January 10, 2023

An Opening Rebound

We’re only a week into the new year, but it’s been a good start for your value stocks. On average, prices of the stocks on the recommended list (excluding ARCO, which we sold last week) have increased nearly 7%. This is a favorable start, both in absolute terms and relative to the 3% jump in the S&P 500 Index.

Like most years, stocks discarded for tax-loss selling, window-dressing and other technical reasons in December are rebounding in January. Most of your value stocks felt the December pressure as the underlying companies are generally viewed as being more cyclical than the broad market. So, a post-year-end rebound makes sense, helped by some supportive labor market news last week that strengthened investors’ conviction that the Fed may soon taper or end its rate hike program.

This year, like all years, has 52 weeks, with the first week having no predictive value whatsoever regarding what happens in the remaining 51 weeks. Earnings season (starting this week) will likely be filled with surprises both favorable and unfavorable. The rest of the year will no doubt include surprises on the economy, inflation, corporate earnings, labor markets, capital markets, global geopolitics and other factors.

The stocks on the recommended list, while generally cyclical, are also generally high quality – with the exceptions of Big Lots (BIG) and possibly Organon (OGN) and Citigroup (C) – so they offer enduring value well beyond the volatility driven by optimistic or pessimistic near-term investor sentiment.

Share prices in the table reflect Monday, January 9 closing prices. Please note that prices in the discussion below are based on mid-day January 9 prices.

Note to new subscribers: You can find additional color on our thesis, recent earnings reports and other news on recommended companies in prior editions of the Cabot Undervalued Stocks Advisor, particularly the monthly edition, on the Cabot website.

Send questions and comments to Bruce@CabotWealth.com.

Today’s Portfolio Changes
None.

Last Week’s Portfolio Changes
Arcos Dorados (ARCO) – Moving the shares from Hold to Sell.

Upcoming earnings reports
Citigroup (C) – Friday, January 13
State Street Corporation (STT) – Friday, January 20
Sensata Technologies (ST) – Tuesday, January 31
Gates Industrial Corporation (GTES) – Monday, February 13
Barrick Gold (GOLD) – Monday, February 13

GROWTH/INCOME PORTFOLIO

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 week.

CSCO shares rose 3% for the week and have 35% upside to our 66 price target. The valuation is attractive at 9.2x EV/EBITDA and 13.8x earnings per share. The 3.1% dividend yield adds to the appeal of this stock. BUY

Comcast Corporation (CMCSA) – With $120 billion in revenues, Comcast is one of the world’s largest media and entertainment companies. Its properties include Comcast cable television, NBCUniversal (movie studios, theme parks, NBC, Telemundo and Peacock), and Sky media. The Roberts family holds a near-controlling stake in Comcast. Comcast shares have tumbled as worry about cyclical and secular declines in advertising revenues and a secular decline in cable subscriptions as consumers shift toward streaming services, as well as rising programming costs and incremental competitive pressure as phone companies upgrade their fiber networks.

However, Comcast is a well-run, solidly profitable and stable company that will likely continue to successfully fend off intense competition while increasing its revenues and profits, as it has for decades. The company generates immense free cash flow which is more than enough to support its reasonable debt level, pay a generous dividend (recently raised 8%) and sizeable share buybacks.

The company promoted the Deputy CFO and nine-year Comcast finance executive to the CFO role, following the promotion of CFO Mike Cavanaugh to president. We see this transition as generally uneventful but wonder if the shuffling was to keep senior executives on board, as there is no path to the chief executive seat given the Roberts family’s lock on the position. One likely motivation is that incoming CFO Jason Armstrong brings a fresh perspective, particularly with his sell-side experience as the former head of Goldman Sachs’ cable and telecom research group.

Comcast shares rose 8% for the past week and have 11% upside to our 42 price target. The shares offer an attractive 2.9% dividend yield. BUY

Dow Inc. (DOW) is the world’s largest producer of ethylene and 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). Recent concerns about a recession have send Dow shares to well-below our estimate of their fair value, even as the company’s long-term prospects and ability to maintain its dividend are attractive. Dow shares are a recommended Buy in our sister publication The Cabot Turnaround Letter.

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

Dow shares rose 10% in the past week and have 8% upside to our 60 price target (same as in the Cabot Turnaround Letter). The quarterly dividend appears readily sustainable and provides an appealing 5.0% yield. The shares trade at a modest 6.9x EV/EBITDA multiple and 12.7x EPS on recession-minded 2023 estimates. BUY

State Street Corporation (STT) – State Street is the world’s largest custodian bank, with $38 trillion in assets under custody/administration. About 56% of its revenues are produced from custody, client reporting, electronic trading and full enterprise solutions services for investment managers. The balance is produced from investment management fees on ETFs, foreign exchange fees, securities financing fees and net interest income. The industry has combined into four dominant firms due to economies of scale. State Street’s shares are out of favor and unchanged since 2007 due to concerns over its anemic growth and steady pricing pressure from competitors. However, we see State Street as a solid, well-capitalized franchise that provides critical services, with a slow-growth but steady revenue and earnings stream. Our interest in STT shares is that we can buy them at an attractive valuation. We also find the dividend yield appealing.

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

State Street shares rose 5% in the past week and have 15% upside to our 94 price target. The company’s dividend (3.1% yield) is well-supported and backed by management’s strong commitment. BUY

BUY LOW OPPORTUNITIES PORTFOLIO

Allison Transmission Holdings, Inc. (ALSN) – Allison Transmission is a midcap manufacturer of vehicle transmissions. While many investors view this company as a low-margin producer of car and light truck transmissions that is destined for obscurity in an electric vehicle world, Allison actually produces no car or light truck transmissions. Rather, it focuses on the school bus and Class 6-8 heavy-duty truck categories, where it holds an 80% market share. Its EBITDA margin is sharply higher than its competitors and on-par with many specialty manufacturers. And, it is a leading producer and innovator in electric axles which all electric trucks will require. The company generates considerable free cash flow and has a low-debt balance sheet. Its capable leadership team keeps its shareholders in mind, as the company has reduced its share count by 38% in the past five years.

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

ALSN shares rose 2% in the past week and have 13% upside to our 48 price target. The stock pays a respectable and sustainable 2.0% dividend yield. BUY

Aviva, plc (AVVIY), based in London, is a major European company specializing in life insurance, savings and investment management products. Amanda Blanc, hired as CEO in July 2020, is revitalizing Aviva’s core UK, Ireland and Canada operations following her divestiture of other global businesses. The company now has excess capital which it is returning to shareholders as likely hefty dividends following a sizeable share repurchase program. We expect that activist investor Cevian Capital, which holds a 5.2% stake, will keep pressuring the company to maintain shareholder-friendly actions.

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

Aviva shares rose 4% in the past week and have 26% upside to our 14 price target. Based on management’s estimated dividend for 2023, the shares offer a generous 6.8% yield. 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 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 week, commodity gold lifted 2% to 1,881/ounce. The commodity was essentially flat in 2022 as rising interest rates depressed its appeal and as the U.S. dollar was impressively strong. Early 2023 optimism that the Fed will relent on its rate hike campaign plus expectations for further weakness in the dollar are helping gold prices. The 10-year Treasury yield slid to 3.57% while the U.S. Dollar Index (the dollar and gold usually move in opposite directions), fell 1% to 103.11. The dollar has fallen 10% from its high of 114.10 this past September 26.

Investors and commentators offer a wide range of outlooks for the economy, interest rates and inflation. We have our views but hold these as more of a general framework than a high conviction posture. Investing in gold-related equities is a long-term decision – investors shouldn’t allow near-term weakness to deter their resolve.

Barrick shares rose 12% in the past week and have 41% upside to our 27 price target. Our resolve with Barrick shares remains undaunted through the recent sell-off. BUY

Big Lots (BIG) – Big Lots is a discount general merchandise retailer based in Columbus, Ohio, with 1,431 stores across 47 states. Its stores offer an assortment of furniture, hard and soft home goods, apparel, electronics, food and consumables as well as seasonal merchandise. Our initial case for Big Lots rested with its loyal and growing base of 22 million rewards members, its appeal to bargain-seeking customers, the relatively stable (albeit low) cash operating profit margin, its positive free cash flow, debt-free balance sheet and low share valuation. Our thesis was deeply rattled by the company’s surprisingly large inventory glut in the first quarter 2022, likely burdening it with new and permanent debt.

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

Big Lots shares remain high-risk due to the permanent debt balance and the likelihood of a suspension of the dividend.

We reiterate our view that Big Lots shareholders who are not willing or able to sustain further losses in the shares should sell now. There is no reasonably definable floor to a stock like Big Lots when fundamentals and valuation are ignored while investors reduce their risk exposure.

Big Lots shares jumped 15% this past week and have 48% upside to our revised 25 price target. The shares offer a 7.5% dividend yield, although, as noted, investors should not rely on this dividend being sustained. HOLD

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.

Citigroup reports fourth-quarter earnings this Friday. The consensus earnings estimate is $1.19/share.

This past week, the yield spread between the 90-day T-bill and the 10-year Treasury bond, which approximates the drivers behind Citi’s net interest margin, widened sharply to negative-104 basis points (100 basis points in one percentage point). Short-term rates rose nearly 20 basis points while long term rates slipped about 20 basis points. This spread is the widest since at least the early 1980s. Our interpretation is that investors are assuming that the Fed rate hikes and other macro drivers will drag inflation down to sub-5% or less this year. Given that the inflation metrics are flattening out or declining (inflation over the past four or five months has been tame at sub-3%), this assumption seems reasonable. The next CPI data will be released this Thursday, January 12.

Citi shares trade at 59% of tangible book value and 7.3x estimated 2023 earnings. The remarkably low valuations assume an unrealistically dim future for Citi.

Citi shares rose 6% in the past week and have 77% upside to our 85 price target. Citigroup investors enjoy a 4.3% dividend yield. We anticipate that the bank is done with share buybacks until there is more clarity on the economic and capital market outlook, which could readily be a year or more away. BUY

Gates Industrial Corp, plc (GTES) – Gates is a specialized producer of industrial drive belts and tubing. While this niche might sound unimpressive, Gates has become a leading global manufacturer by producing premium and innovative products. Its customers depend on heavy-duty vehicles, robots, production and warehouse machines and other equipment to operate without fail, so the belts and hydraulic tubing that power these must be exceptionally reliable. Few buyers would balk at a reasonable price premium on a small-priced part from Gates if it means their million-dollar equipment keeps running. Even in automobiles, which comprise roughly 43% of its revenues, Gates’ belts are nearly industry-standard for their reliability and value. Helping provide revenue stability, over 60% of its sales are for replacements. Gates is well-positioned to prosper in an electric vehicle world, as its average content per EV, which require water pumps and other thermal management components for the battery and inverters, is likely to be considerably higher than its average content per gas-powered vehicle.

The company produces wide EBITDA margins, has a reasonable debt balance and generates considerable free cash flow. The management is high-quality. In 2014, private equity firm Blackstone acquired Gates and significantly improved its product line-up and quality, operating efficiency, culture and financial performance. Gates completed its IPO in 2018, with Blackstone retaining a 63% stake today.

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

GTES shares rose 9% in the past week and have 13% upside to our 14 price target. At the current price and based on estimated 2022 results, the shares offer a 10% free cash flow yield (free cash flow divided by market cap). This is a discount to what the company is worth. 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.

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

TAP shares slipped 1% in the past week and have 36% 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 8.3x estimated 2023 results, still among the lowest valuations in the consumer staples group and below other brewing companies. BUY

Organon & Company (OGN), a spin-off from Merck, specializes in patented women’s healthcare products and biosimilars, and also has a portfolio of mostly off-patent treatments. It may eventually divest its Established Brands segment. The management and board appear capable as they work to boost internal growth augmented by modest-sized acquisitions. The company produces robust free cash flow, has modestly elevated debt and pays a reasonable dividend.

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

OGN shares rose 6% in the past week and have 56% upside to our 46 price target (using the same target as the Cabot Turnaround Letter). The shares offer an attractive 3.8% 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.

While the memory chip (DRAM and NAND) markets are sliding into a deep cyclical downturn (should recover in perhaps 9-15 months), the sensor chip market is experiencing only a mild downturn. The more specialized nature of sensor chips (less vulnerable to supply gluts compared to commodity chips), combined with the resilience in demand for cars and other primary end-markets in the current cycle (compared to the sharper current downturn in demand for smartphones and PCs), is buttressing sensor chip pricing and volumes.

ST shares rose 9% in the past week and have 70% upside to our 75 price target. Our price target looks optimistic in light of the broad market sell-off, but we will keep it for now, even as it may take longer for the shares to reach it. BUY

*Note: DOW price is based on April 1, 2019 closing price following spin-off from DWDP.

Buy – This stock is worth buying.
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.
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.

Current price is yesterday’s mid-day price.
CSCO: Estimates are for fiscal years ending in July of 2023 and 2024