July 18, 2023

On the “Wisdom” of the Markets

As value/contrarian investors, we have little interest in accepting the market’s wisdom. Some might say that we have little ability to accept the market’s wisdom, which is probably what distinguishes us from other investors (and academics) that accept such guidance.

We’ll quote Warren Buffett, founder and head of Berkshire Hathaway, who wrote in his 1987 letter to shareholders, “Mr. Market is there to serve you, not to guide you.” By this, he means that the stock market’s inability to make accurate predictions should help investors make money. And that these predictions shouldn’t provide guidance on how to invest, given that they are so often wrong.

We recently came across a chart in the Wall Street Journal that illustrated the market’s inability to make accurate predictions. The chart graphs the consensus forecast for the Fed Funds rate for a fixed date, December 2024. In January 2022, the market believed (and backed with an immense amount of capital) that the December 2024 Fed Funds rate would be about 1.25%. Pundits fully supported this guess as a fait accompli, even as inflation was running close to an 8% pace. To us, at that time, this seemed like an impossible pairing of high inflation and free money.

Fast-forward to today. The market’s current forecast for the Fed Funds rate at the end of 2024 is nearly 4.00%. That’s a long way away from 1.25%.

Forecasts for a recession seem similarly of little value. We’ve been waiting for the heavily forecast “imminent” and “deep” recession to arrive for nearly two years now. Rick Rieder, Blackrock’s chief investment officer of global fixed income, implies that the U.S. may never again experience a recession, except from a “massive shock to the system.” Rieder may be right, or he may be succumbing to the time-worn error of believing that the business cycle has been repealed. Quoting Buffett again, “We have long felt that the only value of … forecasters is to make fortune-tellers look good.”

Our view is that we want to be macro-aware, but not macro-driven. We have to accept the investing world as it is and may well become, and we want to be well-informed about the wide range of possibilities. But, we invest based on company-specific fundamentals and share valuations. If there is any wisdom in our approach, that is it.

Share prices in the table reflect Monday, July 17 closing prices. Please note that prices in the discussion below are based on mid-day July 17 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
Allison Transmission (ALSN) – Moving the shares from Buy to Hold.

Upcoming Earnings Reports
Tuesday, July 25: Sensata Technologies (ST)
Thursday, July 27: Comcast (CMCSA)
Thursday, July 27: Allison Transmissions (ALSN)
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

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 slipped 1% this past week and have 30% upside to our 66 price target. The valuation is attractive at 9.4x EV/EBITDA and 13.3x earnings per share. The 3.1% 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.

The writers’ strike in Hollywood expanded to include actors. How might this affect Comcast? For its cable operations, the primary reason that Comcast’s subscriber numbers and fees are stable is that more, or most, subscribers buy cable for access to the internet, not for access to TV programming (except for live sports) or telephone service. And, we see little chance that internet access becomes less attractive because the quantity and quality of streaming shows dip temporarily.

For its Universal Studios, Peacock streaming services and other content, show quality and quantity are clearly very important. But, since every studio and streaming service is affected, the overall competitive effect is muted, although those with larger/better libraries are better positioned than Comcast. One positive side effect: no movies equals no production costs. Streaming services might make at least a short-term leap into profitability due to the strike.

Comcast shares were flat in the past week and have 10% upside to our 46 price target. BUY

Buy Low Opportunities Portfolio

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.

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

ALSN shares rose 2% in the past week and have 1% 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 moved this stock to a HOLD last week. 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 rose 3% 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 8.4% 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 1% higher to $1,952/ounce. The 10-year Treasury yield fell to 3.83% from 4.04% last week.

The U.S. Dollar Index (the dollar and gold usually move in opposite directions) fell 2% to 100.08. With investors assuming that the Fed is nearly finished with its interest rate hikes as recent data shows that inflation is being subdued and as marginal data shows the economy is less robust, 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 rose 5% in the past week 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.

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, 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, generally backed its full-year guidance, and the shares remain heavily discounted at 54% of tangible book value, so we are retaining our Buy rating.

Higher interest rates are boosting Citi’s revenues. The mundane Institutional Services businesses, which provide back-office services to other financial businesses (~24% of total revenues), saw revenues rise 18%, much due to higher interest rates from a year ago. This segment continues to be a gem – we have little color on its profitability, although we understand that profits are relatively generous. Consumer credit card revenues rose as well, also driven by higher interest rates although volumes jumped 12%. A year from now, rates will likely be flat, so rate-driven growth is likely peaking now, but the level of profits should remain around this plateau.

Segments directly related to capital market activities, like stock and bond trading and investment banking, fell meaningfully as overall market activity was subdued. Higher expenses helped drive a 45% drop in segment profits. Some of the 13% increase in expenses went to severance payments and risk/control investments which hopefully are sort-of one time, but this segment needs to better match its costs and revenues.

Citi’s Legacy Franchises (its to-be-sold operations including Asia and Mexico) produced a small loss.

The bank is retaining its deposit base, with balances unchanged from the prior quarter and a year ago. Deposit costs rose to 3.09% compared to 0.53% a year ago, which helped keep deposits from moving elsewhere. Citi’s net interest income, or the total profits from lending less costs of borrowing, rose about 16% from a year ago, so the bank has been able to benefit from rising interest rates.

Despite the sharp increase in credit costs compared to a year ago, Citi is reasonably well-positioned for a weaker credit environment. Part of the increase in credit costs was due to the bank boosting its credit reserves, which now equal a hefty 2.93% of its loans. This level is significantly higher than its peers, but the bank is likely to see higher losses and higher reserves due to credit “normalization” (an extrapolation from prior cycles that may or may not have particular relevance to the current cycle). Non-accrual loans, those which have stopped making interest payments and are unlikely to resume, fell 15% from a year ago. Non-accruals are only 0.43% of loans, so the reserves cover these by six times over.

Capital remains sturdy, with the wonky CET1 capital ratio at 13.3%. This dipped only modestly from 13.4% at the end of March, despite Citi returning $2 billion to shareholders in dividends and share repurchases. A year ago, the CET1 ratio was 12.0%. The share count rose 1% from a year ago, reflecting Citi’s efforts to build its capital in advance of more stringent Fed-related capital requirements and a possible weakening of the economy.

Citi shares rose 1% in the past week and have 84% upside to our 85 price target. The shares remain attractive as they trade at 54% of tangible book value of $85.34. The recently raised $0.53 quarterly dividend looks sustainable and offers investors a 4.6% 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.

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 1% in the past week to $74.85/barrel, as resilient demand seems to be meeting stable-at-best supplies. The price of Henry Hub natural gas fell 5% to $2.51/mmBtu (million BTU). Natural gas prices are driven by domestic demand, as import/export volumes are minuscule.

NOV shares rose 6% in the past week as investors seem to be increasingly confident that a floor is being set under oil prices. NOV shares have 38% upside to our 25 price target. The dividend produces a reasonable 1.1% 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.

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

ST shares rose 3% in the past week and have 63% 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

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.
CSCO: Estimates are for fiscal years ending in July of 2023 and 2024