October 17, 2024

With U.S. Stocks Peaking, It’s Time to Think Internationally

We spend the vast majority of our time focused on U.S. stocks, and rightly so.

After all, although America has just 4% of the world’s population and generates 23% of the global GDP, 72% of worldwide investment capital is spent on U.S. stocks. That’s a stat our global investing expert, Carl Delfeld, relayed to me and my colleague Brad Simmerman on our latest Street Check podcast (click here to listen to the entire conversation). I knew the global investment axis tilted toward the U.S. – just maybe not that much.

As a result, U.S. stocks hover near all-time highs, while most other major overseas markets have lagged. That spells opportunity in markets outside U.S. borders.

At present, the S&P 500 trades a price-to-earnings ratio of 26.4 – more expensive than all but India’s benchmark index (26.8). It’s also 3 percentage points higher than the S&P’s five-year P/E average, 3.8 percentage points higher than the 10-year average, 4.65 percentage points higher than its 20-year average.

Meanwhile, Chinese stocks trade at a mere 9.3x earnings – one percentage point below their historical averages – despite their recent, stimulus-fueled run-up. Southeast Asian markets like Vietnam (P/E: 15.4), Indonesia (13.5) and Singapore (12.6) also trade below their historical norms. And major Latin American markets like Chile (P/E: 11.7), Mexico (11.5), Brazil (9.0), and Colombia (6.2) are all historically cheap.

Of course, “cheap” doesn’t always mean value. Some of those countries simply aren’t growing as fast as the U.S. But most are.

Indonesia, for example, reported 5% GDP growth in the second quarter – highest of any G20 country aside from India (6.7%). China, though not growing nearly as fast as it was pre-Covid and struggling so much to reignite growth that it needed significant government and central bank help to resuscitate it, still grew GDP by 4.7% in Q2 – third among G20 nations.

Singapore was fifth at 4.1% growth. Brazil was sixth at 3.3% growth. And Mexico, while lagging behind America’s 3% GDP growth, still expanded by a healthy 2.1% in the second quarter.

Vietnam, which is outside the G20, is growing faster than any of them, at 7.4%.

Does all this mean you should sell off all your U.S. stocks and shift your investment capital into the aforementioned cheaper, faster-growing overseas markets? No. There’s a reason U.S. markets have such a gravitational pull. Again – the U.S. economy accounts for nearly a quarter of the global economy on its own despite having merely 4% of its population. Public companies in the U.S. tend to be more established, more reliable, more predictable – and, thus, less risky. The majority of your portfolio should be in U.S. stocks, even near all-time highs and at inflated valuations.

But it makes sense to devote some of your investment dollars to markets outside the U.S. There’s more risk, yes, especially in markets with complicated political histories like China and Brazil. However, given the relative valuations of many of those overseas markets – coupled with their usual appeal of growing faster than the U.S. economy – there’s less risk now than there is normally.

In the Cabot Value Investor portfolio, two of our current nine holdings are companies headquartered outside the U.S. One of them is Honda (HMC), though, which feels like a bit of a cheat – yes, it’s a Japanese automaker, but it’s obviously well-known in the U.S. and sells a lot of cars here – North America is Honda’s second-largest market outside of Asia. (The other is Aviva (AVVIY), a London-based life insurance and investment management firm that does most of its business in the U.K.) The Honda semi-asterisk aside, that’s 22% of our portfolio that’s devoted to overseas stocks. Devoting roughly 20% of your investment account to international stocks is a good, reasonable goal to strive for in your own portfolio.

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
United Airlines (UAL) – Moves from Buy to Sell Half, Hold the Rest (reached price target!)

Last Week’s Portfolio Changes
None

Upcoming Earnings Reports
Thursday, October 24 – Capital One Financial (COF)

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 11.2x forward earnings estimates and 1.59x sales. The share price peaked at 177 a little over three years ago, in August 2021; it currently trades at 158.

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 was no company-specific news for Capital One Financial this week, and yet the stock was up 5% to reach a new 52-week high above 158! The reason is because many of its financial peers – Goldman Sachs (GS), Wells Fargo (WFC), JPMorgan (JPM), etc. – are reporting stronger-than-expected earnings, pushing bank stocks up more than 3% in the four trading days since the big banks started reporting Q3 results. The thinking, of course, is that all the earnings beats among financials bodes well for Capital One, which reports its Q3 results a week from today, October 24.

Expectations are fairly modest: 7.2% revenue growth but with a 15.7% dropoff in earnings per share. But the full-year EPS outlook is bright (3.4% growth) and it’s much better next year (+21.2%), which is likely at least partially factoring in the yet-to-be-finalized Discover Financial merger. So, even after a big run-up of late, we’ll maintain our 185 price target, giving COF shares 16% upside to our 185 price target. 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 1.30x sales. To be sure, it’s not the cheapest stock in our portfolio. But it is one of the fastest growing – and pays a solid dividend to boot.

There’s been no company-specific news for Dick’s of late. The stock, however, has clawed its way back to 210 after dipping to 200 earlier this month. It’s still well shy of its late-August, post-earnings highs just under 240. But the bounce off 200 support is encouraging.

There’s been no real reason for the drop-off, and the company is coming off a strong second quarter in which adjusted earnings per share improved 55% year over year and net sales rose 7.8%, both higher than analyst estimates. Those results initially gave DKS shares a big boost, but one that has completely evaporated since.

With no reason for the decline, there’s no reason to believe DKS shares won’t bounce right back. The stock has 19% 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 shares stabilized a bit one week after a recall of 1.7 million vehicles due to a steering issue sent shares tumbling below 31 a share for the first time in a month. As I wrote last week, that seemed like a “buy the bad news” situation, as recalls – while never ideal – are pretty common for major automakers. Of course, there hasn’t been much positive news for the company to offset the recall headlines, although Honda did launch its first EV plant in China, which aims to produce 120,000 cars per year. So, the stock hasn’t budged much in the last week.

The stock remains almost unfathomably cheap for a major global company, with shares trading at less than 7x earnings, 53% of book value and 0.35x sales. The stock has been a disappointment for us thus far, but as with United Airlines (see below), I think it’s only a matter of time before bargain hunters catch on and start snatching up this undervalued stock.

I think our patience will be rewarded – eventually. And HMC shares still have 45% upside to our 45 price target. BUY

Toll Brothers (TOL) – Historically, when the Fed cuts interest rates, homebuilder stocks are among the first to benefit. Indeed, in 2019 and early 2020 (before Covid hit), during which the Fed cut rates from 2.5% to 1.5%, homebuilder stocks were up 64%, more than double the 30% bump in the S&P 500. Now, with the Fed finally cutting rates for the first time in four and a half years, the homebuilders are undervalued, trading at 13x forward earnings. Toll Brothers is even cheaper, trading at 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, but the stock resumed its uptrend after a multi-week pause, rising 4.5% to reach 158 – a new all-time high! Trading at less than 11x earnings estimates and with interest rates/mortgage rates tumbling, however, the stock remains “cheap” even at record highs. It has 14% 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 0.38 and a price-to-book value of 1.84. The stock peaked at 96 a share in November 2018; it currently trades at 70.

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.

Thanks to a very strong third-quarter earnings report on Tuesday, United Airlines shares have reached our 70 price target!

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. Having enough cash to spend more than a billion dollars on a stock buyback is perhaps the surest sign yet that airlines – and United in particular – are back.

The question is what should we do with UAL stock now that it has reached our 70 price target, and is up 17% in the last week alone and 88% since its early-August bottom. It’s tempting to sell, or “retire” the stock like we do with most of our holdings when they reach their price target. But as I wrote in the opening – UAL is still cheap! Even after the massive run-up, it trades at just 6x 2025 EPS estimates. With the company’s sales back to pre-Covid levels, the share price may be well on its way back to pre-Covid levels (96 was the high) too.

So, let’s have our cake and eat it too. Let’s sell half our UAL position today, giving us a 42% return in five and a half months. And let’s Hold the rest and bump our price target up to 80 – about 12% higher than the current price. If you don’t already own the stock, I wouldn’t recommend adding it at this price (I’m expecting some sort of pullback in the coming days), hence the Hold rating. But if you did buy on our recommendation in early May, or later, book some profits now, and see where the rest goes after another big quarter. SELL HALF, HOLD THE REST

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

All of that EPS growth makes the share price look quite cheap. ADT shares currently trade at 9.4x earnings estimates and at just 1.23x sales. A solid dividend (3.1%) adds to the appeal of this mid-cap stock.

There was no news for ADT again this week, and the stock literally didn’t budge an inch.

The stock has pulled back about 11% from its highs near 8 in late July, though they still trade above their August and September lows, offering hope that a bottom has already been put in. Given the relatively modest coverage of this mid-cap stock – only six analysts cover it – there may not be a ton of news to drive the share price until the company reports earnings in a few weeks. But we like the value and the fast-growing profits.

ADT has 43% upside to our 10 price target. BUY

Aviva, plc (AVVIY), based in London, is a major European company specializing in life insurance, savings and investment management products. Amanda Blanc, hired as CEO in July 2020, is revitalizing Aviva’s core U.K., Ireland and Canada operations following her divestiture of other global businesses. The company now has excess capital which it is returning to shareholders as likely hefty dividends following a sizeable share repurchase program. While activist investor Cevian Capital has closed out its previous 5.2% stake, highly regarded value investor Dodge & Cox now holds a 5.0% stake, providing a valuable imprimatur 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 up marginally, but remain generally in the high 12s, where they’ve been for most of October.

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 6.9% dividend yield adds to our total return.

The stock has 10% 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.

There’s been no news for CNH since it was added to the S&P MidCap 400 index last month, which seems to have been a shot in the arm for the share price. While the stock is up only modestly in the past few weeks, it’s up 11% in the last month, with the index upgrade being the only news.

CNH shares remain dirt-cheap, trading at 7.8x forward earnings estimates and 0.62x sales. We upgraded the stock back to Buy recently and will maintain our price target of 15, which is 34% 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, though there will be soon: The company will report earnings on October 30. Shares were up nearly 4% in the last week and are flirting with their August and September highs.

GTES shares are up nearly 70% since they were added to the Cabot Value Investor portfolio – our best-performing position. Yet, trading at 11x forward earnings, they still have 10.5% upside to our 20 price target. BUY

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

Current price is yesterday’s mid-day price.

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