January 23, 2024

A Few Words (or Numbers) on the Federal Debt

According to credit rating agency Moody’s, debt obligations of the United States federal government are “judged to be of the highest quality, subject to the lowest level of credit risk” and thus are worthy of a “AAA” credit rating.

The other two major credit rating agencies, Standard & Poor’s and Fitch, disagree. These firms place an “AA+” rating on federal debt. For its part, Moody’s is not fully convinced of its AAA rating, as it recently added a “negative” label, implying that the rating is no longer “stable.”

What is going on here, and is there anything to worry about? As the old saying goes, “Assets come and go, but debt is forever.” We think the federal debt, and the deficits that fuel its growth, is among the primary defining issues for investors for the next 20 years.

A few years ago, modern monetary theory, or MMT, was in vogue. This theory held that the U.S. Treasury could never default on its obligations because it could always print the dollars necessary to service them. We absolutely agree that this part of MMT is completely true.

But, the next logical step for the MMT theory was that the government can therefore borrow however much it wants, without worry. This extension, plus ultra-low interest rates, helped ease the way for the government’s $3 trillion+ of incremental spending in the past few years and the likely chronic budget deficits of 5% or more of GDP in the future.

The two flaws in this MMT extension are that, 1) the federal government can’t just retire its debt with freshly printed dollars without consequence, and, 2) the government needs to borrow new money each year to fund its annual overspending. Retiring its debt with freshly printed dollars would almost certainly spawn high inflation. And, few borrowers would lend new money to the government without either high interest rates to compensate for inflation, or some other mechanism to protect the value of their Treasuries. Across the millennia of human experience, this monetization process has a 100% successful track record of generating hyper-inflation. MMT theorists completely missed this problem. Now that inflation, even at the now-trimmed 4% pace, has arrived, MMT has been finally discredited.

However, while MMT as a theory has been discredited, the government continues to follow MMT in practice. The rough numbers: in the fiscal year ended September 2023, the federal government spent $1.7 trillion more than it took in. This represents about 5.3% of GDP. For the current fiscal year, the White House projects that government spending will exceed revenues by $1.8 trillion. This is remarkable for a peacetime, healthy economy.

But, all seems well enough despite this vast and chronic shortfall. Do deficits even matter anymore?

For interesting color on where this may lead, we read a credible analysis produced by Horizon Kinetics, a $6 billion (assets under management) investment firm, in its 3Q23 Commentary. The firm writes that on September 30, 2023, the U.S. federal debt was about $25.8 trillion and carried an average interest rate of about 2.6%. This produces an annual interest expense of $663 billion, or about 14% of total federal government revenues. Relative to GDP, the interest expense is about 2.5%. If the size of the interest payments seems daunting, it is projected to get much worse.

By 2025, the federal debt is likely to increase to about $29.2 trillion. At an average interest rate of about 4%¹, the annual interest expense would increase to about $1.2 trillion. As such, interest costs would consume about 21% of 2025 government revenues. This creates a daunting hurdle and likely an enduring deficit spiral. It also assumes healthy 3-4% annual real GDP growth and no recessions or major military engagements. The Keynesian endgame, in which all government revenues are consumed by interest payments, seems inevitable.

This math seems awful. Realistically, how likely is this to play out and what can investors do to mitigate, or even benefit?

We’ll talk more about this next week.

1. We use more conservative numbers in our 2025 projection compared to the analysis by Horizon Kinetics.

Share prices in the table and discussion below reflect Monday, January 22 closing prices. Please note that prices in the discussion below are based on mid-day January 22 prices.

Note to new subscribers: You can find additional color 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 Bruce@CabotWealth.com.

This Week’s Portfolio Changes
None.

Last Week’s Portfolio Changes
None.

Upcoming Earnings Reports
Thursday, January 25: Comcast (CMCSA)
Thursday, February 1: NOV, Inc. (NOV)
Tuesday, February 6: Gates Industrial (GTES)
Tuesday, February 6: Sensata Technologies (ST)
Thursday, February 8: Philip Morris International (PM)

Growth/Income Portfolio

Cisco Systems (CSCO) is facing revenue pressure as customers migrate to the cloud and thus need less of Cisco’s equipment and one-stop-shop services. Cisco’s prospects are starting to improve under a relatively new CEO, who is shifting Cisco toward a software and subscription model and is rolling out new products, helped by its strong reputation and entrenched position within its customers’ infrastructure. The company is highly profitable and generates vast cash flow. Its announced deal for Splunk will drain most of its cash hoard but we see this as being replenished relatively quickly.

Cisco is the featured stock in this week’s Cabot Stock of the Week.

CSCO shares rose 2% in the past week and have 28% upside to our 66 price target. Based on 2024 estimates, unadjusted for the Splunk acquisition, the valuation is reasonably attractive at 9.6x EV/EBITDA and 13.1x earnings per share. BUY

Comcast Corporation (CMCSA) – Comcast is one of the world’s largest media and entertainment companies. Its properties include Comcast cable television, NBCUniversal (movie studios, theme parks, NBC, Telemundo and Peacock), and Sky media. The Roberts family holds a near-controlling stake in Comcast. Comcast shares have tumbled as worry about cyclical and secular declines in advertising revenues and a secular decline in cable subscriptions as consumers shift toward streaming services, as well as rising programming costs and incremental competitive pressure as phone companies upgrade their fiber networks.

However, Comcast is a well-run, solidly profitable and stable company that will likely continue to successfully fend off intense competition while increasing its revenues and profits, as it has for decades. The company generates immense free cash flow which is more than enough to support its reasonable debt level, generous dividend and sizeable share buybacks.

There was no significant company-specific news in the past week.

Comcast shares rose 2% in the past week and have 5% upside to our 46 price target. HOLD

Philip Morris International (PM) – Based in Connecticut, Philip Morris owns the global non-U.S. rights to sell Marlboro cigarettes, the world’s best-selling cigarette brand. Cigarettes comprise about 65% of PMI’s revenues. The balance of its revenues is produced by smoke-free tobacco products. The cigarette franchise produces steady revenues and profits while its smoke-free products are profitable and growing quickly. The upcoming full launch of IQOS products in the United States, a wider launch of the IQOS ILUMA product and the recent $14 billion acquisition of Swedish Match should help drive new growth.

The company is highly profitable, generates strong free cash flow and carries only modestly elevated debt (at about 3.2x EBITDA) which it will whittle lower over the next few years. The share valuation at about 13.5x EBITDA and 15.6x per-share earnings is too low in our view. Primary risks include an acceleration of volume declines and/or deteriorating pricing, higher excise taxes, new regulatory or legal issues, slowing adoption of its new products, and higher marketing costs. A strong U.S. dollar will weigh on reported results. While unlikely, Philip Morris could acquire Altria, thus re-uniting the global Marlboro franchise.

There was no significant company-specific news in the past week.

PM shares fell 3% in the past week and have 29% upside to our 120 price target. The shares offer an attractive 5.6% dividend yield. BUY

Buy Low Opportunities Portfolio

Allison Transmission Holdings, Inc. (ALSN) – Allison Transmission is a midcap manufacturer of vehicle transmissions. While many investors view this company as a low-margin producer of car and light truck transmissions that is destined for obscurity in an electric vehicle world, Allison actually produces no car or light truck transmissions. Rather, it focuses on the school bus and Class 6-8 heavy-duty truck categories, where it holds an 80% market share. Its EBITDA margin is sharply higher than its competitors and on-par with many specialty manufacturers. And, it is a leading producer and innovator in electric axles which all electric trucks will require. The company generates considerable free cash flow and has a low-debt balance sheet. Its capable leadership team keeps its shareholders in mind, as the company has reduced its share count by 38% in the past five years.

There was no significant company-specific news in the past week.

ALSN shares rose 2% in the past week and have 2% upside to our 59 price target. Despite the minimal upside to our price target, we continue to like the longer-term potential of this company. As such, we are not yet ready to move the shares to a sell. HOLD

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 significant company-specific news in the past week.

Aviva shares rose 2% in the past week and have 26% upside to our 14 price target. Based on management’s guidance for the 2023 full-year dividend, which we believe is a sustainable base level, the shares offer a generous 7.6% yield. We anticipate a dividend increase for 2024. On a combined basis, the dividend and buybacks offer more than a 10% “shareholder yield” to investors. BUY

Barrick Gold (GOLD), based in Toronto, is one of the world’s largest and highest quality gold mining companies. About 50% of its production comes from North America, with the balance from Africa/Middle East (32%) and Latin America/Asia Pacific (18%). Barrick will continue to improve its operating performance (led by its highly capable CEO), generate strong free cash flow at current gold prices, and return much of that free cash flow to investors while making minor but sensible acquisitions. Also, Barrick shares offer optionality – if the unusual economic and fiscal conditions drive up the price of gold, Barrick’s shares will rise with it. Given their attractive valuation, the shares don’t need this second (optionality) point to work – it offers extra upside. Barrick’s balance sheet has nearly zero debt net of cash. Major risks include the possibility of a decline in gold prices, production problems at its mines, a major acquisition and/or an expropriation of one or more of its mines.

Last week, the company reported disappointing 4Q gold production of 1.04 million tons, which led to a miss of its full-year guidance. Barrick said it produced 4.05 million ounces for the full year, which fell 4% below the low end of its 4.2 - 4.6 million ounce guidance range. Copper production hit the low end of its guidance range. Barrick continues to struggle with meeting its gold production guidance, which suggests that the management is either too hopeful or is unable to generate new growth. Neither of these traits are encouraging. One risk is that Barrick overpays for an acquisition to buy growth.

Over the past week, commodity gold fell fractionally to $2,024/ounce, after nearly reaching $2,100 recently. Gold seems to be holding its $2,000+ pricing. Foreign central banks have stepped up their buying, which is offsetting incrementally higher interest rates in the United States. But, financial investors including hedge funds continue to have low exposure to gold, based on government reports, which could be a bullish indicator.

Our view on gold prices avoids some of these technicals and is based on what we believe is a structural change to inflation levels (no longer at near zero). These changes include war, government spending, crime, oil prices and past-the-peak fading of the benefits of global free trade, in addition to a tight labor market. Aggregate inflation statistics include subcomponents which show starkly different pictures of pricing trends, and these trends can and have changed from month to month. Despite the favorable broad trend, there remains a reasonably good chance that inflation could remain above a 3% pace indefinitely. This would imply permanent 4-6% interest rates.

The 10-year Treasury yield ticked up to 4.10%. The US Dollar Index (the dollar and gold usually move in opposite directions) fell incrementally to 103.25.

Investors and commentators offer a wide range of outlooks for the economy, interest rates and inflation. We have our views but hold these as more of a general framework than a high-conviction posture. Investing in gold-related equities is a long-term decision – investors shouldn’t allow near-term weakness to deter their resolve.

Barrick shares fell 12% in the past week, largely on the disappointing gold production numbers. The shares remain depressed despite gold prices above the $1,800 - $2,000 range, indicating that investors have no confidence in gold prices and little confidence in the company’s ability to generate higher cash flow. Barrick shares have 73% upside to our 27 price target. BUY

Citigroup (C) – Citi is one of the world’s largest banks, with over $2.4 trillion in assets. The bank’s weak compliance and risk-management culture led to Citi’s disastrous and humiliating experience in the 2009 global financial crisis, which required an enormous government bailout. The successor CEO, Michael Corbat, navigated the bank through the post-crisis period to a position of reasonable stability. Unfinished, though, is the project to restore Citi to a highly-profitable banking company, which is the task of new CEO Jane Fraser. Investors have lost hope in Citigroup, creating an impressive bargain.

On Friday, January 12, Citi reported a highly scrubbed but reasonable quarter. Scrubbed revenues rose 2% while scrubbed earnings fell 24%. The Services segment and the U.S. Personal Banking business produced strong results, but Markets and Banking results were sloppy and the Wealth segment was weak. CEO Fraser said that the new 5-segment structure is now in place and that “2024 will be a turning point” for the transformation, although 2024 guidance seems a bit optimistic. Capital and credit remain healthy while deposits and loans were reasonably steady. Citi has set aggressive revenue and cost-cutting targets as CEO Fraser has stepped up her massive full-company overhaul. The shares trade at 60% of the updated tangible book value of $86.19/share, as investors have little confidence in a favorable outcome. The dividend appears solid, and Citi repurchased about $500 million of shares in the quarter, indicating that management and regulators have some elevated degree of confidence in Citi’s capital level and capital generation. No change to our rating.

In the quarter, revenues of $17.4 billion fell 3% and were 7% below estimates. Excluding the impact of divestitures, revenues rose 4%, or +2% if the Argentina currency devaluation were also factored in. Adjusted earnings of $0.84/share fell 24% but were 22% above estimates. Earnings in both periods were highly scrubbed, and in different ways, so the comparison even on adjusted earnings isn’t entirely clean. Major adjustments included the $1.7 billion FDIC special assessment, a $1.3 billion reserve build for Russia and Argentina, an $880 million revenue impact from the Argentine currency devaluation and a $780 million charge for Citi’s restructuring programs.

This past week, Warren Buffett (Berkshire Hathaway’s 2.9% ownership makes it the number four Citi shareholder) said at a recent lunch with Citi CEO Fraser that he supports her restructuring efforts, according to reports by Reuters.

Citi shares were flat in the past week and have 61% upside to our 85 price target. The shares remain attractive as they trade at about 61% of tangible book value of $86.19. The dividend offers investors a 4.0% yield.

When comparing Citi shares with a US 10-year Treasury bond, Citi offers about the same yield and considerably more upside price potential. Clearly, the Citi share price and dividend payout carry considerably more risk than a Treasury bond, but at the current valuation Citi shares would seem to have a remarkably better risk/return trade-off. BUY

CNH Industrial (CNHI) – 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. See our November 30 Alert and the December 5 Monthly letter for more color on our thesis.

There was no significant company-specific news in the past week.

CNH’s shares rose 2% in the past week and have 27% upside to our 15 price target. The 3.3% dividend yield offers a worthwhile interim cash return. 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 37% stake today.

There was no significant company-specific news in the past week.

Gates shares fell 3% in the past week and have 23% upside to our 16 price target. BUY

NOV, Inc (NOV) – This high quality mid-cap company, formerly named National Oilwell Varco, builds drilling rigs and produces a wide range of gear, aftermarket parts and related services for efficiently drilling and completing wells, producing oil and natural gas, constructing wind towers and kitting drillships. About 64% of its revenues are generated outside of the United States. Its emphasis on proprietary technologies makes it a leader in both hardware, software and digital innovations, while strong economies of scale in manufacturing and distribution as well as research and development further boost its competitive edge. The company’s large installed base helps stabilize its revenues through recurring sales of replacement parts and related services.

We see the consensus view as overly pessimistic, given the company’s strong position in an industry with improving conditions, backed by capable company leadership and a conservative balance sheet.

There was no significant company-specific news in the past week.

The price of West Texas Intermediate (WTI) crude oil rose 4% to $75.09/barrel. Rising tensions in the Middle East, including Iran’s attack on an Iraqi base, tit-for-tat Iran-Pakistan attacks and ongoing Red Sea strikes by Houthi rebels, are supporting oil prices. The oil markets seem well-supplied for now.

Outcomes in wars are unpredictable. It would seem that the potential for sharp oil price volatility is higher with the increasingly complicated game of shifting geopolitical and economic alignments. Geopolitical conditions in the Middle East continue to inch closer to a hot regional conflict, which would almost certainly drive oil prices to at least $150/barrel.

The price of Henry Hub natural gas fell 14% to $2.14/mmBtu (million BTU). Cold weather across much of the United States has been priced-in for now and appears to be relenting. While natural gas prices have collapsed 42% from their $3.75 pre-winter peak, they have rarely dipped below $2 in the past 20 years. The current volatility points to the capricious nature of the natural gas outlook in winter.

NOV shares fell 1% in the past week and have 27% upside to our 25 price target. The dividend produces a reasonable 1.0% dividend yield. BUY

Sensata Technologies (ST) is a $3.8 billion (revenues) producer of nearly 47,000 highly engineered sensors used by automotive (60% of revenues), heavy vehicle, industrial and aerospace customers. About two-thirds of its revenues are generated outside of the United States, with China producing about 21%. Investors undervalue Sensata’s durable franchise. Its sensors are typically critical components that generally produce high profit margins. As the sensors’ reliability is vital to safely and performance, customers are reluctant to switch to another supplier that may have lower prices but also lower or unproven quality. Sensata has an arguably under-leveraged balance sheet and generates healthy free cash flow. The relatively new CEO will likely continue to expand the company’s growth potential through acquisitions. Electric vehicles are an opportunity as they expand Sensata’s reachable market. Our Sensata investment remains an underperforming (from a business fundamentals perspective) work in progress.

There was no significant company-specific news in the past week.

The shares will likely remain weak or stagnant for the near-term due to the company’s weak fundamentals and average leadership. We will wait for a favorable change in investor sentiment but are poised to pull the plug. ST shares rose 2% in the past week and have 64% upside to our recently reduced 57 price target. HOLD

Current price is yesterday’s mid-day price.

Strong Buy – This stock offers an unusually favorable risk/reward trade-off, often one that has been rated as a Buy yet the market has sold aggressively for temporary reasons. We recommend adding to existing positions.
Buy – This stock is worth buying.
Hold – The shares are worth keeping but the risk/return trade-off is not favorable enough for more buying nor unfavorable enough to warrant selling.
Sell – This stock is approaching or has reached our price target, its value has become permanently impaired or changes in its risk or other traits warrant a sale.

Note for stock table: For stocks rated Sell, the current price is the sell date price.

Current price is yesterday’s mid-day price.
CSCO: Estimates are for fiscal years ending in July of 2023 and 2024