September 19, 2024

Rate Cuts Are Here … In a BIG Way

The Fed went big!

Everyone knew Jerome Powell and company were going to (finally) cut the federal funds rate for the first time in four and a half years on Wednesday. The question was by how much – 50 basis points (0.50%) or 25 basis points (0.25%)? To my mild surprise (but not to Wall Street’s – the options market had swung to a 59% probability that it would be 50 bps prior to the announcement), the Fed opted for the larger cut, slashing rates from 5.25-5.5% to a 4.75-5.25% range. So far, the market seems unsure how to take the hefty cut – all three major indexes were up more than half a percent immediately following yesterday’s 2 p.m. ET announcement, but then were narrowly in the red by day’s end.

Investors’ mixed feelings, at least initially, seem warranted, since the aggressive first cut signals a couple things. First, the Fed is clearly concerned, at least to some degree, about the “cooling in the labor market,” to use Powell-speak from yesterday’s press conference. Turns out that wasn’t just a Wall Street overreaction when the last two jobs reports came in much lighter than expected. It spooked the Fed too (Powell: “the labor market is actually in solid condition … (but) bears close watching”), and now they’re slamming their foot on the gas to avoid a recession and achieve their long-desired “soft landing.”

Second, on a more positive note, that high inflation is essentially in the rearview mirror. It’s been trending that way for a while, with year-over-year headline CPI numbers dipping below 3% for the first time in years this July (and dipping even further in August). But for the Fed to essentially say it out loud means that inflation, in their mind, is no longer something to fear. That’s good news. While high inflation hasn’t exactly been an anvil weighing down the market the last few years – the S&P 500 is up just over 30% since inflation first topped 4% three and a half years ago, in April 2021 – as we’ve written ad nauseam in this space, the gains have been top-heavy, and the divide between “haves” (Magnificent Seven/mega-cap tech/artificial intelligence stocks) and “have nots” (basically everything else) was more pronounced than at any other time in the market’s history. Thus, it hasn’t always felt like a true bull market these last 23 months, and unless you loaded up on mega-cap tech and AI plays, odds are your portfolio’s return these last three-plus years has trailed the 30% return in the S&P.

The last time the Fed cut rates in a non-Covid-related environment, from July 2019 through February 2020, the S&P was up more than 15% in the ensuing seven months. That’s much better than being up 30% in three and a half years. Should we expect a similar run-up – with broader participation – this time around? We’ll see. But there are good reasons to believe that will be the case. And Wednesday was a big – and fairly bold – first step.

Note to new subscribers: You can find additional commentary on past earnings reports and other news on recommended companies in prior editions and weekly updates of the Cabot Value Investor on the Cabot website.

Send questions and comments to chris@cabotwealth.com.

Also, please join me and my colleague Brad Simmerman on our weekly investment podcast, Cabot Street Check. You can find it wherever you get your podcasts, or you can watch us on the Cabot Wealth Network YouTube channel.

This Week’s Portfolio Changes
None

Last Week’s Portfolio Changes
NOV, Inc. (NOV) Moves from Buy to Sell
United Airlines (UAL) Moves from Hold to Buy

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, 96% of book value, and 1.47x sales. The share price peaked at 177 a little over three years ago, in August 2021; it currently trades at 145.

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

There’s been no company-specific news for Capital One, and yet the stock had an excellent bounce-back week, advancing more than 7%. Of course, like the market, that only mostly recovers its losses from the first week of September. But the move was encouraging nonetheless, especially in the absence of any obvious catalyst. The big one – Capital One’s impending acquisition of Discover Financial – has yet to happen, though company executives are confident it will either by year’s end or in early 2025.

COF has 27% 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 1.33x 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 was no company-specific news for Dick’s this week, though shares got back some of their losses from the previous week, rising 4%. The bounce-back makes sense considering the stock was clearly over-punished for a solid, if unspectacular, second quarter, reported two weeks ago. In the quarter, same-store sales improved 4.5% year over year (vs. 3.4% expected), overall sales ($3.47 billion) narrowly beat estimates, and earnings per share ($4.37) not only blew estimates ($3.86) out of the water but also represented a 55% year-over-year improvement. So what wasn’t to like? Full-year EPS guidance came in a bit light, so the stock sold off, to the tune of more than 10% in a week.

Wall Street appears to be in the process of righting that wrong, capturing the attention of Jim Cramer, who called the post-earnings selloff “insane” and said Dick’s is “firing on all cylinders.” “It’s a cream of the crop retailer, and I think it has a lot more room to run,” Cramer concluded.

I don’t always agree with Jim Cramer. But in this case, we are very much aligned. Dick’s continues to be one of the steadiest, most reliable growth stories in retail. And yet it still trades at a discount. Investors have started to wise up to that fact – the stock is up 45% year to date – but not fully, hence the low valuation. There’s plenty more upside ahead, in my opinion. We maintain a price target of 250. 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.

There was no major news for Honda this week, though shares were up 3.5%, likely in sympathy with the market and following a rough start to September. HMC shares are roughly at the midpoint of their 30-33 range over the last month.

One bit of auto industry news: rivals GM and Hyundai inked a deal to join forces on product development, manufacturing and clean energy technologies. It follows in the footsteps of a deal Honda signed last month with Nissan and Mitsubishi to collaborate on similar initiatives. What all these partnerships mean in practice – and in terms of real dollars – is not yet known. But it does signal a ramping up of the electric- (and hybrid-) vehicle arms race, which could be good for all parties, Honda included.

In the meantime, HMC continues to trade at bargain-basement valuations, with a forward price-to-earnings ratio of 6.2, price/sales of 0.34, and at 52% of book value. The stock has 42% 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), 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 10.4x 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.

Toll Brothers shares were up 7% in the last week ahead of yesterday’s Fed rate cut. Rate cuts have proven bullish for homebuilders in particular, and Toll Brothers is one of the most undervalued of the bunch and yet growing at a healthy clip. Hopefully, our timing here is right – so far, so good.

TOL stock has 22% upside to our 180 price target, which may prove to be conservative. BUY

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

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

Meanwhile, the stock is super cheap. It trades at a mere 4.4x forward earnings estimates, with a price-to-sales ratio of just 0.31 and a price-to-book value of 1.64. The stock peaked at 96 a share in November 2018; it currently trades at 53.

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.

We’ve been patient with United after a very slow start, and now that faith is being rewarded. UAL shares were up another 10% this week and are now up 40% since the early-August bottom below 38.

One news item that may have helped give UAL shares an extra nudge in recent days: the airline just inked a deal with Elon Musk’s SpaceX to offer free Wi-Fi on all its flights using SpaceX’s Starlink satellite internet service. The free service will begin in 2025. United is the first major airline to use Starlink, and it could be a differentiator for some people who would rather not deal with the fees or the spotty reception that come with Wi-Fi use on other carriers (though soon all carriers may do the same – Delta and JetBlue are moving to make their Wi-Fi free too).

We restored our Buy rating in UAL last week on the strength of its recent resurgence. And that stock remains incredibly cheap. Shares have 31% upside to our 70 price target. 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 up more than 1% after falling by roughly the same amount the week before. After struggling to top 12.7 for most of the first half of the year, AVVIY has been mostly above 13 a share the last month-plus.

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 6.6% dividend yield adds to our total return. The stock has 6% 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.

Next Monday, September 23, CNH will be added to the S&P MidCap 400 as part of the index’s quarterly rebalance. Ordinarily, index upgrades like that don’t move the needle much for a stock in the short term, though CNH shares are up more than 6% since that was announced. It’s possible the move is more related to last week’s market rebound.

Regardless, it’s been a nice, steady recovery for CNH since the company reported mixed Q2 earnings results in early August. And shares are still cheap, trading at 7.5x forward earnings estimates and 0.59x sales, though both sales and earnings are expected to dip this year. Declining crop prices coupled with higher production costs have hit farms hard around the world of late, thus lowering demand for farming equipment.

We are back to roughly break-even on CNH shares, but with the stock still down from its highs above 13 in 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 is introducing something called a “cooling hose.” Called the Data Master Cooling Hose, it’s a product intended to enhance performance and cleanliness in data centers. Specifically, it makes for easier assembly, routing and handling in data centers. Demand for “cooling solutions” in data centers has been on the rise, and Gates is meeting that demand with its new hose. We’ll see how the cooling hose impacts the company’s bottom line.

Investors seemed to like the idea, as GTES shares were up 6.5% this week, though that was probably in part market-driven. It’s the first bit of news for the company since it reported rather mixed earnings results in early August, so it’s a welcome catalyst.

GTES shares are now up more than 60% since they were added to the Cabot Value Investor portfolio – our best-performing position. Yet, trading at less than 11x forward earnings, they still have 15% 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.

Copyright © 2024. All rights reserved. Copying or electronic transmission of this information without permission is a violation of copyright law. For the protection of our subscribers, copyright violations will result in immediate termination of all subscriptions without refund. Disclosures: Cabot Wealth Network exists to serve you, our readers. We derive 100% of our revenue, or close to it, from selling subscriptions to our publications. Neither Cabot Wealth Network nor our employees are compensated in any way by the companies whose stocks we recommend or providers of associated financial services. Employees of Cabot Wealth Network may own some of the stocks recommended by our advisory services. Disclaimer: Sources of information are believed to be reliable but they are not guaranteed to be complete or error-free. Recommendations, opinions or suggestions are given with the understanding that subscribers acting on information assume all risks involved. Buy/Sell Recommendations: are made in regular issues, updates, or alerts by email and on the private subscriber website. Subscribers agree to adhere to all terms and conditions which can be found on CabotWealth.com and are subject to change. Violations will result in termination of all subscriptions without refund in addition to any civil and criminal penalties available under the law.