Cabot Undervalued Stocks Advisor Weekly Update

Today I’m plucking my Bank of America (BAC) stock review out of the Growth Portfolio section, and putting it right here in the editorial section of the weekly update. That’s because good news affecting BAC will also affect virtually all bank stocks. You own bank stocks, right? Gosh, I sure hope so! 

Bank of America (BAC – yield 1.8%) is an undervalued large-cap growth stock. New appointments at the Federal Reserve (including new Chairman Jerome Powell) and the Office of the Comptroller of Currency (OCC) solidify the likelihood of banking deregulation in the coming years, which directly benefits bank profitability. The less money a bank spends on attorneys and staff to fill out duplicate government reports and their associated duplicate fees, the more money they get to keep for pro-business activities such as new hires and new services. Those pro-business activities in turn generate higher profits, and increased U.S. government income tax revenue from both corporations and new employees. See how beautifully that works? Goldman Sachs (GS) is expected to be the biggest beneficiary of deregulation among large-cap stocks, with a 10% EPS boost, according to a 116-page report from a well-known investment bank. Therefore, I think it’s fair to conservatively estimate a 5% boost from deregulation to Bank of America’s bottom line.

Bank of America also stands to receive another 10% earnings boost if corporate income tax rates are lowered to 20%, despite the potential removal of home mortgage interest deductibility. (I got that 10% figure from the aforementioned investment bank’s industry analysis.)

Let me help make those concepts real in dollars and cents. Bank of America is expected to earn $1.82 and $2.17 per share in 2017 and 2018. Those consensus estimates rose by two cents each in October, and have not risen at all in November, which means analysts have not yet factored in the favorable pick at the Fed nor potential changes in income tax structure.

Now let’s add a 5% EPS boost from deregulation and a 10% EPS boost from lower income tax rates to Bank of America’s consensus earnings estimates. In that scenario, Bank of America’s expected $2.17 EPS in 2018 increases to $2.50. Whereas the bank is currently expected to see EPS grow 19.2% in 2017—an outstanding year of profit growth—a revised EPS number of $2.50 would represent 37.4% year-over-year profit growth. Raise your hand if you doubt that 37% profit growth won’t affect the share price. Right. It would be silly to think that a huge increase in profits won’t push the share price upward.

Need more ammo to fuel your investment decision? The current 2018 price/earnings ratio (P/E) for BAC is 12.2. Not exactly astronomical. You know what it drops to if the consensus EPS estimate is revised to $2.50? The 2018 P/E would then be 10.6. I smell a bargain.

If you’re not a numbers person, and your eyes just glazed over, what I’m telling you is that BAC is likely to bring you more capital gains than most large-cap bank stocks in the coming year. You have not missed your chance to buy BAC at a good price and benefit from deregulation and lower income tax rates.

I moved BAC from Strong Buy to Buy on October 24, saying, “The stock is up 20% since early September, and despite the bullish price action, a pullback would be normal.” Now that the pullback has taken place, I’m moving BAC back to Strong Buy. Buy BAC now. Strong Buy.

Now that General Electric (GE) announced a 50% reduction in the dividend payout, I am reminded that I forgot to share my October 27 Wall Street’s Best Daily article with you: The General Electric Stock Problem: Five Lessons Learned. If you own shares of GE and have additional questions about how to proceed with your stock, send me an email.

I’m sure there are many subscribers who don’t review every weekly update. If that describes you, here’s the important thing that I want you to know. If you open a random issue of Cabot Undervalued Stocks Advisor and discover that one of your stocks was recently sold from the portfolios, please go back and read my Sell recommendation. I very often sell for reasons other than “this stock is terrible, get rid of it!” The company might be great and growing, but I might sell due to action on the price chart, an increasing debt ratio, news that casts a pall over the industry, etc. You’ve seen me write “dividend investors should hold XYZ stock” or “growth stock investors with a medium-term horizon should hold ABC stock.” I’m quite serious about that. However, as the analyst and author of a publication that needs to address a wide audience, I’m going to keep pruning the portfolios in the effort to provide fresh investment ideas. When in doubt, send an email with questions and comments to crista@cabotwealth.com.

Earnings Season Scorecard

Earnings season is essentially over for companies that report September quarter results. 54% of our affected portfolio companies reported big upside earnings surprises, 32% reported numbers that were very close to analysts’ estimates, and 14% reported disappointing results.

Big earnings beats: Alexion Pharmaceuticals (ALXN), Apple (AAPL), Ameriprise Financial (AMP), BP plc (BP), Bank of America (BAC), Blackstone Group (BX), Boise Cascade (BCC), Delek US Holdings (DK), Goldman Sachs (GS), Legg Mason (LM), Morgan Stanley (MS), Nucor (NUE), Total (TOT), Vertex Pharmaceuticals (VRTX) and Weyerhaeuser (WY)
Slight earnings beats: Cavium (CAVM), PulteGroup (PHM) and Quanta Services (PWR)
Earnings in line with estimates: Johnson Controls (JCI), Schlumberger (SLB) and Vulcan Materials (VMC)
Slight earnings misses: Martin Marietta Materials (MLM), Universal Electronics (UEIC) and XL Group (XL)
Big earnings misses: Chipotle Mexican Grill (CMG), Commercial Metals (CMC), Mattel (MAT) and Molina Healthcare (MOH)

Portfolio Notes

Make sure to review the November 13 Special Bulletin in which I mentioned news, rating changes and/or price action on Mattel (MAT).

Buy-Rated Stocks Most Likely* to Rise More Than 5% Near-Term:

Delek US Holdings (DK)
Martin Marietta Materials (MLM)
Vulcan Materials (VMC)

 *I can review price charts and make an educated determination about what’s likely to occur, but I will sometimes be wrong. I cannot control the stock market; I can only guide you through it.

Today’s Portfolio Changes:

Bank of America (BAC) moves from Buy to Strong Buy.
Blackstone Group LP (BX) moves from Hold to Strong Buy.
Commercial Metals (CMC) moves from Hold to Strong Buy.
GameStop (GME) moves from Hold to Buy.
Legg Mason (LM) moves from Hold to Strong Buy.
Martin Marietta Materials (MLM) moves from Buy to Strong Buy.
Nucor (NUE) moves from Hold to Strong Buy.
PulteGroup (PHM) moves from Buy to Hold. 

Last Week’s Portfolio Changes:

Delek US Holdings (DK) joined the Buy Low Opportunities Portfolio as a Strong Buy.
WestRock Company (WRK) joined the Growth & Income Portfolio as a Strong Buy.

Updates on Growth Portfolio Stocks                          

Apple (AAPL – yield 1.4%) manufactures a wide range of popular communication and music devices. Apple recently launched the iPhone X, which retails for $999-$1,149 at full price. Leading into the launch, news media frequently expressed caution at the high price—and investors in turn took to worrying—only to be surprised at the strength of demand for the new phone. (My mantra is “It’s the media’s job to scare you.”) An analyst at a major Wall Street firm presented a compelling bar chart: there’s a very strong correlation between rising (or falling) iPhone prices and rising (or falling) iPhone gross margins. Apparently, not only are the phones selling well, but Apple’s going to make more profit than usual on the new product!  

This gross margin phenomenon has no doubt contributed to the rapid rise in consensus earnings estimates in recent weeks. Wall Street now expects EPS to rise 24.2%, while the P/E is low in comparison at 15.3. For perspective, Apple’s EPS rose 11.0% in 2017 and fell 9.9% in 2016. The company does not have years of big profit growth anywhere near as often as you might imagine. Apple is entering a cycle in which each of the next four quarterly earnings releases are likely to exhibit excellent year-over-year comps, and possibly upside earnings surprises, as often happens when companies are going through growth spurts.

I believe there’s money to be made in the stock. I expect AAPL to perform well between now and June 2018, but it will assuredly have plateaus and pullbacks along the way. A short-term pullback to the low 160s would be perfectly normal and a buying opportunity. Strong Buy. 

Cavium (CAVM) – As this update goes to press, there has been no additional news on the topic of the rumored intent of Marvell Technology Group (MRVL) to purchase Cavium. The stock initially jumped to 75 amid the takeover excitement, and has since been moving upward. The previous all-time high was 74 in June 2015.

Consensus earnings estimates for Cavium do not change often, although they have slowly increased throughout 2017, including in recent weeks. Wall Street expects Cavium to achieve EPS of $2.83 and $3.56 in 2017 and 2018, reflecting EPS growth rates of 85.0% and 25.8%. With a share price of 77.35, the corresponding P/Es are 27.3 and 21.7. CAVM remains undervalued.

If no buyout offer materializes, the share price could retreat as low as 67 (and I will return my recommendation to Strong Buy). I would expect such a pullback to be brief, and a serious buying opportunity. If you love the idea of buying CAVM below 70, put in a buy limit order. Perhaps you’ll get lucky!

If a buyout takes place, the price could easily be somewhere between 75 and 85. The semiconductor analyst at a well-known Wall Street investment bank estimates that the buyout price could go as high as 92. If a buyout offer emerges, my next move will be to decide whether to sell immediately or wait a few days. I never hold takeover stocks for the six to 24 months it typically takes for the corporate acquisition to be completed. Hold. 

KLX Inc. (KLXI) is an extremely undervalued, small-cap aggressive growth stock in the aerospace and energy services industries. KLX will participate at the Goldman Sachs Industrials Conference on November 14. I anticipate KLXI trading in the 52 to 56 range for a short while before continuing to reach new highs. Buy. 

Martin Marietta Materials (MLM – yield 0.8%) is a supplier of crushed stone, sand, gravel, cement, concrete and asphalt. After a slow 2017, the company is expected to achieve 29% EPS growth in 2018, and the 2018 P/E is 24.2. MLM is an undervalued mid-cap stock, recently trading between approximately 208 and 219. I’m moving MLM from Buy to Strong Buy due to the strong 2018 earnings outlook and the improving price chart. There’s 12% upside as MLM retraces its May 2017 peak at 240, where the stock will still be undervalued. Buy MLM now. Strong Buy.  

PulteGroup (PHM – yield 1.1%) rose roughly 72% this year, and is still climbing. I’m moving PHM from Buy to Hold. Experience shows me that when a stock rises a tremendous amount, it then spends quite a few months resting (with pullbacks!). Look no further than the two-year price chart on Goldman Sachs (GS) to see a good visual of that scenario. I’m going to sell PHM very soon. Long-term investors still own a very undervalued aggressive growth stock, so hold PHM if you’re so inclined. But I’m going to make room for a new investment idea that carries less obvious downside risk. Hold.

Quanta Services (PWR) provides specialized infrastructure and network services to the electric power, oil and natural gas industries. PWR is a very undervalued aggressive growth stock. The share price ratchets up and down, and seems to be bouncing at 35.5 during the current pullback. I expect the stock to resume climbing soon. There’s 20% upside to my fair-value price target of 44. Buy PWR now. Strong Buy.

Vertex Pharmaceuticals (VRTX) is an aggressive growth biotech company that corners the market in treatments for cystic fibrosis (CF). Vertex currently has approximately $363 million in cash equivalents and marketable securities that will be subject to the proposed repatriation tax of 12%, if Vertex decides to bring those assets to the U.S. That’s enough money to pay off all the company’s debt. The large-cap biotech analyst at a major investment bank projects Vertex’s EPS to grow 56% per year in 2018 through 2020. The latest full-year consensus EPS estimates represent 113% and 59.7% growth in 2017 and 2018, with corresponding P/Es of 82.2 and 51.5. Those are big numbers, as befitting a biotech stock, yet VRTX is still undervalued. VRTX has traded between 142 and 166 in the four months since the huge jump in July. This sideways pattern on the price chart essentially forms a launching pad for the stock’s next run-up. Strong Buy.

Vulcan Materials (VMC – yield 0.8%) is a supplier of construction aggregates, asphalt and concrete. After a slow 2017, the company is expected to achieve 38.4% EPS growth in 2018, with a corresponding P/E of 29.7. This undervalued mid-cap stock is rising toward its June peak at 134, where it will still be undervalued. Buy. 

XL Group (XL – yield 2.2%) is an insurer and reinsurer, and an undervalued mid-cap stock. Earnings estimates have remained very steady in recent weeks. The company is expected to take a net loss in 2017 due to catastrophe losses, then earn $3.76 per share in 2018. The corresponding P/E is 10.6. The stock established price support at 39 in September and October, after a steep drop during hurricane season. It then began climbing, only to come back down to 39. The trading patterns appear quite normal. There’s 18% upside as XL retraces its July high near 47. Buy.

Updates on Growth & Income Portfolio Stocks 

BP plc (BP – yield 5.9%) is a European integrated oil company and a very undervalued aggressive growth stock. I expect BP to reach 43 (where it last traded in 2014) in the near future. Hold.

Blackstone Group LP (BX – yield 7.2*) is an alternative asset manager, and very undervalued growth & income stock. Barron’s posted an article on alternative asset management companies on November 7, highlighting Credit Suisse’ recommendation of BX. The stock pulled back in recent weeks. I’m therefore returning the recommendation to Strong Buy. In the coming three to 12 months, I expect BX to ratchet toward 37, where it last traded in early 2015, giving new investors a potential 15% capital gain. Strong Buy.
*The payout varies each quarter, with the total of the last four announced payouts yielding 7.2%.

Commercial Metals Company (CMC – yield 2.6%) is a recycler and manufacturer of steel and metal products, including rebar and fence posts. CMC is a very undervalued aggressive growth stock. I moved CMC from Strong Buy to Hold on October 22, when it rose near 22. Now that the stock has had a big pullback, I’m moving CMC back to Strong Buy. The stock will likely trade between 18.5 and 22 before continuing upward to 24, where it last traded in December 2016. CMC offers new investors a potential 28% capital gain. Strong Buy.

GameStop (GME – yield 9.3%) is a retailer of games, collectibles and technology, with additional ventures in the entertainment field. The new Xbox One X release is flying out of GameStop stores. Bob Puzon, senior vice president of Merchandising for GameStop, commented to Forbes, “Sales of the new Xbox One X have been incredible! We have sold through most of our initial allotment in just one day. We are already working with Microsoft to get our hands on more of the world’s most powerful video game console!”

Last week I wrote, “New segments of the company have been growing rapidly, while the physical gaming business has been declining. The stock is dirt cheap, and investors are simply waiting for a catalyst that will bring stock market attention to the low price and huge dividend yield. That catalyst could come from a product announcement or a good earnings report that continues to show growth in most business segments.”

Lo and behold, the catalyst turns out to be the dividend itself! With the common stock yielding 9.3%, the question is no longer, “Why should I own shares of GameStop?” but “Why shouldn’t I own shares of GameStop?”

GME has been a portfolio problem for a long time, but I don’t sell shares of good companies simply because the price is down. I have specific criteria for holding vs. selling, and believe it or not, the big dividend has kept GameStop in the portfolio. While I believe that the share price will eventually rise and even thrive, shareholders are being paid handsomely to wait.

Those of you who are seasoned investors have lived through all kinds of market anomalies and downturns. You know the important question in the GameStop scenario: “Is the dividend safe?” Because if you can buy the stock at the current price, with a P/E of 5.0, and count on the 9.3% dividend yield to remain intact, you’re looking at a super-attractive income proposition. And that’s not even taking into account the prospect of capital gains!

I believe that the dividend is safe. First off, the payout totals $1.52 per year, while earnings per share (EPS) are expected to be about $3.30, both this year and next year. So the dividend is covered. There’s no need for the company to take on debt to finance the dividend, which is a move you might have witnessed among energy companies after falling oil prices sent profits into a tailspin. (Speaking of debt, the long-term debt-to-capitalization ratio at GameStop is rather low at 26%.)

Want more good news? GameStop raises the dividend annually in March. The stock market might not have any confidence in the company, but CEO Paul Raines does! News flash: you don’t raise dividends when your company is suffering financially. Ergo, GameStop’s not suffering. What’s more, GameStop also repurchases lots of stock every year, and Mr. Raines reiterated his intent to continue doing so in an interview last November.

The stock’s going to suffer through the end of tax-loss selling season in December, like all stocks that have had a bad year. Come January, shares in solidly profitable companies are free to rise, because anyone who was going to sell has already sold. I’m moving GME from Hold to Buy, due to the incredible dividend opportunity. Yes, I expect capital gains down the road, but the dividend is enough to make the stock attractive today. Buy.

Johnson Controls (JCI – yield 2.7%) is a multi-industry, large-cap growth & income stock. Shares of Johnson Controls lost almost 10% of their value following the fourth-quarter earnings release (September year-end). There was no obvious culprit in the media coverage, so I went through the earnings press release vs. the various advance projections by analysts.

Adjusted EPS for the quarter came in on target at $0.87, reflecting margin increases. Revenue also seemed to in line with expectations. Free cash flow came in surprisingly higher than expected. The problem lies in the company’s 2018 adjusted EPS projection, within a range of $2.75 to $2.85, when the consensus estimate had pointed to $2.96. (Full-year 2017 EPS was $2.60.) The company’s full-year 2018 revenue projection seems to be in line with consensus estimates. JCI repurchased 5.5 million shares in the fourth quarter and a total of 15.7 million shares in full-year 2017.

Nobody likes downward earnings revisions. A variety of investment firms lowered their price targets to a range of 41 to 45. The stock seems to have overreacted, compounded by market skittishness over various potential changes to tax laws (tax rates, non-deductibility of interest and repatriation taxes). The prospect of 7.7% 2018 EPS growth combined with a 2.7% dividend yield, though not exciting, is hardly worrisome. I’ll be watching the price chart closely this week: I would optimally like to sell near 40. Hold.

Morgan Stanley (MS – yield 2.0%) is a major U.S. investment bank and wealth manager, and an undervalued growth & income stock. As I mentioned in the review of Bank of America (BAC), above, Morgan Stanley also stands to benefit from changes in bank regulations and income tax rates. If those changes take place, Morgan Stanley’s 2018 EPS, which are currently expected to increase 12.5%, could rise as much as 29%. Based on current, unenhanced EPS projections, I expect MS to rise toward my fair-value price target of 59 during the next six to 12 months, giving new investors a potential 21% capital gain. Buy MS now. Strong Buy.

Schlumberger (SLB – yield 3.0%) is a premier oilfield equipment and services company with a global footprint. Demand for one- to three-year contracts for jackup rigs bottomed in mid-2016 and has since risen about 50% (still rising!), spurring a concurrent improvement in day-rates. Schlumberger is experiencing aggressive earnings growth in both 2017 and 2018, and is undervalued based on 2018 numbers. The stock shot upward from its October lows, then had a small pullback. There’s 30% upside plus dividends as SLB eventually retraces its December 2016 high near 86. Strong Buy.

WestRock Company (WRK – yield 2.9%) is a major player in the global packaging and container industry. WestRock has hundreds of business locations in 30 countries, serving consumer and corrugated markets. WRK is an undervalued, mid-cap growth stock. Fluctuations in currencies and raw material pricing can affect profits. WestRock was featured in the November issue of Cabot Undervalued Stocks Advisor. The stock most recently rose above a trading range in mid-October to new all-time highs, then came right back down towards 58, just in time for us to grab our shares before the price advance takes hold. Buy WRK now. Strong Buy.

Weyerhaeuser (WY – yield 3.4%) operates in the areas of timberland, wood products, real estate, energy and natural resources. Last week, Weyerhaeuser announced a 3.2% quarterly dividend increase to $0.32 per share. Zacks did a favorable write-up of Weyerhaeuser on November 10. WY has been mostly-rising for 12 weeks, reaching new all-time highs. I’m going to let it run, with the goal of selling soon if the 2018 earnings estimates don’t increase. Hold.  

Updates on Buy Low Opportunities Portfolio Stocks

Alexion Pharmaceuticals (ALXN) is a biopharmaceutical company that researches and manufactures treatments of severe and rare health disorders. Alexion currently has approximately $917 million in cash equivalents and marketable securities that could be subject to the proposed repatriation tax of 12%. Profits are growing aggressively and the stock is undervalued. The large-cap biotech analyst at a major investment bank projects Alexion’s EPS to grow 31% per year in 2018 through 2020. ALXN has tentative price support at 115. There’s still some downside risk, but ALXN could also reverse direction quite soon. There’s 40% capital gain potential as ALXN retraces its April 2016 high at 160. Buy ALXN now. Buy.

Boise Cascade (BCC) is one of the largest producers of engineered wood products (EWP) and plywood in North America and a leading U.S. wholesale distributor of building products. BCC is an undervalued, aggressive growth small-cap stock. The stock is ratcheting toward 43, where it last reached an all-time high in February 2015. I would consider any pullback below 36 to be an attractive buying opportunity. Hold.

Chipotle Mexican Grill (CMG) is an undervalued aggressive growth restaurant chain. Pershing Square hedge fund manager Bill Ackman, the largest CMG shareholder, is bullish on Chipotle in this CNBC review. (My skin crawls … Bill Ackman is not my favorite investment professional. On the bright side, he’s very handsome.) In recent days, a Hollywood actor claimed that food at Chipotle made him sick. Chipotle investigated the incident and claims that the man’s sickness was unrelated to his meal at Chipotle.

(Can we be real for a moment? If I sued every restaurant that ever served food to my family members that ended up making us sick, half the restaurants in America would be out of business by now. I always assumed that normal people just figured out which foods and which branch locations to avoid in the future. I don’t order lamb chops in restaurants anymore, period. But I also don’t bother suing people.)

CMG is experiencing aggressive earnings growth, though the share price has very little chance of a rebound past 320 until tax loss selling season is over in January. As long as the profit outlook and valuation remain attractive, I will hold the stock for the prospect of future capital gains. Hold.

Delek US Holdings (DK – yield 2.2%) is a diversified downstream energy company, with businesses that include petroleum refining, transportation, marketing, renewables (producing biodiesel fuel) and asphalt operations. Delek report third-quarter EPS of $0.80 last week when the market was expecting $0.65, surpassing all analysts’ estimates. The earnings beat was achieved via strong refining results, higher gross margins in all business sections and lower costs. Cost and business synergies associated with the June 2017 purchase of Alon USA Energy (ALJ) should continue to provide attractive quarterly results, and wide variances to analysts’ EPS estimates. Delek was featured in the November issue of Cabot Undervalued Stocks Advisor.

DK is an undervalued, aggressive growth small-cap stock. DK began breaking out of a year-long trading range this month. There’s upside resistance at 32, and more resistance at 38 that dates back to early 2015. There’s 38% capital gain potential as DK rises to 38. Buy DK now. Strong Buy.

Legg Mason (LM – yield 2.9%) is a U.S.-based global asset management and financial services company with $755.2 billion in assets under management (AUM) as of October 31. LM is a very undervalued growth stock. Barron’s quickly blessed the stock’s capital gain potential last week. I moved LM from a Strong Buy to a Hold on October 3 as the stock reached the top of its current trading range. Now that LM is at the bottom of that steady trading range, I’m moving it back to Strong Buy. My price target is 44, where LM last traded in October 2015, offering new investors a 17% capital gain opportunity. Buy LM now. Strong Buy.

Mattel (MAT) As I mentioned in yesterday’s Special Bulletin, rumors abound that Hasbro (HAS) might make an offer to buy Mattel. Here’s some additional commentary from Barron’s and various Wall Street analysts. The stock is way down for the year. A takeover offer could push the share price above 25. If Hasbro squashes the takeover rumor, MAT will likely fall back toward the mid-teens until January, when tax-loss selling is over. My suggestion is that investors hold MAT, for either a takeover offer or a corporate and share price rebound in 2018. Hold.

Nucor (NUE – yield 2.7%) is a low-cost producer of a diversified portfolio of iron and steel products, and an undervalued mid-cap growth stock. I had downgraded NUE from Buy to Hold on October 24 when there was less than 10% upside to my 65 price target. Now that the share price has come down (within its normal trading range), I’m moving NUE back to a Strong Buy recommendation. There’s about 17% upside as NUE retraces its December 2016 high of 65. Strong Buy. 

Total (TOT – approx. 4.0%) has delivered a 25% total return since it was added to the portfolio last November. This French integrated oil & gas stock is now overvalued in light of dramatically slowing 2018 consensus earnings estimates. There appears to be a little more upside. Bullish energy industry momentum could push TOT into the low 60s, where it last traded in July 2014. Hold.  

Universal Electronics (UEIC) is a manufacturer and cutting-edge world leader of wireless remote control products, software, and audio-video accessories for the smart home, with a strong pipeline of new products. UEIC is an undervalued micro-cap stock, forecasted to achieve aggressive 2018 EPS growth. Earnings growth has trickled down to just 3.1% for 2017. Analysts expect 21% EPS growth in 2018, and the 2018 P/E is low at 14.1. The debt-to-capitalization ratio is just 3%. There’s 40% upside as UEIC retraces its July high around 72, where the stock will still be undervalued. Expect volatility. Risk-tolerant investors should buy now, and cautious investors should wait until January to consider the stock. Strong Buy.

Comments

You must be logged in to post a comment.