Cabot Value Investor Issue: July 5, 2023

Wither Banks?

Citigroup (C), like its major peers, looked strong in its annual Federal Reserve CCAR stress test, which evaluates how banks’ capital and earnings would hold up in a severe recession. With more than adequate capital to weather the grim scenario outlined in the test assumptions, Citi announced that it is raising its quarterly dividend by 4%, to $0.53/share, starting with the third-quarter dividend. The bank has already repurchased $1 billion of its common shares this quarter (following the news that it will be using an IPO to divest its Mexico consumer operations rather than a sale).

We’re not the biggest fans of these tests. First, they are based on hypotheticals that are contrived and may never actually occur. The current round assumes an 8.75% contraction of the economy, a 40% plunge in house prices and a 10% unemployment rate. London-based Financial Times calls it the “Doomsday Scenario.” So, while this scenario may occur at some point in the distant future, it overly penalizes banks today.

Second, each recession is different and there is no realistic way to engineer a test to accurately guess how, exactly, an upcoming recession would unfold, or how or if policy makers would react or how this theoretical recession would affect a particular bank. The pandemic and the surge in interest rates due to unexpected inflation, are clear examples of this problem – two major events in the past three years that rendered previous projections nearly worthless.

Third, the test completely missed what is now the most important risk: erosion of bank capital due to higher interest rates. This raises doubts about what else the tests are missing. Closely related, only the 23 largest banks were tested. Many banks (those with less than $100 billion in assets, like smaller regionals) that have the greatest capital erosion aren’t subject to the tests, thus leaving a huge gap in monitoring the safety and soundness of the banking system.

Fourth, banks have had a decade to practice, and so they are now probably better than the Fed itself in understanding the tests and how to game them.

The tests highlight the flaws of a prescriptive regulatory program based on a rigid test – regulators are humans (with all of the attendant flaws) with limited resources and unclear incentives but are facing well-funded and highly incentivized management teams, and, of course, the future is unpredictable.

The tests have two major benefits, however. First, they make it clear that the Fed is watching and measuring what banks are doing. This should keep bank managements from taking excessive risks. And second, they allow for a side-by-side comparison of each bank against all of the other majors – helpful to managements and investors in making their decisions.

Does passing this year’s stress test mean that Citi is free to become more aggressive in producing profits? Unfortunately, it does not. As a result of the test, Citi will be subject to a higher minimum capital requirement. Starting in about a year, the bank needs to have a minimum CET1 capital ratio of 12.3%, up from 12.0% currently. Most other majors have either a decrease or no increase. So, Citi remains a riskier bank, relative to others, given the “Doomsday Scenario” outlined in the tests.

The other banks aren’t necessarily in the clear, however. New global bank capital standards under the Basel III requirements are being fully implemented this year. (Basel III refers to the third round of rules as promulgated by the Basel Committee on Banking Supervision, a global organization of bank regulators from 28 banking jurisdictions.) Citigroup, along with other majors, will be subject to even more strict rules regarding the risks they take.

Jamie Dimon, head of JPMorgan, said the rules have another disappointing side effect: They focus heavily on more regulations for trading, investment banking and other operations in which American banks are world leaders. One wonders if frustration by less competitive non-American bankers is working its way into the regulations.

Regardless of the merit or fairness, large banks will continue to bear ever-heavier regulatory burdens. The new rules under Basel III are tight enough that industry executives are already calling them “Basel IV” and there is little doubt that ever more rounds of new rules are coming. We anticipate that domestic regulators will tighten rules for smaller banks, perhaps those with at least $25 billion or $50 billion in assets. Regulators are unlikely to ever roll back their rules.

What does this mean for bank investors? It means that banks are increasingly becoming highly regulated entities like utilities, if they aren’t already. For major banks, this might actually be a positive in that smaller banks will be disproportionately weakened by the new rules – they have fewer resources to understand, battle and implement them, and they have little to no direct experience with the rules. Another positive is that the majors are perceived as being safer, almost to the point of earning a “Good Housekeeping Seal of Approval” from the Fed. This will likely help them continue to attract deposits at the expense of smaller banks.

But, are all these rules good for the banking industry overall? We would say “no.” Market share for lending, trading and other traditional bank activities has moved away from the major banks to unregulated entities like private credit funds and hedge funds, which has left traditional banks with permanently weaker profits. And, perversely, tighter regulations will likely raise risks for the financial system, as unregulated entities have few limits or disclosures on their risk-taking. A major blow-up in a private credit fund could seize up the credit markets in a way that no commercial bank currently could.

All of this writing is a long way of saying that banks have become low-return businesses. But, their stocks don’t need to be. Buying bank shares when they are out of favor tilts the odds in the value investor’s favor. Citi shares trade at a remarkable discount of nearly 50% to their tangible book value. Once the bank can demonstrate that it has cleaned up its operations, is as sound as its high capital ratios imply, and that its underlying profitability is reasonably steady (even at a low-return level), investors will likely bid the shares to closer to tangible book value. We will remain patient and collect a 4.5% dividend yield while waiting.

Share prices in the table and discussion below reflect Monday, July 3 closing 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:
Allison Transmission Holdings (ALSN) – Raised price target from 54 to 59
Molson Coors Beverage Company (TAP) – Moved from Buy to Sell

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 rose 2% this past week and have 28% upside to our 66 price target. The valuation is attractive at 9.5x EV/EBITDA and 13.6x earnings per share. The 3.0% dividend yield adds to the appeal of this stock. 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 rose 1% in the past week and have 10% upside to our 46 price target. 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.

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 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 rose 3% in the past week and have 3% upside to our recently raised 59 price target. Allison shares offer a reasonable 1.6% dividend yield. Given the limited upside to our price target, we are reviewing this stock, but for now are retaining our Buy rating. 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. 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 rose 1% this past week and have 38% 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 8.2% 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 ticked lower to $1,932/ounce. The 10-year Treasury yield rose 14 basis points to 3.86% (100 basis points equals one percentage point). The U.S. Dollar Index (the dollar and gold usually move in opposite directions) was unchanged at 102.99.

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 3% in the past week and have 58% 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.

Citi passed its most recent Federal Reserve stress test and subsequently raised its quarterly dividend by 2 cents, to $0.53/share. Our opening note has more commentary on Citi and the tests.

Citi shares rose 1% in the past week and have 82% upside to our 85 price target. The shares remain attractive as they trade at 56% of tangible book value of $84.21. 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 2% in the past week and have 19% upside to our 16 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. Our thesis for this company is straightforward – a reasonably stable company whose shares sell at an overly-discounted price. Its revenues are resilient, it produces generous cash flow and is reducing its debt. A new CEO is helping improve its operating efficiency and expand carefully into more growthier products.

On Friday, June 9, we moved shares of Molson Coors Beverage Company (TAP) from Buy to Sell. The shares were approaching our 69 price target, with only about 4% upside remaining. This is close enough, given that much of the run-up is being driven by Budweiser’s Bud Light marketing blunder in the United States. Sales of Bud Light have slumped as much as 25%, while sales of Coors, Miller and others have jumped. It’s not clear how long this phenomenon will last, but the share valuation is becoming relatively full. We are reluctant to raise our price target from here.

Since our initial recommendation on August 5, 2020, shares of Molson Coors produced a 90% total return. SELL

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.

The shares trade at the low end of their 20-year range due to investor expectations for an uninspiring future. We see this 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 rose 3% in the past week to $71.21/barrel, while the price of Henry Hub natural gas rose fractionally to $2.74/mmBtu (million BTU).

NOV shares rose 3% in the past week and have 54% upside to our 25 price target. The dividend produces a reasonable 1.2% 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 were flat in the past week and have 69% 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

The next Cabot Value Investor issue will be published on August 1, 2023.