January 05, 2022

Thank you for subscribing to the Cabot Undervalued Stocks Advisor. We hope you enjoy reading the January 2022 issue.

We comment on the abrupt shift in market sentiment that has boosted the prices of our undervalued stocks relative to expensive hyper-growth stocks. Several of our left-for-dead stocks, like Arcos Dorados (ARCO), which jumped 17% in the past two weeks, have suddenly been rediscovered by the market. Others, like Coca-Cola (KO) and Sensata Technologies (ST), are reaching new all-time highs as investors find that their healthy fundamentals haven’t been fully reflected in their share prices.

This shift may not last, and is only two weeks or so in the making. But it reinforces our view that, to quote Warren Buffett, “in the short run, the market is a voting mechanism, but in the long run it is a weighing mechanism.”

Please feel free to send me your questions and comments. This newsletter is written for you and the best way to get more out of the letter is to let me know what you are looking for.

I’m best reachable at Bruce@CabotWealth.com. I’ll do my best to respond as quickly as possible.

Market Overview

Undervalued Stocks Rebound
And just like that, market sentiment has shifted to boost our undervalued stocks relative to expensive hyper-growth stocks. So far, in this very young new year, the average stock in the Cabot Undervalued Stocks Advisory roster has gained nearly 3% while the Nasdaq Composite has slipped nearly 1%.

Over the past two weeks, since our last update, the shift has been more clear. The average price gain of CUSA stocks has been 6.8%, which compares favorably to the 1.4% increase in the Nasdaq Composite. Several of our left-for-dead stocks, like Arcos Dorados (ARCO), which jumped 17% in the past two weeks, have suddenly been rediscovered by the market. Others, like Coca-Cola (KO) and Sensata Technologies (ST), are reaching new all-time highs as investors find that their healthy fundamentals haven’t been fully reflected in their share prices.

This shift may not last and is only two weeks or so in the making. But it reinforces our view that, to quote Warren Buffett, “in the short run, the market is a voting mechanism, but in the long run it is a weighing mechanism.”

As contrarian investors, we see this divergence as highly valuable. Initially, we want to see the shares of worthy companies discarded on short-term concerns – that provides us with the opportunity. Then, we want the market to weigh the fundamentals and drive up the shares to a more appropriate valuation.

We don’t know what the new year will bring, for either the economy or the stock market. Central to our philosophy is not assigning any meaningful weight to market or economic forecasts. We’re not in the prediction business. Using another Warren Buffett quote, “… the only value of … forecasters is to make fortune tellers look good.” Our approach is to take the opportunities that the market gives us, and let time, fundamentals and management teams take it from there.

This year, 2022, will no doubt provide many such opportunities.

Share prices in the table reflect Tuesday (January 4) closing prices. Please note that prices in the discussion below are based on mid-day January 4 prices.

Note to new subscribers: You can find additional color on past earnings reports and other news on recommended companies in prior editions and weekly updates of the Cabot Undervalued Stocks Advisor on the Cabot website.

Send questions and comments to Bruce@CabotWealth.com.

Today’s Portfolio Changes
None.

Portfolio changes during the past month
Cisco Systems (CSCO) – Raising price target from 60 to 66.

Growth & Income Portfolio

Growth & Income
Portfolio

Growth & Income Portfolio stocks are generally higher-quality, larger-cap companies that have fallen out of favor. They usually have some combination of attractive earnings growth and an above-average dividend yield. Risk levels tend to be relatively moderate, with reasonable debt levels and modest share valuations.

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

Bristol Myers Squibb Company (BMY) shares sell at a low valuation due to worries over patent expirations for Revlimid (starting in 2022) and Opdivo and Eliquis (starting in 2026). However, the company is working to replace the eventual revenue losses by developing its robust product pipeline while also acquiring new treatments (notably with its acquisitions of Celgene and MyoKardia), and by signing agreements with generics competitors to forestall their competitive entry. The likely worst-case scenario is flat revenues over the next 3-5 years. Bristol should continue to generate vast free cash flow, has a solid, investment-grade balance sheet, and trades at a sizeable discount to its peers.

If Bristol can demonstrate at least the reasonable potential for merely stable revenues during its patent expiration period, which we believe will happen, the shares are remarkably undervalued. On a free cash flow yield basis, assuming an average of $15 billion/year, the shares trade at a 12% free cash flow yield.

Bristol’s chairman/CEO Giovanni Caforio is presenting at JPMorgan’s Annual Healthcare Conference on January 10 at 7:30am EST. The webcast will be available to the public through Bristol’s website.

BMY shares moved up another 1% in the past two weeks. The shares have about 26% upside to our 78 price target. Valuation remains remarkably low at 7.9x estimated 2022 earnings, compared to 11x or better for its major peer companies. The stock’s 7.4x EV/EBITDA multiple is similarly cheap, compared to 9-10x or better for peers.

Either we are completely wrong about the company’s fundamental strength, or the market must eventually recognize Bristol’s earnings stability and power. We believe the earning power, low valuation and 3.5% dividend yield that is well-covered by enormous free cash flow make a compelling story. BUY

Cisco Systems (CSCO) is facing revenue pressure as customers migrate to the cloud and thus need less of Cisco’s equipment and one-stop-shop services. Cisco’s prospects are starting to improve under a relatively new CEO, who is shifting Cisco toward a software and subscription model and is rolling out new products, helped by its strong reputation and entrenched position within its customers’ infrastructure. The company is highly profitable, generates vast cash flow (which it returns to shareholders through dividends and buybacks) and has a very strong balance sheet.

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

CSCO shares rose 1% in the past two weeks and have 7% upside to our newly increased 66 price target. The stock trades at a post-dot-com peak, having surpassed its prior post-bubble high of about 58 set in mid-2019. The all-time high was set in March, 2000, at just over 80. The shares offer a 2.4% dividend yield. BUY

Coca-Cola (KO) is best-known for its iconic soft drinks yet nearly 40% of its revenues come from non-soda beverages across the non-alcoholic spectrum. Its global distribution system reaches nearly every human on the planet. Coca-Cola’s longer-term picture looks bright, but the shares remain undervalued due to concerns over the pandemic, the secular trend away from sugary sodas, and a tax dispute which could cost as much as $12 billion (likely worst-case scenario). The relatively new CEO James Quincey (2017) is reinvigorating the company by narrowing its oversized brand portfolio, boosting its innovation and improving its efficiency, as well as improving its health and environmental image. Coca-Cola’s balance sheet is sturdy, and its growth investing, debt service and dividend are well-covered by free cash flow.

Brokerage firm Guggenheim raised its rating on KO shares to a Buy and its price target to 66 on Tuesday, citing stronger pricing power, exposure to recovering emerging markets and recoveries in restaurants and bars by the summer.

KO shares rose 4% in the past two weeks and now trade at an all-time high. The shares have about 6% upside to our 64 price target.

While the valuation is not statistically cheap, the shares remain undervalued given the company’s future earning power and valuable franchise. Also, the value of Coke’s partial ownership of a number of publicly traded companies (including Monster Beverage) is somewhat hidden on the balance sheet, yet is worth about $23 billion, or 9% of Coke’s market value. This $5/share value provides additional cushion supporting our 64 price target. KO shares offer an attractive 2.8% dividend yield. BUY

Dow Inc. (DOW) merged with DuPont to create DowDuPont, then split into three companies in 2019 based on product type. The new Dow is the world’s largest producer of ethylene/polyethylene, the most widely used plastics. Investors undervalue Dow’s hefty cash flows and sturdy balance sheet largely due to its uninspiring secular growth traits, its cyclicality and concern that management will squander its resources. The shares are driven by: 1) commodity plastics prices, which are often correlated with oil prices and global growth, along with competitors’ production volumes; 2) volume sold, largely driven by global economic conditions, and 3) ongoing efficiency improvements (a never-ending quest of all commodity companies). We see Dow as having more years of strong profits before capacity increases signal a cyclical peak, and expect the company to continue its strong dividend, reduce its pension and debt obligations, repurchase shares slowly and restrain its capital spending.

Industry conditions will likely be strong for a while. Dow remains well-positioned to generate immense free cash flows over the next few years, even as the stock market cares little about cash but rather is focused on the incremental newsflow related to economic growth, energy prices and any industry capacity changes. In the meantime, Dow shareholders can collect a highly sustainable 4.8% dividend yield while waiting for more share buybacks, more balance sheet improvement, more profits and a higher valuation.

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

Dow shares rose 8% in the past two weeks and have 33% upside to our 78 price target. BUY

Merck (MRK) shares are undervalued as investors worry about Keytruda, a blockbuster oncology treatment (about 30% of revenues) which faces generic competition in late 2028. Also, its Januvia diabetes treatment may see generic competition next year, and like all pharmaceuticals it is at risk from possible government price controls. Yet, Keytruda is an impressive franchise that is growing at a 20% rate and will produce solid cash flow for nearly seven more years, providing the company with considerable time to replace the potential revenue loss. Merck’s new CEO, previously the CFO, is accelerating Merck’s acquisition program, which adds return potential and risks to the story. The company is highly profitable and has a solid balance sheet. It spun off its Organon business in June and we think it will divest its animal health segment sometime in the next five years.

The outlook for Merck’s Covid treatment molnupiravir remains unclear. Demand from a range of countries, including India and Belgium, should boost sales but Pfizer’s treatment appears to be gaining the upper hand due to more successful patient trials. Profits for Merck may be limited, as the company is licensing production to local producers in emerging markets to be sold for as little as 50 cents a pill.

Merck shares continued to tick up, gaining 2% in the past two weeks. The broad market seems to have given up on Merck. We think this is near-sighted – investor expectations are very low, yet the company won’t passively accept its presumed demise. The shares have about 29% upside to our 99 price target.

Merck produces generous free cash flow to fund its current dividend (now yielding 3.6%) as well as likely future dividend increases (the company recently raised its dividend by 6%), although its shift to a more acquisition-driven strategy will slow the pace of increases. BUY

Buy Low Opportunities Portfolio

Buy Low Opportunities
Portfolio

Buy Low Opportunities Portfolio stocks include a wide range of value opportunities, often with considerable upside. This group may include stocks across the quality and market cap spectrum, including those with relatively high levels of debt and a less-clear earnings outlook. The stocks may not pay a dividend. In all cases, the shares will trade at meaningful discounts to our estimate of fair value.

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

Arcos Dorados (ARCO), which is Spanish for “golden arches,” is the world’s largest independent McDonald’s franchisee. Based in stable Uruguay and listed on the NYSE, the company produces about 72% of its revenues in Brazil, Mexico, Argentina and Chile. The shares are depressed as investors worry about the pandemic, as well as political/social unrest, inflation and currency devaluations. However, the company has a solid brand and high recurring demand and is well-positioned to benefit as local economies reopen. The leadership looks highly capable, led by the founder/chairman who owns a 38% stake, and has the experience to successfully navigate the complex local conditions. Debt is reasonable relative to post-recovery earnings, and the company is currently producing positive free cash flow.

Macro issues, including issues in Brazil including its economic conditions (in particular, inflation, running at a 10.7% rate), currency and the chances that a socialist might win next year’s Brazilian presidential elections will continue to move ARCO shares. Brazil is one of the most Covid-vaccinated countries in the world, which reduces pandemic-related demand risks.

The company will hold its annual Investor Day on January 26, 2022, at 7:30am New York time, with a live webcast available through Arcos’ website.

ARCO shares jumped 17% in the past two weeks and have rebounded over 35% from their early-November low. The move has converted a loss into a 12% gain (on paper) since our initial recommendation. This stock provides a great example of how valuation-based price targets can help shareholders ride through, or even take advantage of, near-term market sentiment that can drive some share prices down to depressed levels, then reverse sharply. ARCO shares have about 23% upside to our 7.50 price target.

We remain steady in our conviction in the company’s recovery. BUY

Aviva, plc (AVVIY), based in London, is a major European company specializing in life insurance, savings and investment management products. Amanda Blanc was hired as the new CEO in July 2020 to revitalize Aviva’s laggard prospects. She divested operations around the world to re-focus the company on its core geographic markets (UK, Ireland, Canada), and is improving Aviva’s product competitiveness, rebuilding its financial strength and trimming its bloated costs. Aviva’s dividend has been reduced to a more predictable and sustainable level with a modest upward trajectory. Excess cash balances are being directed toward debt reduction and potentially sizeable special dividends and share repurchases.

Much of our interest in Aviva is based on its plans for returning its excess capital to shareholders, including share repurchases and dividends. These distributions could be substantial. We also look for incremental shareholder-friendly pressure from highly regarded European activist investor Cevian Capital, which holds a 5.2% stake.

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

Aviva shares rose 8% in the past two weeks. Insurance company stocks are sensitive to financial market gyrations (in both directions) they have leveraged balance sheets with their principal tangible assets being investments and securities. Aviva shares have about 21% upside to our 14 price target. BUY

Barrick Gold (GOLD), based in Toronto, is one of the world’s largest and highest-quality gold mining companies. About 50% of its production comes from North America, with the balance from Africa/Middle East (32%) and Latin America/Asia Pacific (18%). Barrick will continue to improve its operating performance (led by its new and highly capable CEO), generate strong free cash flow at current gold prices, and return much of that free cash flow to investors while making minor but sensible acquisitions. Also, Barrick shares offer optionality – if the unusual economic and fiscal conditions drive up the price of gold, Barrick’s shares will rise with it. Given their attractive valuation, the shares don’t need this second (optionality) point to work – it offers extra upside. Barrick’s balance sheet has nearly zero debt net of cash. Major risks include the possibility of a decline in gold prices, production problems at its mines, a major acquisition and/or an expropriation of one or more of its mines.

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

Over the past two weeks, commodity gold prices ticked up fractionally to $1,815/ounce while the 10-year Treasury yield jumped to 1.68% and approached its post-pandemic high of about 1.75%. The U.S. Dollar Index, another driver of gold prices (the dollar and gold usually move in opposite directions) was unchanged at 96.21. The index remains about 2% below its pre-Covid late-2019 level of about 99. Per-ounce gold prices seem range-bound between $1,700 and $1,900. Financial markets are largely captive to Fed policy, which is now driven by high and rising inflation. Gold, 10-year Treasury rates and the dollar are caught between the push of higher inflation and the pull of tighter Fed policy. Here, in early in 2022, it appears that the gaping spread between mid-1% Treasury yields and nearly 7% inflation rate will be closed at least partly by rising interest rates. It would seem highly unlikely that the spread remains any wider than three or four percentage points.

Barrick shares rose 2% this past week and have about 44% upside to our 27 price target. The price target is based on 7.5x estimated steady-state EBITDA and a modest premium to our estimate of $25/share of net asset value.

On its recurring $.09/quarter dividend, GOLD shares offer a reasonable 1.9% dividend yield. Barrick paid an additional $0.42/share in special distributions last year (no clarity on 2022 special dividends), lifting the effective dividend yield to 4.2%. BUY

Citigroup (C) – Citi is one of the world’s largest banks, with over $2.4 trillion in assets. The bank’s weak compliance and risk-management culture led to Citi’s disastrous and humiliating experience in the 2009 global financial crisis, which required an enormous government bailout. The successor CEO, Michael Corbat, navigated the bank through the post-crisis period to a position of reasonable stability. Unfinished, though, is the project to restore Citi to a highly profitable banking company, which is the task of new CEO Jane Fraser.

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

Citi shares jumped 8% over the past two weeks and have about 33% upside to our 85 price target. Our timing on the Citi recommendation was a bit early, as the shares subsequently fell about 13%. This had no effect on our interest in Citi – if anything, it made the shares more appealing. At 8.0x estimated 2022 earnings and 93% of tangible book value. Citi shares are among the cheapest in the banking sector – a major attraction as expectations are low. Critically, there is more to the story than just cheap valuation, as Citi is undergoing an aggressive retrench and rebuild turnaround under a highly capable new CEO. As the bank grinds along with its turnaround, the valuation should continue to lift.

The recent surge in the 10-year Treasury yield has helped boost the shares. The Treasury market has shown little concern about inflation. With inflation currently running at 6.8%, Treasuries would produce a negative post-inflation return of about 5% every year – this seems unsustainable. For perspective, a 6.8% inflation rate over ten years produces a near-doubling of the price level. Treasury investors would be left far behind in terms of spending power.

Given this, Treasury yields and inflation rates should eventually converge (perhaps not to the exact same rate but certainly a lot closer than the current 5-percentage point spread). The market still seems convinced that the inflation rate will tumble back to perhaps a 3% pace, such that more aggressive Fed action beyond their likely three rate hikes is not needed.

We see a greater likelihood that when the Fed stops its bond buying program, bond prices and yields will return to the market’s control, for the most part. This will probably result in higher interest rates across the board and would increase Citi’s earning power.

Citigroup investors enjoy a 3.2% dividend yield and perhaps another 3% or more in annual accretion from the bank’s share repurchase program. BUY

ConocoPhillips (COP), based in Houston, Texas, is the world’s largest independent E&P company, with about two-thirds of its production in the United States. Conoco’s shares are depressed, as investors avoid climate-unfriendly companies, have low interest in exposure to volatile and unpredictable oil and gas prices, worry that company management will lose its new-found capital spending discipline, and are concerned that OPEC+ will reopen their spigots, sending oil prices tumbling.

We see resilient oil prices, as demand remains strong, alternatives aren’t yet plentiful enough, supply growth is restrained as shareholders prioritize cash flow rather than capital spending, and as majors seek to reduce their carbon footprint. We like Conoco’s low valuation, investment-grade balance sheet, strong free cash flow, and public commitment to limiting its capital spending to 50% of its annual cash flow. The shares offer a respectable base-level dividend to shareholders that appears rock solid.

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

West Texas Intermediate crude is currently trading at $77.20/barrel, up nearly 10% from two weeks ago, while natural gas in the United States is priced at $3.64, down about 6% from two weeks ago. OPEC recently said it remains committed to its 400,000/barrel per day production increase – oil prices rose as OPEC didn’t increase its production any higher. Global oil and natural gas demand trends continue to look healthy, helped by the increase in global Covid vaccination rates and greater willingness by governments, consumers and businesses to keep economies open. We continue to see little enduring impact from Omicron on demand. Reflecting robust demand and low supplies, global natural gas prices remain nearly 10x (in the $30-50 range) those of domestic U.S. prices. A larger impact would be a major economic slowdown in the U.S. or elsewhere, which we believe is unlikely in the near term.

ConocoPhillips shares jumped 9% in the past two weeks and have about 4% upside to our 80 price target. BUY

Molson Coors Beverage Company (TAP) is one of the world’s largest beverage companies, producing the highly recognized Coors, Molson, Miller and Blue Moon brands as well as numerous local, craft and specialty beers. About two-thirds of its revenues come from the United States, where it holds a 24% market share. Investors worry about Molson Coors’ lack of revenue growth due to its relatively limited offerings of fast-growing hard seltzers and other trendier beverages. Our thesis for this company is straight-forward – a reasonably stable company whose shares sell at an overly discounted price. Its revenues are resilient, it produces generous cash flow and is reducing its debt. A new CEO is helping improve its operating efficiency and expand carefully into more growthier products. The company recently re-instated its dividend.

In the same report that discussed its optimistic view on Coca-Cola, Oppenheimer said it was lukewarm on beer company shares due to ongoing Covid-related restraint by consumers. We’ll set aside the inconsistency in their article – that consumers will go out and buy soft drinks but not beer – and take the gains in KO shares while we wait for the MolsonCoors fundamentals to lift its stock.

TAP shares jumped 9% in the past week and have about 42% upside to our 69 price target. The stock remains cheap, particularly on an EV/EBITDA basis, or enterprise value/cash operating profits, where it trades at 8.1x estimated 2022 results, still among the lowest valuations in the consumer staples group and below other brewing companies. BUY

Organon & Company (OGN) was recently spun off from Merck. It specializes in patented women’s healthcare products and biosimilars, and also has a portfolio of mostly off-patent treatments. Organon will produce better internal growth with some boost through smart yet modest-sized acquisitions. It may eventually divest its Established Brands segment. The management and board appear capable, the company produces robust free cash flow, has modestly elevated debt and will pay a reasonable dividend. Investors have ignored the company, but we believe that Organon will produce at least stable and large free cash flows with a reasonable potential for growth. At our initial recommendation, the stock traded at a highly attractive 4x earnings.

Organon will present at the JPMorgan Healthcare Conference on January 10 at 2:15pm Eastern time. The presentation is open to the general public and accessible through Organon’s investor relations website.

OGN shares rose 6% in the past two weeks and have about 46% upside to our 46 price target (using the same target as the Cabot Turnaround Letter). The shares continue to trade at a remarkably low valuation while offering an attractive 3.6% dividend yield. BUY

Sensata Technologies (ST) is a $3.8 billion (revenues) producer of nearly 47,000 highly engineered sensors used by automotive (60% of revenues), heavy vehicle, industrial and aerospace customers. About two-thirds of its revenues are generated outside of the United States, with China producing about 21%. Investors undervalue Sensata’s durable franchise. Its sensors are typically critical components that generally produce high profit margins. As the sensors’ reliability is vital to safely and performance, customers are reluctant to switch to another supplier that may have lower prices but also lower or unproven quality. Sensata has an arguably under-leveraged balance sheet and generates healthy free cash flow. The relatively new CEO will likely continue to expand the company’s growth potential through acquisitions. Electric vehicles are an opportunity as they expand Sensata’s reachable market.

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

ST shares surged 13% in the past two weeks to an all-time high as the market increasingly recognizes the value of the company’s steady earnings growth, healthy margins, solid business franchise and underleveraged balance sheet. The shares have about 15% upside to our 75 price target. BUY

Disclosure: The chief analyst of the Cabot Undervalued Stocks Advisor personally holds shares of every recommended security, except for “New Buy” recommendations. The chief analyst may purchase or sell recommended securities but not before the fourth day after any changes in recommendation ratings has been emailed to subscribers. “New Buy” recommendations will be purchased by the chief analyst as soon as practical following the fourth day after the newsletter issue has been emailed to subscribers.

Strong Buy – This stock offers an unusually favorable risk/reward trade-off, often one that has been rated as a Buy yet the market has sold aggressively for temporary reasons. We recommend adding to existing positions.
Buy – This stock is worth buying.
Hold – The shares are worth keeping but the risk/return trade-off is not favorable enough for more buying nor unfavorable enough to warrant selling.
Sell – This stock is approaching or has reached our price target, its value has become permanently impaired or changes in its risk or other traits warrant a sale.

Note for stock table: For stocks rated Sell, the current price is the sell date price.

The next Cabot Undervalued Stocks Advisor issue will be published on February 2, 2022.