June 15, 2022

PRICES ARE MOVING SO FAST AND SO MUCH…
The speed and magnitude of changes in securities prices in the past 5½ months has been breathtaking. A quick recap: S&P500 down 20%, Nasdaq Composite down 31%, dozens of former mega-cap, hyper-growth tech stocks down 75%, investment-grade corporate bond prices down 16%, crude oil up 62% and the U.S. dollar index up 9%.

Bond yields, which move in the opposite direction of bond prices, have surged. The 10-year U.S. Treasury bond yield has more than doubled, from 1.5% to the current 3.4%. The 30-day T-Bill yield has reached 1.18% from essentially 0% as recently as this past March.

The Japanese Yen, long considered a stable safe-haven currency, has plummeted against most other major currencies (down 15% compared to the U.S. dollar and down 7% compared to the Euro). Bitcoin has crumbled 52% while many of the 10,000+ other cryptocurrencies have been wiped out.

When securities prices move this far and this fast, it seems almost inevitable that something will break. Many financial players (and I use that term specifically, to highlight speculators, bankers, fund managers and others who “play” the markets aggressively in hopes of making fortunes before a downcycle hits) use considerable leverage but rely on stable or rising markets to stay afloat. Sophisticated, consultant-minded investment strategists rely on quant models and theories that assume that the future will look a lot like the past.

Hyman Minsky was an American economist who said that in capital markets, stability creates instability. By this, he means that the longer the period of stability, the greater the risk of future instability. How does this work? Investors assume stability will continue, so they take greater risks to capture greater profits. But eventually something will change that leaves investors over-extended (usually with debt) that spawns a financial crisis.

The 2010s were generally a period of exceptional stability, buoyed by very accommodative central banks and relaxed government spending. Risk taking was generously rewarded. Aggressive government support during the pandemic only exacerbated the motivation to take bigger risks.

Persistently high inflation, and the now-aggressive central bank efforts to fight it, has radically shifted the market calculus, driving the sharp price changes as investors scramble to adjust.

Prices are moving so fast that quantitative risk models used by many institutional investors can’t keep up, leaving them exposed to automated errors or emotional human overrides. Other players may be tripped up when their cheap and easy capital sources evaporate, leaving them in an illiquid and under-capitalized position. Credit markets can seize up in such conditions.

While no one wants markets to seize up, as contrarian and value-oriented investors we would find this situation to be a supreme buying opportunity. When sellers offload securities to forestall bankruptcy, they become the epitome of price-insensitive – any price is good enough if it generates cash today. We would be thrilled to provide some of our cash reserves to help take some of those securities off their hands.

With Father’s Day coming up this Sunday, this cartoon (one of our favorites) might help assuage some of the frustration with the stock market:

Share prices in the table reflect Tuesday (June 14) closing prices. Please note that prices in the discussion below are based on mid-day June 14 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

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.

With Cisco, we are stuck with a stock that has fully round-tripped from our initial recommendation at 41.32 to 64 and back to 45 or so. While 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. If we have a recession in global tech spending, Cisco would likely to feel the downturn but not as severely as other technology companies due to the mission-critical nature of its products and services.

Cisco’s CEO recently waded into the debate on gun laws during an all-employee meeting. Our concern is not which side of the debate he is taking, but rather the fact that he is taking any side at all. The gun law issue is highly charged and unrelated to Cisco’s core business or strategy, particularly since Cisco sells almost exclusively to other businesses and not to consumers (where personal stances by CEOs may have some relevance). His stance-taking is already creating infighting which could easily degenerate into distracting the company’s employees from their jobs of improving Cisco’s business performance.

The valuation is attractive at 8.8x 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 fell 5% 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.

Coca-Cola is teaming up with Jack Daniels whiskey maker Brown-Forman to produce a canned version of the famed Jack and Coke drink. This is another example of soft drink makers expanding into the alcoholic beverage markets to boost their growth rates.

KO shares fell 6% in the past week and have 16% upside to our recently and tepidly raised 69 price target. We recently moved the shares to a HOLD as rising interest rates and the market’s weakness put a lid on the target valuation multiple.

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 will likely be strong for a while. Dow remains well-positioned to generate immense free cash flows over the next few years, even as the stock market cares little about cash but rather is focused on the incremental news flow related to economic growth, energy prices and any industry capacity changes. In the meantime, Dow shareholders can collect a highly sustainable (and now very attractive) 4.8% dividend yield while waiting for more share buybacks, more balance sheet improvement, more profits and a higher valuation.

Dow has several headwinds, including potential pricing pressure from new supply in a year or so, rapidly rising natural gas input prices, a complicated demand situation in China, and to some degree reliance on high oil prices for its pricing power. The shares have been strong this year, in a difficult market, and continue to have strong dividend support, but the upside from our perspective is probably capped around our price target.

Dow shares slipped 13% in the past week and have 32% upside to our 78 price target. 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 last June and we think it will divest its animal health segment sometime in the next five years.

The collapse of biotech shares is making it cheaper for Merck to acquire new treatments as it works to bring new products into its portfolio.

Merck shares fell 6% in the past week and have about 17% upside to our 99 price target. The company has a strong commitment to its dividend (3.3% 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. With limited upside, and our reluctance to raise our price target, we recently moved the shares to HOLD. 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 fell 4% in the past week and have 21% upside to our 48 price target. The stock pays an attractive and sustainable 2.1% 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 re-open. 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 dipped 13% in the past week and have 27% upside to our 8.50 price target. BUY

Aviva, plc (AVVID), 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.

The company’s overly complicated “B Share Scheme” has created some confusion among subscribers. There are two major sources of confusion, both fully justified. First, what exactly happened, and second, why do the stock price and brokerage statements show a sharp drop in the share price? Below we attempt to clarify the matter.

The point of the scheme is to return about £3.75 billion (about $4.7 billion) to shareholders. Rather than purchasing the shares outright, the company swapped existing Ordinary shares for new Ordinary shares, paid a cash dividend and then reduced the total shares outstanding. Their rationale was that this plan could be completed relatively quickly and that it would provide for proportional participate by shareholders.

The net effect for shareholders is that they receive cash and securities which total the approximate prior price of the stock. For ADS holders, the value should total around $10.50/ADS, which is roughly the price of the ADS on June 5, the day prior to the transaction.

Some supporting math for a hypothetical holder of 100 ADS: The 100 ADS on June 5 were worth $10.50 each, or $1,050 in total value. After the B Share Scheme, the investor holds 76 new shares, worth $10.50 each, or $798.

Investors also receive £1.0169 per ordinary share in cash. Our hypothetical ADS holder receives $254. This is based on £1.0169 x 2 x $1.25 x 100 ADS (where there are 2 ADS per new ordinary share and assuming $1.25=£1.00 exchange rate).

So, the $798 in ADS plus the $254 in cash is approximately equal to the $1,050 in total value before the scheme was executed. The new ADS trades under the “AVVID” ticker.

The net effect is that each shareholder owns the same proportion of the company as before, but now have a cash dividend. Aviva engineered the terms to keep the share price from changing – essentially the £3.75 billion dividend reduces the company’s value enough to offset the lower share count. Aviva went to great lengths to make sure that the post-transaction EPS and stock price were fully comparable to the pre-transaction history. Several brokerage firms made mistakes when they updated their price charts – showing a price drop from around $14 when they should not have adjusted the stock’s history. There may not be anything that can be done about this.

The company’s Circular says that the cash payout is expected to be treated as a dividend – we would advise taxable shareholders to consult with a tax expert to be certain.

Please feel free to email me if this isn’t clear. It took me well over an hour to sort this out and there are no guarantees that I am right.

Aviva shares fell 7% in the past week and have about 42% 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 7.8% yield. Based on this year’s actual dividend, the shares offer an attractive 5.3% 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 $1,815/ounce. The 10-year Treasury yield surged to 3.38%, the highest since early 2011. The spread between this yield and inflation of 8.6% remains exceptionally wide compared to a long-term average spread of perhaps one to two percentage points, strongly suggesting many more interest rate hikes ahead. Chatter about the “real” yield turning positive is based on other yields and inflation rates and we consider them to be less useful. Sharply rising interest rates continue to push up the U.S. Dollar Index, another driver of gold prices (the dollar and gold usually move in opposite directions), which is now at 105.32, a 20-year high.

Barrick shares fell 5% in the past week and have about 37% 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.

Big Lots shares fell 3% in the past week – much less than the broad equity market but this is due to the sharp selloff in prior weeks. The shares have 49% upside to our recently reduced 35 price target. 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 14 basis points to 1.64%. 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 3.4% or so.

Citi shares fell 11% over the past week, as a recession would increase its credit losses, a flatter yield curve would weigh on its net interest margin and weaker capital markets would mean fewer investment banking revenues. The shares have about 83% 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 although in a recession the bank would likely curtail share buybacks to preserve capital. BUY

Molson Coors Beverage Company (TAP) is one of the world’s largest beverage companies, producing the highly recognized Coors, Molson, Miller and Blue Moon brands as well as numerous local, craft and specialty beers. About two-thirds of its revenues come from the United States, where it holds a 24% market share. Investors worry about Molson Coors’ lack of revenue growth due to its relatively limited offerings of fast-growing hard seltzers and other trendier beverages. Our thesis for this company is straightforward – a reasonably stable company whose shares sell at an overly discounted price. Its revenues are resilient, it produces generous cash flow and is reducing its debt. A new CEO is helping improve its operating efficiency and expand carefully into more growthier products. The company recently reinstated its dividend.

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

TAP shares fell 6% in the past week and have about 35% upside to our 69 price target. The stock remains cheap, particularly on an EV/EBITDA basis, or enterprise value/cash operating profits, where it trades at 8.7x estimated 2022 results, still among the lowest valuations in the consumer staples group and below other brewing companies. The 3.0% dividend 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 slipped 12% in the past week and have about 39% 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 fell 10% in the past week and have about 70% upside to our 75 price target. Our price target looks optimistic in light of the broad market selloff, 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.

*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.