Cabot Value Investor Issue: November 7, 2024

Small-Cap Stocks Are the “Other” Big Election Winners

The election is over, a winner has been swiftly declared, and the Fed is set to cut rates again later today. The market loves it all, as evidenced by Wednesday’s quick burst to new all-time highs. Now that we’ve gotten through the usual pre-election slog, we have arrived on the other side with little damage done and with stocks seemingly primed for their usual November-December run-up – with an assist from the Fed.

Look for the rally to finally spread to small-cap stocks.

Historically, small caps outperform large caps. According to Tyler Laundon, Cabot’s esteemed small-cap stock expert, small caps outpace large caps, on average, in three out of every five years. Over the past five years, however, large caps have blown small caps out of the water: The S&P 500 is up 87% during that time, more than double the 41% gain in the Russell 2000 over the same span. The benchmark small-cap index peaked in November 2021; it currently trades 7% below that high, despite recent momentum.

But I think that momentum is just getting started. The Russell was up more than 7% in the last three months coming into the election and got a hefty 5% boost in trading on Wednesday. It’s not just a matter of “small caps were due.” The double whammy this week of an “America First” candidate being theoretically good for business among smaller companies, which primarily do all their business in America, plus the Fed all but assuredly (99% chance, according to the CME Group’s FedWatch Tool) slashing rates by another 25 basis points later today, is rocket fuel for small caps.

The question is, which small caps should you buy?

Fortunately, as value investors, there’s plenty to choose from in an asset class that’s underperformed the market by more than 50% in the last five years. And given their outlook – small-cap companies are expected to expand their earnings faster than large caps in 2025 – this unloved group is right in our growth-at-value-prices wheelhouse at Cabot Value Investor.

One small-cap stock with a very familiar name stands out to me…

New Buy

The Cheesecake Factory Inc. (CAKE)

Yep, the Cheesecake Factory. Chances are you’ve eaten there, indulged in one of their high-calorie but oh-so-tasty cheesecakes and browsed through menus long enough to be a James Joyce novel. With 345 locations in North America, many of you don’t have to travel far to find one. Lately, more and more people have been making that drive.

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. In the third quarter, reported last week, sales improved by 4.2% while diluted EPS expanded by 65%. Same-store sales increased 1.6%.

The Cheesecake Factory is still expanding, 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.

It’s not the super-fast footprint expansion you see from startups like Cava Group (CAVA) or Dutch Bros (BROS). But considering the company, whose first restaurant opened in Beverly Hills in 1978, is nearly half a century old, it’s solid growth.

But like most restaurant chains, Cheesecake Factory had a rough go during Covid. Sales declined 20% in 2020, and profits are only now getting back to pre-Covid levels. And the stock imploded, nose-diving from a high of 64 in April 2017 to just 17 a share in March 2020. CAKE clawed all the way back to 64 by November 2021…only to come crashing back to 27 by the following July, dragged down by the bear market that year.

Now that stock is up to the 49-50 range, a 52-week high, buoyed by a 7% gain on Wednesday – an indication that restaurant stocks are near the top of the “Trump Trade” beneficiaries, because of his perceived boost to a somewhat stagnant U.S. economy.

Despite the recent runup, CAKE shares trade at just 13.5x 2025 EPS estimates and at 0.64x 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 24% below their 2017 and 2021 highs, there’s plenty of room to run. Given both the potential market and economic tailwinds of a settled election and a Fed rate-cutting program being a boon for small caps as a whole, I think CAKE could reach – or potentially surpass – those 2017 and 2021 highs fairly quickly. Let’s set a price target of 65, 30% higher than the current price.

Even if there is some pullback in the coming days on the heels of Wednesday’s big move, you can use the dividend (2.3% yield; ex-dividend date November 13) as a temporary cushion until shares get going again. 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 Recommendation – The Cheesecake Factory (CAKE)

Capital One Financial (COF) – Move from Buy to Sell/Retire (reached 185 price target!)

Honda Motor Co. (HMC) – Move from Buy to Sell

Gates Industrial (GTES) – Move from Buy to Sell/Retire (reached our 20 price target!)

Last Week’s Portfolio Changes
None

Upcoming Earnings Reports
Friday, November 8 – CNH Industrial (CNH)

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.

Capital One Financial (COF) has reached (topped, in fact) our price target of 185! Trump’s win sent COF shares rocketing up more than 13% on Wednesday, as his anti-regulation stance is deemed bullish for Capital One’s proposed $35 billion deal to buy Discover Financial (DFS) getting done. Could there be more upside ahead? Sure. But at 189 a share, the stock is currently $12 north of its previous highs of 177 and trades at a less appetizing 12.7x forward earnings (COF had previously been in the 10x forward earnings range). Plus, even if the Discover deal does get done within days of Trump being sworn in in January, mergers tend to have a “buy the rumor, sell the news” effect on the acquiring company. So let’s not get greedy. Let’s sell – or, should I say, “retire” COF now that it’s eclipsed our price target for a 25% return in just over three months! MOVE FROM BUY TO SELL

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 13.6x forward earnings estimates and at 1.23x 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.

Dick’s shares tumbled 6% this past week on no news. It’s currently bumping up against August lows in the 190s. With no reason for the pullback and with earnings due out November 26, I’d expect the stock to bounce back soon. DKS shares have 31% upside to our 250 price target. BUY

Honda Motor Co. (HMC) had a bad earnings report, with profits down 20% in the first half of its fiscal year. Car sales in Asia tumbled, with sales in China particularly struggling. Meanwhile, the Japanese automaker lowered its full-year profit forecast by $330 million, to $6.2 billion – lower than the $7.2 billion in profits the company earned last year.

Yikes.

That grim earnings report, out yesterday, not only knocked HMC back 9% to a new 52-week low at 27 but changed our entire calculus. This was a growth-at-value-prices pick … and Honda is no longer growing. HMC has long been the one true laggard in our portfolio, and yesterday’s report and subsequent selloff make this an easy decision. Let’s sell HMC shares and open up another spot down the road in our Growth/Income Portfolio. MOVE FROM BUY TO SELL

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 10.8x 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.

There was no company-specific news for Toll Brothers this week. Shares were off a little more than 1%, including a 4% pullback on Wednesday. Perhaps today’s latest (presumed) Fed rate cut will quickly right the ship for TOL shares. We still have a solid gain on it, and eventually, both interest and mortgage rates will start to fall; TOL – along with other homebuilder stocks – will begin to rise again.

TOL shares have 22% 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 6x forward earnings estimates, with a price-to-sales ratio of just 0.46. The stock peaked at 96 a share in November 2018; it currently trades at 78.

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 just keep motoring higher, up more than 9% since our last issue, with an 8% boost on Wednesday following Trump’s win. There was no company-specific news; rather, UAL continues to go further skyward thanks to a record year for airline travel and the airline’s own success with cutting back on unprofitable routes. Low oil prices are surely helping in that regard as well.

The most recent direct catalyst was United’s October 15 earnings report. The airline reported adjusted EPS of $3.33, down from a year ago but well ahead of the $3.13 consensus estimate. Meanwhile, sales of $14.84 billion came in ahead of the $14.77 billion estimate and did mark a 2.5% year-over-year uptick. On top of it all, United’s board authorized a $1.5 billion share buyback – its first repurchase plan since the company suspended its last one due to Covid, in 2020.

The big post-earnings runup pushed shares above our initial price target of 70, and we decided to sell half our position to book profits and hold the rest. With the stock still way undervalued (7.1x EPS, 0.48x sales) and plenty of wind in its sails, we will keep our Hold a Half rating until there are signs of trouble or momentum fizzling. HOLD A 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) – 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 10x earnings estimates and at just 1.30x sales. A solid dividend (3.1%) adds to the appeal of this mid-cap stock.

Two weeks ago, 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, although they were largely unchanged this week. And the stock remains cheap, trading at 10x forward earnings. The shares have 36% upside to our 10 price target. And now they have momentum. 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.

There was no major company-specific news for Aviva this week. Shares were down another 2% and are now trading at their lowest level since early August. The stock has been in a bit of a rut – down 6.3% in the last month – but the overall trend is still up, with shares up 8.7% YTD.

Aviva remains one of the most reliable stocks in our portfolio and is coming off a strong first half of the year in which it reported 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. And yet, the stock remains cheap, trading at 10x earnings estimates and at a mere 0.32x sales, with a microscopic 0.04 enterprise value/revenue ratio. The 7.2% dividend yield adds to our total return.

The stock has 17% upside to our 14 price target. 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 reports third-quarter earnings tomorrow, November 8. Expectations are quite low: a 22.5% decline in revenues, with a 35.7% dropoff in EPS. The company has beaten estimates in each of the last two quarters, so hopefully these estimates prove overly pessimistic too.

CNH shares were up 1.5% this week ahead of the report and have been trending well of late. They’re still super cheap, trading at 8x forward earnings and 0.64x sales. CNH has 30% upside to our 15 price target. BUY

Gates Industrial Corp. plc (GTES), like Capital One Financial (COF), has reached our price target! It took longer to get there – Gates was recommended by my predecessor, Bruce Kaser, in August 2022. But thanks to a strong Q3 earnings report a week ago, GTES shares have blown past Bruce’s 20 price target, and are now an exact double since Bruce recommended the stock a little over two years ago. Sales and earnings were both down in Q3, despite topping estimates, so I think the prudent move here is to “retire” our GTES position at a 100% profit, and Sell all our shares. That makes for a thorough bit of housecleaning in one issue, as we say goodbye to a third of our existing portfolio (while welcoming in a new small-cap position). But in two of the three cases, we’re bidding the stocks a fond farewell, and a happy retirement.

Take a bow, Bruce! MOVE FROM BUY TO SELL

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

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