A Near-Term Pullback is Possible, but 2021 Looks Good

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After lagging in 2020, value stocks have been volatile thus far in 2021.

However, they are off to a strong start for the year, with the Russell 3000 Value Index up 2.52% headed into today’s trading. Value stocks face challenges from COVID-19’s continuing impact on the economy, and the likely potential of a corporate tax hike with Democrats in control of Congress and the presidency.

However, this is being offset by the hope that an expanded stimulus package and other forms of aggressive spending from the Democrats will ignite the economy over the next few years.

I am skeptical of the market’s current view on this stimulus vs. tax increase debate. The tax increase is permanent and has a direct impact on the bottom line of many companies. A large part of the stimulus, like the checks most American citizens have received, or will receive, soon, is temporary and only impacts the companies’ bottom line to the extent that spending flows through the economy. It may be of little help to many of them.

While the stimulus and tax increases may be good public policy, I feel that the combination will be a drag on the expected recovery in corporate earnings this year.

I do expect the market to come to this realization over the next few weeks, and I would not be surprised to see a pullback after the pretty much non-stop rally that we have enjoyed since November, and that has led to some aggressive valuations.

However, I continue to like our Buy List, which has a lot of companies that draw significant amounts of income from outside the United States. This will mitigate the impact of the tax increase. The valuations of our companies are reasonable, the COVID-19 crisis will pass and the Fed remains very accommodative. I am confident that we will have another profitable year.

BKH: An Attractive Dividend Grower

Black Hills Corporation (BKH) is a utility holding company that operates regulated electric and natural gas utilities, as well as small power generation and coal mining units which primarily sells to the company’s regulated businesses.

The company’s Electric Utilities segment generates, transmits and distributes electricity to approximately 214,000 electric utility customers in Colorado, Montana, South Dakota and Wyoming.  This unit owns 939 megawatts (MW) of power generation and 8,892 miles of electric transmission and distribution lines.

The Gas Utilities segment serves approximately 1,066,000 natural gas utility customers in Arkansas, Colorado, Iowa, Kansas, Nebraska and Wyoming. This unit owns and operates approximately 4,775 miles of intrastate gas transmission pipelines, 41,210 miles of gas distribution mains and service lines and seven natural gas storage sites. This unit nearly doubled in size following the 2015 acquisition of SourceGas Holdings LLC for $1.89 billion.

The Power Generation segment produces electric power from its wind, natural gas and coal-fired generating plants and sells the electric capacity and energy primarily to the company’s regulated utilities under long-term contracts. The Mining segment produces coal at the company’s mine near Gillette, Wyoming, and sells and delivers it primarily under long-term contracts to adjacent mine-mouth electric generation facilities owned by BKH’s Electric Utilities and Power Generation businesses. Mine-mouth electric generation facilities are built close to a mine where coal is excavated from a dig site. Then, the coal is placed on a conveyor belt and moved directly into the plant to be burned.

As a regulated operation, the company has achieved steady growth by putting new assets online and are granted a return on these assets by state regulatory commissions. Earnings per share (EPS) has grown from $2.98 in 2015 to $3.53 in 2019, aided by the acquisition.

When fourth-quarter 2020 results are released in a few weeks, they are expected to show full-year earnings of $3.60 to $3.75 a share, despite a $0.05 to $0.10 a share drag from COVID-19. Favorable weather and good execution in natural gas operations all compensated for the COVID-19-related weakness.

BKH has given preliminary guidance for 2021 for EPS of $3.75 to $3.95 a share. The drag from COVID-19 will reverse, and the company is expected to benefit from favorable rate rulings and new capital projects.

While the market seems to be shying away from utilities due to interest rate concerns, there is good value in the stock at roughly 16X this year’s EPS estimates, with estimates not impacted by any change in the corporate tax rate, as the company is given a fixed after-tax return by regulators on 92% of its assets.

BKH offers a dividend yield of 3.8%, with the dividend likely to increase by 4% to 5% per year. By comparison, the company recently sold 10-year bonds yielding only 2.5%, making the stock attractive by comparison. Buy BKH under $62. My target is $67.

Review of Our Positions

3M (MMM) fell last week on an analyst downgrade which stated that Democratic control of Congress could lead to environmental legislation that could cost MMM billions to clean a chemical it manufactured that ended up entering the water supply. I would not panic and sell the stock here. Rather, I would wait to hear what management says about the issue on its Jan. 26 fourth-quarter earnings conference call.

The company is expected to report EPS of $2.16 vs. $2.15 on a 2.6% increase in revenues. However, the company has had good upside earnings surprises since the pandemic, and I would not be surprised if the expectation were surpassed again, especially with the recent sales improvement in the Electronics and Transportation segment. Outside the environmental issue, things look good at 3M, and the company sells at a discount to its peers at 17.3X this year’s EPS estimates. 3M is a buy below $164. My target is $180.

Cognizant Technology Solutions (CTSH) will report fourth-quarter earnings in the first week of February, with expectations for EPS of $0.90 vs. $1.07 on a 1% revenue decline to $4.25 billion. While investments in growth initiatives will hurt profitability this quarter, I do believe that estimates may be too low based on recent improved results from the company. EPS guidance for 2021 should approach $4.00 a share, up from about $3.65 in 2020, and I believe my $85 target is realistic based on these earnings. I am raising my buy under price in CTSH to $75.

Genuine Parts (GPC) is not expected to report fourth-quarter earnings until next month, and I will have an earnings preview in next month’s issue. The shares have been trading steadily, making a new 52-week high yesterday, and I believe that once the current surge of COVID-19 cases ends, the stock can reach my $110 target. EPS should rebound to a record $5.75 to $6.00 this year, as driving miles will increase and the company is continuing to save money by consolidating its product offerings. GPC is a buy below $95.

I am bumping my price target up to $27.50 on HP Inc. (HPQ), which is still under 11X EPS estimates of $2.60 for the fiscal year ending October 2021. While I believe that there is some risk in the back half of the fiscal year as personal computers are facing tough competition after laptop sales surged during the pandemic, we are seeing improvement in the company’s printing division through workers returning to the office and significant cost-cutting measures. Aggressive share buybacks at prices that are very accretive to per share earnings will also help drive the expected 14% gain in EPS this year. My new buy under price for HPQ is $22.50.

Ingredion (INGR) will report fourth-quarter earnings in mid-February, and I will have a preview in next month’s issue. The stock remains one of my favorites for 2021, as the company’s institutional food business will benefit from the winding down of the pandemic. With a weaker dollar and continued growth in healthier food choices, EPS should increase to $6.50 from $5.95. At just 13X this estimate, with a dividend yield of 3.2%, INGR is a buy under $85. My target is $100.

Keurig Dr. Pepper (KDP) has drifted steadily higher since last month’s recommendation. I believe that this trend can continue, with the company realizing consistent growth in all its product categories, while also trading at a significant discount to its peer beverage companies. KDP is a buy below $31.75. My target is $36.

Kronos Worldwide (KRO) continues to trade well, with titanium dioxide prices up over 20% in the December quarter, and inflationary expectations on the rise with the expectation that government spending will increase meaningfully in the coming years. I believe that there is a potential upside to this year’s EPS estimates of $0.70, and with momentum good in the shares, hold my $17 target. Buy on any market weakness that sends the stock below $13.50. The 4.7% dividend yield should provide support to the stock and add to total returns.

Old Republic (ORI) declared a $1.00 a share special dividend, which you will receive on Jan. 15. The company will report earnings in late January, with expectations of EPS of $0.43 vs. $0.49 on a less than 1% decline in revenues. Earnings will be pressured by lower results in worker’s compensation due to lower employment levels from a year ago, as well as lower interest income. However, strength in title insurance could drive better-than-expected results. With financial stocks performing well, and the company selling at a discount to book value, ORI is a buy under $18. My target is $22.

Safety Insurance (SAFT) seems to be running into near-term resistance when the stock reaches $82 a share. However, I do think that this price can eventually be surpassed and that the stock can achieve my $88 target. EPS will probably decline from a likely record $7.40 last year as the amount of driving activity and number of accidents in Massachusetts will return to more normal levels this year after being depressed in 2020 due to the pandemic. However, I believe that the company will still earn $6.50 a share, and as confidence in that estimate grows, my $88 target will be achieved. The 4.5% dividend yield will continue to attract investor interest. I am increasing my buy under price for SAFT to $78. My $88 target is well below last year’s high of $95.

Valvoline (VVV) will report fiscal first-quarter earnings sometime in early February, with expectations for EPS of $0.37 vs. $0.35 on a 4% gain on revenue as the company’s Quick Lube business continues to grow from the opening of new locations and higher same-store sales. My $27 target in the stock assumes just a relatively modest multiple of 16.5X September 2021 EPS estimates. I believe that, with business conditions going to improve in the current fiscal year, the 10% expected increase in EPS to $1.65 for the year will easily be attainable. VVV is a buy under $21.