Cabot Value Investor Issue: October 3, 2024

Rate Cut Gains; Now, Chaos Reigns

The market doesn’t like uncertainty or chaos. And right now, there’s plenty of both.

We are one month out from a presidential election and the winner remains uncertain amidst one of the tightest races – at least according to the polls – in recent memory. Meanwhile, war in the Middle East has escalated and spread to Lebanon and Iran, all within the last week. A massive hurricane just leveled a wide swath of the southeastern U.S., leaving more than 160 dead and hundreds more still missing. Finally, 45,000 dockworkers went on strike at 36 U.S. ports between Maine and Texas, a development that (once again) threatens to create major supply chain issues if it drags on for long.

That’s a lot for investors to worry about, and it comes during the traditional “spooky season” – October, the month in which the market has bottomed in each of the last four years.

And yet, stocks are coming off a surprisingly strong September, thanks primarily to the Fed, whose 50-basis point rate cut helped send both the S&P 500 and the Dow (but, notably, not the Nasdaq) to new all-time highs by month’s end. So it’s hard to read too much into a couple down days to open October. Still, things feel very unsettled in the world right now, and there are plenty of macro headwinds that could derail the momentum stemming from the elation that followed (and preceded) the Fed’s decision to cut rates for the first time in four and a half years. It’s why volatility, as measured by the VIX, has spiked to its highest level in nearly a month.

All of that uncertainty means it’s a good time to add a lower-risk play to the Cabot Value Investor portfolio. So, while I thought about adding a small-cap stock now that that long-ignored segment of the market appears poised to play catch-up in a lower-rate environment, or a Chinese stock in the wake of the Chinese central bank and government’s myriad stimulus measures announced last month, to the portfolio, both asset classes felt a little risky for my taste given the uncertain backdrop I just discussed. Instead, with our Buy Low Opportunities looking a bit light these days with only three current holdings, I sought out deep value in a stable, growing company that – for whatever reason – the market has largely overlooked of late.

Fittingly, I found that security in a well-established company that specializes in … security.

New Buy

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. Billed as the “First Security System Network,” ADT was founded in 1874 by Edward Callahan who, after a nighttime break-in at his Baltimore home, created a telegraph-based “call box” that could signal for assistance to a central office, connecting 50 other homes in his neighborhood to it. He called it “American District Telegraph,” and it was incorporated that summer as the first-ever residential security system network.

Today, 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. It recently added an ADT+ app and Trusted Neighbor offering that allows customers to grant access to trusted neighbors or friends when they’re away from home (or their small business) with just a few clicks from their phone. And the Google Nest camera system allows customers to see what’s going on inside and outside their house/business from virtually anywhere. At a time when break-ins at small businesses in particular are on the rise, the Nest system offers peace of mind.

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 33%, to 68 cents, and then to 83 cents (+22%) in 2025.

All of that EPS growth makes the share price look quite cheap.

Despite its 150-year history, ADT didn’t become a public company until January 2018, with an IPO price of 14. It’s never gotten back to its IPO price since and currently trades at exactly half that price at 7 per share. But for the first time in a while, it has some momentum, up more than 18% in the last year, although it’s down from its July highs just under 8. Now that the company is not only solidly profitable but growing profits at double-digit rates, the share price looks woefully undervalued, trading at just 9.7x estimates and 1.26x sales. A solid dividend (3.1%) adds to the appeal.

Just a mid-cap stock ($6.5 billion market cap) that can be volatile at times (it has a beta of 1.53), ADT is far from a no-risk stock. But the combination of value and growth gives shares way more upside than down, in my opinion. The average price target among the six Wall Street analysts who cover the stock is 9, or 27% above the current share price. But even a share price of 9 would mean it would be trading at 10.8x 2025 earnings estimates – still quite cheap. So, let’s set our sights a bit higher and start with a price target of 10, giving it 41% upside to the current price. Considering the stock nearly reached that level in early 2023, I think that’s a reasonable expectation. 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
None

Last Week’s Portfolio Changes
CNH Industrial (CNH) Moves from Hold to Buy

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

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

And yet the stock is cheap, trading at 10x forward earnings estimates, 97% of book value, and 1.49x sales. The share price peaked at 177 a little over three years ago, in August 2021; it currently trades at 146.

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

There’s been no news for Capital One of late, and the stock held its ground this week after a modest bump in the wake of the Fed rate cut. The company is still awaiting its big catalyst – approval of the Discover deal – which executives are optimistic will occur by either later this year or early next year. If approved, it would give Capital One its own payment network, making it less reliant on Visa and Mastercard and adding $2.7 billion in synergies by 2027, according to management.

Third-quarter earnings are likely the nearer-term potential catalyst, and they will be reported on October 24.

In the meantime, COF has 27% upside to our 185 price target while we wait. 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 14x forward earnings estimates and at 1.28x 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 were down 5% this past week for no good reason. There was no real company-specific news other than that it’s extending a two-decade-long partnership with Synchrony Financial (SYF) to offer its ScoreRewards Credit Card program, which offers regular customers discounts, rewards and account management. But that’s not moving the needle in either direction for DKS shares.

DKS has been very up-and-down in the last two months, with shares bottoming at 194 in early August and topping out at 239 later that month. It’s currently closer to the bottom of that range, which, given the lack of bad news that would warrant a pullback, makes this a great entry point. DKS shares have 22% upside to our 250 price target. 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 just keeps holding in the 31-32 range on no news. The next real catalyst may not come until next month, when the company reports earnings. Although that may depend on the market and its appetite for value stocks, which has been improving of late (see United Airlines, below).

And there’s certainly deep value here, with HMC shares trading at the bargain-basement values of 6.4x earnings, 0.35x sales, and a mere 53% of book value. It has 40% upside to our 45 price target. The 4.2% dividend yield helps while we wait for Wall Street to catch on to the value. 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 10.6x estimates – and growing faster than the average bear. In fiscal 2024, analysts anticipate 18.4% EPS growth on 7.1% 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, and the stock mostly held its ground after advancing more than 23% in the last two months. Most of TOL’s gains occurred before the Fed’s rate cut, so it’s likely that they were mostly baked in, at least in the short term.

TOL shares have 17% upside to our 180 price target. Up roughly 10% in the first month since we added it to the portfolio, it’s possible that price target is conservative. BUY

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

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

Meanwhile, the stock is super cheap. It trades at a mere 4.7x forward earnings estimates, with a price-to-sales ratio of just 0.34 and a price-to-book value of 1.75. The stock peaked at 96 a share in November 2018; it currently trades at 55.

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.

Another week, another solid jump in the UAL share price, with shares advancing another 3%, at one point reaching new two-year highs above 58 before pulling back to the 55-56 range. There was no major news. UAL is in the midst of a remarkable turnaround in the last two months after bottoming below 39 a share.

Why the sudden strength? The summer travel boom surely helped. 2024 is on track for record airline travel numbers, with full-year revenue expected to eclipse $1 trillion! United itself flew a record 44 million-plus passengers in the second quarter and set a daily record of 565,000 passengers. Meanwhile, the United app is the most downloaded airline app, with 89% of customers engaging digitally on their travel days. And the low oil prices have been helping keep costs down for United and other airlines.

Add it all up, and then sprinkle in the dirt-cheap value, and you can see why investors have been piling in of late. Whether UAL can sustain that momentum will likely depend on the results of its third-quarter earnings report, which is due out on October 16.

The stock has 25% upside to our 70 price target. And now we have a solid, double-digit gain on it. 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 was no company-specific news for Aviva this week. Shares were down 4%, dipping below 13 for the first time in nearly a month. After struggling to top 12.7 for most of the first half of the year, AVVIY has been mostly above 13 a share the last couple months.

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 10.5x earnings estimates and at a mere 0.33x sales, with a microscopic 0.06 enterprise value/revenue ratio. The 6.7% dividend yield adds to our total return. The stock has 9% upside to our 14 price target, though given the still-cheap valuation, we may need to raise that target soon. 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.

There’s been no news for CNH since it was added to the S&P MidCap 400 index last week, which seems to have been a shot in the arm for the share price. While the stock didn’t budge this past week, it’s up 10% in the last month, with the index upgrade being the only news.

CNH shares remain dirt-cheap, trading at less than 8x forward earnings estimates and 0.63x sales. We upgraded the stock back to Buy last week and will maintain our price target of 15, 35% higher than the current price. BUY

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.

There was no news for Gates this week. The only recent news came a couple weeks ago when the company announced that it was introducing something called a “cooling hose.” Called the Data Master Cooling Hose, it’s a product intended to enhance performance and cleanliness in data centers. Specifically, it makes for easier assembly, routing and handling in data centers. Demand for “cooling solutions” in data centers has been on the rise, and Gates is meeting that demand with its new hose. We’ll see how the cooling hose impacts the company’s bottom line.

Whether it’s related or not, GTES shares have picked up steam of late, advancing about 7% in the last three weeks. GTES shares are up more than 60% since they were added to the Cabot Value Investor portfolio – our best-performing position. Yet, trading at less than 11x forward earnings, they still have 14% upside to our 20 price target. BUY

The next Cabot Value Investor issue will be published on November 7, 2024.

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