June 13, 2024

Stubborn but Predictable Inflation Is a Fine, Happy Medium for the Market

Good enough.

That was the resounding sentiment on Wall Street after Wednesday morning’s inflation print came in slightly better than expectations … but still stubbornly above 3% year over year. The headline CPI number for May, 3.2% year over year, was just below the 3.3% economists anticipated; the month-over-month increase (0.2%) was also a bit lighter than expected (0.3%).

Investors liked the results, at least initially, as stocks were up to new record highs on Wednesday. Yes, inflation is still proving quite “sticky,” as the year-over-year number has now been in a range between 3% and 3.7% for exactly a year, since last June. We’ll see how long the Fed sticks to its 2% mantra – Jerome Powell and company have suggested that they won’t start cutting rates (and they didn’t again on Wednesday) until inflation dips below 3%. My guess is they might move the goalposts a bit on that vow as long as inflation keeps ticking incrementally downward, as it has for the last two months.

How much further does the CPI number need to fall for the Fed to take it as a green light to start cutting short-term interest rates from multi-decade highs? Who knows. In the meantime, the market is doing just fine even with high rates and sticky inflation.

Since inflation dipped below 4% last June (or actually it was the June CPI number, reported in July), the S&P 500 is up 21%, the Nasdaq has rallied 26%, and the more sober (and perhaps more reflective of the market these days) Dow is up 13%. In the two years prior to that (actually 25 months), when inflation was above 4% and rose as high as 9.1% in June 2022, the S&P 500 was up 3%, the Dow was flat, and the Nasdaq was actually down more than 2%.

Conclusion? Sticky inflation isn’t preventing investors from buying stocks. High inflation was. Thankfully (knock on wood), it appears the days of high inflation – or at least higher than 4% – are in the rear-view mirror. Eventually, the Fed will start to cut rates. But as long as inflation doesn’t rise back above its year-long range, I doubt it will matter much whether rate cuts commence in July, September (as expected), or not until after the election.

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.

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This Week’s Portfolio Changes
Citigroup (C) Moves from Buy to Sell

Last Week’s Portfolio Changes
Canadian Solar (CSIQ) – New Buy with a 28 price target

Upcoming Earnings Reports
None

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.

Canadian Solar Inc. (CSIQ) is not only Canada’s largest solar energy company; it’s a global leader in the solar space. And it’s gotten much larger in the last two years, since the Canadian government announced a 50% income tax cut for zero-emission technology manufacturers (which the new 2023 legislation extended by three years). Canadian Solar’s revenues were up 41.5% in 2022, another 2% in 2023 (both record highs), and are on track to tack on another 1.2% this year and a whopping 20.2% in 2025. If it meets those estimates, the company will have gone from $3.5 billion in annual revenues to $8.25 billion in just five years. Earnings per share have more than doubled since 2021, and while they’re expected to take a step back this year, they’re projected to reach new highs of $4.75 per share next year.

And the company is right in the sweet spot for the North American solar boom. It manufactures solar photovoltaic modules and runs large-scale solar projects across Canada, and in 29 other countries, even spinning off a subsidiary – CSI Solar Ltd. – last year that trades on the Shanghai Stock Exchange. The company boasts 61 gigawatt (GW) module capacity, is up to 125GW solar module shipments, and has a project pipeline of 26.3GW. That doesn’t include its battery storage shipments (4.5 GW hours, or GWh) or capacity (20GWh expected by year’s end).

It’s a big company that operates on a global scale, and it’s growing fast. And yet … the stock is a small cap, with a market capitalization of a mere $1.26 billion. It used to be three times as big, trading as high as 63 a share in January 2021. Today, it trades just a hair under 19 a share, and at just 8x forward earnings, 0.49x book value, and a paltry 0.18x sales. The latter two numbers are the cheapest the stock has ever been.

There was no news for Canadian Solar this week, though the stock was down about 3% in its first week in the portfolio after many ups and downs.

This new addition to the Growth/Income Portfolio is a play on the gaping chasm between the booming growth in the solar energy sector (in both the U.S. and Canada) and the sluggish performance in solar stocks. While solar stocks have never lived up to their considerable promise, they also usually don’t stay down for long – or at least not this down.

With the best combination of growth and value in the solar subsector, I believe CSIQ has considerable upside, and I’ve set a price target of 28 – 47% higher than the current share price. Considering the stock touched as high as 63 in early 2021, that price target may even be conservative. BUY

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.

There was no company-specific news for Honda this week, but the stock finally had a decent week, up nearly 2%. The stock has remained stubbornly in the 32-34 range for nearly two months, but I think eventually Wall Street will take notice of its new hybrid-fueled growth, especially with shares trading at bargain-basement values of less than 8x earnings, 0.41x sales, and 65% of book value. HMC has 37% 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 15.1x EBITDA and 16.7x 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 news for Philip Morris this week.

The stock was down marginally, but mostly held at 103. The stock is up more than 15% since the first-quarter earnings report in late April, when sales of its new nicotine pouch, Zyn, exploded by 80% year over year and improved its share of the nicotine pouch market to 74%. Philip Morris is also set to launch its next product, the heated tobacco device IQOS, in the U.S. in the coming months. IQOS is already a big hit overseas: Global shipments of IQOS grew by 21% to 33.1 billion in the quarter.

So there’s a lot to like here, and we maintain a price target on PM shares of 120, 16% higher than the current price. The 5% dividend yield adds to the appeal. BUY

United Airlines (UAL) – People are flying in planes again in Covid’s aftermath, and no major airline is taking advantage of it quite like United.

United Airlines is the fastest-growing major U.S. airline. The third-largest airline carrier in the world by revenues behind Delta (DAL) and American (AAL), United is expected to grow sales by 7.4% in 2024 – more than its two larger competitors – and that’s with revenues already topping a record $50 billion in 2023 – 19.6% higher than in 2022, which was also a record year. For United, business has not only returned to pre-pandemic levels; it’s better.

Meanwhile, the stock is super cheap. It trades at a mere 5x forward earnings estimates, with a price-to-sales ratio of just 0.32 and a price-to-book value of 1.90. The stock peaked at 96 a share in November 2018; it’s currently in the low 50s.

A company that’s making more money than ever before (gross profits reached a record $15.2 billion last year, though earnings were still second to 2019 levels on a per-share basis), and yet its stock trades at barely more than half its peak from five and a half years ago. A true growth-at-value-prices opportunity.

United is launching the airline industry’s first media network.

Called Kinective Media, it will use traveler behavior to create more personalized ads and content for passengers watching streaming content on one of its seatback screens. It’s the first of its kind and could provide United with a whole new revenue stream given its potential appeal to marketers.

UAL shares were up 3% this week on the news, but still have 30% upside to our 70 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.

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 AISC) 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.

There was no company-specific news for Agnico Mines this week. Gold prices dipped a little but remain historically elevated at well over $2,300 an ounce. In the absence of any news, AEM shares were also down marginally along with gold prices. They have 14% upside to our 75 price target. 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 for Aviva this past week.

AVVIY shares were flat this week and have remained in the low to mid-12s since flirting with new highs above 12.7 last month. Any break above that level would be bullish. The stock remains cheap, trading at less than 12x earnings estimates, with a price-to-sales ratio of 0.40 and a price-to-book of 1.41. Shares have 13% upside to our 14 price target. The 6.9% dividend yield adds to our strong total return thus far. BUY

Citigroup (C) – It’s time to say goodbye to Citigroup.

While shares have made progress this year, up 17%, they’ve retreated from 64 to 60 in the last three weeks, and are now at their lowest point since April, dipping below their 50-day moving average. In a value portfolio, a four-point dip in three weeks normally isn’t much cause for concern. But in this case, it’s part of a pattern with Citigroup since it was added to the Cabot Value Investor portfolio in late 2021: one step forward, two steps backward. The result? A stock that’s down 10% in two and a half years.

I had hoped that the strong results from the company’s first-quarter earnings report might help turn the tide in a more permanent way. Instead, Citi shares have dipped to two-month lows at a time when the market is at all-time highs. That’s not a good sign.

With last week’s addition of Canadian Solar (CSIQ), the Citigroup sale will leave us with an even 10 shares in the portfolio, which is the ideal number in my book. MOVE FROM BUY TO SELL

CNH Industrial (CNH) – 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.

There was no company-specific news for CNH Industrial this week.

Last month, the company reported earnings that were a bit mixed.

Both sales (-9.8%) and earnings per share (-5.7%) declined from the same quarter a year ago. However, both figures beat modest estimates, with EPS (33 cents) coming in well ahead of the 26 cents that were estimated.

Broken down by segment, CNH’s Agriculture wing (its largest at $3.37 billion, or 70% of total revenues) saw a 14.1% decline in sales year over year. Construction revenues dipped 10.7% year over year. Financial Services were the lone bright spot, with revenues increasing 24.8% over last year.

Overall, CNH’s cash/cash equivalents dipped to $3.24 billion from $4.32 billion at the end of 2023. Total debt was up a tick, to $27.78 billion. But cash from operating activities improved to $894 million from $701 million.

CNH shares are down sharply since the report, getting an initial bump but giving back about 14% since as Wall Street seems to have decided there was more bad than good in the results. The stock does seem to have stabilized, however, and is was even up slightly in the last week. Trading at less than 7x earnings (and just 0.56x sales), CNHI shares have 38% upside to our 14 price target. The 4.6% dividend yield is at least providing a life raft as the stock has taken on water in recent weeks. 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 company-specific news for Gates this week.

Like CNH, Gates is coming off some mixed earnings results from earlier this month. The 31-cent EPS results outpaced analyst estimates of 30 cents and was up 20% from the 25 cents it earned in the first quarter a year ago. However, sales of $862.6 million even more narrowly missed analyst estimates and, more importantly, represented a 3.9% decline from the $897.7 million in revenue from Q1 a year ago. The underwhelming results sent GTES tumbling about 8.7% in the immediate aftermath; it recovered all the losses but has since sunk back nearly to post-earnings levels in the mid-16s.

GTES shares were up close to 2% this week, as it seems the worst of the selling may be behind the stock. It has 20% upside to our 20 price target. They trade at less than 12x earnings, 1.27x sales and 1.37x book value, so they remain undervalued by traditional measures. GTES remains our best-performing stock, with a return of 56% in less than two years. 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 company-specific news for NOV this past week. There was good news for the oil and gas industry, however: Crude oil prices appear to have bottomed. They were up from $73 to $78, and NOV shares followed suit, up 3.5% since our last issue. If crude prices push above $80 a barrel for the first time since April, it could be bullish for the energy sector, NOV included.

NOV shares have 34% upside to our 24 price target. It trades at just 11x forward earnings estimates and 0.80x sales. 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.

Worthington completed its acquisition of Hexagon Ragasco, a Norwegian company that specializes in lightweight, customizable LPG composite cylinders used for leisure, household and industrial applications, for approximately $98 million. Hexagon Ragasco did $64 million in sales last year – a drop in the bucket compared to Worthington’s $4.9 billion.

Worthington is also selling 49% of its Sustainable Energy Solutions (SES) segment to Hexagon Composites, Hexagon Ragasco’s parent company, for roughly $10 million. Both transactions are relatively minor and haven’t moved the needle much for WOR investors. WOR shares were down 1% this past week and have backslid from 67 to 53 since late March. The stock is getting a nice bounce today so perhaps the worst of the selling is over. The company reports fourth-quarter Fiscal 2024 earnings on June 26, so perhaps that will help turn the tide.

WOR shares have 36% upside to our 73 price target. They trade at just 0.55x sales. BUY

Note for stock table: For stocks rated Sell, the current price is the sell date price.

Current price is yesterday’s mid-day price.

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