Cabot Value Investor Issue: December 5, 2024

Market Party Is On, but No One Invited Healthcare Stocks (Yet)

The across-the-board market rally in the month since Donald Trump was elected to a second term in the White House has been both encouraging and not all that surprising, as stocks tend to rally in the weeks and months following a presidential election. The S&P 500 is up about 6% since the election, but perhaps more tellingly, the Equal Weight S&P index is up more than 4%, meaning this isn’t just a thin, Magnificent 7-fueled rally that we’re accustomed to seeing over the last couple years. The post-election rally has touched almost every sector. Almost.

The lone exception? Healthcare.

As a group, healthcare stocks are the only one of the 11 S&P sectors that’s down in the last month. Granted, the -0.6% pullback is hardly catastrophic. But when you consider that no other sector has a gain of less than 1.4% over the last month, it stands out. And the reason for the underperformance has everything to do with the following five letters: RFK Jr.

Yes, while Trump’s return to office has been popular on Wall Street, his appointment of Robert F. Kennedy Jr. as secretary of the U.S. Department of Health and Human Services hasn’t been. That’s because, in some corners, Kennedy is viewed as a radical and potentially dangerous “health czar” due to his hardline stance against vaccinations of all types and his track record for spreading health misinformation. Now, whether or not you agree with those criticisms doesn’t matter, at least not when it comes to your portfolio. What matters is what the market thinks.

Of course, the market – like people – often overreacts. Just like knee-jerk reactions to one underwhelming data point in an earnings report can lead to a 10-15% sell-off in the ensuing days (increasingly often, it seems), only to have the stock slowly creep its way back once Wall Street realized it may have overreacted, that seems to be what’s happening with healthcare stocks. After falling nearly 4% in the week that followed the RFK announcement, the sector has clawed its way back exactly to pre-appointment levels. It seems investors are starting to think they overreacted, and that having RFK Jr. as health czar won’t be such a bad thing for healthcare companies (or that he won’t get confirmed at all).

Still, with healthcare-related stocks the only sector that’s down in the last month and the worst-performing sector period this year, with a mere 7.7% return in 2024, that spells opportunity for value investors like us. The need for healthcare isn’t going away. In fact, as my colleague Tom Hutchinson writes frequently in his Cabot Dividend Investor advisory, as 75 million Baby Boomers enter their golden years, the need for healthcare has never been greater.

So today, we add a large-cap, hiding-in-plain-sight healthcare stock that has actually outperformed in the last month, but hasn’t made up much ground in the last two years …

New Buy

The Cigna Group (CI)

Cigna is the fifth-largest healthcare company in the U.S., with $229 billion in revenue over the last 12 months. It’s a health benefits and medical care provider with a market cap of $92 billion, 170 million customers in over 30 countries, that pays a dividend (1.7% yield) and is on track to grow sales by 25% and earnings by 13.5% this year and another 10.8% next year. And yet, the stock is down 9% from its September peak around 366 and trades at roughly the same price it did two years ago, in December 2022. Its return on equity (ROE) over the last 12 months is a mere 7.9%, well below the 13% average ROE.

Why the underperformance? Earnings have been inconsistent, with EPS declining 18.8% last year and 31.4% in 2021. But that appears to be changing, with double-digit growth expected both this year and next, led by its Evernorth Health Services branch, which reported 36% revenue growth (to $52.5 billion) in the third quarter thanks to organic growth in its Specialty and Care Services wing, plus new client wins. Overall, EPS improved 10.9% in Q3 on an adjusted basis, which discounts a $1 billion non-cash investment loss in VillageMD, in which Evernorth holds a minority stake. VillageMD is a Chicago-based startup that operates doctor-staffed clinics; things aren’t going great – VillageMD has had to scale back expansion as its clinics aren’t attracting enough patients. Cigna’s $2.5 billion investment in the startup looks like a bad deal, but the worst of the losses are likely in the rearview mirror.

That should clear the way for more unfettered growth from Cigna. Meanwhile, the stock is cheap, trading at 10.6x forward earnings estimates and a paltry 0.42x sales. Its enterprise value/revenue ratio is also small at just 0.52. This is the cheapest CI shares have been across the board in more than a year, despite the fact that the stock has actually outperformed healthcare stocks by essentially a 2-to-1 margin over the last year, with a 23% return. But it’s down 9% from the highs and hasn’t gone anywhere in two years, mostly due to uneven profit growth. Now that those appear to be more consistent, CI looks cheap, and Wall Street is starting to take notice: shares are actually up 4.6% in the last month and the average analyst target on the stock is 399, 21% higher than the current price.

Even at 399 a share, that would still be just 12.6x next year’s earnings, which seems conservative. So let’s set a more aggressive target of 420, giving CI shares a 27% upside from the current price. With a low beta (0.51) and two years of stagnation, it could take some time to get there. So let’s add the stock to our Buy Low Opportunities portfolio and let it marinate for the next year while healthcare stocks play catch-up to the rest of the 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
New Buy – The Cigna Group (CI), with a 420 price target

Last Week’s Portfolio Changes
New Buy – BYD Inc. (BYDDY), with a 90 price target

Upcoming Earnings Reports
Monday, December 9 – Toll Brothers (TOL)

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.

BYD Company Limited (BYDDY) has long been one of China’s top automakers. What really sent its sales into hyperdrive, however, was when it made the switch to all battery electric and hybrid plug-in vehicles in 2022. Revenues instantly tripled, going from $22.7 billion in 2020 (a record, despite the pandemic) to $63 billion in 2022. Last year, sales improved another 35%, to $85 billion. This year, it’s on track for $106.4 billion, or 25% growth, with another 20% growth expected in 2025. The EV maker has emerged as a legitimate rival to Tesla.

But there’s even greater upside. Right now, BYD does roughly 90% of its business in China, accounting for one-third of the country’s total sales of EVs and hybrids this year. The company is trying to change that, recently opening its full-assembly plant outside of China, with a new plant in Thailand starting deliveries. A plant in Uzbekistan puts together partially assembled vehicles. A plant in Brazil is expected to open early next year. And BYD has plans to open more new plants in Cambodia, Hungary, Indonesia, Pakistan and Turkey. Mexico and Vietnam are possible targets as well. Despite no plans to do business in America just yet, BYD is on the verge of becoming a global brand.

And while BYDDY stock has fared well, it hasn’t grown as fast as the company. At 15.4x earnings estimates, BYDDY currently trades at less than 20% of its five-year average forward P/E ratio (89.6). And its price-to-sales (1.04) ratio is about half the normal five-year ratio. As BYD continues to expand globally, look for its valuation to catch up with its industry-leading performance.

BYD is off to a somewhat slow start in its first two weeks in the portfolio. Shares are down about 1.7% as the company has reignited its price war in China with Tesla in time for the holidays. BYD is offering 1,000 to 3,000 yuan off some models, though Tesla has outdone it by offering a 10,000-yuan discount plus five-year, 0% loans on its Model Y SUVs in December. So, it’s possible that could move the needle more toward Tesla in China over the next month. But the simple fact that Tesla felt the need to out-discount BYD shows you how much Elon Musk views BYD as a threat in the world’s largest market – and possibly a threat in other parts of the world as BYD expands.

BYD’s November sales further enhanced its emergence as a true rival to Tesla. It sold a record 506,804 electric vehicles, up 67.9% from last November and nearly 10% more than the 462,890 EVs Tesla sold in the entire third quarter! That, in a nutshell, is why we added BYDDY to the Cabot Value Investor portfolio two weeks ago. BYD is becoming an equal to Tesla. But Wall Street has yet to treat it as such. Thus, we set a 90 price target on the stock, giving it 39% upside from here. Long term, that seems pretty conservative. BUY

The Cheesecake Factory Inc. (CAKE) is ubiquitous. With 345 North American locations, chances are you’ve eaten at one, indulged in their specialty high-calorie but oh-so-tasty cheesecakes and browsed through menus long enough to be a James Joyce novel. But despite being seemingly everywhere already and nearly a half-century old, the company is still growing.

Sales have improved every year since Covid (2020), reaching a record $3.44 billion last year. This year, revenues are on track for $3.57 billion. But the earnings growth is the real selling point. EPS more than doubled in 2023 (to $2.10 from 87 cents in 2022) and are estimated to swell to $3.31 in 2024, a 57.6% improvement, and to $3.69 next year.

It’s still expanding too, opening 17 new restaurants year to date. It expects to open a total of 22 new restaurants by year’s end. Those aren’t just Cheesecake Factories – the company also owns North Italia, a handmade pizza and pasta chain; Flower Child, a health food chain that caters to those with special diets (vegetarians, vegans, gluten-free, etc.); and Blanco, a Mexican chain owned by Fox Restaurant Concepts, which The Cheesecake Factory Corp. acquired in 2019.

Despite some recent strength in the stock, CAKE shares trade at just 13.8x 2025 EPS estimates and at 0.69x sales. The bottom-line valuation is well below the five-year average forward P/E ratio of 15.6; the price-to-sales ratio is in line with the five-year average.

With shares trading at roughly 20% below their 2017 and 2021 highs, there’s plenty of room to run.

There’s been no company-specific news for The Cheesecake Factory since we last wrote. And yet, CAKE shares – perhaps due to a combination of a strong market and the onset of the holiday shopping season – are up nearly 10%. The last bit of news came in late October when the company reported Q3 earnings, which were solid. Sales improved by 4.2% while diluted EPS expanded by 65%. Same-store sales increased 1.6%. Initially, the impressive quarter did little for the share price. Perhaps now it’s playing catch-up.

I’ve set a price target of 65, 28% higher than the current price. The 2.2% dividend yield adds to the appeal. 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 14.2x forward earnings estimates and at 1.29x 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.

Another stellar quarter has helped DKS shares get their groove back.

Both sales and earnings topped estimates and, perhaps more importantly, the company raised full-year same-store sales guidance to a range of 3.6% to 4.2%, up from the previous range of 2.5% to 3.5%. Earnings per share improved 15% year over year, while sales ticked up only slightly. The company credited a robust back-to-school shopping season for its strength in the third quarter. Also, Dick’s is expanding its new House of Sport concept – 100,000-square-foot arenas that feature rock climbing walls and running tracks. It expects to open 15 new ones next year and is aiming for a range of 75 to 100 nationwide by 2027.

DKS shares, after slumping for weeks prior to the earnings report, are up 10% since the report. They have 18% upside to our 250 price target. BUY

Toll Brothers (TOL) – Historically, when the Fed cuts interest rates, homebuilder stocks are among the first to benefit. Indeed, in 2019 and early 2020 (before Covid hit), during which the Fed cut rates from 2.5% to 1.5%, homebuilder stocks were up 64%, more than double the 30% bump in the S&P 500. Now, with the Fed finally cutting rates for the first time in four and a half years, the homebuilders are undervalued, trading at 13x forward earnings. Toll Brothers is even cheaper, trading at 10.7x estimates – and growing faster than the average bear. In fiscal 2024, analysts anticipate 19% EPS growth on 7.5% revenue growth, both of which would easily top 2023 results (13.6% EPS growth on a 2.7% downturn in revenues).

Toll Brothers isn’t the biggest homebuilder in the U.S. – its $10 billion in revenue last year paled in comparison to the likes of D.R. Horton’s ($35 billion), PulteGroup’s ($16 billion), or Berkshire Hathaway holding Lennar’s ($34 billion). But it’s cheaper and growing faster than all of them.

Toll Brothers reports earnings next Monday, December 9. Analysts anticipated 5% sales growth and 5.6% EPS growth. The company has beaten bottom-line estimates by double digits in each of the last four quarters, so perhaps the numbers are again conservative. We’ll see.

In the meantime, TOL shares are up 3.5% in the last two weeks as interest rates are starting to finally come down again, with mortgage rates dipping to their lowest point (6.34%) in six weeks. The stock is doing its job as an undervalued play on a lower-interest-rate environment, with shares up 12% in three months. TOL still has 15% upside to our 180 price target. 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 scant 7.7x forward earnings estimates, with a price-to-sales ratio of just 0.56. The stock peaked at 96 a share in November 2018; it currently trades at 94.

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.

United shares remain airborne! The stock is up another 4% in the last two weeks, likely getting a boost from the usual Thanksgiving week travel boom (anecdotally, my family and I rode on two jam-packed United flights over break – a surprisingly pleasant experience). United expects its busiest holiday season ever, with 60 nonstop flights a day from U.S. airports to European ones in November and December.

At 98 a share as of Wednesday afternoon, UAL shares have broken above the previous high of 96 (set in 2018!). If you want to sell here, with a nearly 100% profit in the seven months since we recommended the stock, I won’t argue with you. It’s blown well past our 70 price target, and we booked profit on half the position once it did. But given the market strength and UAL’s tendency to just keep rising of late, officially, I’ll hang on to our remaining half until the stock encounters some turbulence. HOLD HALF

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.

ADT Inc. (ADT) is literally a household name.

It’s a 150-year-old home security company whose octagon-shaped blue signs with white lettering that say “Secured by ADT” are ever-present in neighborhoods across the country. ADT provides security to millions of American homes and businesses, with products ranging from security cameras, alarms and smoke & CO detectors, to door/window/glass break sensors and more, all of which can alert one of ADT’s industry-best six 24/7 monitoring centers if any one of those security systems is breached.

Business has been fairly stable, with annual revenues hovering in the $5 billion range for four of the last five years (2021 was an exception, with a dip down to $4.2 billion during Covid) and is on track to do it again both this year and next. But where the century-and-a-half-old company has really improved of late is profitability. The last two years marked the first time the company has been in the black in consecutive years, with earnings per share going from 15 cents in 2022 to 51 cents in 2023; this year, EPS is expected to improve another 43%, to 73 cents, and then to 83 cents (+14%) in 2025.

All of that EPS growth makes the share price look quite cheap. ADT shares currently trade at just under 10x earnings estimates and at just 1.33x sales. A solid dividend (3.1%) adds to the appeal of this mid-cap stock.

There’s been no news for ADT of late, and shares have been mostly stagnant in the 7.5 to 7.6 range.

In late October, ADT reported earnings that beat on both the top and bottom lines, prompting a 7% boost in shares since. Adjusted EPS of 20 cents topped 17-cent estimates, while revenues ($1.24 billion) narrowly edged estimates ($1.22 billion), and marked a 5% year-over-year improvement. EBITDA ($659 million) also came in slightly higher than expectations. Meanwhile, the company maintained its full-year revenue guidance of $4.9 billion and raised EPS guidance to 73 cents at the midpoint – a 3.6% increase. Its recurring monthly revenue reached $359 million, a new record.

The numbers weren’t jaw-dropping, but there was a lot to like in the report, and investors quickly snatched up ADT shares accordingly – they were trading below 7 prior to the report. But the stock remains cheap, trading at less than 10x forward earnings. The shares have 32% upside to our 10 price target. 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 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.

AVVIY shares were virtually unchanged the last two weeks despite making some news. The U.K.-based life insurance and investment management firm is launching a 3.4 billion-pound ($4.2 billion) takeover bid of rival Direct Line Insurance Group. If successful, it would create one of Britain’s largest car insurers. Direct Line rejected the initial deal, so Aviva may need to up its price. The company is being advised by both Goldman Sachs and Citigroup on the takeover bid, which bodes well. We’ll see where it goes; if approved, adding a major car insurer like Direct Line could raise Aviva’s ceiling, and perhaps give it more upside than the 14 price target we have on it. BUY

The next Cabot Value Investor issue will be published on January 9, 2025.

Copyright © 2024. All rights reserved. Copying or electronic transmission of this information without permission is a violation of copyright law. For the protection of our subscribers, copyright violations will result in immediate termination of all subscriptions without refund. Disclosures: Cabot Wealth Network exists to serve you, our readers. We derive 100% of our revenue, or close to it, from selling subscriptions to our publications. Neither Cabot Wealth Network nor our employees are compensated in any way by the companies whose stocks we recommend or providers of associated financial services. Employees of Cabot Wealth Network may own some of the stocks recommended by our advisory services. Disclaimer: Sources of information are believed to be reliable but they are not guaranteed to be complete or error-free. Recommendations, opinions or suggestions are given with the understanding that subscribers acting on information assume all risks involved. Buy/Sell Recommendations: are made in regular issues, updates, or alerts by email and on the private subscriber website. Subscribers agree to adhere to all terms and conditions which can be found on CabotWealth.com and are subject to change. Violations will result in termination of all subscriptions without refund in addition to any civil and criminal penalties available under the law.