May 23, 2023

Value Investing and the Growth-Driven S&P 500

The S&P 500 continues to grind higher, now posting a year-to-date gain of 10%. Investors are collectively buying the current narrative that supports these gains: The Fed is poised to cut interest rates later this year to avoid an almost-certain recession.

Another driver: Investor perceptions that artificial intelligence, or AI, will quickly embed itself deeply into every aspect of all human endeavors, resulting in a long bull market and accelerating corporate profits. This idea may sound ambitious, but it is supported by Goldman Sachs. The bank estimates that AI could boost productivity by 1.5 percentage points a year for the next decade (essentially boosting annual GDP growth by the same amount) and add 4 percentage points to corporate profit margins (to record highs) as well.

Investors need look no further than the year-to-date surges in stocks like Alphabet (GOOG), up 40%, Microsoft (MSFT), up 33% and Nvidia (NVDA), up 110%. These are perceived as direct beneficiaries of AI technology.

Shares of Meta Platforms (META), Apple (AAPL) and Amazon (AMZN) have also surged this year, posting gains of about 35% each. Pushing these shares higher is their “safety trade” merit – safe havens for the coming economic downturn, as well as beneficiaries of lower interest rates.

What these six stocks also have in common is that they are the largest stocks in the S&P 500, excluding Berkshire Hathaway. With their immense weight (a collective 25% of the index) and strong gains, they have produced close to 80% of the total gains in the index. If it wasn’t for these stocks, the S&P 500 would be posting a modest gain of perhaps 2% this year. For comparison, the Dow Jones Industrial Average has produced a year-to-date total return of only 1.7%.

Growth investors, backed by the strong recovery in the tech mega-caps, are having a banner year with a gain of 19.2%. Value investors are suffering with a barely profitable year. So far.

While we “don’t do macro” we are not naïve to the small chance of an interest rate cut later this year. Not only is inflation stubbornly well above the Fed’s 2% target even by its own hand-crafted metrics, the Fed would not risk losing its remaining inflation-fighting credibility by prematurely cutting interest rates.

We also have lived through plenty of tech hype cycles to recognize that as impressive as AI may be, and recognize that it may eventually be a societal game-changer on par with the internet and the iPhone, it won’t by any stretch be the immediate accelerant that Goldman and others are predicting.

The run-up in the S&P 500 seems to be buoyed by a small number of stocks driven by some perhaps shaky assumptions. If investor enthusiasm behind these assumptions begins to fade, today’s favorite stocks may not hold up well – while shares of solid and more modestly valued companies look well positioned to retain their value, at a minimum. Value investing may be momentarily out of favor, but that is the best time to stay with the discipline.

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

Today’s Portfolio Changes
Comcast (CMCSA) – Raising price target to 46 and changing rating from Hold to Buy.

Last Week’s Portfolio Changes
None.

Upcoming Earnings Reports
Wednesday, May 24: Aviva, Plc (AVVIY)
Friday, May 26: Big Lots (BIG)

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, generates vast cash flow (which it returns to shareholders through dividends and buybacks) and has a very strong balance sheet.

On May 17, Cisco reported a reasonable quarter, with earnings of $1.00/share, which were 15% above year-ago profits and 3% above consensus earnings estimate of $0.97/share. Revenues, non-GAAP income, non-GAAP per-share earnings and operating cash flow were all quarterly records.

Revenues rose 14% and were about 1% above estimates. Adjusted EBITDA of $5.2 billion rose 11% but fell incrementally below estimates. Cisco incrementally raised its full-year revenue and profit guidance. It also said that it will produce modest (yet positive) revenue growth in FY2024 and grow earnings per share at a rate faster than revenues. Cisco will step up its share repurchases given its immense cash hoard (fortunately, rather than making a large acquisition).

New product orders fell 23%, suggesting that demand continues to fall off from the strong pace last year. However, with the guidance for positive fourth-quarter and full-year 2024 growth, it appears that the sharp order decline pace will flatten.

In the quarter, Cisco saw strength in its security and software offerings and said that it continues to overcome the supply constraints of prior quarters. As usual, the company is restraining its costs. While margins improved from the second quarter, they fell compared to a year ago. Cisco’s cash production remains impressive. The company produced nearly $5 billion of free cash flow in the quarter, then used just over half of this to repurchase shares and pay the dividend. Net cash increased by $1.7 billion.

All-in, it looks like Cisco should be able to maintain some reasonable revenue and profit strength as the tech cycle weakens.

CSCO shares rose 4% this past week and have 34% upside to our 66 price target. The valuation is attractive at 8.8x EV/EBITDA and 12.9x earnings per share. The 3.2% dividend yield adds to the appeal of this stock. BUY

Comcast Corporation (CMCSA) – With $120 billion in revenues, 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 due to worries 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.

Chair/CEO Brian Roberts said that the company is likely to sell its 33% stake in Hulu to Disney next year, rather than buy Disney’s 67% stake. The final valuation is subject to negotiation but would likely generate at least $6 billion of after-tax proceeds to Comcast, based on a $27 billion valuation for all of Hulu.

Comcast shares rose 3% in the past week and remain just below our 42 price target. Given the company’s revenue and profit resilience, plus the possibility that it sells its Hulu stake and uses the cash proceeds to repurchase shares, we are raising our price target to 46 and returning them to a 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 1% in the past week, have 10% upside to our 54 price target and offer a 1.9% dividend yield. 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. We expect that activist investor Cevian Capital, which holds a 5.2% stake, will keep pressuring the company to maintain shareholder-friendly actions.

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

Aviva shares were unchanged this past week and have 34% upside to our 14 price target. Based on management’s guidance for the 2023 dividend, the shares offer a generous 7.8% yield. On a combined basis, the dividend and buyback provide more than a 10% return to shareholders. 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.

On May 3, Barrick reported a reasonable quarter, with adjusted earnings that fell 46% but were 2 cents above the $0.12/share consensus estimate. Adjusted EBITDA fell 28% although the margin (at 45%) was healthy. While gold production fell 4% and copper production fell 13%, these volumes were in-line with management’s guidance. Gold volumes sold fell 4% while cost of sales rose 16%, more than offsetting the 1% increase in pricing. The company maintained its full-year production guidance. Overall, the company continues to face rising costs and elevated capital spending, but the increases look contained. Barrick remains well-managed with high-quality assets.

Barrick’s net debt position ticked up to $400 million, compared to $342 million in the prior quarter and $(743) million a year ago. In essence, the company is funding about half of its 10 cents/share quarterly dividend with borrowing. We anticipate that higher cash flow the rest of the year will more than fund its dividend although we anticipate zero bonus dividends. No change to our rating.

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

Over the past week, commodity gold fell 2% to $1,974/ounce. The down-tick is likely due to the approaching “deadline” for a federal budget deal – the closer the deadline, the closer a resolution to the confrontation. The key assumption, with which we agree, is that some deal will be reached that raises the debt ceiling and avoids a default.

The 10-year Treasury yield ticked up 21 basis points to 3.71%. The U.S. Dollar Index (the dollar and gold usually move in opposite directions) rose 1% to 103.33.

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 8% in the past week, driven by the combined effects of lower gold prices and higher interest rates. The shares have 52% upside to our 27 price target. BUY

Big Lots (BIG) – Big Lots is a discount general merchandise retailer based in Columbus, Ohio, with 1,431 stores across 47 states. Its stores offer an assortment of furniture, hard and soft home goods, apparel, electronics, food and consumables as well as seasonal merchandise. Our initial case for Big Lots rested with its loyal and growing base of 22 million rewards members, its appeal to bargain-seeking customers, the relatively stable (albeit low) cash operating profit margin, its positive free cash flow, debt-free balance sheet and low share valuation. Our thesis was deeply rattled by the company’s surprisingly large inventory glut, now resolved, but which leaves the company with a hefty and permanent $300 million debt burden.

Big Lots shares remain high-risk due to the new debt balance, weak fundamentals and the possibility of a suspension or reduction of the dividend. Sentiment in the shares is very weak – investors unwilling or unable to sustain further losses in the shares should sell now, as sentiment could weaken further and drive the shares lower.

Regarding the dividend, Big Lots now has every incentive to eliminate it. Investors clearly are not convinced that it will be maintained, given the company’s likely weak profits for at least the current fiscal year. And, eliminating the $35 million in cash payouts would help the company retire its $300 million debt as well as ease future seasonal borrowings.

There was no significant company-specific news in the past week. However, several retailers have reported weak earnings recently, casting doubt on Big Lots’ ability to earn its way out of its troubles.

Big Lots shares fell 2% this past week and have over 100% upside to our revised 25 price target. The shares offer a 15.2% dividend yield, although, as noted, investors should not rely on this dividend being sustained. We continue to hold onto Big Lots’ shares as we believe the company will ultimately rebuild about half of its prior earnings base. The shares’ highly discounted valuation provides a reasonable valuation cushion, even as investor sentiment continues to push the shares lower. HOLD

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.

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

Citi shares declined 1% in the past week and have 86% upside to our 85 price target. The shares remain attractive as they trade at 54% of tangible book value of $84.21 and offer a sustainable 4.5% dividend yield.

When comparing Citi shares with a U.S. 10-year Treasury bond, Citi offers a higher yield and considerably more upside price potential (about 86% according to our work vs. 0% for the Treasury bond). Clearly, the Citi share price and dividend payout carry considerably more risk than the Treasury bond, but at the current valuation, Citi shares would seem to have a remarkably better risk/return trade-off. 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, with Blackstone retaining a 63% stake today.

On May 4, Gates reported an encouraging quarter even though adjusted earnings fell incrementally short of the consensus estimate. Investors looked through the higher-than-expected tax rate and costs of a cyberattack as operating results were strong. Gates maintained its full-year guidance and authorized a $250 million (about 6% of current market cap) share repurchase program. In the quarter, sales rose 4% excluding currency and were fractionally below estimates. Adjusted EBITDA rose 12% and was 4% above estimates. The margin expanded to an impressive 19.4%, although without some scrubbing of otherwise legitimate business costs the margin would have been 15.8%.

Debt net of cash fell 15% from a year ago although only incrementally compared to year-end. Leverage ticked down to a reasonable 2.7x EBITDA, the share count fell 3%, and free cash flow improved with a 105% conversion (free cash flow to net income).

The company announced that a major shareholder is selling about 26 million shares in a secondary offering, which pushed the shares down about 7% on the news. The seller is almost certainly private equity firm Blackstone, which owns about 63% of the shares – Blackstone acquired the company in 2014. The offering totals about 10% of GTES shares. Very favorably, Gates will repurchase close to 19 million of the shares, so the change in shares outstanding will decline by about 9%. Blackstone will continue to hold an estimated 54% of total shares.

GTES shares fell 13% in the past week, due to the secondary, and have 35% upside to our 16 price target. We see the sell-down as a technical decline not related to the company’s fundamentals and thus a chance to buy shares at a discounted price. BUY

Molson Coors Beverage Company (TAP) is one of the world’s largest beverage companies, producing the highly recognized Coors, Molson, Miller and Blue Moon brands as well as numerous local, craft and specialty beers. About two-thirds of its revenues come from the United States, where it holds a 24% market share. Investors worry about Molson Coors’ lack of revenue growth due to its relatively limited offerings of fast-growing hard seltzers and other trendier beverages. Our thesis for this company is straightforward – a reasonably stable company whose shares sell at an overly discounted price. Its revenues are resilient, it produces generous cash flow and is reducing its debt. A new CEO is helping improve its operating efficiency and expand carefully into more growthier products. The company recently re-instated its dividend.

On May 2, Molson Coors reported a strong quarter, with underlying earnings rising 86% and more than double the consensus estimate. Revenues rose 8% ex-currency and were about 5% above estimates. Strong pricing, sales of higher-margin products, relatively stable volumes and flattish marketing spending drove the sharp increase in profits, even as raw materials costs rose 7%. Molson Coors reaffirmed its guidance for low-single-digit revenue and profit growth and for underlying free cash flow to be $1 billion (+/- 10%). All-in, the quarter shows that this company is a reasonably reliable profit and free cash flow generator that investors have overlooked. The shares are approaching our 69 price target.

Free cash flow improved from a year ago. Net debt was unchanged from the prior quarter but fell 10% from a year ago. Net debt relative to EBITDA was 3.0x and appears on track to reach the company’s 2.5x longer-term target. Reducing debt reduces the company’s risk and accretes value to shareholders.

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

TAP shares ticked down 2% in the past week and have 10% upside to our 69 price target. The stock remains relatively cheap, particularly on an EV/EBITDA basis, or enterprise value/cash operating profits, where it trades at 9.6x estimated 2023 results, still among the lowest valuations in the consumer staples group and below other brewing companies. 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.

The shares trade at the low end of their 20-year range due to investor expectations for an uninspiring future. We see this 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 ticked up 1% in the past week to $71.89/barrel, while the price of Henry Hub natural gas rose fractionally to $2.54/mmBtu (or, million BTU). We have no insight into the direction of crude oil or natural gas prices. Our interest is in prices staying reasonably elevated to encourage continued/higher drilling activity, which seems likely given the current low level of activity across both oil and natural gas segments.

NOV shares were unchanged in the past week and have 65% upside to our 25 price target. The dividend produces a reasonable 1.3% 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 safety 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.

ST shares rose 1% in the past week and have 80% upside to our 75 price target. Our price target looks optimistic, but we will keep it for now, even as it may take longer for the shares to reach it. BUY

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