September 12, 2024

The Mag. 7 Market Is Over. What Stocks Will Fill the Void?

The Magnificent Seven have run into a brick wall in the second half of 2024.

After carrying the market in the first half of the year, and through much of 2023, the seven largest mega-cap tech stocks – Amazon (AMZN), Apple (AAPL), Google (GOOG), Meta (META), Microsoft (MSFT), Nvidia (NVDA) and Tesla (TSLA) – have all seen the air let out of their balloons in the last two and a half months, or longer in some cases. On average, those seven stocks, which comprise roughly 30% of the S&P 500, are down 3.7% since the beginning of July. Not coincidentally, the S&P 500 as a whole is flat, after being up about 15% in the first six months of the year, during which every one of the Mag. 7 performed even better.

Eventually, the Magnificent 7 will be back, though it’s doubtful they’ll be able to replicate their glorious runs from last November through this June. During that eight-month stretch, the seven mega-caps were up an average of 58% – and that includes a dud performance from TSLA, which actually declined 1.5% in that span. Artificial intelligence fervor, of course, had a lot to do with that run, at least in the cases of NVDA (+200%) and MSFT (+32%). Now that the AI hype cycle has cooled and appears to be transitioning to a “reality phase” in which investors want to see evidence of a return on investment for all the dollars the big-tech companies have poured into AI, the Mag. 7, or at least Nvidia and Microsoft, no longer have a new, exciting catalyst. All seven remain among the strongest growth companies in the world, and will likely make good, solid investments (to varying degrees) over the next three to five years, and beyond. But for this 23-month bull market to extend well into 2025, new leadership will have to emerge. Seven stocks carrying an entire 500-stock index is all well and good when those seven stocks are up 58% in eight months. The next major upmove will require far more participation.

Who will step up to the plate? Utility stocks have quietly been the best-performing sector this year, up more than 21% on average. But utilities aren’t the type of stocks that get investors energized – and they haven’t been enough to slow the steady flow of cash into money market funds, which now hold a record $6.3 trillion. That’s cash on the sidelines just waiting to be deployed, and it’s been growing since the second quarter of 2022 (when it was a “mere” $5 trillion), essentially coinciding with the Fed’s interest rate hikes from near zero to a multi-decade high of 5.25%-5.5%.

Now that the Fed is all but certain to start cutting rates next week, that in itself could act as a catalyst to lift all sectors – and pry some of that $6.3 trillion from the cold dead hands of those who have a large percentage of their cash tied up in money market funds. Last week, I made the case for homebuilders to be among the first subsectors to get a bump once the Fed starts to slash, adding Toll Brothers (TOL) to the portfolio as (in my opinion) the most attractive value option. But it will take more than just homebuilders getting going to reignite investor enthusiasm and push the market well past its midsummer highs.

Until then, it remains the rare “stock picker’s bull market.” Yes, the bull market is now 23 months old, and the S&P 500 has gained a handsome 51% since October 2022. But the rally has been far too top-heavy, and many stocks - and investors - haven’t participated. Changing that narrative will require more than just the Magnificent Seven, whose best run seems to be behind them.

I believe it will happen eventually, perhaps soon if the Fed really floors the gas on rate cuts. In the meantime, we will continue to look for unloved and overlooked stocks that are growing at healthy enough clips to warrant inclusion in the Cabot Value Investor 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
NOV, Inc. (NOV) Moves from Buy to Sell
United Airlines (UAL) Moves from Hold to Buy

Last Week’s Portfolio Changes
Toll Brothers (TOL) – New Buy with a 180 price target

Upcoming Earnings Reports: None

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 less than 10x forward earnings estimates, 91% of book value, and 1.40x sales. The share price peaked at 177 a little over three years ago, in August 2021; it currently trades at 133.

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, but the stock was down 6% anyway and has now given back much of its second half of August rally through just the first seven trading days of September. It’s not alone – financials as a group are down nearly 5% in September – but the sharp pullback after such an encouraging last few weeks of August has been a bit disheartening.

Still, there’s been no fundamental reason for the giveback in share price, and shares remain north of their early-August low of 131. Berkshire Hathaway did sell 2.65 million shares of COF in the second quarter, reducing Warren Buffett and company’s position by 21%. But they still own $1.4 billion in COF stock, and news of Berkshire lightening its COF load – reported late last month – didn’t seem to be the thing that triggered a backward slide in the share price.

Meanwhile, that potentially game-changing merger with Discover Financial seems well on track to approval, perhaps as early as later this year, according to Capital One executives.

COF has 37% 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 15.7x forward earnings estimates and at 1.29x 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 reported good-not-great earnings last Wednesday, which was enough to send DKS shares tumbling more than 12% since. First, the good: the $4.37 in earnings per share blew analysts’ Q2 estimates of $3.86 out of the water and marked a 55% improvement year over year, while sales ($3.47 billion) narrowly topped estimates ($3.44 billion). Same-store sales growth came in at 4.5%. All of it was enough for the retailer to raise full-year 2024 guidance to a range of $13.55 to $13.90 in EPS (up from $13.35 to $13.75 previously) and same-store sales growth to 2.5% to 3.5% (up from 2-3% previously). However, the midpoint EPS guidance number ($13.73) came in shy of analyst estimates $13.84), hence the selloff. That seems like an overreaction to a mostly encouraging report. Lingering bad feelings from industry peer Foot Locker’s full-year guidance “miss” (it didn’t raise full-year EPS expectations like analysts had hoped) may have contributed to the selloff in the last week.

We’ll see how the stock behaves in the coming days, and whether some kind of bounce-back is in order, especially if/when the market gets back in gear. Even with the down week, DKS shares are still well up from their August 7 bottom around 194. They now have 21% 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.

The only real news for Honda this week is that it suspended production at three Chinese plants and laid off 2,000 workers. That’s not great from an optics standpoint, but probably doesn’t move the needle much in the big picture and could be viewed as a good thing – cutting costs in China after Honda sales plummeted 21.5% there in the first half of the year, and declined (by 1%) in August, the fifth consecutive months of sales declines in China. Given the struggles of China’s economy – and recent sales declines in the country from many fellow automakers including Tesla and upstart BYD (BYDDY), previously the fastest-growing EV maker in China – this looks more like a China problem, not a Honda one.

Honda is still coming off a strong quarter, reported in mid-August. Profits improved 8.7% and global sales increased 17%, assisted by a 9% uptick in U.S. sales – thanks to growing demand for its hybrid vehicle models here. A weak yen also had a hand in the company’s profitable quarter, adding nearly 48 billion yen ($326 million) to Honda’s quarterly operating profit. A spike in motorcycle sales in Brazil, India and North America also helped the company offset the aforementioned weakness in China (-23% sales). Despite the China weakness, the company maintained its full-year operating profit forecast of 1.42 trillion yen.

Shares were down 4% this week, mostly in sympathy with the market though today’s China headline probably didn’t help much. The stock is laughably cheap, trading at 6.2x forward earnings estimates, 0.34x sales and 52% of book value. The stock has 47% upside to our 45 price target. The 4.3% dividend yield helps tide us over until the share price becomes more in line with the company’s value. BUY

Toll Brothers (TOL) – Historically, when the Fed starts to cut rates, homebuilder stocks are among the first to benefit. Indeed, in 2019 and early 2020 (before Covid hit), when 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 set to finally cut rates for the first time in two and a half years, the homebuilders are undervalued, trading at 13x forward earnings. Toll Brothers is even cheaper, trading at 9.6x 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 major news for Toll Brothers this week, as we await the true catalyst that could move the stock – the Fed cutting interest rates, likely starting next week. Whether the Fed starts by cutting the federal funds rate by 25 or 50 basis points this month could determine how quickly TOL and other homebuilder stocks get moving.

Until then, TOL probably won’t budge much – TOL was down 1.2% in its first week in our portfolio, which was less than the overall market. It has 30% 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 mere 4.1x forward earnings estimates, with a price-to-sales ratio of just 0.29 and a price-to-book value of 1.51. The stock peaked at 96 a share in November 2018; it currently trades at 48.

A company that’s making more money than ever before (gross profits reached a record $15.2 billion last year, though earnings were still second to 2019 levels on a per-share basis), and yet its stock trades at barely more than half its peak from five and a half years ago. A true growth-at-value-prices opportunity.

UAL shares are bucking the market’s downward trend this month and were up more than 9% this past week. At 48 a share, they’re nearly back to our entry price of 50, despite dipping as low as 37 last month.

Strangely, there’s been no obvious news behind the bounce-back in United shares, although it’s possible bargain hunters returning from summer vacation spotted what we see: deep value in a stalwart airline that’s still growing just fine. It’s certainly not from a bump in airline stocks as a group – the JETS ETF is flat so far this month.

Given the recent strength, and the fact that the stock is now back above its 200-day moving average (45), let’s bump UAL back up to Buy, with 46% upside to our 70 price target. MOVE FROM HOLD TO 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 a little more than 1%, likely in sympathy with the market, but remained largely above 13 a share in the last month after struggling to top 12.7 through the first half of the year.

The one bit of bad news for this U.K.-based life insurance and investment management company of late was that its India branch is under investigation for tax evasion. So far, at least, that hasn’t put much of a dent in the share price, and I doubt it will have much of an impact on the company or the stock.

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 10.2x earnings estimates and at a mere 0.34x sales. The 6.5% dividend yield adds to our total return. The stock has 7.7% 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.

On September 23, CNH will be added to the S&P MidCap 400 as part of the index’s quarterly rebalance. It’s doubtful to move the needle much for the stock, but it’s noteworthy in the middle of a stretch in which there’s been a dearth of news for CNH. The last big news came more than a month ago in the form of the company’s Q2 earnings report.

The results were mixed. Revenue declined “only” 16% year over year to $5.49 billion, beating analyst estimates of $5.32 billion. Earnings per share of 38 cents were in line with analyst expectations but down from 52 cents in the same quarter a year ago. The company also lowered full-year profit guidance, down to a range of $1.30 to $1.40 from a previous range of $1.45 to $1.55. Declining crop prices coupled with higher production costs have hit farms hard around the world of late, thus lowering demand for farming equipment.

CNH shares are down about 5% since the report, though they have rebounded nicely in recent weeks and have seemingly left the mid-9s bottom from mid-August well in the rearview mirror. CNH shares are quite cheap, trading at 7x earnings estimates and 0.58x sales.

Given the recent weakness in the stock (down from highs above 13 in early April), we will maintain our Hold rating for now. HOLD

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.

Gates shares were down about 5% this week on no news. The stock is still above its early-August lows but is creeping dangerously close to that level. We will watch it closely to make sure GTES holds support in the coming days.

Like CNH, Gates hasn’t made many headlines since a rather mixed earnings report a little over a month ago. Earnings per share of 36 cents narrowly topped estimates of 35 cents and were flat year over year. Sales, however, fell just shy of estimates ($885.5 million vs. $893 million expected) and were down 5.4% year over year. The relatively “blah” report – neither good nor overly bad – initially triggered some fierce selling in GTES shares (the stock was down 13% in the first week of August), then the stock recovered most of those losses, bouncing back up above 18 to close out August. But it’s been caught up in the September selling and is nearing its post-earnings lows.

It remains our best performer, up more than 50%, and the stock has 23% upside to our 20 price target. It trades at just 10x forward earnings estimates. BUY

NOV, Inc. (NOV) – It’s time to say goodbye to NOV. Simply put, the stock has not performed since my predecessor added it to the Cabot Value Investor portfolio in April 2023. It’s down 13% since then, and while it’s important to give value stocks – especially in this investment climate – plenty of rope, a stock falling for nearly a year and a half is more than enough rope, especially now that oil prices have sunk below $70 a barrel for the first time in more than a year. At less than 16 a share, NOV shares haven’t been this low since June 2023, and it will take a big move just to get back to our entry point, much less our price target of 24. I’m not confident NOV has that in it.

Let’s sell, stop the bleeding, and open up another spot for a future addition to our Buy Low Opportunities Portfolio. MOVE FROM BUY TO SELL

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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