January 3, 2025

In today’s note, we discuss pertinent developments and institutional ratings changes for some of the stocks in the portfolio, including Alcoa (AA), Duluth Holdings (DLTH), SLB Ltd. (SLB) and the SPDR S&P Retail ETF (XRT).

The fabled “Santa Claus Rally” failed to appear this season, prompting concern for the early part of 2025 among many investors. We discuss what it entails for our investment approach.

We take a brief look at the positive implications of a under-the-radar healthcare sector company, Fortrea Holdings (FTRE), while initiating a Buy rating on the stock.

We’ll also discuss some potentially positive catalysts for two of our portfolio holdings as it relates to the metal, petroleum and automobile industry outlook in the year ahead.

Comments on Portfolio Holdings

In last week’s podcast we focused on the automotive industry as I shared my thoughts on the prospects for a strong performance in that space this year. Let’s now take a look at an industry which is integral to vehicle manufacturing—and whose prosperity in some measure depends on it: the aluminum market. This discussion relates directly to our holding in Alcoa (AA), but also indirectly for our holding of SLB Ltd. (SLB), for reasons I’ll explain here.

With fuel and shipping costs historically high, a burgeoning trend in the global automotive sector is focused on the need to make transport vehicles lighter (known as “lightweighting”) to minimize those costs. As an industry analyst recently observed, this trend affects not only air freight carriers and trucks, but also tanker trailers and lighter-bodied water vessels. Moreover, it has a spillover impact on other major industries, including petroleum—mainly liquified natural gas (LNG) manufacturing—but also oil exploration and production.

Worldwide aluminum demand is rising and is projected to exceed supply growth in 2025. After dipping in 2023, the metal is further expected to resume its historical growth rate going forward, thanks in part to falling interest rates, better GDP growth in the U.S. and EU, as well as recent policies aimed at reviving China’s manufacturing sector. More specifically, it’s estimated that annual aluminum demand from the global automotive industry alone will more than double from this year’s $129 billion to $262 billion by 2033. The growing shift toward the “electrification of everything” is further expected to support the aluminum market.

In the final month of 2024, aluminum prices were on the weaker side after the latest batch of economic data out of China showed the nation’s average daily aluminum output rose to a record in November, as exports encouraged high levels of production. Prices were down 5% in the first three weeks of December before recovering somewhat in the final week to finish with a monthly loss of 3.5%. This was one of the big reasons for the December pullback in Alcoa’s stock price.

For full-year 2024, however, aluminum prices were up 15% from a year ago, and the long-term trend looks decidedly more sanguine. According to a Commerzbank AG report, lower production levels of the metal are expected from China in 2025 and beyond, due partly to a sharp increase in input costs along with national rules for the reduction of emissions. The investment bank projects aluminum prices of $2,800 a ton in the second half of this year, a 9% increase from current levels if realized.

Then there’s the pledge by incoming President Donald Trump to increase tariffs on imports from Canada and Mexico, which are two of America’s top suppliers of aluminum and steel, by 25% (in addition to a 10% duty on Chinese goods). The proposed hike is set to take place on January 20. To be exact, around 70% of America’s aluminum comes from foreign countries, with Canada supplying 60% of that total.

It’s widely expected that if those tariffs are fully implemented, prices for both steel and aluminum will increase, at least on a short-term basis. Analysts from Citigroup said that for U.S. aluminum prices, the Midwest premium over that of the London Metal Exchange could “more than double to as much as 50 cents more” in a move that could benefit six U.S. smelters, led by Alcoa. Additionally, the analysts warned “it could take years to reconfigure [the aluminum] supply chain.”

Analysts believe the tariff hike will serve as an incentive for Alcoa to boost its capacity expansion in response to higher demand for domestic aluminum, which in turn could stimulate revenue growth while improving the firm’s operational capabilities.

Meanwhile, at a recent investor conference, Alcoa’s top brass pointed out that it now has about 960 metric tons of aluminum being produced in Canada, with just under 300,000 tons in the U.S. By the company’s calculation, the part of its production that receives the 10% tariff (assuming an estimated average price of around $2,500 per ton) is expected to benefit in premiums to the tune of about $300 million.

Another piece to this puzzle is China, which happens to be the world’s top supplier of the commodity, accounting for more than half of the world’s total aluminum production. It’s also the top user of the metal, accounting for almost 60% of global consumption.

In a keynote speech in mid-December, China’s premier stated that the government’s most important policy task in 2025 will be to “vigorously boost consumption” through “moderately loose monetary policy” and “more active fiscal policy.” In response to this statement, a major U.S. investment bank called it “most aggressive stimulus tone in a decade,” despite an uncertain implementation scheme.

While sentiment toward China’s stimulus efforts is decidedly skeptical, there are preliminary signs that the initiative might succeed in boosting its economy. China’s services activity expanded at the fastest pace in nine months for December, while the manufacturing sector grew for a third straight month, according to Bloomberg this week, which suggests domestic demand is indeed improving in the wake of the latest stimulus efforts.

A benchmark sign of improvement is that China’s official non-manufacturing purchasing managers’ index (PMI) rose to 52.2 in December, which was conspicuously above the consensus forecast. The reading for manufacturing activity was 50.1, putting it above the critical level that divides growth from contraction and reaching the longest streak of expansion since last March.

Pertinently for the aluminum industry, Bloomberg reported that: “New orders for [China’s] construction industry expanded for the first time this year, reflecting increased activity as companies rushed to build projects ahead of the Lunar New Year holiday starting in late January, according to the NBS. This likely benefited from the government’s increased bond sales and spending on infrastructure in recent months.”

Moreover, a recent study by CME Group concluded that if China is successful in its fiscal and central bank policy measures, it could have profoundly positive implications for both aluminum and crude oil prices.

Using as a proxy for the Chinese economy the Li Keqiang Index (which tracks bank loans, electricity consumption and rail freight volume), growth rates peaked in 2007, 2010, 2017 and 2021, according to a recent study by CME Group. Prices for oil and aluminum both peaked about a year later. By contrast, improvements in the Li Keqiang Index historically lead to higher prices for both commodities.

According to the study, China’s last major stimulus in 2009 “generated a powerful bull market that peaked in late 2011 for oil and industrial metals,” with oil prices rising from below $40 per barrel to above $110, while aluminum prices increased by a whopping 114%.

Granted that the current stimulus plan is much smaller in size than the one in 2009 relative to China’s GDP, and currently higher debt ratios in the nation’s non-financial sector could also limit the effect of the stimulus measures. CME Group concludes the “jury is still out on the degree to which China’s latest stimulus will boost growth.”

But given China’s latest emphasis on standing behind—and increasing where necessary—its stimulus measures, the odds favor a successful conclusion, which in turn should benefit both oil and aluminum. And given the responsiveness of Alcoa’s revenues to higher aluminum prices, this bodes well for the stock price from a long-term perspective.

In addition, Alcoa announced in January 2024 a plan to improve its profitability by $645 million a year (compared to the base year 2023), which management recently reiterated its commitment to. The plan is focused on managing costs and reducing complexity by improving the firm’s production processes along with other measures, as well as reducing debt. In Q3, Alcoa said it had implemented several improvements to achieve approximately 80% of that target, with the company being on track to deliver the full target by the end of this year.

All in, after selling a quarter of our position in Alcoa, the stock retains a Hold rating in the portfolio.

RATING CHANGES: I’m downgrading Duluth Holdings (DLTH) from Buy to Sell after the company’s consistent failure to successfully implement turnaround measures. Duluth’s disappointing third-quarter results continue to be digested by investment firms on Wall Street, who are focusing on an 8% drop in both direct-to-consumer sales and retail store sales. Additionally, a number of downgrades have lately been instituted in the wake of the Q3 report as analysts increasingly question the firm’s turnaround prospects. Sell

Our short-term, season-focused trading position in the SPDR S&P Retail ETF (XRT) was predicated on a successful retail holiday sales season along with an anticipated Santa Claus Rally. The latter didn’t pan out, and while there was a promising show of strength in late November and early December the rally ultimately faded. With the holiday shopping season over, I’m placing XRT on a Sell as we exit essentially at break-even. Sell

NEW POSITION: To replace one of the vacancies in the portfolio, I’m placing Fortrea Holdings (FTRE) on a Buy based on several key signs that point to a successful turnaround in the company’s fortunes. The company, which had its IPO in June 2023 as a spinoff from Labcorp (LH), is a contract research organization that provides services for the development of medical devices and biopharmaceutical products, with operations in over 90 countries. The firm is benefiting from a new CEO with a solid track record in the biopharma industry, as well as from recent activist investor intervention (nearly a quarter of the stock is owned by known activists). As we’ve talked about in the newsletter in recent weeks, I expect this sector to be a strong performer this year, and I’ll have more to say about Fortrea next week. Buy

Friday, January 3, 2025 Subscribers-Only Podcast:

Covering recent news and analysis for our portfolio companies and other topics relevant to value/contrarian investors.

Today’s podcast is about 15 minutes and covers:

• A discussion of the failure of the Santa Claus Rally to appear and what it means for our approach to managing the portfolio in the near term.
• An in-depth discussion of the global aluminum industry and how increasingly positive developments in that industry should benefit at least two of our stock holdings.
• Two ratings changes within the portfolio.
• A new addition to the portfolio.
• Final note
  
  • One of our favorite catalysts, activist intervention, is a big reason for our favorable outlook for healthcare sector specialist Fortrea Holdings (FTRE).

Market Outlook

Today is the last day of the fabled Santa Claus Rally and it looks like old Saint Nick failed to appear on Wall Street for this year’s edition of that event. And while a failed Santa Claus Rally doesn’t necessarily mean doom and gloom lie ahead for equities, it does serve as a cautionary note for investors to look closely for signs of inordinate weakness that might lead to underperformance down the road.

One of those signs is courtesy of the bond market, as U.S. Treasury bond yields are getting dangerously high by the standards of the last few years. The 10-year Treasury yield is nearing 5%, which in the past has served to attract income-oriented investors away from lower-yielding stocks and into the relative safety of higher-yielding bonds.

More significantly, rising T-bond yields often serve as a catalyst for removing liquidity from the stock market and into fixed-income securities. And abundant liquidity has been the main hallmark of the stock market for much of the past year, which means a reversal of this trend is likely to be a problem for stocks if it happens.

I think it’s also worth noting that one of my favorite short-term indicators of the broad market’s internal strength—namely the NYSE 52-week new highs and lows—has shown considerable weakness lately. New lows have been consistently above 40 on most days, which is considered to be above normal and a reflection of increasing internal selling pressure. The new high-low differential has also been negative on many recent days (also not good).

The softening environment is why I think we need to be exceptionally selective in picking stocks going forward—at least until the market’s internal health improves. And with Santa evidently failing to show up on Wall Street this year, it provides another reason for focusing on turnaround candidates that are so much under the radar they’re unlikely to suffer very much in a broad selling wave.

To reiterate my previous admonition: caution, along with a judicious approach to stock selection, is of paramount importance going forward.

Please know that while I don’t yet personally own shares of all Cabot Turnaround Letter recommended stocks, this will materially change in the coming weeks as I become fully integrated as your new chief analyst.

Please feel free to share your ideas and suggestions for the podcast and the letter with an email to either me at cdroke@cabotwealth.com or to our friendly customer support team at support@cabotwealth.com. Due to the time and space limits we may not be able to cover every topic, but we will work to cover as much as possible or respond by email.

Portfolio

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