Cabot Value Investor Issue: January 8, 2025

Is 2025 Finally the Year of the Small Cap?

Small caps are starting to become Charlie Brown when Lucy pulls the football away.

Last fall, after years of underperformance, it seemed like small caps were finally about to kick the football. From Labor Day to Thanksgiving, the Russell 2000 was up 16.8%, decisively outpacing the 10.7% run-up in the S&P 500 and even the Magnificent Seven-aided 14.2% rally in the Nasdaq during that time.

Then the last six weeks happened, and small caps were flat on their back screaming, “Aaugh!!” yet again, a la Charlie. Since the Thanksgiving top, small-cap stocks have fallen nearly 8%, at a time when the S&P and Nasdaq are down a mere 2%-2.5%. After finally poking its head above new all-time highs in late November, the Russell is now unbudged since the start of 2022 and hasn’t beaten the S&P since 2019. For an asset class that historically outperforms its large-cap brethren – three out of every five years, according to Cabot’s small-cap expert Tyler Laundon – this is a significant cold streak.

At 26.2x forward 12-month earnings estimates, the Russell 2000 is now slightly cheaper than the Nasdaq (26.4x), an extremely rare occurrence. Small caps are speculative by nature, and many don’t turn a profit at all, so for them to be technically cheaper than an index fronted by cash cows like Amazon (AMZN), Apple (AAPL), Nvidia (NVDA) and Microsoft (MSFT) shows just how neglected they’ve been.

But there are reasons to believe that 2025 could finally be small caps’ year.

For one, small-cap companies are expected to grow faster (17.5%) than large caps (14.5%) this year. That used to be a given, but not in recent years. Small-cap earnings per share have contracted in each of the last two years, by -14.2% in 2023 and by an estimated -3.2% last year, according to EPS figures aggregated by FactSet. That’s mostly due to the Federal Reserve, which has put an even bigger dent in small caps than large caps since most smaller companies do the majority of their business on U.S. soil – where business has been slowed first by high inflation and, more recently, high borrowing costs. Now, with both numbers coming down as the Fed finally started slashing interest rates in September and looks to cut by at least another 50 basis points this year, it should make for a friendlier and more profitable environment for small caps.

Sprinkle in the value – small caps are trading at just over a third of their valuations from three years ago and at roughly half their valuations from two years ago – and the case for small caps has rarely been more air-tight. Now, we just need to see it for longer than two or three months. As former Cabot CEO Tim Lutts used to say, “Investment trends last longer than most people expect.” Reversing a trend like small-cap underperformance can be like trying to turn around a cargo ship that gets stuck in the Suez Canal. Once it happens, though, the shift could go quickly, with money pouring into small caps from either the record $6.9 trillion that’s currently sitting in money market funds or extracted from the Mag. Seven and artificial intelligence stocks that gobbled up the lion’s share of investment dollars over the last two years of this still-young bull market.

The conditions are ripe for a small-cap resurgence. And there are legions of small-cap stocks that have either flown under Wall Street’s radar or been beaten into submission these last few years. Today’s pick falls decidedly into the latter category…

New Buy

Peloton Interactive (PTON)

Few companies encapsulate the rise-and-fall of the Covid economy and market like Peloton (PTON).

Chances are, you know the name, or possibly own a Peloton yourself (I do!). It’s the stationary bike with a built-in touch screen that contains a world of interactive fitness programs run by professional trainers in real-time, so you can bike, do yoga, lift weights, do cardio workouts, etc., with a network of 3.7 million other subscribers. You pay a monthly fee for the privilege (about $46, the equivalent of a gym membership), and about $2,100 for the bike itself. There’s also a treadmill offering now – the Peloton Tread+ is the most souped-up version – which costs a bit more than the bike.

When the pandemic arrived in 2020 and forced us all to become shut-ins for a year or so, seemingly everyone bought a Peloton. Indeed, the company’s sales ballooned from less than a billion dollars in Fiscal 2019 (its fiscal year runs from July through June) to $4 billion in Fiscal 2021, which ended right around the time people were starting to return to society. Once that happened, people stopped buying Pelotons. So sales contracted: to $3.58 billion in FY ’22, to $2.8 billion in FY ’23, to $2.7 billion in FY ’24. In three years, Peloton lost about a third of its Covid-inflated business.

PTON shares went on a much wilder ride. From March 2020, the month Covid shut down most parts of the U.S., to the end of that year, PTON stock went from 19 a share to 162 a share – a run-up of more than 700% in less than nine months. By the second half of 2021, when vaccines were widely available and people started getting together again in the warm summer months, PTON shares had dipped to the 120s – not a precipitous drop-off, but a noticeable downturn. Then, once Peloton’s sales started slipping and you no longer saw a Peloton commercial every time you turned on the television, the bottom fell out in the stock. From July 2021 to July 2022, PTON plummeted from the 120s to less than 10 a share. And they didn’t stop falling for another two years, slumping below 3 per share in both May and August of last year.

While Pelotons themselves remain popular – my wife and I still use ours regularly, as do half the people we know here in Vermont, where an indoor form of exercise is essential to help get you through the long, harsh winters – the stock had become a punchline, a Covid relic that was a flash in the pan in the same way Zoom (ZM), Chegg (CHGG) and several meme stocks were. But now, sales have nearly stopped declining and are poised to possibly grow again starting next fiscal year (which begins in July). Meanwhile, Peloton isn’t hemorrhaging money the way it was the last few years. To be clear, even at its apex, the company was never profitable, and still isn’t. But after suffering EPS declines of -$8.77, -$3.64 and -$1.77 in each of the last three fiscal years (in chronological order), this year (FY ’25, which ends in June) the losses are expected to be -$1.51 and contract to a mere -$0.39 next year. Aggressive cost-cutting – it cut operating expenses by 30% in its most recent quarter thanks to lower payroll and fewer marketing costs (most people know what Peloton is by now) – is helping the company narrow the profit gap. The company is on track to lower costs by about $200 million this fiscal year.

The narrower losses are allowing the company to generate free cash flow – $11 billion in the latest quarter – and actually start putting that cash to work again in an effort to attract and retain more customers. It has invested in software updates such as personalized workout plans and private “teams” for every subscriber. It’s offering new apps such as Strength+ and fitness “games.” And it is exploring new strategic partnerships to broaden its reach and perhaps start attracting new customers again.

Meanwhile, the company just underwent a regime change – always an appealing catalyst for turnaround candidates. Former Ford executive Peter Stern has taken over as CEO, assuming the helm from embattled former CEO Barry McCarthy after two mostly unsuccessful years on the job.

Add it all up, and suddenly there are a lot of potential catalysts for Peloton for the first time since the pandemic. And investors are taking notice. Since that August bottom below 3 per share, PTON stock has nearly tripled. Granted, it’s only up 25% in the last year – in line with the market – but momentum has returned, with shares stretching into double digits in mid-December before pulling back to the mid-8s as of this writing. The stock currently trades at 1.17x sales, about a quarter of its five-year average and galaxies below the 20x P/S ratio from late 2020 and even the 6.9x sales shares were going for in late 2021.

Coming off a quarter in which EPS surprised to the upside by 100% and shares subsequently popped more than 25%, it’s a good time to take a swing at PTON – ahead of its fiscal second-quarter earnings report in a few weeks, and with shares having retreated from their mid-December highs. The average price target on the stock is 9.28, with one analyst going so far as to grant it a 20 price target. That seems a bit aggressive given that sales aren’t supposed to start growing again until next fiscal year, but I think a target of 12 – below its two-year highs above 13, but above that December high in the mid-10s – seems like a reasonable goal. That would give PTON 41% upside from its current price. If the Q2 earnings report surprises to the upside similar to how the Q1 results did, it’s possible PTON could reach our target quickly. And that’s especially true if small-cap stocks finally get in gear. 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 – Peloton (PTON), with a price target of 12

Last Week’s Portfolio Changes

None

Upcoming Earnings Reports

None

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. In 2023, sales improved another 35%, to $85 billion. In 2024, 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.

The Chinese electric vehicle giant sold 207,734 EVs in December, pushing its 2024 total to 1.76 million battery-electric vehicles sold. Total vehicle sales improved 41% for the year, though the biggest jump came in the company’s hybrid models. While fourth-quarter results aren’t due out until March, its sales outpaced Tesla’s for the first time in the third quarter. To me, buying BYD now has the potential to be like buying TSLA shares 10 years ago.

Despite the strong December sales numbers, BYDDY shares are down 6% in the two weeks since the data was released and are bumping up against their December lows. If they find support here, a swift bounce-back could be in order. The stock has 38% upside to our 90 price target, which may prove to be 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 in 2023. In 2024, 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 through the first three quarters of 2024. 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 13.7x 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 25% below their 2017 and 2021 highs, there’s plenty of room to run.

There was no company-specific news for Cheesecake Factory this week, but the stock bounced back, up 2%. Prior to that, the stock had given back most, but not all, of its 10% post-Black Friday bump. It was up 35% in 2024.

The last bit of company-specific 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%. The strong quarter got Wall Street’s attention: six major firms have either upgraded their price target or initiated coverage on CAKE since the report.

CAKE shares have 32% upside to our 65 price target. The 2.1% 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. In 2024, the top line is on track to top $13 billion for the first time. It should top $13.5 billion in 2025.

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 15.4x forward earnings estimates and at 1.4x 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.

There was no company-specific news for Dick’s this week, and shares were up about 1% after a couple down weeks but remain shy of their Christmas highs above 235.

The stock has been on an upward trajectory since reporting earnings in November. It was yet another solid quarter for the sporting apparel giant. 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 are up 8.5% since the earnings report. They have 9% 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 less than 9x estimates – and growing faster than the average bear. In fiscal 2024, revenue improved 10% year over year while adjusted EPS was up 12.7%, which compared favorably to 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 $10.5 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 shares keep holding steady in the mid-120s after a big post-earnings drop-off the second week of December. Interest rates have been holding in place of late, which is better than the early-December spike but still not quite what homebuilders are looking for, especially after the Fed slashed rates by another 25 basis points last month. Mortgage rates remain just south of 7%. Until that number meaningfully comes down, TOL shares are facing an uphill battle.

Eventually, however, the cumulative effect of lower interest rates – even if the Fed slashes rates at a slower pace than anticipated – will show up in both bond yields and, more importantly, mortgage rates. The Fed has already lowered short-term rates from a range of 5.25-5.5% to 4.25-4.5% in the last three-plus months. Another 50 basis points would get them down below 4%. And it won’t stop there.

So, let’s play the long game with TOL. TOL shares have 43% upside to our 180 price target. At less than 9x forward earnings, shares are incredibly cheap. 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 0.58.

A company that’s making more money than ever before (gross profits reached a record $15.2 billion in 2023, 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.

Winter Storm Blair has grounded flights across the country, but it did little to slow UAL shares, which are threatening to break back above all-time highs north of 102. The stock is up 4.5% since last week’s update.

There wasn’t much in the way of company-specific news for United. Earnings are due out January 21.

We sold half our shares in November and are letting the rest ride but are maintaining a Hold rating. Any real turbulence will likely prompt us to bail on this big winner before our remaining profits erode much. For now, though, the stock is still very much in favor, and shares have more than doubled since we added it to the portfolio last May. 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; in 2024, 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 9x earnings estimates and at just 1.21x sales. A solid dividend (3.1%) adds to the appeal of this mid-cap stock.

There’s been no company-specific news for ADT of late, and shares have stabilized the last couple weeks after selling off for most of December. The stock still trades at two-month lows, but perhaps the worst of the selling is over.

In late October, ADT reported earnings that beat on both the top and bottom lines. 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. Now, they’ve fallen back roughly to their pre-earnings levels. So, the stock remains cheap, trading at 9x forward earnings. The shares have 44% 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 as well as ongoing pressure on the company to maintain shareholder-friendly actions.

Aviva has finalized its agreement to buy Direct Line Insurance Group for 3.7 billion pounds ($4.65 billion), creating the largest motor insurance company in the United Kingdom. The deal is expected to be completed by mid-2025. AVVIY shares are down more than 6% since its Direct Line takeover bid was first reported on November 27 – which is normal share price action for the acquiring company. But shares should eventually bounce back, as the Direct Line addition should give this U.K.-based insurance and investment management firm a market cap of $21.2 billion, up from its current $15.6 billion. That gives AVVIY shares 36% upside from their current price. The 7.2% dividend yield should tide us over until shares get going again. BUY

The Cigna Group (CI) 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 $82 billion, 170 million customers in over 30 countries, that pays a dividend (2% 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 hasn’t budged much in two years and trades at a mere 8.9x earnings estimates and 0.35x sales. It’s the cheapest CI shares have been in more than a year.

Why the underperformance? Earnings have been inconsistent, with EPS declining 18.8% in 2023 and by 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 in the latest quarter. And healthcare stocks as a group were the second-worst performer of the 11 major S&P 500 sectors in 2024, up a mere 0.87%. As Baby Boomers reach their golden years, healthcare is more in demand than ever, so the sector won’t stay down long. And CI has a habit of outperforming when times are good.

Cigna shares finally had a good week, despite an analyst downgrade. CI was up 1.3% since our last issue, which qualifies as a victory on the heels of a six-week slump. There wasn’t much news, other than Truist lowering its price target on the stock from 420 to 390 while maintaining a Buy rating. That 390 price target is still 40% higher than the current price.

We downgraded CI to Hold a few weeks after it got off to a rough start due to factors that had very little to do with the company specifically. Let’s keep it at Hold until we see more momentum. HOLD

The next Cabot Value Investor issue will be published on February 6, 2025.

Copyright © 2025. 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.