Cabot Top Ten Trader Issue: October 28, 2024

Leadership Remains Intact

All in all, the evidence remains unchanged: The major indexes are positive but not exactly powerful, with resistance (such as near 500 on QQQ) still capping many measures, but when looking at things from a bottoms-up perspective, leadership remains intact, with strong stocks refusing to give much ground and fresh breakouts from the past month generally acting well. Of course, earnings season is still ongoing, and while it’s been fine thus far (a couple of breakdowns, but that’s to be expected), you can never rule out the market’s key leadership being dented or some abnormal action appearing, especially if some secondary worries (rising interest rates) worsen. But you can always find something that could go wrong in the market—right now, the buyers are in control, and if anything, the leadership ranks are expanding as time goes on. We’ll keep our Market Monitor at a level 8 for now, but could raise it further if earnings season remains fruitful.

This week’s list is very broad, with everything from industrials to real estate to true-blue growth stories. Our Top Pick is Herc Holdings (HRI), a cyclical name that just busted out of a long-term consolidation on giant volume.

Stock 1

Capital One (COF)

Why the Strength
The Federal Reserve’s recent policy shift to easier money is expected to be a major boon to the banking sector; combined with impressive recent net interest income and revenue growth trends, it explains why bank stocks are acting well. Among the sector’s top performers is Capital One, the well-known bank holding company specializing in credit cards, auto loans, banking and savings accounts. With nearly $500 billion in assets, the company is the nation’s ninth-largest bank and the third-largest issuer of major credit and debit card. A key reason for the strength is analysts’ belief that the bank’s net interest margins will significantly improve under the Fed’s looser rate policy, and the fact that the firm doesn’t focus on the highest-quality spenders (not junk, but not upper-end like, say, American Express) shouldn’t be an issue with the Fed providing a tailwind. Indeed, investors were wowed by Capital One’s 7% net interest margins in Q3, which increased by 6% from a year ago, while yields on its loan portfolio rose 5% (to 13%)—and both improvements were attributed to the early-stage benefits of the lower rate environment. Total revenue here was up “only” 7%, so it wasn’t a wild growth wave, but most core businesses looked good, including the domestic credit card and auto loan businesses, both of which increased by 2%. More important for the stock, earnings of $4.51 a share beat estimates by 75 cents and prompted analysts to hike their outlooks. Other segments were resilient, including domestic card loans (which Capital One called the “biggest driver in total company marketing”), which grew 2% to $147 billion, while consumer banking loans rose 1% to $77 billion. Going forward, a big focus for Capital One is its announced acquisition of Discover Financial Services, which management called a “singular opportunity” to create a consumer banking and global payments platform with strong capabilities and a franchise of more than 100 million customers once it finalizes (expected in early 2025). Analysts see earnings picking up over the next three quarters, while a decent dividend (1.5% yield) and modest valuation (12x trailing earnings) help the cause.

Technical Analysis
COF isn’t a go-go stock, but it’s shown the ability to trend when things are in its favor—like we saw late last year when the stock lifted off its lows and rallied nicely into the 150 area by April on hopes of an easier money environment. Those hopes were put on hold for a while, of course, which led COF to chop sideways for a few months, but the stock began to get going in September, with higher highs hit again this month and again last Friday on earnings. (The fading action seen on Friday was quickly met with buying today, a good sign.) We’re OK taking a swing at COF here.

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Stock 2

Carnival (CCL)

Why the Strength
At some point, the travel boom that’s leading to very tight capacity, higher ticket prices and tons of advanced bookings will slow down—but for the cruise industry in general and for Carnival in particular, that time is definitely not now, and when combined with solid cost controls, the firm’s bottom line is picking up in a big way and should continue to do so. Carnival’s fiscal third quarter (ending in August, reported a month ago) was yet another great one, leading the firm to hike its annual outlook for the third time this year: Not only did sales (up 15%) and earnings (up 48%) do great, but cruise costs excluding fuel actually fell a bit for the quarter (should be up only 3.5% in 2024 as a whole), helping operating income per cruise day rise by 26%. (Free cash flow this year is expected to be over $3 billion, or something like $2.50 per share.) More important, though, were a string of positive forward-looking indicators, including record bookings for 2025, which are ahead of 2024 (which itself was the prior record) and at higher prices (all brands selling at higher prices than last year); the firm said that, as of a month ago, nearly half of 2025 is already sold out, Carnival is already taking 2026 orders and had $6.8 billion of customer deposits (up from a record $6.3 billion a year ago), all of which should make it a very sure bet that the firm will have many more quarters of buoyant earnings and cash flow. As a secondary positive, Carnival is rapidly paying down debt ($7.3 billion prepayments since the start of 2023!), boosting its credit rating and cutting interest costs. Industry peer Royal Caribbean will report earnings Tuesday morning, which could move the stock, but there’s little doubt the underlying trends here are bullish.

Technical Analysis
CCL rallied strongly in the middle of 2023 to the 20 level—but for the next 15 months, that area proved to be a ceiling, with the stock bobbing and weaving, unable to stage a real breakout. But now it looks like we might be seeing a character change, with an early October wobble to the 25-day line giving way to a race to new highs near 22 before a very low-volume, orderly pullback during the past two weeks. We’ll see how the Royal Caribbean reports affects things, but in general we’re OK taking a swing at CCL here or on dips, albeit with a stop just under 19.

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Stock 3

CBRE Group (CBRE)

Why the Strength
CBRE Group is the world’s largest commercial real estate services firm, offering leasing, sales, consulting and property management services to landlords around the globe. It’s no surprise business took a hit during the pandemic and afterwards, as remote work took hold, leaving downtowns and office parks wanting for occupants; the overall higher interest rate environment crimped things for a while as well. But the market has stabilized and the strong economy and generally easier money have started tailwinds that should continue to propel CBRE forward. Last week management reported an excellent third quarter, with revenue lifting just over $9 billion, its highest ever and up 15% from a year ago (fastest growth in at least a couple of years), with earnings per share of $1.20, which was 22 cents above expectations. All three of its business segments grew by double digits as U.S. office demand, especially for A-level space where CBRE thrives as a broker, grew nearly 20% in the quarter. Demand for asset management – in which CBRE identifies, buys and manages properties on behalf of real estate investors – also did very well, with CBRE’s assets under management hitting $148 billion. The company also has established a strong business line offering consulting, property management and other services around alternative energy and sustainability as well as strategic site advice related to labor and infrastructure trends. Taken altogether, management says they believe commercial property health turned the corner this year, with a likely sustained recovery ahead given the prior bust, and their bullish outlook reflects it: Q4 should see revenue rise 14% to $10.2 billion and EPS jump 58% to $2.22. Further out, CBRE executives say 2025 should see the business handily top its peak EPS of $5.69 (from back in 2022) as business continues to grow double digits. It’s not changing the world, but this is a blue-chip real estate operation that should benefit from a fresh upcycle that’s in its early stages.

Technical Analysis
CBRE is one of many longer-term breakouts we’re seeing, where the stock peaked with the market in 2021, fell sharply the following the year (down 38%) and then hacked around for a couple of years before setting up more properly during the past few months. The breakout came after earnings in July, and CBRE acted great afterwards, with higher highs and higher lows along with a kiss of the 10-week line. Last week’s quarterly report brought another fresh round of buying, and we’re OK grabbing some shares on this minor post-report exhale with a tight stop.

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Stock 4

Celestica (CLS)

Why the Strength
Contract manufacturing specialist Celestica partners with leading companies across numerous high-growth industries—including aerospace and defense, communications, healthcare and energy—to deliver solutions for their most complex challenges. It operates across two segments: Advanced Technology Solutions (ATS, including aerospace and defense, health tech and smart energy) and Connectivity & Cloud Solutions (CCS, telecom, enterprise communications, servers and storage), and lately the latter business has been the main attraction. Indeed, the highest spending customers for Celestica have been AI data center clients (particularly high-speed ethernet switch sales for AI and machine learning workloads), which are having trouble keeping up with the ongoing boom in demand. Celestica’s latest product, the DS4100, is an 800G switch designed to address the high demands of data center networking across a spectrum of environments including enterprise, service provider and cloud provider domains. Celestica’s just-released Q3 report highlighted the strength of the CCS segment, which saw a big 42% year-over-year revenue increase, driven by continued buying from hyperscaler customers in this segment, including “very strong demand” for the company’s networking switches within its Hardware Platform Solutions portfolio. The solid revenue growth contributed to a “healthy” margin expansion within the CCS segment of 8% (up over one percentage point). Total revenue of $2.5 billion increased 22%, with earnings of $1.04 beating estimates by 11 cents and leaping 60%. Elsewhere, ATS segment revenue of $814 million was 5% lower, driven by lower industrial demand but partially offset by “solid” growth in the Aerospace and Defense and Capital Equipment businesses, and with enterprise end market sales increasing 38%. Looking ahead, growth should remain rapid for another quarter or two before slowing in 2025, but those estimates are almost surely conservative. All in, Celestica is a good secondary play on the AI boom.

Technical Analysis
CLS has had a big, big run since its initial breakout in the summer of 2023, so it’s not in the early stages of the advance. That said, after a sloppy base-building effort that included three big-volume selling weeks when the market cratered in July/August, shares stormed back in September and October, and after a reasonable dip to the 25-day line, the earnings reaction (which came on the biggest daily volume in about a year) looks promising. We’ll set our entry range down a bit, looking to grab shares on a normal exhale.

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Stock 5

Credo Tech Group (CRDO)

Why the Strength
The continued acceleration of the AI data center buildout will require increasingly faster data transmission capabilities, which is a key reason for the strength behind Credo. The California-based company is emerging as a leading high-speed connectivity provider for data centers, delivering a range of solutions including integrated circuits, active electrical cables (AECs) and SerDes chiplets (for handling serial data communication over extremely short distances). Significantly, Credo’s AEC solutions are fast becoming the standard for in-rack connectivity at speeds of 50G and above, and it enjoys a dominant position in this market, while its digital signal processors (DSPs) are also widely used for optical interconnects in cloud-scale data centers. In fiscal Q1 (ended July), Credo reported revenue of $60 million that increased by a whopping 70% from the year-ago quarter, along with significant margin improvements. However, while EPS of four cents improved from the year-ago per-share loss, it missed estimates by 2%—and was likely the reason for the stock’s plunge after results were released in early September. But the recovery was swift as investors no doubt considered the many positives in the Q1 report, including the announcement that Credo expects to see a new 10% customer (identified by management as an “emerging hyperscaler”) in the current fiscal Q2. The company said AECs is currently the main source of revenue and that product line will likely play a crucial role in driving growth in fiscal 2025 and beyond, with production underway for solutions with port speeds of up to 800G. What’s more, Credo said the optical DSP business is “building momentum” and that it expects to ship more DSP units than it has shipped in all previous years combined in 2025. The top brass also expects the rise of generative AI to drive greater demand for its advanced power-efficient, high-speed connectivity solutions and anticipates an “inflection point” across the entire range of its connectivity solutions in 2025, driven by new and existing customers. Wall Street expects triple-digit earnings growth this fiscal year and next; earnings aren’t out until Thanksgiving or so.

Technical Analysis
CRDO’s change of character occurred in May, when earnings propelled it to new highs and pushed the stock higher for a few weeks—but then things got wild, with a sharp plunge with the market in July/August and, after a snap back, another air pocket after the September quarterly report. But against all odds, CRDO has stormed back from that drop, ripping to new price and RP peaks this month and holding firm during the market’s recent consolidation. We’re OK with a small buy in the 40 area, albeit with a looser stop.

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Stock 6

Duolingo (DUOL)

Why the Strength
Duolingo is the leading language platform out there, helping nearly 104 million people per month (up 40% from a year ago) and 34 million people per day (up 59%) learn foreign languages in a fun, humorous, game-like manner. The firm’s social-first marketing efforts (such as an April Fool’s campaign that garnered over 100 million impressions) seem quirky but have proven to work well, as have investments in social interactions (leaderboards, daily streaks, friend quests) that have boosted engagement. The firm operates a freemium model—most of the above-mentioned users use the platform for free (albeit with ads), but the big draw is paid subscribers, which totaled eight million at the end of June (up 52%), with a subscription coming with no ads and with numerous game-like bonuses and challenge attempts. Obviously, the firm has a giant reservoir of free users to tap, which is one of the main growth ideas here, as is a move overseas (its Japan operations are off to a fast start, and it hired marketing managers in France and Korea earlier this year, too). The firm is experimenting with a higher, pricier paid tier that has some GenAI capabilities (real-time spoken conversations!) that should help, too. Altogether, growth here has been rapid and reliable despite expectations that things might slow: Sales have been cranking ahead at 40%-plus rates, earnings are taking off and free cash flow came in at double earnings in Q2. This remains a good, unique story, and the down-the-road potential that its small math and music offerings will became major contributors is very enticing. The Q3 report is due November 6.

Technical Analysis
In the market, it’s the unsual action you need to pay attention to, and that certainly applies to DUOL. The stock looked like it was staging a longer-term breakout last last year, but the sellers showed up near 250 repeatedly in the ensuing months and eventually punished the stock, with shares falling 42% to the August low. However, the action since has been a jaw-dropper, with DUOL snapping back initially, and after some brief tightness, zooming to new price highs—and, in the past month, it’s traded very tightly, which is usually a constructive sign. Earnings are coming up quick, but if you want to roll the dice, we’re OK with a small position here or (preferably) on dips with a stop near 250.

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Stock 7

Herc Holdings (HRI) ★ Top Pick ★

Why the Strength
Major trends in public and private funding for projects like AI data centers, battery storage, semiconductor facilities and liquified natural gas (LNG) plants are expected to drive strong continued growth for Herc in the coming quarters. The company formerly known as Hertz Equipment Rental operates as an equipment rental specialist, mainly supplying the construction industry with aerial, earthmoving and material handling equipment, as well as trucks and trailers, air compressors and lighting equipment. And as the reshoring of manufacturing to the U.S. continues, along with the expansion and modernization of the electrical grid, Herc sees a huge opportunity, bolstered by the long-term trend of the construction sector moving more toward renting equipment over owning it (saves cost and hassle). In spite of a tough year-ago comp, Herc’s Q3 revenue of $965 million rose 6% year-on-year with rental equipment revenue hitting a record and increasing 13% (the reason for the stock’s strength). Earnings of $4.28 increased 9% (but missed estimates by 13 cents), while the firm’s rental prices were up 2% in the quarter and up nearly 4% year to date, and volume “significantly” outpaced overall rental market growth on both an organic and total revenue basis. Going forward, management said its focus is on pursuing opportunities in high-growth markets, many of which are in areas of the country where Herc has been engaged in some M&A, including Texas, Arizona, Southern California and the eastern seaboard. Indeed, the company made a total of eight acquisitions in the nine months ended September, including two acquisitions in Q3; altogether the buyouts added 26 locations and 16 new greenfield locations. Herc expects the new locations to drive efficiencies and profitability as part of its long-term plan and sees continued “incremental opportunities” in megaprojects for transportation infrastructure, energy and utilities (the firm’s current national account business leaders). Wall Street sees 8% earnings growth this year and 13% growth for 2025, both of which will likely prove conservative.

Technical Analysis
HRI tagged 200 at the last bull market top, crashed to 83 during the 2022 bear and then gyrated wildly for the next couple of years, with resistance in the 170 area and support in the 90 to 100 range. The latest dip, though, bottomed at much higher levels, and now HRI has shown a clear character change, with shares rising seven weeks in a row and blasting out to all-time highs on out-of-this-world volume last week. It’s a bit extended, but we’re betting that any retreat will be tolerable—we’re OK entering here or (preferably) on a modest pullback.

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Stock 8

Mueller Industries (MLI)

Why the Strength
Memphis-based Mueller is an industrial manufacturer that specializes in copper and copper alloy products while also producing goods made from aluminum and industrial metals, plus temperature control goods like coaxial heat exchangers (which transfer heat between two fluids, allowing for precise temperature control). Its products are used in many systems, including HVAC, water distribution, refrigeration and automotive, and it also serves the medical, energy transmission and aerospace industries through a network of companies and brands throughout North America, Europe, Asia, and the Middle East. Two-thirds of the firm’s annual revenue is in its Piping Systems segment (pipes, tubes and valves), while the remainder of sales are evenly split between the Industrial Metals (production and sale of copper and brass alloy rods) and Climate (HVAC systems and related climate control products) areas. In the latter segment, Mueller enjoys the top spot globally as a manufacturer of insulated flexible duct systems, refrigeration and gas valves, plus a variety of products serving the HVAC industry. A big part of Mueller’s growth strategy involves M&A to support end-market diversification and the expansion into new geographies, and to that end, the recent completion of a $600 million acquisition of Nehring Electrical Works—a high-quality wire and cable manufacturer—is expected to provide Mueller with greater exposure to the utility, telecommunication, electrical distribution and OEM markets; in particular, management said the deal will give the company a new platform for long-term growth in the electrical and power infrastructure space. The company also just reported excellent top- and bottom-line results and significant cash flow despite “generally restrained business conditions” in Q3. Revenue came in at $1 billion and increased an eye-opening 22% from a year ago, while per-share earnings of $1.48 beat estimates by 12% (the main reasons for the strength). Analysts see 10%-ish top-line growth this year and next, while management expects “significant” free cash flow generation from the Nehring acquisition, all while earnings estimates look low and the valuation (16x earnings) is reasonable.

Technical Analysis
MLI doesn’t get many headlines, but the stock has been a relatively smooth performer since the market bottom a year ago, with shares generally riding the 10-week line higher with only a couple of tedious dips (one in June, another in September). The 73 to 75 area was a tough nut to crack during the past three months, but the earnings-induced move to new highs bodes well. If you’re game, aim for dips of a couple of points.

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Stock 9

Powell Industries (POWL)

Why the Strength
Powell Industries is an electrical infrastructure provider with a specialty in low and medium voltage, the types of electricity used in industrial processes. There’s a lot of complexity in stepping down high voltage and managing electrical flows in the large facilities its customers tend to have. The Texas company has a long-held specialty in providing equipment for the oil and gas industry, as well as electric utilities themselves and has growing exposure to the data center market. More specific help has come in the form of a judgment ending the climate-change-related federal pause on LNG exports. The fossil fuel industry needs a lot of energy to power the liquifying of natural gas, and recently the flow of permits has started again, a good sign for Powell. Long-term Powell isn’t just a fossil fuel beneficiary—It expects hydrogen, biofuel and carbon capture to be areas of growth—but right now the U.S. oil and gas industry makes up nearly 60% of sales (utilities account for another 20%), and demand has been positive overall, helping Powell power to one its best quarters in memory this spring: Sales were up 50% in fiscal Q3, ended June, to $288 million, with net income hitting $46 million, or $3.79 a diluted share (up 149%) as the company says efficiencies in its manufacturing and delivery process have enabled them to capture wider gross margins than they used to. Powell doesn’t offer guidance, but says it is confident in its near- and medium-term outlook for its end markets with a $1.3 billion order backlog, which has been inching up despite the huge growth. Powell has an odd habit of waiting to report fiscal Q4 (ending in September) until December, when Wall Street expects the period to show revenue jump 37% year over year to about $287 million, with EPS of $3.55, up 64% from improving margins—but it’s worth noting that the firm has been trashing estimates, which has led to a huge uptick in Wall Street’s earnings outlook for this year (now $11.78 per share, up from $9 or so three months ago!) and next. It’s a solid industrial power story.

Technical Analysis
POWL is having a great year, though not without a ton of volatility—after a huge run after earnings in February, the stock thrashed around in a 40% range for a few months as the 40-week line caught up. But following the final post-Labor Day retreat, the stock went vertical, persistently motoring to new highs above 280 before its recent dip to the 25-day line. We suggest targeting entries on pullbacks and using a loose stop to give POWL room to maneuver (shares move an average of 12 points per day).

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Stock 10

Sweetgreen (SG)

Why the Strength
Sweetgreen is a unique restaurant story, with a buoyant core cookie-cutter angle that should lead to plenty of growth in the years ahead—though it’s also something of a play on a new store model, too, with robotics and automation playing a key role. The underlying attraction here, of course, is the menu, with the company’s niche being in healthy salads and warm bowls that include tons of yummy items (glazed brussel sprouts, sweet potatoes, blackened chicken and more), which made it a key lunchtime go-to in the cities—but it’s branched out into more protein-focused plates like miso glazed salmon and caramelized grilled steak that’s added more dinner orders to the mix (now 40% or so of sales and growing). As for the store count, there were 231 restaurants at the end of June, with 10% to 15% growth likely for many years to come (it recently entered Ohio and North Carolina; should open 25 or so this year); each location brought in an average of $2.9 million, with same-store sales up 9% in Q2 (though half was from higher pricing) and with solid restaurant-level margins of 22%. That alone is attractive, but adding to the allure here is the firm’s Infinite Kitchen concept—it serves the same offerings, but uses machines to allow clients to dispsense their own dishes (there are a few employees there to help if need be), with the result being much higher restaurant-level margins (31% at one location that’s been open a year) and far lower employee turnover; seven of the 25 store openings this year will be Infinite Kitchens with another two or three being retrofitted. To be fair, growth here is expected to slow some, and earnings are in the red (though EBITDA is positive), but the long-term picture here is very bright. The Q3 report is due November 7.

Technical Analysis
We’ve written about SG a few times this year, but the stock really hasn’t been able to get going since June—after a pop to new highs in the weeks after earnings back then, shares have hit slightly higher highs a couple of times but, net-net, haven’t gone much of anywhere. So why write about it today? Because the setup has improved, with SG tightening up as some daily volume clues have appeared. And, of course, the earnings report could be a catalyst if all goes well. We’re OK with a nibble on a breakout above 40, and then potentially adding more if earnings are well received.

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Previously Recommended Stocks

The next Cabot Top Ten Trader issue will be published on November 4, 2024.

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