August 29, 2023

The End of Summer

It seems like only yesterday when winter/spring faded and summer rolled in. Our kids wrapped up their classes, reminding me of Alice Cooper’s timeless classic “School’s Out.” As Van Halen wrote, “Summer’s here and the time is right, for dancin’ in the streets.”

The stock market did some sweet dancing with an 11% surge from Memorial Day through early August. Unlike the cold, narrow winter at the start of the year, in which seemingly only the Magnificent Seven stocks ran higher, most stocks thrived in the summer sun. From the official start of the season, the average stock in the S&P 500 sprouted a 10% gain.

However, as the summer slips away, perhaps along with the stock market rally, investor attention is turning back to the hard work ahead. With all of the complexities we discussed in our note last week, and new ones emerging daily, a different vibe comes to mind. BTO’s “Takin’ Care of Business” provides a good motivator for the tasks at hand, while Toby Keith’s “Hard Way to Make an Easy Living” can both provide a useful rejoinder to those who think investors sit around all day and appear to do little, yet at the same time reminds us how lucky we are to have a job that involves minimal physical effort or safety risks, unlike so many others who thankfully do the real work in our society.

Even the sports season is shifting its tone. With due credit to observations from George Carlin, the easy-going baseball season, in which teams play in a park, is transitioning to the trench warfare of the gridiron.

Our oldest son has just started his first college classes as a freshman, while our two other boys are returning to high school this week. Their days of swimming pools and video games will be replaced by algebra, history, science and English lessons. Hopefully their experiences won’t follow too closely the words of Pink Floyd’s “The Wall” but rather the lyrics of Timbuk 3 in “Future’s So Bright I Gotta Wear Shades.”

As investors get back to work, a timeless reminder of how to play the game might be Kenny Rogers’ “The Gambler,” whose lyrics advised that “you gotta know when to hold them, and know when to fold them.” Let’s hope there is a lot more holding than folding the rest of the year. Then, we all can “Party Like it’s 1999,” or something like that.

Share prices in the table reflect Monday, August 28 closing prices. Please note that prices in the discussion below are based on mid-day August 28 prices.

Note to new subscribers: You can find additional color 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 Bruce@CabotWealth.com.

This Week’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.

On August 16, Cisco reported a solid fiscal fourth quarter, with adjusted earnings of $1.14/share increasing 37% and beating the $1.06 estimate by about 8%. Revenues rose 16% and were about 1% above estimates. Revenue metrics were robust and profits were further boosted by expanding gross margins. Guidance for full-year 2024 was for 1% revenue growth and 4% earnings growth, supporting our case that the company is a slow but steady grower with a fortress balance sheet ($18 billion more cash than debt) that is returning much of its prodigious free cash flow to shareholders through dividends and share buybacks.

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

CSCO shares rose 1% for the week and have 18% upside to our 66 price target. Based on fiscal 2024 estimates, the valuation is attractive at 9.9x EV/EBITDA and 13.8x earnings per share. BUY

Comcast Corporation (CMCSA) – With $120 billion in revenues, 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 significant company-specific news in the past week.

Comcast shares fell 1% in the past week and remain at our 46 price target. For now, we are keeping our Hold rating. The shares aren’t particularly cheap, but the fundamentals remain sturdy. HOLD

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 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. 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.

ALSN shares ticked up 1% in the past week and remain at our recently raised 59 price target. The shares offer a reasonable 1.5% dividend yield. We are keeping our Hold rating for now, given the acceptable valuation combined with the strong management and company fundamentals. HOLD

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. We expect that activist investor Cevian Capital, which holds a 5.2% stake, will keep pressuring the company to maintain shareholder-friendly actions.

On August 16, Aviva reported first-half earnings of £0.20/share, increasing 10% from a year ago and beating the consensus estimate of £0.19. The company continues to grind forward with healthy performance following its shrink-to-growth turnaround.

Gross premiums written rose 12% and funds continue to flow into its wealth products. Costs remain controlled with no increase from a year ago on an adjusted basis despite 7% underlying inflation. Operating profits rose 8% and capital strength is sturdy. Aviva generated 26% growth in its funds generation. The company is on track to meet or exceed its targets.

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

Aviva shares fell 1% this past week and have 47% upside to our 14 price target. Based on management’s guidance for the 2023 dividend, which we believe is a sustainable base level, the shares offer a generous 8.6% yield. On a combined basis, the dividend and buybacks offer more than a 10% “shareholder yield” to investors. 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 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.

On August 8, Barrick reported a reasonable quarter, with adjusted earnings of $0.19/share falling 21% from a year ago but beating the consensus estimate of $0.18/share. Results were broadly improved from the prior quarter (first quarter 2023). The company said it is on target to meet its full-year 2023 production guidance. Rising costs continue to chip away at otherwise decent profitability, but management seems well aware that they need to deliver on their production and profit goals. We are watching what effect achieving these near-term goals will have on Barrick’s long-term fundamentals.

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

Over the past week, commodity gold rose 1% to $1,947/ounce. The 10-year Treasury yield declined to 4.22% after reaching a 15-year high. Rising bond yields are weighing on gold prices but not by much, it appears. Usually, these two prices move in opposite directions. Perhaps the growing awareness of the tenuous U.S. Federal government financial picture, highlighted by the Fitch downgrade, as well as the hefty new bond issuances, are pushing yields higher.

The U.S. Dollar Index (the dollar and gold usually move in opposite directions) ticked up incrementally to 104.11. Rising yields are pushing up demand for the dollar, but weighing incrementally on gold prices.

Investors and commentators offer a wide range of outlooks for the economy, interest rates and inflation. We have our views but hold these as more of a general framework than a high-conviction posture. Investing in gold-related equities is a long-term decision – investors shouldn’t allow near-term weakness to deter their resolve.

Barrick shares rose 2% in the past week and have 68% upside to our 27 price target. 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.

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

Citi shares fell 2% in the past week and have 105% upside to our 85 price target. The shares remain attractive as they trade at 49% of tangible book value of $85.34. The recently raised $0.53 quarterly dividend looks sustainable and offers investors a 5.1% yield.

When comparing Citi shares with a U.S. 10-year Treasury bond, Citi offers a higher yield and considerably more upside price potential. Clearly, the Citi share price and dividend payout carry considerably more risk than the Treasury bond, but at the current valuation Citi shares would seem to have a remarkably better risk/return trade-off. 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 43% stake today.

On August 4, Gates reported a good quarter that came in ahead of estimates across the board. The company incrementally raised its profit guidance for the year. Adjusted earnings of $0.36/share rose 13% from a year ago and beat estimates by about 9%. Revenues rose 3% (by 4% excluding acquisitions and currency effects) and were fractionally above estimates. Adjusted EBITDA of $197 million rose 9% and was 3% above estimates.

The company continues to execute well, illustrated by its expanding gross and EBITDA margins. Free cash flow was strong at 114% of net income. Gates repurchased $250 million in shares during the quarter, equal to about 7% of its market value. The balance sheet remains sturdy with cash essentially unchanged from a year ago although debt has ticked up incrementally to fund the share buybacks. Leverage at 2.8x EBITDA has improved due to stronger EBITDA.

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

GTES shares rose 1% in the past week and have 35% upside to our 16 price target. The recent price dip, due apparently almost entirely to the Blackstone sale, offers a worthwhile opportunity to add to positions. 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 ticked down about 2% in the past week to $80.40/barrel, as resilient demand seems to be meeting stable-at-best supplies. The price of Henry Hub natural gas rose 6% to $2.76/mmBtu (million BTU). Natural gas prices are driven by domestic demand, as import/export volumes are minuscule, although supply disruptions in Australia are leading to incrementally higher local prices in the U.S.

NOV shares rose 1% in the past week as investors seem to be increasingly confident that a floor is being set under oil prices. NOV shares have 21% upside to our 25 price target. The dividend produces a reasonable 1.0% 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 safety 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. Our Sensata investment remains an underperforming (from a business fundamentals perspective) work in progress.

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

ST shares rose 1% in the past week and have 99% upside to our 75 price target. Our price target looks optimistic and we are re-evaluating it in light of our concerns over the company’s management and strategy. BUY

Current price is yesterday’s mid-day price.

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.