Cabot Turnaround Letter Issue: November 29, 2023

Profiting at Year-End From Loser Stocks

While most investors hold winning stocks, every investor has loser stocks. It’s just a natural part of investing. This year, many widely held stocks have turned out to be losers. While mega-cap tech stocks have surged, nearly half of the stocks in the S&P 500 have posted negative returns year-to-date, and one in five has tumbled by 25% or more. Small-cap stocks almost across the board have had a rough year: The Russell 2000 small-cap index has gained only 3%, with a broad swath of small-cap stocks sliding sharply.

But, rather than throwing in the towel and waiting for a fresh start next year, investors can look to convert this year’s losers into assets and winners.

Taxable investors can use their loser stocks to reduce their tax bills. Short-term capital gains are taxed as ordinary income, with rates as high as 37% at the federal level alone. Adding state taxes can raise the combined short-term capital gains tax rate to 47% or higher. Long-term capital gains tax rates are lower, but investors of course want to avoid paying taxes as much as possible.

So, investors can sell their loser stocks to generate realized capital losses, which can potentially shield some or all of their profits from taxes. Short-term losses, for positions held less than a year, can be netted against short-term gains. Short-term losses can also be used to offset long-term gains in some circumstances. And, if combined losses exceed gains, they can be used to offset up to $3,000 of ordinary income, making losses a valuable asset. This asset can extend into future years, as realized losses that aren’t used in one year can be carried forward to future years.

Investors wanting to maintain a position in a particular stock or ETF will want to avoid getting tripped up by the 30-day wash sale rule which can invalidate the tax benefits of a capital loss. Surprisingly, cryptocurrency losses aren’t yet subject to the 30-day wash sale rule. Before making any tax-related trades, investors should consult with their qualified tax advisor to help ensure proper tax treatment.

Another way to capitalize on losers is by buying down-and-out shares produced by artificial year-end selling pressure.

Tax-motivated selling, as discussed earlier, is a major source of artificial pressure on share prices. Individual investors as well as professional advisors that manage taxable accounts are primary sources of tax-motivated selling. Surprisingly, mutual funds also make tax-related trades, as these funds distribute their capital gains to their shareholders around year-end. Managers would rather avoid hitting investors with these taxable events, so they offset gains by selling losers.

Year-end brings three other sources of artificial selling pressure. The first is window dressing by professional investors. These managers want to avoid showing their clients and consultants that they held losers, so they sell these stocks to keep them out of year-end reports. This is particularly true in a year when many managers held previously touted stocks that went on to produce embarrassing and large losses. These managers have a strong career-driven motivation to sell these losers at any price.

Also, managers tend to chase performance as the year-end approaches in order to maximize their performance-based annual bonuses. This means selling losers before they go down any further.

A third source is behavioral. Investors of all types tend to want to start the new year with a fresh perspective – so loser stocks are offloaded without regard to price.

Once the selling pressure fades around year-end, many of the worst-performing stocks bounce upward, sometimes sharply. Nimble investors can capture some of the bounce before longer-term fundamentals return as primary drivers in late January or so.

Each year, the Cabot Turnaround Letter sorts through the market’s year-to-date losers to find the ones most likely to bounce sharply. Although our investing approach focuses on underlying business fundamentals and share valuation, we, too, can be tempted by the attractive risk/return trade-off that can come with year-end selling driven by artificial pressures.

Last year, all seven bounce stocks we recommended rose more than the S&P 500 through the end of January 2023. Four of these names, Match Group (MTCH), Meta Platforms (META), Walt Disney Company (DIS) and Paramount Global (PARA), increased by 25% or more in the first month of the year. While not every stock in every year of our articles does this well, our record has proven its worth over time.

Discussed below are five laggards that look poised to rebound over the next few months. Several current Cabot Turnaround Letter recommended names also look promising for a bounce, including Bayer AG (BAYRY), Newell Brands (NWL), Frontier Group Holdings (ULCC) along with nearly all airline stocks, as well as Viatris (VTRS) and Vodafone (VOD).

Closing prices on November 24, 2023.
Valuation based on earnings for calendar year 2024 except for OKTA which is based on the fiscal year ending January 2025.
Sources: Company releases, Sentieo, S&P Capital IQ, Nasdaq and Cabot Turnaround Letter analysis.

AMC Networks (AMCX) – AMC Networks (unrelated to movie theater company AMC Entertainment (AMC)) owns a range of cable networks and content production franchises. The shares are unchanged this year but have fallen 80% since peaking in early 2021 and remain near their all-time lows. Investors worry about AMC’s sliding profits now that its “Walking Dead” franchise is past its prime. Without strong new content, there is less reason for advertisers and cable networks to stay involved with the company, especially as consumers abandon cable subscriptions. One other cloud: The Dolan Family, not known to be shareholder friendly, controls the company through its 79% voting interest, and the new CEO is the wife of chairman James Dolan.

But while the narrative isn’t attractive, AMC is addressing its issues. The underrated new CEO is putting her cable industry experience to work by launching new revenue and cost-cutting initiatives and boosting the prospects of the AMC+ streaming service. In the most recent quarter, revenues fell 7% and operating profits fell by 9% but these were not nearly as bad as investors expected. And the streaming platform continues to increase its subscriber count (at 11.1 million, +4% in the third quarter). Free cash flow is surging, at $103 million year-to-date compared to $3 million a year ago due to better working capital management and lower capital spending. This cash is helping AMC meet its elevated debt obligations. Investor expectations are low, reflected in its heavily discounted 4.9x EBITDA valuation.

Driven Brands Holdings (DRVN) – Driven Brands owns and franchises a range of auto service businesses including Meineke Muffler, Maaco (car painting), CarStar (glass replacement) and Take 5 Car Wash. The company has over 4,800 locations in 14 countries. Its CEO is a successful former chief operations officer at Burger King. Driven Brands’ shares have tumbled 50% since announcing weak results this past August. Major problems include weak performance and outlook for its car wash business which produces about a third of total company profits, and difficulty integrating and adding new glass services stores. The surprise exit of the CFO this past summer also weighs on investor confidence. Bears worry that the company will be plagued by slowing consumer spending, rising competition in the car wash operations (which would seem to be a low barrier-to-entry business), and general difficulties in running a sprawling multi-franchise company.

The bull case is encouraging: The business is high margin and generating fast growth, capital spending is low, the glass segment integration issues seem highly likely to be resolved, and the company is selling 29 problematic car wash locations. Management appears capable and continues to remain optimistic about 2024 growth and profits. The company has a strong history of highly profitable growth, so a return to health seems reasonable. Peer companies like Valvoline (VVV) are performing well, and the core Meineke and Maaco segments are franchise powerhouses. Driven Brands’ shares trade at a sizeable discount to relevant peers, suggesting that a turn in the calendar might provide a turn in shareholder perception.

Mohawk Industries (MHK) – Mohawk is a well-managed producer of carpets, tiles and other flooring materials for commercial and residential uses. Its operations span the globe, providing it with cost and distribution advantages over its many competitors. However, the volatile shares have tumbled 70% from their cyclical peak in late 2017 and now trade unchanged from their 2004 price. Demand remains subdued, leaving factories across the industry at under-capacity volumes. This has led to profit-eroding discounting. Also, until recently, raw material and energy prices were surging, adding pressure to already-tight margins. However, it appears that industry conditions are bottoming and input prices are easing. Mohawk is also closing some factories and cutting unnecessary costs. Third-quarter results were mixed but better than dour consensus estimates, although the fourth-quarter outlook remains uninspiring. The company has a strong market position and continues to innovate, helping keep it relevant during the down cycle. Mohawk has low-enough debt and plenty of cash flow to sustain it until the eventual upturn. Trading at 9x trough earnings, the shares could lift sharply if investors re-embrace risk in the new year as they usually do.

Okta (OKTA) – Okta’s software verifies the identity of workers when they log into company computers. It also provides a range of closely related identity and access management tools. Demand surged during the pandemic, and has since returned to a sustainable pace, but the share price has slumped 75% as investors look for faster growth elsewhere. Also hurting the share price: cost-cutting to make the company profitable has led to operational disruptions, and an embarrassing hack left investors wondering if Okta’s magic is gone. However, Okta is a well-managed company (led by an attentive founder) and will likely make the necessary adjustments to generate both hefty growth and profits. Demand remains strong, with secular industry growth at 15% or more. Okta has a very strong market position as it essentially shares the market with one company, Microsoft, which many customers avoid due to its dominance in other software categories. While the shares are nominally expensive, their price appears to undervalue the company as Okta is only now focusing on profits. At some point, Okta will likely be acquired given its stronghold on a key technology. Prospective investors should know that the company reports earnings on November 29.

Pfizer (PFE) – Pharmaceutical giant Pfizer prospered during the pandemic as its Covid vaccine became one of the two industry standards. However, the post-pandemic letdown has left the company with a relatively stable but uninspiring portfolio of non-Covid treatments and a pipeline with unclear prospects. Revenues for this year, estimated at around $59 billion, will be 40% below year-ago levels, while profits will be down 75%. Investors have responded by aggressively selling the company’s shares, which have slid 50% from their peak to the lowest price since the depths of the initial pandemic sell-off and are now unchanged from 20 years ago. The current view is that the company’s revenues and profits will be stagnant for years. Pfizer’s soon-to-close and expensive $43 billion all-cash deal for Seagen, which is unprofitable, also weighs on the stock. However, expectations for Prizer’s new products are almost zero, given the low 8.4x earnings multiple, yet the company’s development pantry is by no means empty. The shares also offer an attractive 5.5% dividend yield. Any relenting of the selling pressure, which has accelerated as year-end approaches, could provide a crisp bounce to Pfizer’s shares.

Standing on the Shoulders of Giants: New Ideas from 13F Filings

We source our new ideas by using a variety of methods. One of our more productive methods is to see what other like-minded investors are buying. All institutional investors overseeing assets totaling $100 million or more must file publicly available 13F reports with the Securities and Exchange Commission within 45 days of the end of every calendar quarter. These reports offer a murky but useful view of who owns what stocks.

Like most data-driven sources, the 13F provides a vast amount of raw material that needs to be refined to become usable. Our first step is to focus on our roster of perhaps 60 favored managers – those with value mindsets, long-term holding periods, quality investment teams and proven reputations for performance and integrity. Among this roster, we look for large positions that have recently been increased, smaller positions that have had sizeable increases, or new names that were started at meaningful sizes. These traits indicate that the manager has conviction in the stocks. We add another step that adjusts for the reality that the report shows positions with at least a 45-day lag and may no longer be high conviction ideas.

Each passing candidate stock then goes through our standard analytical funnel, which winnows the list to only those that meet our rigorous investing criteria. From an initial list of hundreds of fund holdings, we typically end with a small but highly-refined group of attractive stocks. Discussed below are four worthwhile stocks culled from the November 15 batch of 13F filings. This month’s Buy recommendation, Fidelity National Information Services (FIS), could be included in this 13F group given the recent purchases by Baupost Group, Hotchkis & Wiley, Dodge & Cox, JANA Partners and Capital Group.

Closing prices on November 24, 2023.
* Valuations based on based on calendar year 2024 estimates.
Sources: Company releases, Sentieo, S&P Capital IQ, Nasdaq and Cabot Turnaround Letter analysis.

Kenvue (KVUE) – Previously Johnson & Johnson’s consumer health business, Kenvue owns iconic brands including Band-Aid, Johnson’s Baby Shampoo, Listerine, Neutrogena and Tylenol. Following an unusual exchange offer, this company separated from J&J in August and its former parent continues to hold a 9.5% stake. Kenvue’s shares have slipped almost 25%, pulling their valuation down to 11.9x next year’s EBITDA and making them worth a closer look. A major overhang is litigation that alleges that Kenvue failed to properly warn that prenatal exposure to acetaminophen could lead to ASD and ADHD. Investors worry that a guilty verdict in an upcoming trial could saddle Kenvue with $5 billion or more in payouts. Kenvue’s baby talc product is another source of litigation: while J&J retained U.S.-related liabilities, Kenvue is liable for damages outside of the country. Another worry is more fundamentals-driven. Investors expect a company like Kenvue to produce 3-5% organic sales growth, which it is likely to deliver this year, but in its most recent quarter, most of the revenue growth came from higher pricing (+7.1%), as volumes fell 3.5%. Despite its impressive brands, Kenvue won’t be able to raise its prices indefinitely and will need to restore volume growth. This is more difficult and a bit worrisome, as it requires gaining market share on already-crowded retail store shelves.

While these concerns are legitimate, much of their potential impact has already been factored into Kenvue’s shares. Even though the medical and liability allegations are far from settled, with a reasonably likely chance that Kenvue will win, investors have priced in as much as $8 billion in acetaminophen and baby talc liabilities. Much of the worry over weak product volumes seems to be overdone, as nearly two-thirds has been due to the elimination of low-value products and weak sales in China. A slow start to the cold/flu season hasn’t helped, either, although consumers may be skipping decongestants that have been proven ineffective. Analysts are trimming their estimates, which is helping to reduce expectations. The shares are now included in the S&P 500 index, which provides an enduring buying constituency.

Kenvue is highly profitable. Its strong free cash flow (likely around $2.2 billion this year) and modest net debt (at about 1.8x EBITDA) support its dividend and shares repurchases. Management seems capable. Notable investor Wellington Management has taken a 3.7% stake, while another well-regarded value investor, Yacktman Asset Management, opened a sizeable new position, both likely concluding that the upside potential is healthy enough to justify the risks.

NOV, Inc (NOV) – This high quality company, formerly named National Oilwell Varco, builds drilling rigs and produces a wide range of gear, aftermarket parts and related services for oil and natural gas drillers, wind towers and drill ships. About 64% of its revenues are generated outside of the United States. Its emphasis on proprietary technologies makes it a leader in hardware, software and digital innovations. The company’s large installed base helps stabilize its revenues through recurring sales of replacement parts and related services. NOV’s shares remain moribund due to weak demand across most of its markets. However, international demand is starting to tick upward, pricing is improving and order growth is ramping, even if modestly. The company continues to tighten its cost structure and generates positive free cash flow. NOV’s balance sheet carries modest debt. The company has a Buy recommendation in our sister publication, Cabot Value Investor. Although the shares have produced only a modest gain so far, we are encouraged by the fundamental improvements underway as well as the vote of confidence provided by Greenhaven Associates. This firm, led by legendary yet not widely known Edgar Wachenheim, recently initiated a sizeable position in NOV.

Nutrien Ltd (NTR) – Canada-based Nutrien, created by the 2018 merger of Agrium and Potash Corp, is one of the world’s largest producers of agricultural chemicals including potash, nitrogen and phosphate. Its Nutrien Ag Solutions segment is the world’s largest retailer of agriculture products with over $20 billion in revenues. The company’s shares have tumbled by 50% from their 2022 peak and are back to their 2018-2019 range, as near-ideal pricing is now sliding back to normal as industry shortages are being resolved. Volumes and demand are likely to remain healthy, although weaker corn and other commodity prices have tempered previously robust demand. While most investors are giving up on Nutrien share due to the near-term commodity outlook, the highly regarded Canadian investment firm Black Creek Investment Management has been adding the shares, which now comprise its largest position at 11% of its assets under management. This firm takes a long-term view similar to Berkshire Hathaway’s approach. While their purview is global, their Canadian base likely gives them a closer perspective on Nutrien’s fundamentals compared to other investors. One source of hidden value that Black Creek no doubt sees is Nutrien’s retail business, which could readily be worth 40% of the company’s total value. Nutrien shares pay an appealing 3.8% dividend yield, providing long-term investors with current returns while waiting for an inevitable product upcycle to return.

Ovintiv (OVV) – Ovintiv is a Denver, Colorado-based oil and natural gas exploration and production (E&P) company. Smead Capital, with $5.1 billion in assets under management, has raised its stake in Ovintiv, making it the manager’s largest energy holding other than Occidental Petroleum and ConocoPhilips (both of which it is trimming). We note that Dodge & Cox, a highly regarded value investor, remains Ovintiv’s largest shareholder with a 10% stake. The appeal is likely driven by two supportive views. First, these companies are neglected by investors despite their strong cash flows and low valuations. Ovintiv is restraining its capital spending while returning 50% of post-dividend free cash flow to investors. Its debt is modestly elevated but management is focused on paying it down by a third with much of the remaining free cash flow. The shares trade at a modest 3.5x multiple of cash operating profits. While oil and natural gas prices are volatile and unpredictable, Ovintiv’s prospects would clearly benefit from merely enduring stability in prices. The second driver is increasing consolidation in the oil patch. Mega-deals like ExxonMobil’s purchase of Pioneer Natural Resources and Chevron’s acquisition of Hess imply a growing need for large energy producers to expand by buying companies rather than by drilling. Like other mid-cap E&Ps, Ovintiv could be an appealing buyout target.

Disclosure note: The chief analyst personally owns shares of NOV, Inc, (NOV).

RECOMMENDATIONS

Purchase Recommendation: Fidelity National Information Services (FIS)

Fidelity National Information Services (FIS) 347 Riverside Avenue, Jacksonville Florida 32202 www.fisglobal.com

Symbol FIS Market Cap $32.2 billion Category Large Cap Business Financial Technology Revenues (2023e) $9.8 Billion Earnings (2023e) $2.0 Billion 11/24/23 Price $55.50 52-Week Range: 46.91-79.32 Dividend Yield: 3.80% Price target: $85

Background:
We wrote about this company in our February 2023 article, “On Our Radar Screen: A Look at our Research Process Using An Approaching Opportunity in Fidelity National Information Services.” At the time, the company had much of what we are looking for in a turnaround and its shares made it most of the way through our research funnel. But, it wasn’t quite ready for an investment. We were hesitant due to the near-term outlook for the business fundamentals and on the share price, which was about $74. We said we wanted “to buy the shares at $55 (or lower, depending on how much the fundamentals deteriorate) to make it worthwhile. We’ll follow one of our core precepts: patience.”

With the shares now trading at about $55, down 26% from when we wrote our article, and with the turnaround starting to play out, we believe it is time to buy the shares.

Fidelity National provides technology and processing solutions that are critical to the operations of financial institutions and other companies. Revenues are generally provided under multi-year contracts, and are driven by transaction fees, professional services and software license fees. The majority of its customers are in the United States and Europe.

The company has a long and convoluted story. In the 22 years following its 1968 creation as data processing firm Systematics, the company had a relatively quiet existence. However, that changed with its acquisition in 1990 by ALLTEL, followed by its acquisition in 2003 by title insurance company Fidelity National Financial. It was then combined with Certegy in 2006 in a $2.2 billion deal, soon followed by a split-off from its former parent as Fidelity National Information Services. The company then embarked on an aggressive acquisition program including Metavante in 2009 ($3 billion), Sungard in 2015 ($9.1 billion) and Worldpay in 2019 ($35 billion), among other smaller deals.

Fidelity’s shares have slid nearly 65% from their 2021 peak and are now back to their 2014 price level. Many of its problems stem from the addition of Worldpay, but Fidelity National’s overly complex acquisition-driven structure appears to have made it a poorly integrated sprawl of loosely related services unable to adapt to a changing marketplace. Revenue growth has slowed and its margins are under pressure from specialized upstarts like Toast and from other better-managed competitors. Further, the leadership had focused on growth rather than efficiency and durability, with incentive compensation packages that produced excessive compensation not matched by strong execution.

Analysis:
Changes are underway to finally move Fidelity in the right direction. The board has been refreshed, with five of the 12 members being replaced in 2022 or 2023 along with the board chair and lead independent director. The new board looks well-qualified to oversee the company’s leadership. In October 2022, the long-time CEO was replaced with Stephanie Ferris. The former CEO/chairman made a full exit from the company shortly thereafter. Ferris is an industry veteran, starting with her early days at Fifth Third Bank’s tech processing unit, followed by an impressive rise through the ranks during several acquisitions to become the CFO of Worldpay, and then president of Fidelity National in early 2022. She clearly knows the industry and Fidelity’s operations – we see her as a capable new leader. A new CFO joined in August.

Helping provide outside pressure, and a shareholder vote of confidence in the leadership, is the presence of several highly regarded investment managers. Dodge & Cox (6.2% stake), Capital Research (5.5%), Baupost Group (1.2%), JANA Partners (0.6%) and Hotchkis & Wiley are well-known for their patient but attentive roles as shareholder advocates.

The company is moving quickly. In November 2022, the company announced the Future Forward efficiency program aimed at streamlining its operations. The program is on track to deliver $625 million in annualized run-rate savings by the end of 2024. Perhaps more important, the company is now focusing on better execution: responding to customer needs, developing new products, and expanding into new and faster-growing client segments.

This past July, Fidelity announced an exit from its Merchant Solutions business with the sale of a 55% stake in Worldpay to a private equity firm. Following the transaction’s planned closing in the first quarter of 2024, Fidelity will use the $12 billion in net cash proceeds to reduce its debt by about $8.8 billion (to a balance of about $10 billion) and repurchase at least $3.5 billion of shares. Fidelity will retain a 45% stake, valued at approximately $8.3 billion, which will likely become more valuable given its new, highly focused owner.

After the deal, Fidelity seems highly likely to use its capital sensibly, as it will be reined in by its priority to keep gross debt at no more than 3.0x EBITDA, maintain an investment grade balance sheet, and pay out 35% of its net earnings (excluding its interest in Worldpay’s earnings) as dividends.

Free cash flow is sturdy at around $2 billion a year and could increase to $2.5 billion by 2025. Helping support free cash flow is a low 3.5% weighted average interest rate on its debt.

While near-term challenges and industry competition could bring disappointing results, the company’s renewed operational, strategic and leadership discipline should produce a more prosperous future. Recent results are encouraging – third-quarter revenues grew 4% organically, backlog rose 2%, and the adjusted EBITDA margin expanded by 70 basis points.

We are setting our $85 price target using conservative fundamental and valuation assumptions.

We recommend the purchase of Fidelity National Information Services (FIS) shares with an $85 price target.

Ratings Changes

On November 13, we moved shares of Kopin Corp (KOPN) from Suspended to Buy. With the release of Kopin’s third-quarter results, 10Q and related conference call, our reason for suspending the shares has been resolved. We are restoring the shares to Buy along with our original $5.00 price target.

Disclosure: The chief analyst of the Cabot Turnaround Letter personally holds shares of every company on the Current Recommendations List. The chief analyst may purchase securities discussed in the “Purchase Recommendation” section or sell securities discussed in the “Sell Recommendation” section but not before the fourth day after the recommendation has been emailed to subscribers. However, the chief analyst may currently hold and may purchase or sell securities mentioned in other parts of the Cabot Turnaround Letter at any time.

Performance

The following tables show the performance of all our currently active recommendations, plus recently closed out recommendations.

Large Cap¹ (over $10 billion) Current Recommendations

Mid Cap¹ ($1 billion - $10 billion) Current Recommendations

Small Cap¹ (under $1 billion) Current Recommendations

Most Recent Closed-Out Recommendations

Notes to ratings:
1. Based on market capitalization on the Recommendation date.
2. Total return includes price changes and dividends, with adjustments as necessary for stock splits and mergers.
* Indicates mid-month change in Recommendation rating. For Sells, price and returns are as-of the Sell date.
** BNRE return includes spin-off value of BAM shares.
*** GE total return includes spin-off value of GEHC shares at January 6, 2023 closing price to reflect our sale.

The next Cabot Turnaround Letter will be published on December 27, 2023.