September 21, 2022

Rate Hikes: Starting to Get Serious
Central banks around the world are boosting interest rates at a pace faster than perhaps any other time in living memory. Since mid-March, only six months ago, the U.S. Fed Funds rate has surged from essentially zero to about 2.35% and will be at 3.0% by the end of this week. The Bank of Canada recently raised its rate to 3.25% from 0.25%. In Europe, the increases have been slower but still impressively swift. The Bank of England’s overnight rate jumped from 0.1% last November to 1.75% today, while the European Central Bank raised its key interest rate from negative 0.25% to positive 0.75% earlier this month.

Nearly all of these central banks promise a steady stream of more rate increases in coming months and quarters to battle high inflation. The Fed itself is essentially promising a 4.0% Fed Funds rate. Only Japan seems to have missed the memo, but they are paying for it with a currency that has collapsed by 25% against the U.S. dollar since late March. Much of the rate hike surge is driven by a newfound commitment to inflation fighting that was lost in recent years.

The pace of increases would seem to put immense pressure on the business models of non-traditional financial institutions, including business development companies (BDCs). While traditional banks are broadly well-positioned, with durable operating models and capital structures, non-traditional financials generally depend on short-term borrowings, and thus are highly sensitive to rising short-term interest rates. When the “cost of goods sold” goes from zero to 3% or 4%, these companies’ business models can readily unravel. Paired with rising credit losses brought by a weakening economy, non-traditional lenders would seem to be a ripe source of risk and possibly a spawning pool for stress and contagion across the financial system. These problems can readily migrate to the equity markets, as equity investors rein in their own risk appetites.

Recommended stock Big Lots (BIG) is a victim of this shrinking risk appetite. True, the company has a sizeable self-inflicted wound from its merchandising error. But, until there is clarity on how its inventory glut will be resolved and what Big Lots’ end-game financial condition will look like, investors perceive immense risk and thus are selling the shares without regard to any other metric. As such, there is little discernable downside limit to the stock price in the interim period. Given this, we suggest that shareholders with limited appetite for further share price decay should sell Big Lots shares. We are keeping our formal Hold recommendation, however, for more risk-tolerant investors.

In a market nervous about rising interest rates, on top of falling earnings, military invasions, elections, inflation, supply constraints and a basket of other problems non-existent 2½ years ago, Big Lots shares won’t be the only ones dumped by price-insensitive investors.

Share prices in the table reflect Tuesday (September 21) closing prices. Please note that prices in the discussion below are based on mid-day September 21 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.

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

CSCO shares fell 4% in the past week and have 55% upside to our 66 price target. The valuation is attractive at 8.6x EV/EBITDA and 12.1x earnings, the shares pay a sustainable 3.6% 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. BUY

Dow Inc. (DOW) merged with DuPont to create DowDuPont, then split into three companies in 2019 based on product type. The new Dow is the world’s largest producer of ethylene and polyethylene, the most widely-used plastics. Investors undervalue Dow’s hefty cash flows and sturdy balance sheet largely due to its uninspiring secular growth traits, its cyclicality and concern that management will squander its resources. The shares are driven by: 1) commodity plastics prices, which are often correlated with oil prices and global growth, along with competitors’ production volumes; 2) volume sold, largely driven by global economic conditions, and 3) ongoing efficiency improvements (a never-ending quest of all commodity companies). We see Dow as having more years of strong profits before capacity increases signal a cyclical peak, and expect the company to continue its strong dividend, reduce its pension and debt obligations, repurchase shares slowly and restrain its capital spending.

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

Dow shares fell 5% in the past week and have 71% upside to our 78 price target. The quarterly dividend appears readily sustainable and provides an appealing 6.1% yield. The shares trade at a low 4.4x EV/EBITDA multiple.

Investors are offloading Dow’s shares on the assumption that a deep-ish recession will force it to eventually cut its dividend, as a 6.1% yield is too high for a company without dividend concerns. However, we view the dividend as enduring and a deep-ish recession as unlikely. Barring a deep recession, a collapse in oil prices or a surge in supply, Dow’s fundamental earnings picture seems solid. 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 six 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.

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

Merck shares were flat in the past week and have about 15% upside to our 99 price target. The company has a strong commitment to its dividend (3.2% 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

State Street Corporation (STT) – Based in Boston, State Street is the world’s largest custodian bank, with $38 trillion in assets under custody/administration. About 56% of its revenues are produced from back-, middle- and front-office services including custody, client reporting, electronic trading and full enterprise solutions for investment managers. The balance is produced from investment management fees on ETFs, foreign exchange fees, securities financing fees and net interest income. The industry has combined into four dominant firms due to economies of scale. State Street’s shares are out of favor and unchanged since 2007 due to concerns over its anemic growth and steady pricing pressure from competitors. However, we see State Street as a solid, well-capitalized franchise that provides critical services, with a slow-growth but steady revenue and earnings stream. Our interest in STT shares is that we can buy them at an attractive valuation. We also find the dividend yield appealing.

Banks like State Street and Citigroup are starting to see an exodus of deposits, as corporate and other customers look for better returns elsewhere for their cash. The outflow is broadly a positive for banks: they have excess deposits, as pandemic-related inflows artificially swelled their balance sheets. By only slowly raising the interest rates they pay on deposits, banks like State Street and Citi can shrink their deposit bases while expanding their profit margins.

State Street shares fell 4% in the past week and have about 35% upside to our 94 price target. The company’s dividend (3.6% yield) is well supported and backed by management’s strong commitment. BUY

Buy Low Opportunities Portfolio
Allison Transmission Holdings, Inc. (ALSN) – Allison Transmission is a mid-cap manufacturer of vehicle transmissions. While many investors view this company as a low-margin producer of car and light truck transmissions that is destined for obscurity in an electric vehicle world, Allison actually produces no car or light truck transmissions. Rather, it focuses on the school bus and Class 6-8 heavy-duty truck categories, where it holds an 80% market share. Its 35% EBITDA margin is sharply higher than its competitors and on-par with many specialty manufacturers. And, it is a leading producer and innovator in electric axles which all electric trucks will require. Another indicator of its advanced capabilities: Allison was selected to help design the U.S. Army’s next-generation electric-powered vehicle. The company generates considerable free cash flow and has a low-debt balance sheet. Its capable leadership team keeps its shareholders in mind, as the company has reduced its share count by 38% in the past five years.

The company signed an agreement to supply Turkey’s leading bus and truck manufacturer Anadolu Isuzu with the Allison 100S electric axle. Anadolu Isuzu is a small producer but is itself a joint venture between the Anadolu Group of Turkey and Isuzu Motors, Itochu and HICOM, which have deep roots in the Japanese, Malaysian and Chinese auto markets. One might view the Turkish program as a field test for some much larger potential customers.

Allison shares rose 1% in the past week and have 35% upside to our 48 price target. The stock pays an attractive and sustainable 2.4% dividend yield to help compensate investors while waiting for the recovery. BUY

Arcos Dorados (ARCO), which is Spanish for “golden arches,” is the world’s largest independent McDonald’s franchisee. Based in stable Uruguay and listed on the NYSE, the company produces about 72% of its revenues in Brazil, Mexico, Argentina and Chile. The shares are depressed as investors worry about the pandemic, political/social unrest, inflation and currency devaluations. However, the company has a solid brand, high recurring demand, impressive leadership (including founder/chairman who owns a 38% stake) and successful experience in navigating local conditions, along with a solid balance sheet and free cash flow.

Macro issues have a sizeable impact on the shares’ trading. The Brazilian inflation rate eased to 8.73% in August, providing a favorable turn. In October, Brazil holds its presidential elections, with incumbent Jair Bolsonaro facing a previous president, Luiz Inacio Lula de Silva. Bolsonaro leans right and has threatened a “vote steal” campaign if he loses. De Silva is a socialist who appears to be leading in the polls. A smooth, non-contested transition and post-election period, or the winner taking a somewhat centrist approach, would be much better for Arcos shareholders than other outcomes.

The Brazilian currency also drives the shares. Since early 2020, the currency has generally stabilized in the 1.00 real = $0.20 range. As the company reports in US$, any strength in the local currency would help ARCO shares.

Arcos shareholders can monitor the iShares MSCI Brazil ETF (EWZ) for sentiment toward the overall Brazilian stock market.

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

ARCO shares rose 1% this past week and have 12% upside to our 8.50 price target. The ongoing rebound appears to be some recognition that the sell-off following the earnings report was not warranted. 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 (UK, 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.

Most stock charting services show only a brief history for the AVVIY ticker, due to the overly complicated share repurchase scheme. Investors can visit the Aviva investor relations website here https://www.aviva.com/investors/ for a longer-term history. This chart shows only the London-traded shares, but is representative of the U.S.-traded ADR.

Aviva shares slipped 2% in the past week and have about 41% upside to our 14 price target. Based on management’s estimated dividend for 2023 (which we believe is highly credible), the shares offer a generous 8.4% yield. Based on this year’s actual dividend, the shares offer an attractive 5.7% dividend yield. Investors have little confidence in these dividends – the fear appears to be based on the risk of falling bond values in Aviva’s bond portfolio as interest rates rise. These declines would reduce the company’s capital level and thus the size of its excess capital. Our view is that the company would not have promised such elevated dividends without factoring in the pressure from rising interest rates. 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 about 2½% to $1,674/ounce. The 10-year Treasury yield surged to 3.59%, which is an 11-year high. The next meaningful hurdles are the 4.00% yield last touched in 2008, and the 5.00% yield last touched in 2007.

The U.S. Dollar Index, another driver of gold prices (the dollar and gold usually move in opposite directions), ticked upward to 110.19 and continues to reach heights not seen since the July 2001 peak at about 121. Given the underlying fundamentals of high U.S. interest rates relative to most of the rest of the developed world, the safe-haven traits of the U.S. dollar in a world of rising global geopolitical tensions, and the resilience of the U.S. energy supply and overall economic strength, it is readily possible that the dollar will eclipse its prior 2001 high. Gold will not do well in this environment. Investors are extrapolating this fear and thus steadily selling gold.

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

Barrick shares fell 3% in the past week and have about 79% upside to our 27 price target. Our resolve with Barrick shares remains undaunted through the recent sell-off. BUY

Big Lots (BIG) – Big Lots is a discount general merchandise retailer based in Columbus, Ohio, with 1,431 stores across 47 states. Its stores offer an assortment of furniture, hard and soft home goods, apparel, electronics, food and consumables as well as seasonal merchandise. Our initial case for Big Lots rested with its loyal and growing base of 22 million rewards members, its appeal to bargain-seeking customers, the relatively stable (albeit low) cash operating profit margin, its positive free cash flow, debt-free balance sheet and low share valuation.

Our thesis was deeply rattled by the company’s dismal first-quarter results although second-quarter results, while dismal, were better than the market’s dour consensus. The company needs to offload its still-bloated inventory at sharp discounts while also now loading the company with what is probably permanent debt.

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

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

Big Lots shares fell 8% this past week. Shareholders not willing or able to sustain further losses in the shares should sell now. The market continues to punish the shares as rising interest rates are seen as producing a weaker economy, and thus weakening Big Lots’ profit outlook. There is no reasonably-definable floor to a stock like Big Lots when fundamentals and valuation are ignored while investors reduce their risk exposure.

The stock has 81% upside to our 35 price target. The shares offer a 6.2% dividend yield, although, as noted, investors should not rely on this dividend being sustained. HOLD

Citigroup (C) – Citi is one of the world’s largest banks, with over $2.4 trillion in assets. The bank’s weak compliance and risk-management culture led to Citi’s disastrous and humiliating experience in the 2009 global financial crisis, which required an enormous government bailout. The successor CEO, Michael Corbat, navigated the bank through the post-crisis period to a position of reasonable stability. Unfinished, though, is the project to restore Citi to a highly-profitable banking company, which is the task of new CEO Jane Fraser.

In addition to the favorable comments about deposit run-offs at banks (see comments above for State Street Corporation), Citi and other major banks may see improved expense ratios as they trim their pandemic-high expense ratios.

This past week, the yield spread between the 90-day T-bill and the 10-year Treasury note, which approximates the drivers behind Citi’s net interest margin, widened to 0.29% from 0.22% a week ago. The current spread is at the low-end of its range over the past 40 years, with a 2.00 percentage point spread being a rough average, as shown in the chart below. If spreads were to return to a 2-point spread, bank profits would likely surge, assuming that other sources of profits including credit quality remain unchanged.

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. However, a recession and tighter capital markets would likely weed out some competitors like buy-now-pay-later companies, crypto payment services and digital-only banks. Also, tech talent may become more available at reasonable wages and potential technology company acquisition targets would likely be cheaper. Citi might emerge from a recession even stronger.

Citi shares trade at 59% of tangible book value. This immense discount, which assumes a dim future for Citi, appears to be misplaced. For comparison, beleaguered Credit Suisse, which faces potential collapse, trades at 31% of tangible book value. One could accurately say that Citi is more than 2x as healthy as Credit Suisse.

Citi shares fell 3% in the past week and have about 78% upside to our 85 price target. Citigroup investors enjoy a 4.3% 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

Gates Industrial Corp, plc (GTES) – Gates is a specialized producer of industrial drive belts and tubing. While this niche might sound unimpressive, Gates has become a leading global manufacturer by producing premium and innovative products. Its customers depend on heavy-duty vehicles, robots, production and warehouse machines and other equipment to operate without fail, so the belts and hydraulic tubing that power these must be exceptionally reliable. Few buyers would balk at a reasonable price premium on a small-priced part from Gates if it means their million-dollar equipment keeps running. Even in automobiles, which comprise roughly 43% of its revenues, Gates’ belts are nearly industry-standard for their reliability and value. Helping provide revenue stability, over 60% of its sales are for replacements. Gates is well-positioned to prosper in an electric vehicle world, as its average content per EV, which require water pumps and other thermal management components for the battery and inverters, is likely to be considerably higher than its average content per gas-powered vehicle.

The company produces wide EBITDA margins, has a reasonable debt balance and generates considerable free cash flow. The management is high quality. In 2014, private equity firm Blackstone acquired Gates and significantly improved its product lineup and quality, operating efficiency, culture and financial performance. Gates completed its IPO in 2018, with Blackstone retaining a 63% stake today.

At the Morgan Stanley Laguna Conference this past Friday, Gates’ CEO said that demand remains resilient but that the company is aware of the risks ahead. He also said that they are pricing their products to reflect the rising cost environment and that non-energy cost increases seem to be flattening. Raw material supply disruptions, especially in polymers, remain a problem such that the company is unable to work down its “very highly elevated” backlog. The company is continuing its drive to reduce costs and complexity. Overall, our view is that Gates is showing that it is handling a complicated situation relatively well.

GTES shares fell 5% in the past week and have about 30% upside to our 14 price target. BUY

Molson Coors Beverage Company (TAP) is one of the world’s largest beverage companies, producing the highly recognized Coors, Molson, Miller and Blue Moon brands as well as numerous local, craft and specialty beers. About two-thirds of its revenues come from the United States, where it holds a 24% market share. Investors worry about Molson Coors’ lack of revenue growth due to its relatively limited offerings of fast-growing hard seltzers and other trendier beverages. Our thesis for this company is straight-forward – 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 re-instated its dividend.

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

TAP shares fell 2% in the past week and have about 37% 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 8.6x estimated 2022 results, still among the lowest valuations in the consumer staples group and below other brewing companies. The 3.0% 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 3% in the past week and have about 65% upside to our 46 price target (using the same target as the Cabot Turnaround Letter). The shares continue to trade at a remarkably low valuation while offering an attractive 4.0% 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.

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

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

ST shares fell 2% in the past week and have about 85% 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.

*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.