August 15, 2024

A New Era of Low Inflation Has Begun

Inflation is dead.

OK, it’s not “dead.” But at 2.9% in July, as reported Wednesday morning, it has now (narrowly) reentered the Federal Reserve’s magical 2% realm for the first time in nearly three and a half years – since March 2021. For all the inflation angst during those past three and a half years, the market has fared pretty well overall – the S&P 500 is up 30% since the first CPI print north of 3% was reported in mid-May of 2021. On a per-year basis, that only slightly trails the average annual return in the large-cap index of 9.90% since its inception in 1928.

So….no harm, no foul? Sort of. We did have to endure a bear market when inflation was peaking in 2022. And when the dust settled on all the selling and a new bull market emerged in late 2022/early 2023, the divide between “haves” (Magnificent Seven/mega-cap tech/artificial intelligence stocks) and “have nots” (basically everything else) was more pronounced than at any other time in the market’s history. Thus, it hasn’t always felt like a true bull market these last 22 months, and unless you loaded up on mega-cap tech and AI plays, odds are your portfolio’s return these last three-plus years has trailed the 30% return in the S&P.

The good news is, the bull market isn’t over! As I wrote in this space a week ago, I didn’t think this was the end – even though things were looking quite precarious after a 13% correction in the Nasdaq and an 8.5% pullback in the S&P on the heels of a less-than-stellar U.S. jobs report, escalating tensions in the Middle East, and the dreaded Japanese “carry trade.” Sure enough, stocks have gotten in gear in the last week, with the S&P up 4.5% and the Nasdaq up more than 6%. It appears the worst is behind us, at least for now.

Does that mean the next leg of the rally will be more egalitarian than it has been for most of the last 22 months? We’ll see. There have been stretches – like in the spring of 2023, November and December of last year, and this July – during which participation in this bull market has been more widespread, with small caps, value stocks and many unloved sectors joining the party. But those stretches have been fleeting. Hopefully, a low inflation rate will translate to better market breadth, as it did from 2012-2020, a nine-year stretch in which inflation never topped 3%. During that time, the S&P Equal Weight Index (+179%) mostly kept pace with the S&P 500 (+193%), despite often heavy weightings from the likes of Apple (AAPL), Amazon (AMZN), Google (GOOG) and some of the other usual Big Tech suspects.

Hopefully, this new period of low inflation will produce similar across-the-board returns.

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

Send questions and comments to chris@cabotwealth.com.

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This Week’s Portfolio Changes
None

Last Week’s Portfolio Changes
United Airlines (UAL) Moves from Buy to Hold

Upcoming Earnings Reports
Thursday, August 22 – Canadian Solar (CSIQ)

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.

Canadian Solar Inc. (CSIQ) is not only Canada’s largest solar energy company; it’s a global leader in the solar space. And it’s gotten much larger in the last two years, since the Canadian government announced a 50% income tax cut for zero-emission technology manufacturers (which the new 2023 legislation extended by three years). Canadian Solar’s revenues were up 41.5% in 2022, another 2% in 2023 (both record highs), and are on track to tack on another 1.2% this year and a whopping 20.2% in 2025. If it meets those estimates, the company will have gone from $3.5 billion in annual revenues to $8.25 billion in just five years. Earnings per share have more than doubled since 2021, and while they’re expected to take a step back this year, they’re projected to reach new highs of $4.75 per share next year.

And the company is right in the sweet spot for the North American solar boom. It manufactures solar photovoltaic modules and runs large-scale solar projects across Canada, and in 29 other countries, even spinning off a subsidiary – CSI Solar Ltd. – last year that trades on the Shanghai Stock Exchange. The company boasts 61 gigawatt (GW) module capacity, is up to 125GW solar module shipments, and has a project pipeline of 26.3GW. That doesn’t include its battery storage shipments (4.5 GW hours, or GWh) or capacity (20GWh expected by year’s end).

It’s a big company that operates on a global scale, and it’s growing fast. And yet … the stock is a small cap, with a market capitalization of less than $1 billion. It used to be four times as big, trading as high as 63 a share in January 2021. Today, it trades at 14 a share, and at 6x forward earnings, 37% of book value, and a paltry 0.14x sales. It’s the cheapest the stock has ever been.

There was no company-specific news for Canadian Solar this week, and the stock barely budged, at least in the aggregate – it was up until Wednesday’s 3% pullback, also on no news. The stock has been disappointing thus far, but a potential catalyst looms in the form of earnings next Thursday, August 22. Expectations are quite low, with analysts anticipating big year-over-year drop-offs in sales and earnings. But last quarter, Canadian Solar topped EPS estimates by 2,000%, sparking a nice multi-week rally in the share price. Let’s hope for a similar result next week.

CSIQ shares have a whopping 93% upside to our 28 price target. BUY

Capital One Financial (COF) is a diversified bank that provides banking services to consumers and businesses, as well as auto loans. Though it is probably best known for its credit cards – if you watch any TV, you’re probably familiar with its, “What’s in your wallet?” tagline. It’s the fourth largest credit card company in the U.S., with $272.6 billion in purchase volume in the first half of 2023 alone. And it’s on the cusp of getting even bigger: Capital One is in the process of acquiring fellow credit card giant Discover Financial (DFS) for $35 billion. If approved, the deal could be completed either later this year or early next year and would make Capital One the largest credit card issuer in the U.S. and the sixth-largest U.S. bank by assets.

Even absent the Discover buyout, Capital One is growing just fine on its own. Its revenues have expanded from $28.5 billion in 2020 to $36.8 billion in 2023; this year, they’re expected to swell another 5%, to $38.7, with another 5% uptick estimated in 2025.

And yet the stock is cheap, trading at a mere 10x forward earnings estimates, 88% of book value, and 1.36x sales. The share price peaked at 177 exactly three years ago, in August 2021; it currently trades at 135 a share.

The bank has caught Warren Buffett’s attention. In May 2023, Berkshire Hathaway disclosed that it had taken out a nearly $1 billion stake in Capital One. With earnings per share expected to rise more than 25% by the end of 2025, and with Discover Financial possibly adding an even greater windfall should the deal gain approval, it’s easy to see why the Oracle of Omaha likes it.

There was no company-specific news for Capital One this week.

The stock appears to have bottomed 10 days ago, at 131, after the weak jobs report and the accompanying recession fears took a chunk out of financials in particular. While those fears still loom to a degree, so does the prospect of the Discover deal closing. It appears to be gaining momentum, as legal experts have expressed skepticism as to whether the antitrust concerns holding up the deal carry much weight. The Federal Reserve and the Office of the Comptroller of the Currency are currently reviewing the acquisition proposal, and Capital One executives are confident the deal will gain approval either later this year or early next.

With that major catalyst dangling out there, COF shares have 35% upside to our 185 price target, which may even be conservative should the deal gain approval, as expected. BUY

Dick’s Sporting Goods (DKS) has been growing steadily for years.

From 2016 to 2023, the sporting goods chain’s revenues have improved 64%, from just under $8 billion to just under $13 billion. This year, the top line is on track to top $13 billion for the first time. It should top $13.5 billion next year.

Dick’s, in fact, has grown sales in each of the last seven years – including in 2020 and 2021, when most other retailers saw sales nosedive due to Covid restrictions. But Dick’s all-weather ability to keep growing no matter what’s happening in the world or the economy speaks to its versatility. Since Covid ended, however, Dick’s sales have entered another stratosphere. As youth sports returned in 2021, Dick’s revenues jumped from $9.58 billion to $12.29 billion. They’ve been rising steadily each year since and are expected to do so again this year.

But Dick’s isn’t purely a growth stock—it’s also undervalued. DKS shares currently trade at just 16x forward earnings estimates and at 1.38x sales. To be sure, it’s not the cheapest stock in our portfolio. But it is one of the fastest growing – and pays a solid dividend to boot.

Now that’s more like it! DKS shares, despite no company-specific news this week, were up 9%, erasing all their losses from the first week of August. Of course, that merely continues the pattern of massive ups and downs week to week in this suddenly volatile stock. If the stock is up again next week, we may really have something.

Regardless of the week-to-week gyrations, the intermediate-term trajectory is decidedly up (+47% year to date) and plenty of upside remains – I’ve given DKS shares a 250 price target, 16% higher than the current price. BUY

Honda Motor Co. (HMC) – After years of declining sales, Honda was rejuvenated in 2023 thanks to hybrids. The Japanese automaker sold 1.3 million cars last year, up 33% from 2022; a quarter of the cars it sold were hybrids, led by its popular CR-V sport utility vehicle (SUV) and Accord mid-size sedan. The CR-V was the best-selling hybrid in the U.S. last year, with 197,317 units sold. The Accord wasn’t far behind, with 96,323 sold. All told, Honda’s hybrid sales nearly tripled in 2023, to 294,000 units.

So, Honda is making the full pivot to hybrids, with the Civic soon to become the latest addition to its hybrid fleet. Investors have started gravitating more to the companies that sell them. Invariably, those are well-established, big-name car companies made famous by many decades of selling internal combustion engine vehicles; most aren’t ready to fully abandon their roots but want to tap into the surging national (and global) appetite for electric, so they instead are turning to hybrids as a compromise. As a result, these once-stodgy car companies are tapping into new revenue streams, and their share prices are surging accordingly.

Among the hybrid-rejuvenated, brand-name automakers, Honda offers the best value.

Honda reported another strong, hybrid car-fueled quarter last Wednesday. In its fiscal first quarter of 2025, the Japanese carmaker reported an 8.7% year-over-year profit increase on a 17% improvement in global sales, assisted by a 9% uptick in U.S. sales – thanks to growing demand for its hybrid vehicle models here. A weak yen also had a hand in the company’s profitable quarter, adding nearly 48 billion yen ($326 million) to Honda’s quarterly operating profit. A spike in motorcycle sales in Brazil, India and North America also helped the company offset weakness in China, where total sales tumbled 23% due to escalating competition, rampant price cuts and a shift toward all-electric vehicles – an area in which Honda is still playing catch-up. Still, the company maintained its full-year operating profit forecast of 1.42 trillion yen.

HMC shares are up since the report, but only by a point (29 to 30), and appear to have put in a temporary bottom. Looking at the big picture, things look bright: Honda just had another good quarter thanks primarily to the catalyst that convinced us to add it to the Value Investor portfolio – soaring hybrid sales, particularly in the U.S.

HMC shares are off to a slow start for us but have become laughably cheap for a major global automaker, trading at 6x forward earnings estimates and 0.34x sales. The stock has 47% upside to our 45 price target. The 4.5% dividend yield helps tide us over until the share price becomes more in line with the company’s value. BUY

Philip Morris International (PM) – Based in Connecticut, Philip Morris owns the global non-U.S. rights to sell Marlboro cigarettes, the world’s best-selling cigarette brand. Cigarettes comprise about 65% of PMI’s revenues. The balance of its revenues is produced by smoke-free tobacco products. The cigarette franchise produces steady revenues and profits while its smoke-free products are profitable and growing quickly. The upcoming full launch of IQOS products in the United States, a wider launch of the IQOS ILUMA product and the recent $14 billion acquisition of Swedish Match should help drive new growth.

The company is highly profitable, generates strong free cash flow and carries only modestly elevated debt (at about 3.2x EBITDA) which it will whittle lower over the next few years. Primary risks include an acceleration of volume declines and/or deteriorating pricing, higher excise taxes, new regulatory or legal issues, slowing adoption of its new products, and higher marketing costs. A strong U.S. dollar will weigh on reported results. While unlikely, Philip Morris could acquire Altria, thus reuniting the global Marlboro franchise.

Philip Morris shares are on the cusp of reaching our 120 price target.

The stock has been gathering momentum since the company reported another solid quarter in late July. Revenue improved 9.6% year over year in the second quarter, while earnings per share of $1.59, while down slightly (-0.6%) year over year, beat estimates. The cigarette maker’s smoke-free products continued to carry the day, with nicotine pouch sales – led by its signature Zyn product – up 50.6%, while heated tobacco items (led by IQOS) improved 13.1% in shipment volume. Both offset what were essentially stagnant cigarette sales (0.4% uptick in shipment volume). Smoke-free products now account for 38% of Philip Morris’ total revenues.

The rosy quarter was good enough to prompt the company to lift full-year EPS guidance from 9% to 11% growth to 11% to 13% growth.

PM shares are up more than 9% since the report, reaching two-year highs above 117. It’s within 2% of our 120 price target. The 4.4% dividend yield adds to what is now a solid total return since the stock was added to the portfolio last September. BUY

United Airlines (UAL) – People are flying in planes again in Covid’s aftermath, and no major airline is taking advantage of it quite like United.

United Airlines is the fastest-growing major U.S. airline. The third-largest airline carrier in the world by revenues behind Delta (DAL) and American (AAL), United is expected to grow sales by 5.9% in 2024 – more than its two larger competitors – and that’s with revenues already topping a record $50 billion in 2023 – 19.6% higher than in 2022, which was also a record year. For United, business has not only returned to pre-pandemic levels; it’s better.

Meanwhile, the stock is super cheap. It trades at a mere 4x forward earnings estimates, with a price-to-sales ratio of just 0.24 and a price-to-book value of 1.28. The stock peaked at 96 a share in November 2018; it currently trades at 40.

A company that’s making more money than ever before (gross profits reached a record $15.2 billion last year, though earnings were still second to 2019 levels on a per-share basis), and yet its stock trades at barely more than half its peak from five and a half years ago. A true growth-at-value-prices opportunity.

There was no company-specific news for United this week, though airline stocks have ceased their recent slide, and UAL shares are up 4% since we last wrote. The stock’s precipitous three-month fall from 55 to 39 prompted us to downgrade it to Hold last week, and we’ll keep it right there until it can demonstrate a bit more stability. But there’s no denying the value – few big-cap stocks that are growing sales (+5.7% in Q2) and earnings (+23.1%) like United can be had for cheaper, at the moment. If you want to buy it here, I won’t argue with you. But we’ll keep our official rating at Hold for now. HOLD

Buy Low Opportunities Portfolio

Buy Low Opportunities Portfolio stocks include a wide range of value opportunities. These stocks carry higher risk than our Growth & Income stocks yet also offer more potential 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.

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 U.K., 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. While activist investor Cevian Capital has closed out its previous 5.2% stake, highly regarded value investor Dodge & Cox now holds a 5.0% stake, providing a valuable imprimatur and as well as ongoing pressure on the company to maintain shareholder-friendly actions.

Aviva reported earnings on Wednesday, and they were solid.

The London-based life insurance and investment management provider reported first-half (rather than quarterly) 2024 results, with operating profits of £875 million, up 14% from the first half of 2023 and ahead of analyst estimates. Insurance premiums increased 15%, which helped, as did a 49% boost in its protections business thanks in large part to the company’s acquisition of AIG Life earlier this year.

The strong quarter prompted this note from Jefferies analyst James Pierce: “Aviva continues to demonstrate strong delivery versus its targets, beating consensus expectations across all its headline metrics. In our view, Aviva remains the only U.K. insurer that can reliably deliver long-term special capital returns, accretive M&A (mergers and acquisitions), attractive ordinary dividend growth, and consistent earnings-per-share growth.”

“Consistent” is precisely how I would describe the company and the stock. AVVIY shares are up nearly 6% since our last issue, recovering the losses from the previous week’s market sell-off. And yet the stock remains cheap, trading at a mere 12.6x earnings estimates and 0.42x sales. The stock still has 10% upside to our 14 price target, though given today’s earnings growth, it’s possible we’ll need to raise that target.

The growing and high-yielding (6.6% yield) dividend adds to Aviva’s appeal – and our total return thus far. BUY

CNH Industrial (CNH) – This company is a major producer of agriculture (80% of sales) and construction (20% of sales) equipment and is the #2 ag equipment producer in North America (behind Deere). Its shares have slid from their peak and now trade essentially unchanged over the past 20 years. While investors see an average cyclical company at the cusp of a downturn, with a complicated history and share structure, we see a high-quality and financially strong company that is improving its business prospects and is simplifying itself yet whose shares are trading at a highly discounted price.

CNH again reported mixed earnings results two weeks ago.

Revenue declined “only” 16% year over year to $5.49 billion, beating analyst estimates of $5.32 billion. Earnings per share of 38 cents were in line with analyst expectations but down from 52 cents in the same quarter a year ago. The company also lowered full-year profit guidance, down to a range of $1.30 to $1.40 from a previous range of $1.45 to $1.55. Declining crop prices coupled with higher production costs have hit farms hard around the world of late, thus lowering demand for farming equipment.

CNH shares were up 3% initially after the report but have retreated about 8% since, likely due to a combination of the market pullback and investors not loving the underwhelming results. CNH shares are quite cheap, trading at less than 7x earnings estimates and 0.54x sales.

Given the recent weakness in the stock (down from highs above 13 in early April), we will maintain our Hold rating for now. HOLD

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. Following several sell-downs, Blackstone has a 27% stake today.

Gates Industrial also reported earnings two weeks ago, and its results were also mixed.

Earnings per share of 36 cents narrowly topped estimates of 35 cents and were flat year over year. Sales, however, fell just shy of estimates ($885.5 million vs. $893 million expected) and were down 5.4% year over year. The relatively “blah” report – neither good nor overly bad – initially triggered some fierce selling in GTES shares (the stock was down 13% in the first week of August), but it appears the worst is behind it, and the stock was up 2.5% this week. It remains our best performer, up more than 55%, and the stock has 20% upside to our 20 price target. BUY

NOV, Inc (NOV) – This high-quality, mid-cap company, formerly named National Oilwell Varco, builds drilling rigs and produces a wide range of gear, aftermarket parts and related services for efficiently drilling and completing wells, producing oil and natural gas, constructing wind towers and kitting drillships. About 64% of its revenues are generated outside of the United States. Its emphasis on proprietary technologies makes it a leader in both hardware, software and digital innovations, while strong economies of scale in manufacturing and distribution as well as research and development further boost its competitive edge. The company’s large installed base helps stabilize its revenues through recurring sales of replacement parts and related services.

We see the consensus view as overly pessimistic, given the company’s strong position in an industry with improving conditions, backed by capable company leadership and a conservative balance sheet.

NOV reported Q2 earnings in late July, and unlike CNH and Gates, it had a great quarter!

Revenue ($2.22 billion) improved 5.9% from the second quarter of 2023; earnings per share ($0.57) improved 46%; and profit margins increased from 7.4% to 10%. Its adjusted EBITDA margin came in at 12.7%, the highest since 2015. Energy equipment accounted for more than half of total revenues ($1.2 billion) and was up 8% year over year.

Investors liked what they saw from NOV, and shares were up more than 12% in the first week after the report, bringing them to within an inch of new 2024 highs. Unfortunately, market forces – and tumbling crude oil prices (as low as $72 a barrel last week) – sent shares tumbling right back to where they were before earnings, in the high 17s. That’s where they remain now, but with crude oil prices rising again, perhaps the share price will as well, especially if oil can stay above $80 a barrel again.

The stock is 36% below our 24 price target. And shares are quite cheap, trading at less than 11x earnings estimates and at 0.79x sales. BUY

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

Current price is yesterday’s mid-day price.

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