April 18, 2024

It’s a Bond Yield Market

There’s a lot of noise out there. Sticky inflation and the Fed’s response to it; Iran getting involved in the Israel-Palestine war; war in Ukraine now in year three; a pivotal U.S. presidential election drawing ever closer; first-quarter earnings season underway, etc., etc. But the only thing that truly matters to the market, at least lately, is bond yields. Specifically, yields on the 10-year U.S. Treasury bonds. The last couple years, the inverse bond yield-stock market correlation has been undeniable.

Take a look at this two-year chart comparing the S&P 500 (light blue line) to the 10-year bond yield (dark blue line):

Two years takes us almost all the way back to when the Fed began hiking the Federal Funds rate (in March 2022) from near zero to its highest level (5.25%-5.50%) in more than two decades. Look at what’s happened since. While yields on the 10-year Treasury bond have spiked 64%, the S&P has posted a ho-hum 15% gain. More tellingly, when yields spike – like they did in last October, when they nearly touched 5% for the first time since 2007, just before the financial crisis – stocks crater. In fact, each of the last two Octobers, the market has bottomed while bond yields have surged to new highs.

Conversely, when 10-year Treasury yields have eased, like they did in November and December after the Fed signaled that it was ready to cut interest rates in 2024, prompting yields to dip below 4%, stocks have soared. Now that Jerome Powell and company are pushing rate cuts likely to the back half of the year – perhaps even the fourth quarter – as inflation remains stubbornly in the 3-3.5% range, bond yields are surging again, to 4.64% as of this writing – a five-month high. Predictably, stocks are sagging, enduring their first pullback of more than 3% since last October.

Yes, the bond yield-stock market correlation is alive and well. And right now, that’s a bad thing.

Is there a magic number below which bond yields drop and stocks tend to perk up? Not really. Any dip back below 4% would almost certainly result in another spending spree on Wall Street. But really, it’s about the trend. When bond yields are falling in a meaningful way, as they did in the last two months of 2023, stocks rise fast.

Of course, bond yields likely won’t retreat much until the Fed sounds a bit less hawkish than they have of late, and that will surely require some more encouraging inflation data. The next key date is April 26: That’s when the Personal Consumption Expenditures (PCE) number for March – the Fed’s preferred inflation gauge – gets released. That number was down to 2.4% year over year in January and February, or less than half of what it was last January and February when PCE was still well above 5%.

Core PCE is a bit higher, at 2.8%. But both numbers have been trending steadily downward, unlike the Consumer Price Index (CPI), which garners far more attention.

Further declines from 2.4% PCE and 2.8% Core PCE could prompt bond yields to pull back. If PCE starts to prove just as sticky as CPI, yields could stay north of 4.5% for a while. Regardless, April 26 (next Friday) is an important date for investors.

Meanwhile, I continue to think this market pullback is a good thing. For one, it’s keeping valuations in check after the S&P had reached its highest price-to-earnings ratio (28) in almost three years. Second, it’s quite normal – no bull market simply goes up unchallenged for too long. In the halcyon market days of 2020 (post-Covid crash) and 2021, stocks pulled back more than 3% five times in 21 months, and more than 5% twice. This two-week retreat is the first pullback of more than 3% since last October; it was five consecutive months of gains, just the 30^th time that’s happened in the S&P 500 since 1950.

So, as value investors, we should embrace the current pullback. Heck, I wouldn’t mind stocks retreating a bit more. It would open up more value opportunities as we add to our portfolio in the coming months, giving us better entry points for when the Fed starts to finally cut interest rates, bond yields come crashing back to earth (remember when they were below 2% from 2019 through early 2022?), and share prices run higher.

Until then, pay attention to bond yields. Nothing else really matters when it comes to the market in 2024.

Note to new subscribers: You can find additional commentary on past earnings reports and other news on recommended companies in prior editions and weekly updates of the Cabot Value Investor on the Cabot website.

Send questions and comments to chris@cabotwealth.com.

This Week’s Portfolio Changes
Cisco Systems (CSCO) Moves from Buy to Sell

Last Week’s Portfolio Changes
None

Upcoming Earnings Reports
Tuesday, April 23: Philip Morris (PM)
Friday, April 25: Agnico Eagle Mines (AEO)
Friday, April 25: Comcast (CMCSA)
Friday, April 25: NOV, Inc. (NOV)

Growth/Income Portfolio

Growth & Income Portfolio stocks are generally higher-quality, larger-cap companies that have fallen out of favor. They usually have some combination of attractive earnings growth and an above-average dividend yield. Risk levels tend to be relatively moderate, with reasonable debt levels and modest share valuations.

Cisco Systems (CSCO) isn’t growing, and this is a Growth & Income portfolio. Earnings and revenue were both down 5% year over year in the latest quarter and are expected to retreat even further in 2024. And the stock hasn’t budged in two years (in fact, it’s down more than 6%) and is now touching its lowest point since December. I’m willing to be patient in a value portfolio. But not that patient.

Cisco has been a solid performer since my esteemed predecessor, Bruce Kaser, added it to the portfolio in late 2020, posting a double-digit return with a dividend yield consistently north of 3%. But momentum for the stock and the company has faded, and it’s time to clear space in the portfolio for a stock with more immediate upside. SELL

Comcast Corporation (CMCSA) – Comcast is one of the world’s largest media and entertainment companies. Its properties include Comcast cable television, NBCUniversal (movie studios, theme parks, NBC, Telemundo and Peacock), and Sky media. The Roberts family holds a near-controlling stake in Comcast. Comcast shares have tumbled due to worries about cyclical and secular declines in advertising revenues and a secular decline in cable subscriptions as consumers shift toward streaming services, as well as rising programming costs and incremental competitive pressure as phone companies upgrade their fiber networks.

However, Comcast is a well-run, solidly profitable and stable company that will likely continue to successfully fend off intense competition while increasing its revenues and profits, as it has for decades. The company generates immense free cash flow which is more than enough to support its reasonable debt level, generous dividend and sizeable share buybacks.

There was no company-specific news for Comcast ahead of next week’s (April 25) earnings report. Analysts are expecting modest improvement: 1.7% revenue growth and 7.6% earnings per share growth. The company has handily beaten estimates in each of the last four quarters, so it’s quite possible those estimates are too modest.

Shares were down 1% this week, likely in sympathy with the market. They now have 17% upside to our 46 price target. Meanwhile, the stock now trades at a mere 9x forward earnings estimates and at just 1.3 times sales. Keeping at Hold, but a good quarter could convince us to restore our Buy rating. HOLD

Honda Motor Co. (HMC) – After years of declining sales, Honda was rejuvenated in 2023 thanks to hybrids. The Japanese automaker sold 1.3 million cars last year, up 33% from 2022; a quarter of the cars it sold were hybrids, led by its popular CR-V sport utility vehicle (SUV) and Accord mid-size sedan. The CR-V was the best-selling hybrid in the U.S. last year, with 197,317 units sold. The Accord wasn’t far behind, with 96,323 sold. All told, Honda’s hybrid sales nearly tripled in 2023, to 294,000 units.

So, Honda is making the full pivot to hybrids, with the Civic soon to become the latest addition to its hybrid fleet. Investors have started gravitating more to the companies that sell them. Invariably, those are well-established, big-name car companies made famous by many decades of selling internal combustion engine vehicles; most aren’t ready to fully abandon their roots but want to tap into the surging national (and global) appetite for electric, so they instead are turning to hybrids as a compromise. As a result, these once-stodgy car companies are tapping into new revenue streams, and their share prices are surging accordingly.

Among the hybrid-rejuvenated, brand-name automakers, Honda offers the best value.

Honda announced plans to launch six next-generation electric vehicles in China by 2027 under its new brand, Ye. It’s part of the company’s goal to derive 100% of its Chinese revenues from electric vehicles by 2035.

Aside from that, there were no major developments for Honda this week. HMC shares were down more than 4%, most likely in sympathy with the market, and are down 7.5% since touching new 52-week highs above 37 at the end of March. Normal consolidation. Honda shares remain dirt-cheap at 7x earnings and with a price-to-sales ratio of 0.46. The EV/EBITDA is a microscopic 0.04.

The stock has 29% upside to our 45 price target. BUY

Philip Morris International (PM) – Based in Connecticut, Philip Morris owns the global non-U.S. rights to sell Marlboro cigarettes, the world’s best-selling cigarette brand. Cigarettes comprise about 65% of PMI’s revenues. The balance of its revenues is produced by smoke-free tobacco products. The cigarette franchise produces steady revenues and profits while its smoke-free products are profitable and growing quickly. The upcoming full launch of IQOS products in the United States, a wider launch of the IQOS ILUMA product and the recent $14 billion acquisition of Swedish Match should help drive new growth.

The company is highly profitable, generates strong free cash flow and carries only modestly elevated debt (at about 3.2x EBITDA) which it will whittle lower over the next few years. The share valuation at about 14x EBITDA and 14.3x per-share earnings estimates is too low in our view. Primary risks include an acceleration of volume declines and/or deteriorating pricing, higher excise taxes, new regulatory or legal issues, slowing adoption of its new products, and higher marketing costs. A strong U.S. dollar will weigh on reported results. While unlikely, Philip Morris could acquire Altria, thus reuniting the global Marlboro franchise.

There was no company-specific news this past week. However, Philip Morris will report first-quarter earnings next Tuesday, April 23. Analysts anticipate 4.7% sales growth and 14.6% EPS growth.

PM shares were flat this past week, and we probably shouldn’t expect much movement prior to next week’s earnings report. They have 34% upside to our 120 price target. The 5.8% dividend yield is a nice reward for patient investors. BUY

Buy Low Opportunities Portfolio

Buy Low Opportunities Portfolio stocks include a wide range of value opportunities. These stocks carry higher risk than our Growth & Income stocks yet also offer more potential upside. This group may include stocks across the quality and market cap spectrum, including those with relatively high levels of debt and a less clear earnings outlook. The stocks may not pay a dividend. In all cases, the shares will trade at meaningful discounts to our estimate of fair value.

Agnico Eagle Mines (AEM) is the world’s third-largest and likely the highest-quality and lowest-risk gold mining company. Its strategy of “proven geological potential in premier jurisdictions” appropriately describes its exclusive focus on quality mines in the legally safe countries of Canada, Mexico, Australia and Finland. In the past few years, Agnico has made several in-region acquisitions including Kirkland Lake in 2022 for $11 billion and Yamana Gold’s Canadian assets for $2.6 billion. The plan for the next five years is to fully integrate and improve these operations and grow production in its existing mines.

As the owner of some of the industry’s highest-quality mines, Agnico has production volumes that look steady for years to come. While some of its ten major mines will see tapering output, nearly all of the others will have steady increases, driven by continued investment and exploration. Agnico’s gold reserves are high quality and increased 11% last year, supporting its outlook for at least stable production volumes. In 2023, the company’s production came in at the high end of its guidance range.

Agnico continues to be an efficient operator, with all-in sustaining costs (or ASIC) of about $1,200/ounce, which is roughly 12% below the industry average. Helping its economics are the quality of its mines, the close geographic proximity of its Ontario and Quebec mines and the surplus capacity in its Detour Lake facility that will allow for higher throughput with minimal incremental costs.

We see in Agnico a well-managed company that meets/exceeds its production and cost guidance yet has shares that are noticeably undervalued.

Gold prices continue to soar, topping $2,400 an ounce for the first time ever – a week after topping $2,300 an ounce for the first time ever! All told, gold prices are up 21% in the last two months as fears of sticky inflation, high bond yields, and the Fed kicking the can down the road on rate cuts have pushed people toward the yellow metal, a time-tested safe haven.

Agnico shares, meanwhile, are up 39% since mid-February and have settled in the 61-62 range this month while most other sectors have pulled back. Shares still have 20% upside to our 75 price target. Earnings are due out April 25. BUY

Aviva, plc (AVVIY), based in London, is a major European company specializing in life insurance, savings and investment management products. Amanda Blanc, hired as CEO in July 2020, is revitalizing Aviva’s core U.K., Ireland and Canada operations following her divestiture of other global businesses. The company now has excess capital which it is returning to shareholders as likely hefty dividends following a sizeable share repurchase program. While activist investor Cevian Capital has closed out its previous 5.2% stake, highly regarded value investor Dodge & Cox now holds a 5.0% stake, providing a valuable imprimatur and as well as ongoing pressure on the company to maintain shareholder-friendly actions.

There was no company-specific news this past week. Nevertheless, shares were down a whopping 7%, giving back literally all of their March gains. With no other reason for the selling, this is likely a case of a stock with “meat on the bone” getting picked apart in the midst of an April mini-selloff.

So, that creates a better value for those who missed the boat prior to the March run. AVVIY shares have 21% upside to our 14 price target. The 7.3% dividend yield helps make up for the 7% retreat this month. BUY

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. Investors have lost hope in Citigroup, creating an impressive bargain.

Citigroup had a good first quarter. Revenue came in at $21.1 billion, ahead of $20.4 billion expected. Earnings per share of $1.86 blew away analyst estimates of $1.23. However, EPS was down 27% from last year’s first-quarter tally due to higher expenses and credit costs. Revenue was also down, about 2% year over year, but it was only down compared to a first quarter last year in which the bank sold an overseas business.

The highlight was Citi’s investment banking unit, which saw a 35% revenue bump on the strength of a solid Q1 for the market. While the results were mostly good, because the headline numbers showed year-over-year declines in revenue and earnings, investors sold out of C shares last week. The stock is down 3.5% since we last wrote.

The selling is likely overdone, and the down week for the market didn’t help. The top- and bottom-line beats are encouraging, and my guess is C shares will bounce back as investors have more time to digest the results. I wrote last week that I might keep this one on a short leash and an earnings miss could be enough to cut bait. But the bank didn’t miss, and it’s on track for double-digit revenue growth this year, and trading at a mere 10x earnings estimates. So, let’s hang on to Citi shares and see if they rebound in the coming weeks. BUY

CNH Industrial (CNHI) – This company is a major producer of agriculture (80% of sales) and construction (20% of sales) equipment and is the #2 ag equipment producer in North America (behind Deere). Its shares have slid from their peak and now trade essentially unchanged over the past 20 years. While investors see an average cyclical company at the cusp of a downturn, with a complicated history and share structure, we see a high-quality and financially strong company that is improving its business prospects and is simplifying itself yet whose shares are trading at a highly discounted price. See our November 30 Alert and the December 5 Monthly letter for more commentary on our thesis.

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

CNH shares were down 6% after touching new 2024 highs a week ago – not surprising given the market pullback. They now have 21% upside to our 15 price target. The 3.7% dividend yield offers a reasonable interim cash return. 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 line-up and quality, operating efficiency, culture and financial performance. Gates completed its IPO in 2018. Following several sell-downs, Blackstone has a 27% stake today.

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

Gates shares were down 1% this past week but are still holding close to 52-week highs after big February and March gains. Shares have 16% upside to our new 20 price target. BUY

NOV, Inc (NOV) – This high-quality, mid-cap company, formerly named National Oilwell Varco, builds drilling rigs and produces a wide range of gear, aftermarket parts and related services for efficiently drilling and completing wells, producing oil and natural gas, constructing wind towers and kitting drillships. About 64% of its revenues are generated outside of the United States. Its emphasis on proprietary technologies makes it a leader in both hardware, software and digital innovations, while strong economies of scale in manufacturing and distribution as well as research and development further boost its competitive edge. The company’s large installed base helps stabilize its revenues through recurring sales of replacement parts and related services.

We see the consensus view as overly pessimistic, given the company’s strong position in an industry with improving conditions, backed by capable company leadership and a conservative balance sheet.

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

The price of West Texas Intermediate (WTI) crude oil dropped from $85 a barrel to $83, and NOV shares declined along with it, falling more than 7% since we last wrote. Henry Hub natural gas prices were down even more sharply, falling from $1.87/million BTUs to $1.67, their lowest point in a month.

The April 25 earnings report could help stop the bleeding for NOV shares if the company can top estimates of 7.7% revenue growth and a 15.6% EPS decline. Shares have 29% upside to our 24 price target. BUY

Worthington Enterprises (WOR) – Following the split-up of Worthington Industries late last year, “Enterprises” focuses on producing specialized building products (42% of sales) and consumer products (48%). The value of these operations was previously obscured by the market’s perception that the original Worthington Industries was primarily a steel processor. While the market sees an average company with a mix of only partly related products, we see a high-quality company with strong positions in valuable and profitable niches, backed by capable management and a solid balance sheet.

There was no company-specific news this past week.

WOR shares were down 1% and are still feeling reverberations from a disappointing earnings report in late March. Revenues were down 9% in the company’s fiscal third quarter, while earnings per share declined 1%. Wall Street understandably didn’t love the results, though EPS did come in 16% ahead of consensus estimates, and both gross margins and adjusted EBITDA margins ticked up slightly.

The stock has 25% upside to our 73 price target. BUY

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.
Buy – This stock is worth buying.
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.

Copyright © 2024. All rights reserved. Copying or electronic transmission of this information without permission is a violation of copyright law. For the protection of our subscribers, copyright violations will result in immediate termination of all subscriptions without refund. Disclosures: Cabot Wealth Network exists to serve you, our readers. We derive 100% of our revenue, or close to it, from selling subscriptions to our publications. Neither Cabot Wealth Network nor our employees are compensated in any way by the companies whose stocks we recommend or providers of associated financial services. Employees of Cabot Wealth Network may own some of the stocks recommended by our advisory services. Disclaimer: Sources of information are believed to be reliable but they are not guaranteed to be complete or error-free. Recommendations, opinions or suggestions are given with the understanding that subscribers acting on information assume all risks involved. Buy/Sell Recommendations: are made in regular issues, updates, or alerts by email and on the private subscriber website. Subscribers agree to adhere to all terms and conditions which can be found on CabotWealth.com and are subject to change. Violations will result in termination of all subscriptions without refund in addition to any civil and criminal penalties available under the law.