September 26, 2024

At Long Last, Value Stocks Join the Rally

Value stocks are starting to play catch-up.

The Vanguard Value Index Fund ETF (VTV), a good proxy for value stocks, is up 9% since the first week of August, more than half its year-to-date gain of 16.6%. While value stocks still trail the S&P 500 (+20.9% YTD) and growth stocks (the Nasdaq is +22.4% YTD), the gap is narrowing. Now that the Fed is finally cutting interest rates from multi-decade highs, perhaps this “in name only” bull market will spread to more corners of the market beyond just the Magnificent Seven, artificial intelligence stocks, and the other mostly tech-related plays that have carried this 23-month rally.

The recent acceleration of the VTV seems to indicate that the market’s breadth is already improving. So does the 9.5% uptick in the Russell 2000 Small-Cap Index – another long-forgotten wing of the market that has been underperforming for years – since the early-August bottom. A more inclusive rally these last six weeks has been a boon for our portfolio, where most of our eight holdings are near multi-month or, in a couple cases, 52-week highs!

It’s time to strike while the iron is hot. I will be adding a new position to the Buy Low Portfolio in next week’s October issue. After years of being mostly ignored by Wall Street – the VTV was up a mere 8.8% from the start of 2022 through the first week of August this year – value stocks appear to finally be getting some overdue attention. That should bode well for the Cabot Value Investor portfolio in the coming months.

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
CNH Industrial (CNH) Moves from Hold to Buy

Last Week’s Portfolio Changes
None

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 10x forward earnings estimates, 97% of book value, and 1.50x sales. The share price peaked at 177 a little over three years ago, in August 2021; it currently trades at 146.

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 this week, though shares ticked up another point to 146, at least in the aggregate. Initially, after the Fed’s rate cut announcement last Wednesday, COF shares, along with other financial stocks, got a big bump, with COF spiking as high as 153 – a 2024 high. But they’ve since sagged back nearly to their pre-announcement levels. The real potential catalyst for COF shares, of course, is the pending deal with Discover Financial. Capital One executives have expressed optimism that the deal could be completed either later this year or early next year.

In the meantime, COF has 27% upside to our 185 price target while we wait. 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 16.4x forward earnings estimates and at 1.35x 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 news of late for Dick’s, though shares of the sports apparel retailer have been ticking back up – by 2% this week – as the economic and stock market picture improve. DKS shares still trade below their pre-earnings level, however, as the stock was punished for daring to have merely a solid, if unspectacular, second quarter, reported in early September.

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. And COF shares still have 15% 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.

There’s been no major news for Honda of late, though the stock was up 3% this week. HMC shares have recovered all of their early-September losses, when the stock dipped below 31, but have yet to push through brick-wall resistance at 33, which it hasn’t managed to eclipse since early June despite numerous re-tests. A break above the 33 level would be bullish.

Meanwhile, the stock remains quite cheap, trading at a mere 6x earnings, 0.36x sales and 55% of book value. The high dividend yield (4.1% currently) has helped sustain us while the share price has struggled to get going in recent months. Now that the rally appears to be spreading to some forgotten corners of the market, it’s possible the hedge funds will finally take notice of this prime growth-at-value-prices story in one of the more recognizable brands on the planet.

HMC has 37% upside to our 45 price target. 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 10.5x 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.

We recommended Toll Brothers at the beginning of this month in advance of the anticipated start to the Fed cutting interest rates. It was based partly on the past history of homebuilder stocks being among the first subsectors to get a boost when the Fed cuts rates, as was the case in 2019. Sure enough, TOL is off to a good start, getting another 2% bump in the past week since the announcement.

On the company-specific front, Toll Brothers announced a partnership with leading solar company Sunrun to provide solar power and storage to Toll Brothers-built homes. The agreement starts with all Toll Brothers homes built in California and also includes other communities across the country. We’ll see how much that moves the needle on the sales front – chances are, lower mortgage rates will be the bigger catalyst driving demand for new Toll Brothers homes.

TOL shares have 17% upside to our 180 price target, which is already starting to look a bit conservative, especially in the wake of the Fed’s large (50-basis point) first cut. 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 4.5x forward earnings estimates, with a price-to-sales ratio of just 0.32 and a price-to-book value of 1.68. The stock peaked at 96 a share in November 2018; it currently trades at 54.

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.

Taylor Swift has been very good to United Airlines.

The airline’s chief commercial officer, Andrew Nocella, said as much last week, citing a 25% uptick in United flights on weekends when Swift’s Eras Tour concerts are held. (Jacob Mintz, Cabot’s longtime options trading expert, can attest: he recently flew his family to the Eras Tour concert in London, which set a new attendance record at historic Wembley Stadium! Jacob’s family, however, flew British Airways.) United isn’t alone in getting a Swift bump, of course – the uber-famous singer/songwriter reportedly contributed $5.7 billion to the U.S. economy in 2023 between ticket sales, hotels, food and, yes, travel expenses.

Even without Taylor Swift, United is doing just fine, with sales expected to improve 2.7% in the third quarter; results are due out in mid-October.

Meanwhile, UAL shares have been on a tear, up from 37 to 54 since an early-August bottom. The stock still has 28% 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 1.5% as they claw their way back to their late-August highs around 13.55. 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 10.8x earnings estimates and at a mere 0.34x sales. The 6.5% dividend yield adds to our total return. The stock has 5% 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.

CNH was added to the S&P MidCap 400 index this Monday as part of the index’s quarterly rebalance. The index upgrade may be partly responsible for the stock’s recent strength, as CNH shares are up more than 10% in the last two weeks. There’s certainly been no other news, and essentially no news since the company reported mixed earnings results in early August.

CNH shares remain dirt-cheap, trading at 8x forward earnings estimates and 0.64x sales. With momentum clearly back on its side – and now that we’re back in the black on it – let’s upgrade the stock back to Buy, while maintaining our price target of 15 – 35% higher than the current price. MOVE FROM HOLD TO 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. The previous week, the company announced that it was 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.

Whether it’s related or not, GTES shares have picked up steam of late, advancing about 7% in the last two weeks. 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.

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