November 21, 2023

Has the Stock Market End Game Arrived?

Most stocks produce lackluster returns. A recent study¹ by Hendrick Bessembinder, a professor at Arizona State University’s WP Carey School of Business, looked at U.S. stock market returns from 1926 to 2022. Nearly 60% of all stocks detracted from shareholder value during this time period. From 1926 to 2016, half of the total wealth created in the stock market was produced by only 90 stocks. By 2022, the number was only 72 stocks.

Not just a local phenomenon, a similar pattern emerges among stocks around the world. In a separate study², Bessembinder showed that only 2.4% of the 64,000 stocks from around the world created 100% of global market wealth during the 1990 to 2020 period.

So far this year, the trend has accelerated. Recent results indicate that nearly 90% of the year-to-date return of the S&P 500 has come from only seven stocks – the so-called Magnificent Seven mega-cap tech stocks. The other 493 stocks have provided almost zero value. Small-cap stocks as a group have produced negligible value.

Reflecting their long-term performance dominance, the Mag Seven stocks now represent nearly 30% of the total market value of the S&P 500 – a concentration almost unseen in the index’s history.

Taken to its logical conclusion, all of the gains in the stock market would be generated by only the single largest stock. All of the others would have flat, or negative, returns. What once may have been an extrapolator’s fantasy is nearly reality today.

If this trend continues, the only worthwhile strategy would be to own only the largest and best-performing stocks. This could have huge implications for investing. First, it would argue strongly against diversification. If only a few stocks will work, then all of the others will be money losers, so why drag down returns by owning them? It’s a bit like football’s “Prevent Defense” strategy used by a winning team’s defense to prevent the opponent from scoring late in a game. This term was dropped when coaches realized that the only thing it prevented was the defensive team’s victory. Diversification would simply become “diversifying away your profits.”

Another implication would be to render useless any investing approach other than owning the largest and best stocks. Value, small-cap, quality, momentum – all would become average performers at best, and eventual losers as more money migrates to the small handful of winners. Money chasing the winners would leave all other stocks starving.

For the remainder of this year, we could readily see this trend continuing. The Goldilocks economy of not-too-hot and not-too-cold seems to be on the horizon. Fed rate hikes are likely on hold for the foreseeable future, even if trims aren’t forthcoming. Professional investors who are behind their benchmarks can load up on super-liquid mega-cap tech stocks with the comforting assurance that these stocks will be winners – creating a self-fulfilling prophecy.

Sure, next year will arrive in 27 trading days. But no one cares about that right now. Should they?

1. Bessembinder, Hendrik (Hank), Shareholder Wealth Enhancement, 1926 to 2022 (June 17, 2023). Available at SSRN: https://ssrn.com/abstract=4448099 or http://dx.doi.org/10.2139/ssrn.4448099
   
2. Bessembinder, Hendrik (Hank) and Chen, Te-Feng and Choi, Goeun and Wei, Kuo-Chiang (John), Long-Term Shareholder Returns: Evidence from 64,000 Global Stocks (March 6, 2023). Financial Analysts Journal, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3710251 or http://dx.doi.org/10.2139/ssrn.3710251

Share prices in the table reflect Monday, November 20 closing prices. Please note that prices in the discussion below are based on mid-day November 20 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 and generates vast cash flow (which it returns to shareholders through dividends and buybacks). Its announced deal for Splunk will drain most of its cash hoard but we see this as being replenished relatively quickly.

Cisco reported impressive first-quarter fiscal 2024 results, with earnings of $1.11/share rising 29% from a year ago and beating the $1.03 estimate by 8%. However, guidance for second-quarter and full-year 2024 pointed to weak results that were below estimates, which pushed the shares down 10% in the following trading days.

In the quarter, revenues rose 8% and were in line with estimates. Software revenue increased 13%, indicating more progress with Cisco’s transition away from reliance on hardware. Backlog (termed “Remaining Performance Obligations) rose 12%. The 67.1% gross margin compared to 63.0% a year ago – the jump was a huge reversal from chronic margin weakness and was the highest in 17 years. Higher productivity, lower shipping and lower component costs as well as favorable mix and pricing drove the sharp improvements.

Operating expenses were reasonably restrained, rising 5%. Higher gross profits and restrained operating expenses flowed to higher operating profits. The resulting 36.6% non-GAAP operating margin was impressively strong compared to 31.6% a year ago. Cisco’s balance sheet and cash flow appear as strong as ever.

Behind the weak guidance: Cisco said that its customers are digesting a heavy inflow of tech deliveries. The logic is essentially like a pig moving through a python (or, in this case, goods through the supply chain). During the pandemic, Cisco’s suppliers were unable to deliver sufficient components, creating a logjam at the suppliers. As suppliers eventually delivered more, the logjam moved to Cisco. Now, as Cisco is able to deliver better, the logjam has moved to customers. In response, customers are ordering less (orders were down 20% at Cisco in the quarter), so Cisco’s revenues in the next two quarters will be subdued as this logjam is cleared.

Cisco said that once the logjam is cleared, its regular growth pattern should re-emerge. However, this means that 2024 revenues and profits will be flat compared to a year ago, unless the recovery happens faster.

We’re mostly OK with management’s reasons (they provided some reasonable evidence on the call) but are left to wondering how much is due to macro weakness. The secular case for tech upgrades remains as strong as ever, but budgets may be squeezed, which will limit spending.

Cisco’s guidance contained a favorable nugget: that the company’s core profitability seems to have permanently ticked up. Guidance for 2024 implies operating margins of close to 35%, meaningfully higher than the 31.5% rate for each of the past three years.

We suspect that the guide-down for the year is conservative enough to preclude any more guidance cuts through at least the end of the fiscal year in August 2024. The effects of the Splunk deal are widely known and will likely be highly touted as the closing approaches next year. For now, no change to our Cisco rating.

CSCO shares slid 9% in the week and have 38% upside to our 66 price target. Based on fiscal 2024 estimates, unadjusted for the Splunk acquisition, the valuation is attractive at 8.9x EV/EBITDA and 12.3x (on July 2024) earnings per share. BUY

Comcast Corporation (CMCSA) – 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 will present at the UBS Investor Conference on December 4 at 9 am EST. The presentation will be live-streamed on the Comcast investor relations website.

Comcast shares rose 3% in the past week and have 8% upside to our 46 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 13.5x EBITDA and 15.6x per-share earnings 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 re-uniting the global Marlboro franchise.

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

PM shares rose 2% in the past week and have 30% upside to our 120 price target. The shares offer an attractive 5.7% dividend yield. 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 10% upside to our $59 price target. The shares offer a reasonable 1.7% dividend yield. 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.

Aviva provided its third-quarter trading update. Revenues grew at a healthy pace in two major segments, including General Insurance (+13%) and Protection & Health (+23%). Retirement segment growth was positive but not stellar (+2%). Wealth assets had YTD net inflows of new assets equal to 6% of total assets, down 9% from the pace a year ago. Aviva continues to develop its businesses that require less capital support, which allows the company to distribute the excess capital back to shareholders as dividends and buybacks.

The YTD combined operating ratio – an indicator of profitability – improved incrementally from a year ago. Management reiterated their 2023 target of growing operating profit by 5-7% this year, despite some unusual losses due to Canadian wildfires and two hurricanes, indicating that overall profit growth remains healthy. Capital and related financial strength ratios continue to be robust.

Aviva reiterated its confidence in paying a roughly 33.4 pence/share dividend. The company also maintained its confidence in meeting its medium-term financial targets.

Aviva shares rose 4% this past week and have 30% 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 7.7% 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 $1,976/ounce. Gold prices seem stuck between about $1,800 and $2,000. Until the price shifts meaningfully outside of this range, in one direction or another, we consider most of the movements to be noise. The 10-year Treasury yield slid to 4.46%.

The structural forces behind inflation may be permanent – war, government spending, crime, oil prices and past-the-peak fading of the benefits of global free trade, in addition to tight labor market – which could keep inflation at the 3-5% pace indefinitely. Permanent inflation would imply permanent 4-6% interest rates. We see this as a reasonably acceptable normal, which is more in line with history than the 0-3% rates of the past decade. The market has yet to fully digest this new normal.

The U.S. Dollar Index (the dollar and gold usually move in opposite directions) fell 2% to 103.43. Rising yields and relative safety are maintaining demand for the dollar. The U.S. Dollar Index reached a peak of 119 in early 2001, a price that is around 10% above the current level. The world is a very different place than it was in the pre-9/11 era, so we have no way to effectively compare conditions across this time span. However, today, we see global capital moving to the safety of U.S. dollar assets relative to most other developed nation currencies. Gold may be seen as a lesser source of safety, partly due to its illiquidity.

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 4% this past week and have 71% 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 has started its huge staff reduction program. As much as 10% of its staff could eventually lose their jobs. Citi needs this type of aggressive cost-cutting and simplification if it is ever to achieve a higher share valuation. We are incrementally encouraged by the moves.

Investors have lost hope in Citigroup. The shares trade essentially unchanged from 2010 prices and are at or near lows not seen since 2012, only a few years after the worst of the global financial crisis. Valued at roughly 50% of tangible book value, Citi shares are pricing in what amounts to a ceiling on its earnings power of about $4.50-$5.00/share, based on the assumption that a roughly 8x multiple is “about right.” This perhaps is based on the 4Q23 estimate of $1.18/share being the permanent run-rate ($1.18 x 4 quarters = $4.72).

We find it hard to believe that Citi’s earnings won’t improve over the fourth quarter run rate. Not only are consensus annual estimates at $6/share, but the company is taking a more aggressive cost-cutting stance and its stronger segments continue to show growth.

Another way to look at the valuation: using the general rule of thumb that banks trade at a P/TBV that is 10x its return on tangible common equity, Citi shares are pricing in roughly $4.35/share of earnings. The rough math is that by valuing the shares at 50% of tangible book value, investors are assuming a 5.0% return on tangible common equity [5.0% x $87 TBV = $4.35 EPS]. While anything is possible, it would seem exceptionally unlikely that Citi would be stuck at $4.35/share of earnings.

The recently raised $0.53/share quarterly dividend looks sustainable outside of a devastating market calamity.

Citi shares rose 7% in the past week and have 87% upside to our 85 price target. The shares remain attractive as they trade at about 50% of tangible book value of $86.90. The dividend offers investors a 4.7% 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.

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

Gates shares rose 6% this past week and have 33% 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.

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

The price of West Texas Intermediate (WTI) crude oil was essentially unchanged at $77.99/barrel. Oil prices appear to be quiet and largely unmoved by the Israel-Gaza conflict, but the potential for sharp volatility seems higher with the increasingly complicated game of shifting geopolitical and economic alignments. A major new catalyst, in addition to all of the others, would be export or production cuts from the Middle East should Iran become directly or even explicitly indirectly involved (including if the U.S. restores its sanctions).

The price of Henry Hub natural gas slid to $3.08/mmBtu (million BTU). The near-term weather outlook points to warmer-than-expected temperatures while gas storage levels are high.

NOV shares were flat in the past week and have 29% 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.

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

The shares will likely remain weak or stagnant for the near term. We will wait for a favorable change in investor sentiment but are poised to pull the plug. Given this, we recently moved the shares from Buy to Hold.

ST shares climbed 5% in the past week and have 75% upside to our recently reduced 57 price target. HOLD

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.

Current price is yesterday’s mid-day price.
CSCO: Estimates are for fiscal years ending in July of 2023 and 2024