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Cabot Benjamin Graham Value Investor 281

Since the last issue, five stocks have declined and 10 gained more than 10%. Many are now at or near fair value, and eight are rated Sell or Sell a Portion. Also in this issue, I recommend two new stocks and profile a new small-cap stock that’s on my watch list.

Cabot Benjamin Graham Value Investor 281

Benjamin Graham is called The Father of Value Investing. His influence has inspired many successful investors, including Warren Buffett.

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Value investing is a marathon, and it requires patience and perseverance. Usually, it is not the intent of a value investor to make a quick profit but to outperform the market in the long term. Some value investments might have waiting periods of years, and others might be quick arbitrage opportunities.

In essence, a value investor believes that a prudent investor can value the intrinsic value of a company more precisely than timing the market, and eventually, the market will correct the stock to its intrinsic value.

This month, we have seen volatility in many of our recommendations—in both directions. Of our 26 recommendations, five stocks had negative returns and 10 stocks had more than 10% returns.

On the downside, the most significant loser this month is Signet Jewelers (SIG), which fell 30% on the day it released its quarterly loss. It’s now down 20% from the day I recommended the stock (November 9). Signet had a variety of headwinds that led to large-scale negative publicity, and ultimately, its depressed market valuation: technical hiccups faced while outsourcing its in-house credit portfolio, an investigation on its credit practices by the Consumer Finance Protection Bureau and decreasing same-store sales. Most of these headwinds are short-term in nature, however, and if the company can accomplish long-term same-store growth, SIG’s depressed stock price could be a long-term opportunity.

The central premise of my original recommendation was Signet’s new management led by Virginia Drosos, who is strategically focusing on long-term stability and growth. On stability, Signet is outsourcing its $1.0 billion prime credit portfolio, and on growth, Signet is focusing on omnichannel (online) sales, including the acquisition of R2Net, which owns online diamond retailer JamesAllen.com. Its 15% share of the jewelry market gives Signet a significant advantage in its online strategy.

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The online trend this holiday season can be seen in this web traffic report from similarweb.com (the blue line is Kay Jewelers and the orange line is Helzberg Diamonds). And Kay jumped 12 points and Zales climbed 13 points in a month to rank 10th and 6th in online jewelry shopping according to similarweb.com.

As Signet executes its online initiatives, it will increase the likelihood of the company’s long-term turnover, so I recommend buying more shares on dips to lower your cost. Having said that, the inherent risk in retail industry should not be ignored, and I recommend a smaller than average position in Signet (or Hanesbrands, as we will discuss later). Signet is a turnaround company, and it may not fit for a risk-averse investor. However, the company’s success in its online endeavor will greatly increase the potential of a healthy return. I’ve decreased the stock’s intrinsic value to 68 this month. HOLD.

Four other stocks among our 26 recommendations was down this month: Cognizant Technology (CTSH: -4%), ARLP (-4%), Apple (AAPL: -2%) and Blackstone (BX: -1%).

On the positive side, we have seen more than 9% growth in Discovery Communications (DISCA: +16%), Stifel Finance (SF:+13%), Lowe’s (LOW: +10%), Home Depot (HD: +12%), Ross Stores (ROSS: +21%), Thor Industries (THO: +16%), and Nike (NKE: +15%), FedEx (+10%), LKQ (+9%) and T. Rowe (TROW: +9%). During the same time period, the S&P 500 rose 2.58%.

As a long-term investor, these near-term price movements do not impact our view of the intrinsic value. However, we keep track of them to check how close the market values a stock to its fair value.


“The intelligent investor is a realist who sells to optimists and buys from pessimists.” — Warren Buffett

Economic and Market Update

The economy is recovering. The unemployment rate, at 4.1%, is the lowest since 2001, consumer confidence and household saving rate (3.2%) is near the pre-recessionary level, and the housing market is back on track.

One might argue that the current economic conditions are right for stocks, but at the same time, it’s important to note that the present economic factors are already factored into the market’s valuation (the treasury yield and earnings yield are converging).

It is a challenging environment for a value investor. To find bargains at the current market valuation is like gold digging in an used-up mine. As we undertake such an adventure, we are prone to make more mistakes—either falling into a value trap or compromising our bargaining power with Mr. Market.

New Buy Recommendations

In this issue, I introduce two kinds of stocks. First is a ‘cigar butt’ stock—cheap with questionable growth expectations. Second is a ‘good business at a fair price’ stock.

Hanesbrands (HBI)

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Hanesbrands (HBI) is a ‘cigar butt’ stock. Hanesbrands is one of the largest clothing companies in the U.S. Before recommending Hanesbrands, I want you to consider the stock with caution—I will discuss the inherent risks in the apparel industry later.

HBI is an undervalued stock (trading at PE of 13x), with well-recognized brands in the company’s portfolio: Hanes, Champion and College Apparel. Revenue stood at $6 billion in FY 2016 (ending December 2016) with a 13% operating margin, which is estimated to be around that of Fruit of the Loom (owned by Berkshire Hathaway).

Hanesbrands has an impressive track record under the leadership of Richard Noll, who served as the CEO from 2006 to 2016. Noll’s long-term strategy to improve efficiency and increase international exposure can be seen in the two graphs below. The strategy can be summed up as acquiring companies with strong brand positions in innerwear and activewear segments and using Hanesbrands’ cost-efficient model to streamline the acquired business.

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The acquisition-driven business is finally showing some revival in organic growth. After months of declining organic growth, there was a 2% increase in organic growth this quarter led by double-digit international organic growth. Hanesbrands’ strategy for international diversification seems to be proving right as U.S. retail market is tightening.

Since Richard Noll stepped down as the CEO, former COO Gerald Evans has taken charge as CEO. Evans has promised to take more online initiatives, but it’s too early to make a sound judgment on the new stewardship. Hanesbrands’ online penetration is just around 10%, and it has ample room for growth if the company executes prudently.

Although HBI is evidently cheap, I recommend that you invest cautiously and take only a small position. The apparel industry is highly cyclical with stiff competition. Bankruptcies are frequent, with two major bankruptcies in recent history: Fruit of the Loom in 1999 and American apparel industries in 2015. For such an industry, good management is of paramount importance. Any sign of rigorous expansion with high leverage will prompt us to exit, no matter how cheap the stock.

A token of comfort lies in the company’s credit covenant, which says: “The indentures governing the Senior Notes also restricts our ability to incur additional secured indebtedness in an amount that exceeds the greater of (a) $3.0 billion or (b) the amount that would cause our consolidated secured net debt ratio to exceed 3.25 to 1.00, as well as certain other customary covenants and restrictions.”

With the hope that management will continue to do its prudent acquisitions with limited credit exposure, will focus on organic growth and continue its supply chain efficiency scale-ups, I recommend the stock as a Buy at this low valuation. However, considering the above-discussed risk factors, I would invest only a portion of my normal investment. The estimated fair value is 28 per share. BUY.

LCI Industries (LCII)

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The second category of stocks is “good business at a fair price’ so they’re not cheap. In normal economic conditions, these stocks might not be considered as a fair priced, but due to prevailing low interest rates, stocks at a lower than normal free cash flow yield can be considered as having satisfactory fair value. As a broad approximation, a good business trading a P/E of around 20x to 25x can be considered in this category today.

Two companies in this category are in the recreational space. As the economy recovers and consumers increase spending, companies in the recreational space are showing robust recovery. We already hold one such stock, Thor Industries (THO), which is the leading manufacturer of towable and motorized RVs.

The first stock is LCI Industries (LCII), previously known as Drew industries. The company manufactures and supplies axles, chassis, furniture etc. for RV manufacturers and related recreational industries.

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As the economy recovered since the financial crisis, LCI has seen impressive growth in its top and bottom lines (as shown at right) along with the RV market.

Such an impressive track record (at pace with RV manufacturers) shows LCI’s leadership in the industry. In addition, operating margin has been improving despite fluctuating raw material and wage expense. Due to the labor shortage, the company has undertaken rigorous investments in automation, which is expected to deliver benefits in the long term.

The estimated fair value of the company is 135 per share, which is only 6% above the current traded price. The stock is not cheap, so invest only a portion of your normal position in the stock. And if you hold THO, I would not recommend additional exposure to the RV industry as it’s hard to predict if the RV sales have reached its peak—though there’s room for further growth if millennials show interest in RVs. BUY.

Watch List

Another industry in recreational area that is beginning to show cyclical improvement in sales growth is boat manufacturing, particularly performance sports boats. Four leading public companies in this space are Marine Products (MPX), Malibu Boats (MBUU), MCBC Holdings (MCFT) and Brunswick (BC).

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A look at Google Trends (shown at right) indicates that since the recession, interest in RVs (the red line) has picked up to pre-recessionary levels. However, interest in boats (the blue line) has just begun to show improvement.

It would be speculative to say now is the beginning of the recreational-boats business cycle, especially because of millennials’ lack of interest in boating activity. However, if the assumption is valid, early entrants will reap the benefits.

Malibu Boats (MBUU) could be a good choice in this industry (MCBC Holdings’ Mastercraft brand would the next choice). CEO Jack Springer is strategically leading the company to maintain the number-one position in the industry. Malibu’s Axis brand is #1 in the performance sports category and Cobalt is #1 in the 24’ to 29’ sterndrive category. Malibu’s distribution network has expanded significantly since its acquisition of Cobalt. I believe Malibu acquired Cobalt Boats at a very reasonable price. Malibu is also focusing on vertical integration with engine manufacturing (due 2019), and as a result, it may see some cost improvements.

Malibu acquired Cobalt for around $130 million, and this quarter, revenue recognized from Cobalt is around $37 million (estimating approximately $14 million annual net income contribution after operating improvements). If the synergy works out, Malibu can expect $39 million in net income in a year without accounting for any organic growth, giving a it a one-year forward P/E ratio of 15. In such an assumption, MBUU is selling at a good discount.

Apart from the risk associated with the speculative assumption of the business cycle, Malibu also has a $80 million tax liability for its pre-IPO private equity owners, which is a huge liability for a company with an $83 million current asset—thus, the company is in the watch list. However, if you wish to move with a short-term (one to two years) bet with some fundamental justification, Malibu could be a reasonable buy with a fair value estimate of around 35 to 40 per share. I will keep this stock on my watch list until I can arrive at a firmer opinion on the assumptions.

Additional Buys

Alphabet (GOOG) Many of you are likely to be holding GOOG, and I would recommend increasing your position if you are holding only a minor position in your portfolio.

Alphabet needs no introduction. Having started as a small search-engine startup, Google has become one of the largest companies in the world, with more than $100 billion in cash (60% of which is parked abroad). With a P/E of 34x, Google is not cheap, but still trading at discount to my estimated fair value.

Recent developments at Google show the long-term outlook to be promising, especially regarding its increasing presence in content distribution. Google’s new bet is on YouTube TV, which is an endeavor to enter the broadcasting space. The strategy behind YouTube TV is to give YouTube subscribers a better platform to media channels. Television broadcasting companies find it hard to sell their content to Netflix or Amazon because their brands are not visible through their platforms. However, Google joined the space dominated by Hulu, Sling, and Direct Now to provide TV content through the internet.

For TV content providers, it’s a great value proposition. It gives their brand visibility to a whole lot of millennial YouTube subscribers. Due to its recent launch, YouTube TV does not have as much penetration and content as that of its competitors. Sling (owned by Dish TV) currently has around two million subscribers. An additional 2 million subscribers to YouTube TV will boost their subscription revenue to $840 million per year. It’s the tip of an iceberg for Alphabet, which is expecting more than $100 billion in revenue this year. However, the initiative will give the company long-term exposure in the media space. YouTube Red’s original contents together with YouTube TV will provide a great platform for YouTube’s 180 million U.S. subscribers. The combined platform will provide extended opportunities for advertisement revenue, which I expect Alphabet to start realizing in the short-term (one to two years).

Along with YouTube TV, Alphabet’s moonshot project, Waymo, is well positioned to be the leader in the self-driving race. Alphabet’s current fair value at 1,213 is trading at a good discount and I recommend it as a Buy. BUY.

Apple (AAPL) is another recommendation in our portfolio that I’m upgrading from Hold to Buy. The integrated platform in Apple devices makes Apple deeply ingrained in its consumer base. Apple has been a value stock for quite a long period of time and due to its sheer size, the market was not able to give it a considerable premium. I’m revising the fair value to 198 considering the success of iPhone X. BUY.

Sell Recommendations

Cognizant Technology (CTSH)
The fair value of CTSH is revised to 70 in light of its decreasing sales growth, triggering a Sell. SELL.

Stifel Financial (SF)
Wealth management firm Stifel has reached our fair value estimate of 60. Sell a portion and hold the rest. SELL A PORTION.

Intercontinental Exchange (ICE)
As ICE is approaches its fair value of 73, I recommend selling a portion. SELL A PORTION.

Prudent Portfolio

Stocks in the Prudent Portfolio are ranked based on various factors, including the prospect of appreciation, maximum downside risk and expected annualized yield. I suggest that you allocate more capital to the stocks with the better rankings.

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Updates on Current Recommendations

Alliance Resource (ARLP)’s fair value is revised to 22 considering its growth revisions. The MLP still offers a 11% dividend and is a good option for income investors. HOLD.

Toll Brothers (TOL) In accordance with our macro viewpoint, Toll Brothers had a good quarterly and annual result. In the fourth quarter, revenue grew 9% year-over-year (YoY) to $2.03 billion. The number of home units sold also grew 9% to 2,424 units. There was robust growth in new contracts (+20%) and order backlogs (+27%). On an annual basis, revenue grew 12.5% to $5.8 billion and operating income grew 31% to $644 million.

TOL hit its fair value of 50 before the Q4 earnings announcement and is now back to 47. To stay safe from any downturn in the housing market, I recommend selling some shares and keeping the rest as a near-term (one to two year) bet. SELL A PORTION.

Big Lots (BIG) In the last update, I recommended a Hold on BIG as it approached its fair value of 59. The Q4 result announced this week showed no significant improvement in sales. Same-store sales were only 1% higher, with no improvement in margins. I do not see any immediate improvement in sales unless management changes its conservative policies. BIG shares are cheap compared to other off-price stores, but management seems to be hyper-conservative even in this low interest rate environment. I recommend selling some shares and keeping the rest as a long-term bet. SELL A PORTION.

Nike (NKE) is another stock that reached its fair value. The remarkable brand that co-founder and chairman emeritus Phil Knight has built over his lifetime has outperformed Adidas over the years. The stock is fully valued at the current P/E of 25 and I would not hold it for the long term from a value perspective. SOLD.

T. Rowe Price (TROW) has hit its fair value, but you don’t need to rush to sell at this point. Asset management has been doing great since the financial recovery. Capital appreciation in T. Rowe’s equity portfolio seems to have boosted its total assets under management, although Blackrock seems to be sucking most of the money from the market led by its passive funds, leading to stiff competition for mutual fund managers like T. Rowe regarding attracting capital and fees. I’m slightly raising TROW’s fair value to 105.21 considering the ongoing trend in the equity market, but I recommend that you reduce your holdings as the stock nears its revised fair value. SELL A PORTION.
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Cabot Benjamin Graham Value Investor is published by Cabot Wealth Network, independent publisher of investment advice since 1970. Neither Cabot Wealth Network nor our employees are compensated by the companies we recommend. Sources of information are believed to be reliable, but are in no way guaranteed to be complete or without error. Recommendations, opinions or suggestions are given with the understanding that subscribers acting on the information assume all risks. © Cabot Wealth Network. Copying and/or electronic transmission of this report is a violation of U.S. copyright law. For the protection of our subscribers, if copyright laws are violated, the subscription will be terminated. To subscribe or for information on our privacy policy, call 978-745-5532, visit https://cabotwealth.com// or write to support@cabotwealth.com

THE NEXT CABOT BENJAMIN GRAHAM VALUE INVESTOR WILL BE PUBLISHED JANUARY 11, 2018

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