Cabot Value Investor Issue: August 1, 2023

What Is Next for the Stock Market?

We’re not very good at making stock market predictions. Usually, we are wrong. So, we generally avoid making them. But, we do pay close attention to various market indices and valuations. And, as fans of history, to prior market trends.

This year is starting to look just a little like 1987. In that year, long ago, the stock market surged out of the calendar gates to generate a 37% gain by late August. The 2023 return of 19% so far this year is clearly weaker, but it is generally in the same ballpark.

Another feature of 1987 is the change in interest rates. The 10-year Treasury started that year at 7.01%. While high compared to today’s standards, yields were at their lowest level in over a decade. At the time, it seemed like an impossibly low rate. And, it was. During 1987, Treasury yields drove steadily higher, reaching nearly 10% by early October. This has a very familiar ring when thinking about the jump in interest rates today.

Watchers of history know what happened in late 1987. In a single day, on October 19, the stock market crashed nearly 23%. Many blame portfolio insurance, a trendy hedging technique at the time, for creating a cascade of sell orders beyond what market-makers could handle. While likely a major factor, it wasn’t the only factor. Excessive optimism, elevated share valuations and sharply higher interest rates no doubt powered the sell-off.

Will such a tumble happen this year? We have absolutely no idea. However, we know that immense investor exuberance in a sharply rising interest rate environment tempts fate. We are not lured in the slightest to chase this rally, but rather we are staying focused on value and contrarian stocks.

For the record, the world of course didn’t end in 1987. For all the gyrations, the S&P 500 ended the year with a 5.3% total return. The S&P was at 247 and went on to generate an 18x return through this past Monday.

Share prices in the table reflect Monday, July 31 closing prices. Please note that prices in the discussion below are based on mid-day July 31 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.

Today’s Portfolio Changes
None.

Portfolio Changes Since Last Month
Comcast (CMCSA) – Moving the shares from Buy to Hold.
Allison Transmission (ALSN) – Moving the shares from Buy to Hold.

Upcoming Earnings Reports
Friday, August 4: Gates Industrial (GTES)
Tuesday, August 8: Barrick Gold (GOLD)
Tuesday, August 15: Aviva, plc (AVVIY)
Wednesday, August 16: Cisco Systems (CSCO)

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.

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.

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 ticked down from their new 52-week high as they fell 2% for the week. The shares have 27% upside to our 66 price target. The valuation is attractive at 9.5x EV/EBITDA and 13.7x 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.

Comcast reported a strong quarter, with adjusted earnings of $1.13/share increasing 12% from a year ago and beating the consensus estimate of $0.98 by 15%. Revenues rose 2% and were about 1% above estimates. Adjusted EBITDA rose 4% and was about 6% above estimates.

Margins expanded nearly across the board. The company generated strong free cash flow of $3.4 billion despite the elevated $3.0 billion in capital spending which included funding the construction of its new Epic Universe theme park. Comcast repurchased $2.0 billion in shares, helping reduce the share count by about 7% from a year ago.

In Connectivity & Platforms, profits rose by 4.4% due to lower costs, as revenues were flat. Comcast was able to raise residential prices by 4.5% which helped offset modest losses in total customer count and in weaker video and advertising revenues. Domestic wireless and international broadband revenues remain small but continue to grow rapidly (20+%). The residential broadband customer count was nearly flat – impressive although perhaps seasonally boosted.

In Content & Experiences, profits rose by 7.5%, helped by record results in Theme Parks and a return to profits in the Studios segment, which more than offset weakness in Media profits and higher overhead costs. Media profits fell due to lower advertising revenues and higher losses in the Peacock streaming unit (loss was $651 million compared to a loss of $467 million a year ago).

Super Mario Bros. became the second-highest-grossing animated film in worldwide revenues, and Peacock doubled its subscriber base (to 24 million). Comcast added 316,000 wireless lines as this service continues to ramp up.

We are wary of the company’s elevated capital spending, now at over 12% of revenues and up 20% from a year ago. Comcast is building a new theme park – an acceptable one-time surge as long as the park becomes adequately profitable. But, the company is also investing in “line extensions and scalable infrastructure” which sound more like recurring spending. Cable and telecom companies must spend constantly to maintain and upgrade their basic facilities – much of this money provides no profit boost or competitive edge. Rather, it merely maintains the status quo and is in effect negative 100% ROI spending. This bug is a constant weight on our valuation target. Comcast is well-managed and has wide margins so it can afford the spending, but nevertheless, the cash flows out of the company’s coffers with little benefit in return.

The balance sheet carries reasonable but massive net debt of $87 billion, even if it is only 2.4x EBITDA and at management’s target level.

Comcast shares rose 5% in the past week and have 1% upside to our 46 price target. Given the small upside remaining to our price target, we moved the shares to a Hold last week. We are re-evaluating this target and our rating in light of the strong earnings report. HOLD

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.

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.

Allison Transmission Holdings, Inc. (ALSN) – Allison Transmission is a midcap 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.

Allison reported a strong quarter, with earnings of $1.92/share increasing 52% compared to a year ago and beating the consensus estimate by 12%. Revenues rose 18% and were 6% above estimates. EBITDA of $288 million rose 27% and was 7% above estimates.

Allison’s EBITDA margin expanded to an impressive 36.8%. The company raised its full-year sales, earnings and cash flow guidance. Allison repurchased over 2% of its share count in the quarter.

Sales growth was strong (14% or more) in all markets except the Outside North America Off-Road segment, which is the company’s smallest segment (fell 25%). Profits were helped by higher volumes and higher prices in excess of inflation but partly offset by higher overhead costs. The balance sheet remains appropriately levered and free cash flow is robust.

ALSN shares were flat in the past week (despite the strong earnings report) and have 1% upside to our recently raised 59 price target. The shares offer a reasonable 1.6% dividend yield. With the earnings report in the bag, we are re-evaluating our rating and price target. 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.

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

Aviva shares slid 4% this past week and have 40% 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 8.3% 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.

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

Over the past week, commodity gold rose 2% to $2,008/ounce. The 10-year Treasury yield ticked up to 3.94%. Usually, these two prices move in opposite directions.

The U.S. Dollar Index (the dollar and gold usually move in opposite directions) was essentially unchanged at 101.72. With investors assuming that the Fed is nearly finished with its interest rate hikes, the appeal of the dollar is fading. Low interest rates and a weaker dollar generally are supportive of higher gold prices, although the link is not necessarily instantaneous or proportional.

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 were flat in the past week (despite gold breaching $2,000) and have 55% 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.

On Friday, July 14, Citi reported adjusted earnings of $1.37/share, down 37% from a year ago and missing the $1.44 estimate by about 5%. Profits were weighed down by lower revenues (down 1%), higher operating expenses (+9%) and higher credit costs (+43%). With a weak 5.6% return on equity and still deep into its tech, compliance, personnel and strategy upgrade, Citi has a long way to go to becoming a higher-value bank. However, the bank appears to be on the right track, is retaining its deposit base, has reasonably healthy credit and capital, generally backs its full-year guidance, and its shares remain heavily discounted. We are retaining our Buy rating.

Citigroup, like other major banks, will likely be required to hold additional capital when the new Basel III rules are fully implemented here in the United States.

Citi shares were flat in the past week and have 79% upside to our 85 price target. The shares remain attractive as they trade at 56% of tangible book value of $85.34. The recently raised $0.53 quarterly dividend looks sustainable and offers investors a 4.5% yield.

When comparing Citi shares with a U.S. 10-year Treasury bond, Citi offers a higher yield and considerably more upside price potential (over 70% according to our work vs. 0% for the Treasury bond). 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, with Blackstone retaining a 63% stake today.

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

GTES shares rose 1% in the past week and have 18% upside to our 16 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.

NOV reported earnings of $0.39/share, more than double the year-ago results and about 34% above the consensus estimate of $0.29/share. Revenues rose 21% and were in line with estimates. Adjusted EBITDA rose 63% and was about 5% ahead of estimates. Overall, the company’s outlook is improving, albeit slowly.

The company is seeing increased demand in the offshore and international land markets which is more than offsetting weaker demand in North America. New orders remain healthy. The global supply chain issues are being resolved, but NOV is seeing its inventories surge as delivery times contract. NOV is implementing another cost-cutting program targeting about $75 million in reductions.

The company’s weak working capital generation year-to-date will likely normalize by the end of this year but leave free cash flow in the red rather than in the black (prior guide was +$100-$300 million). Next year, free cash flow should be somewhere around $500 million or more. NOV’s balance sheet is conservatively levered.

On a side note, the company used the term “artificial intelligence” only once in its press release.

The price of West Texas Intermediate (WTI) crude oil rose 3% in the past week to $81.21/barrel, as resilient demand seems to be meeting stable-at-best supplies. The price of Henry Hub natural gas slipped 3% to $2.61/mmBtu (million BTU). Natural gas prices are driven by domestic demand, as import/export volumes are minuscule.

NOV shares rose 7% in the past week as investors seem to be increasingly confident that a floor is being set under oil prices. NOV shares have 24% upside to our 25 price target. The dividend produces a reasonable 1.0% 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 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.

On July 25, Sensata reported a reasonable quarter but its third-quarter guidance was disappointing. Also, the company reversed its decision from only a few months ago to create a new “Insights” segment, suggesting a problem with strategy, conviction, or analysis, or a weakening of the proposed segment’s outlook, or possibly intense shareholder pushback – none of which is good.

Sensata is struggling to generate any revenue growth and its profits are being supported by incremental margin expansion from spending controls that seem to only barely offset margin pressure from its acquisitions. We are losing confidence in management’s ability to convert its Megatrend aspirational spending (electrification, etc.) into actual profits. And, we are concerned that the spending controls will come off once the profit outlook improves.

The company touted its debt reduction, but this was almost fully offset by a cash reduction, eliminating any meaningful de-leverage effect. Sensata repurchased $25 million of its own stock – notable – but this amount is almost irrelevant to a $7 billion market cap company.

Now trading at 9.5x EBITDA and 11.2x earnings, the valuation isn’t particularly attractive. Sensata has been a value trap and we may have misjudged its management quality. We are remaining patient, but our patience is running a bit thin.

In the quarter, adjusted earnings of $0.97/share rose 17% from a year ago and were about 3% above the consensus estimate of $0.94/share. Revenues rose 3% on an organic basis and were 3% above estimates.

ST shares fell 9% in the past week due to the sloppy earnings and have 78% upside to our 75 price target. Our price target looks optimistic, 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 Value Investor 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.

The next Cabot Value Investor issue will be published on September 5, 2023.