Cabot Value Investor Issue: August 1, 2024

With Rate Cuts Imminent, It’s Time to Buy Another Bank Stock

Rumors of the U.S. economy’s death were greatly exaggerated.

It’s been two years since the dreaded yield curve inverted. When that happens, it’s historically been a sure sign that a recession is soon to follow. Only once before, in the mid-1960s, has the U.S. economy managed to defy the yield curve and evade an ensuing recession. Now, 24 months later and with no recession in sight (in fact, GDP is growing faster than expected!), this could be the second time it’s avoided that supposed death knell.

In addition to 2.8% GDP growth in the second quarter, consumer spending accelerated faster than expected (2.3% vs. 1.5% estimated), and with nearly half of all large-cap companies reporting, second-quarter corporate earnings growth is at 9.8%, which would be the highest since the Covid-inflated 31.3% growth in the fourth quarter of 2021.

This is a healthy economy, and with interest rates having peaked a year ago (and most likely coming down starting in September) and inflation inching toward the Fed’s magic 2% number, it could get even better. Outside of technology and communications companies, which have gotten a major assist from the artificial intelligence boom, no sector is growing earnings faster than financials. According to FactSet, the average large-cap financial company has grown earnings by 15% year over year in the second quarter. And yet, financials are the second cheapest of the 11 major S&P 500 sectors, trading at an average of less than 14x forward earnings.

Double-digit growth and well-below-average valuations (the S&P as a whole trades at 21x forward earnings) is a great recipe for finding stocks with massive upside. So today, we add a financial company that does a little bit of everything. And Warren Buffett added it to his Berkshire Hathaway portfolio just over a year ago…

New Buy

Capital One Financial (COF)

Capital One Financial is one of those American companies that feels ubiquitous.

From their nonstop television commercials featuring Samuel L. Jackson, Spike Lee, Charles Barkley, and Jennifer Garner (among others) and their catchy, “What’s In Your Wallet?” slogan, to their sponsorship of college football’s Orange Bowl (er, I should say, the “Capital One Orange Bowl”), to its myriad bank branches (it has 280 of them across the U.S.), Capital One seems like it’s been around forever.

And yet, it hasn’t. The company is only 30 years old almost to the day, founded on July 21, 1994. It’s 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, hence the “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, according to U.S. News and World Report. 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.

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. Earnings per share are expected to expand 5% this year and 20.6% next year.

Those estimates may be modest, as they don’t necessarily account for the impact of lower interest rates. Capital One has been growing steadily despite high borrowing costs for things like auto loans and credit cards, which may soon be less of an obstacle.

COF stock is having a nice year, up more than 16% and currently trading at a new 52-week high. And yet, shares remain cheap at 11.4x forward earnings estimates, 1.54x sales and exactly 1x book value. The share price peaked at 177 exactly three years ago, in August 2021; it currently trades at 152 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. To be sure, that’s a modest stake by Berkshire’s standards – it represents less than 1% of the company’s portfolio. Nevertheless, COF shares are up nearly 70% since Buffett’s bet on it.

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, let’s set a price target of 185. Even at current estimates, reaching that share price would only give COF a forward price-to-earnings ratio of roughly 14 – the average valuation of large-cap financials at the moment. A 185 price target gives us 22% upside from the current share price. I think it could get there quickly, especially once the Fed starts cutting rates.

Trading at 52-week highs, we can’t in good conscience put Capital One in the Buy Low Opportunities portfolio to give us five stocks in each of our two portfolios. It belongs in the Growth/Income section, especially because it pays a modest (1.6% yield) dividend. But since growth at value prices has been my main objective since taking over this portfolio, the skew toward the growth-oriented portfolio feels about right in this bull market. BUY

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.

Also, please join me and my colleague Brad Simmerman on our weekly investment podcast, Cabot Street Check. You can find it wherever you get your podcasts, or you can watch us on the Cabot Wealth Network YouTube channel.

This Week’s Portfolio Changes
Capital One Financial (COF) – New Buy with a 185 price target

Last Week’s Portfolio Changes
None

Upcoming Earnings Reports
Wednesday, August 7 – Honda Motor Co. (HMC)

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 a mere $1.1 billion. It used to be four times as big, trading as high as 63 a share in January 2021. Today, it trades at 16 a share, and at 7x forward earnings, 42% of book value, and a paltry 0.16x sales. The latter two numbers are the cheapest the stock has ever been.

There was no news for Canadian Solar this week, and the stock scarcely budged. In another down week for the market, that’s not a bad thing. It seems the worst is behind CSIQ, as the stock bottomed at 14 a month ago. Unlike most stocks, CSIQ shares had a very good July, up more than 17%. Renewed strength in the small-cap space undoubtedly helped – the Russell 2000 was up 10% in July – and Canadian Solar’s own microscopic value is certainly helping its cause. Plus, after years of selling, renewable energy stocks are starting to gain traction, up more than 4.5% in July.

CSIQ shares have 68% upside to our 28 price target. 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 under 16x forward earnings estimates and at 1.34x 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.

Back and forth Dick’s shares have gone, up 10% three weeks ago, down 6% two weeks ago, and now up 6% this past week. There’s been no company-specific news precipitating such wild swings, mind you. General market volatility – and a confusing U.S. retail climate – have likely played prominent roles in all the ups and downs. The stock is still trading well below its mid-July highs above 226 and has 17% upside to our 250 price target. We have a solid gain on DKS through the first month. 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 reports earnings next Wednesday, August 7.

The Japanese automaker has grown sales by double digits in each of the last four quarters; a fifth straight quarter of double-digit gains would demonstrate the brand’s resilience in a tough global retail climate. Toyota’s earnings report today (August 1) could offer some clues as to how Honda might fare.

HMC shares were up 3% this week, though they remain in the 31-32 range they’ve been in for the past two months. Perhaps next week’s earnings can change that for the better.

HMC has 39% upside to our 45 price target. The stock remains dirt cheap, trading at less than 7x forward earnings, 0.39x sales and at just 62% of book value. The 4.2% dividend yield adds to the appeal. 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. The share valuation at about 15.1x EBITDA and 18.2x per-share earnings estimates is still too low in our view. 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 is still riding the high of its strong second quarter, reported a little more than a week ago.

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.

The strong earnings results have catapulted PM shares to a two-year high above 115, with gains coming both before and after the report. The stock is now within 5% of our 120 price target. The 4.8% 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 less than 5x forward earnings estimates, with a price-to-sales ratio of just 0.28 and a price-to-book value of 1.46. The stock peaked at 96 a share in November 2018; it’s currently in the upper 40s.

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.

UAL shares were down about 1.5% this week as investors continue to process the company’s mixed earnings report from two weeks ago.

Profits improved 23% year over year and handily topped estimates. Revenues, meanwhile, improved 5.7% year over year but fell just short of estimates. Third-quarter guidance also came in a bit light, though full-year EPS guidance ($9-$11) remained the same.

Record demand, particularly for international flights, in the wake of Covid has been driving sales growth for United, which was our main premise (in addition to the bargain price) for buying it. The latest quarterly data, despite falling just shy of estimates in a couple places, only enhanced that thesis.

UAL shares have 51% upside to our 70 price target. And the stock remains the cheapest in our portfolio. It can’t stay this cheap much longer before the institutions spot a bargain. BUY

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.

There’s been no news for Aviva, and yet the stock has topped the ever-elusive 13 level for the first time in more than two years.

It’s possible the company is still gaining traction from a 249-million-pound deal to buy Probitas, announced a few weeks back, which should expand Aviva’s market reach in its global corporate and specialty division. Even at two-year highs, shares of the U.K.-based life insurance and investment management firm remain cheap, trading at 12x earnings estimates, with a price-to-sales ratio of 0.42. Shares are closing in on our 14 price target, with 7.6% upside still to go. Earnings are due out August 14, which could push it over the top. The 6.4% dividend yield adds to our strong 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 reported mixed second-quarter earnings results on Wednesday.

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.

Despite all that, CNH shares were up 3% in early Wednesday trading, and are up 5% since we last wrote. It’s possible investors are focusing on the fact that sales weren’t as bad as expected. Meanwhile, CNH shares are quite cheap, trading at 7x earnings estimates and 0.56x sales.

Let’s see how shares respond in the coming week after investors have more than a few hours to digest the Q2 results. For now, we’ll maintain our Hold rating. 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 on Wednesday 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 – did little to dampen investor enthusiasm, at least initially, as GTES shares were up about 2% in early Wednesday trading, and are up 3% since our last update.

We now have a portfolio-best 67% gain on GTES. The stock still has 12% 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 last Thursday, 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 are up more than 12% since the report. They’re closing in on a 2024 high, though they’ll have to punch through 21 resistance to get there.

The stock is now just 15% below our 24 price target. And shares are still relatively cheap, trading at 14x earnings estimates and at 0.92x sales. BUY

The next Cabot Value Investor issue will be published on September 5, 2024.

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