs the Canadian Dollar.
Barrick shares fell 6% in the past week and have about 64% upside to our 27 price target. The price target is based on 7.5x estimated steady-state EBITDA and a modest premium to our estimate of $25/share of net asset value. 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 bullish case for Big Lots rests with its loyal and growing base of 22 million rewards members, its appeal to bargain-seeking customers, the relatively stable (albeit low) 5.5% cash operating profit margin, its positive free cash flow, debt-free balance sheet and low share valuation at 3.1x EV/EBITDA and 7.3x per-share earnings based on conservative January 2023 estimates.
Our thesis was deeply rattled by the company’s dismal first-quarter results. Offloading its bloated inventory will require sharp discounts, which will weigh on profits while the $271 million in new borrowing ramps up the risk. 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 potential for a dividend cut.
There was no significant company-specific news in the past week.
Big Lots shares jumped 12% in the past week, likely as investors considered that a recession will not necessarily bring the downfall of the company. The shares have 49% upside to our recently reduced 35 price target. We would consider the dividend to be unsustainable and caution that investors should not count on any dividends from Big Lots. 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.
There was no significant company-specific news in the past week.
The spread between the 90-day T-bill and the 10-year Treasury note, which approximates the drivers behind Citi’s net interest margin, narrowed by 11 basis points to 0.96%. There are 100 basis points in one percent. When commentators discuss the “flat yield curve,” they are referring to the current situation where yields on maturities of two years and longer are all essentially the same at around 2.9% or so.
A recession would likely increase Citi’s credit losses, a flatter yield curve would weigh on its net interest margin, and weaker capital markets would mean fewer investment banking revenues.
Citi shares were flat over the past week and have about 82% upside to our 85 price target. Citigroup investors enjoy a 4.4% dividend yield and perhaps another 3% or more in annual accretion from the bank’s share repurchase program once it reaches its new target capital ratio and if a slowing/stalling economy doesn’t meaningfully increase its credit costs. 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 5% in the past week and have about 19% 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 9.3x estimated 2022 results, still among the lowest valuations in the consumer staples group and below other brewing companies. The 2.6% 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 fell 4% in the past week and have about 40% 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 3.4% 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 safely 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 rose 1% 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 subscribers.
| Growth/Income Portfolio | |||||||
| Stock (Symbol) | Date Added | Price Added | 7/12/22 | Capital Gain/Loss | Current Dividend Yield | Price Target | Rating |
| Cisco Systems (CSCO) | 11-18-20 | 41.32 | 42.86 | 3.7% | 3.5% | 66.00 | Buy |
| Coca-Cola (KO) | 11-11-20 | 53.58 | 62.67 | 17.0% | 2.7% | 69.00 | Hold |
| Dow Inc (DOW) * | 04-01-19 | 53.50 | 50.42 | -5.8% | 5.6% | 78.00 | Buy |
| Merck (MRK) | 12-9-20 | 83.47 | 93.60 | 12.1% | 2.9% | 99.00 | Hold |
| Buy Low Opportunities Portfolio | |||||||
| Stock (Symbol) | Date Added | Price Added | 7/12/22 | Capital Gain/Loss | Current Dividend Yield | Price Target | Rating |
| Allison Transmission Hldgs (ALSN) | 02-22-22 | 39.99 | 37.82 | -5.4% | 2.2% | 48.00 | Buy |
| Arcos Dorados (ARCO) | 04-28-21 | 5.41 | 6.34 | 17.2% | 2.5% | 8.50 | Buy |
| Aviva (AVVIY) | 03-03-21 | 10.75 | 9.53 | -11.3% | 5.9% | 14.00 | Buy |
| Barrick Gold (GOLD) | 03-17-21 | 21.13 | 16.44 | -22.2% | 2.4% | 27.00 | Buy |
| BigLots (BIG) | 04-12-22 | 35.24 | 23.03 | -34.6% | 5.2% | 35.00 | Hold |
| Citigroup (C) | 11-23-21 | 68.10 | 46.13 | -32.3% | 4.4% | 85.00 | Buy |
| Molson Coors (TAP) | 08-05-20 | 36.53 | 57.40 | 57.1% | 2.6% | 69.00 | Buy |
| Organon (OGN) | 06-07-21 | 31.42 | 32.86 | 4.6% | 3.4% | 46.00 | Buy |
| Sensata Technologies (ST) | 02-17-21 | 58.57 | 40.32 | -31.2% | 1.1% | 75.00 | Buy |
*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.
| CUSA Valuation and Earnings | |||||||
| Growth/Income Portfolio | |||||||
| Current price | Current 2022 EPS Estimate | Current 2023 EPS Estimate | Change in 2022 Estimate | Change in 2023 Estimate | P/E 2022 | P/E 2023 | |
| CSCO | 43.31 | 3.36 | 3.56 | 0.0% | 0.0% | 12.9 | 12.2 |
| KO | 63.10 | 2.47 | 2.65 | 0.0% | 0.0% | 25.5 | 23.8 |
| DOW | 51.14 | 8.03 | 7.21 | -0.9% | -1.0% | 6.4 | 7.1 |
| MRK | 93.69 | 7.37 | 7.41 | -0.1% | 0.0% | 12.7 | 12.6 |
| Buy Low Opportunities Portfolio | |||||||
| Current price | Current 2022 EPS Estimate | Current 2023 EPS Estimate | Change in 2022 Estimate | Change in 2023 Estimate | P/E 2022 | P/E 2023 | |
| ALSN | 37.95 | 6.24 | 7.05 | 0.0% | -2.2% | 6.1 | 5.4 |
| ARCO | 6.39 | 0.48 | 0.49 | 0.0% | 0.0% | 13.3 | 13.0 |
| AVVIY | 9.66 | 1.07 | 1.31 | 0.0% | -1.8% | 9.0 | 7.4 |
| GOLD | 16.46 | 1.12 | 1.18 | -2.0% | -1.9% | 14.7 | 14.0 |
| BIG | 23.53 | (2.43) | 2.26 | -6.9% | 3.7% | (9.7) | 10.4 |
| C | 46.68 | 6.74 | 6.81 | -0.7% | -5.0% | 6.9 | 6.9 |
| TAP | 58.03 | 3.93 | 4.27 | -0.3% | 0.0% | 14.8 | 13.6 |
| OGN | 32.76 | 5.28 | 5.68 | -0.8% | -0.2% | 6.2 | 5.8 |
| ST | 40.76 | 3.83 | 4.41 | -0.5% | -1.6% | 10.6 | 9.2 |
Current price is yesterday’s mid-day price.
CSCO: Estimates are for fiscal years ending in July.