Be Prepared for a More Challenging Market

As we’ve entered the final month of summer and delved deeper into the second half of the year, the strong rally we have seen since the March lows has started to lose some steam. This year’s rally has primarily been driven by declining inflation, and it now appears to be reflected in generously valued stock prices. So, for the bulls to maintain control, they may need another catalyst.

Unfortunately, a near-term catalyst may be hard to come by, as the market now faces more challenges. Specifically, the 10-year Treasury yield has broken above 4% despite the decline in inflation. While the Federal Reserve may be finished raising short-term rates, cutting rates may not happen in the next 12 months. This fact, along with no clear evidence of a recession, has pressured long-term rates, which remain well below the Federal Funds rate of 5.25%.

Concerns about earnings and the economy are also hurting stocks. The current earnings season has been good relative to expectations that were not challenging, but the market is always looking ahead. The bar for earnings expectations next year is higher, with expected growth of 10%. This will make the market sensitive to any news that questions what will happen to the economy in 2024. We are seeing this play out in today’s market action, with Moody’s downgrade of U.S. Banks, poor trade data from China, and a sharp decline in Chinese property stocks weighing on U.S. markets.

Given these uncertainties, along with the fact that we are heading into a historically challenging time of the year for stocks, my recent picks have been relatively conservative. I remain confident that all our stocks represent sound values and will finish 2023 strongly, even if we are headed for a short rough patch now.

Overall, I am a bit more cautious right now, which is why I advised selling U.S. Bancorp (USB) this afternoon. Today’s report from the Fed showed that late payments on credit cards have reached an 11-year high, and that reveals strain in consumer finance. I should also add that USB has been a bumpy ride since we picked it up back in April in the wake of the Silicon Valley Bank failure. We’ve made good money here, so I felt it was time to take our gains off the table.

HON: Good Opportunity with Stock Depressed

Honeywell International (HON) is our new pick for the month of August. Many of you are probably familiar with the company, as it is a well-known company with a market capitalization of $130 billion that gets plenty of discussion in the financial media. More importantly, this diversified manufacturer enjoys strong returns on capital, generates a lot of free cash flow and is strong financially.

Let’s take a brief look at the company’s four operating segments:

  • Aerospace is the largest and most well-known of Honeywell’s segments. This business makes a variety of products for the air transport industry, including propulsion engines, integrated avionics, power systems and flight safety equipment. Spare parts and maintenance are also provided. In 2022, this segment accounted for 33% of total revenues.
  • Performance Materials and Technology is a global provider in developing and manufacturing high-quality performance chemicals and advanced technologies that enable industrial customers to operate in a more efficient manner. This segment accounted for 32% of total revenues in 2022.
  • Honeywell Building Technologies is a global provider of software, products and technologies that ensure that industrial and commercial facilities are safe, sustainable, efficient and productive. This segment accounted for 16% of revenues in 2022.
  • Safety and Productivity Solutions is a leading provider of products and software that improve productivity, workplace safety, and personnel and facility performance to customers around the globe. This unit’s products include personal protection equipment and related apparel and gas detection technology, as well as custom-engineered sensors, switches, and controls for sensing and productivity solutions. This segment accounted for 19% of revenues in 2022.

Through these four segments, Honeywell works with several industries, including aerospace and travel, building technologies, energy, healthcare, life sciences, logistics and warehouses, retail and utilities. And it achieved total revenues of $35.5 billion in 2022.

Financial Review

Speaking of financials, Honeywell’s business has been resilient even in recent years. Yes, Honeywell was hit hard by the pandemic, with organic sales down 11% in 2020, and EPS slipping from $8.16 to $7.10. But the fact that profitability held up so well is a testament to the value-added nature of the company’s products and services, as well as the company’s ability to be flexible in difficult times.

Plus, results have snapped back nicely, with improvement across all the company’s segments despite supply chain restraints. Organic sales grew 4% in 2021, driven by a 22% gain in safety and productivity solutions. Then in 2022, sales increased 3%, with Honeywell Building Technologies sales gaining 15%. By 2022, EPS was at a record $8.76, as the company was successfully able to navigate pandemic and supply chain issues.

Results have remained strong halfway through 2023, with organic revenues up 8% and 3% in the first and second quarters, respectively. This time, it was aerospace’s turn to lead the gains, with organic growth up 14% and 16% in the first and second quarters, respectively. EPS also increased to $4.29 from $3.48. And for the full year, management expects EPS of $9.05 to $9.25 and organic sales growth of 4% to 6%.

Despite the good results, the stock has not done well this year. I think this is due to the fact that the stock was a little ahead of itself at the end of last year, as well as concerns about how the economy may impact the businesses outside of aerospace.

However, we saw how well the company manages tough times during the pandemic, and in the absence of a $0.60 pension-related expense this year, HON should earn at least $10 a share next year.

As I said in my initial recommendation, a quality company like Honeywell, with its strong return on assets, free cash flow conversion and strong competitive position, is a good place to invest when a lot of the market seems frothy. Buy HON under $200. My target is $220.

Position Review: Well Positioned to Improve

Several of our Value Authority positions have reported results from the latest quarter in recent weeks. I’ve provided updates on each, and if you’ve missed any of these earnings reports, you can refer to my recent alerts for further information.

Brady Corp. (BRC) will report fiscal fourth-quarter earnings in late August or early September. Expectations are for EPS of $0.93, vs. $0.87 last year, on a 2.4% rise in revenues, with the introduction of new products expected to enhance results. While BRC has struggled to sustain rallies this year, it remains a high-quality company trading at just 13X EPS estimates for the next fiscal year. The stock seems to be well positioned to start doing better. Buy BRC below $50. My target is $62.

Dollar General (DG) will report fiscal second-quarter results on August 31, with expectations for EPS of 2.48, vs. $2.98 last year, on a 5.5% increase in revenues. Higher revenues will strictly be driven by new store openings, as the company’s consumers continue to have their pricing power pressured by inflation. An unfavorable product mix with consumers avoiding unnecessary purchases will pressure margins.

I am hopeful that the company started to see the light at the end of the tunnel this quarter, given that inflation has slowed, and job and wage growth are still good. I recommended DG following its poor first quarter, and with the stock selling at just 16.7X this year’s depressed earnings estimate, any signs of improvement will attract attention from investors. Buy DG under $170. My target is $200.

Fidelity National Information Services (FIS) has not strayed too far from $60 since reporting second-quarter earnings. The stock remains undervalued, given what private equity paid for a majority interest in the company’s WorldPay segment. Significant cost cuts should help improve earnings going forward. FIS is a buy under $60. My target is $72.

First Busey (BUSE) has given up some of its post-earnings gains, but the stock remains well above its highs for the year. There are a few factors helping to support the higher stock prices: the company’s loan book appears to be in good shape, and while further interest margin pressure is possible, it will be manageable. The stock is a good value at 11X next year’s EPS estimates, which reflects higher credit costs and further margin compression. The stock also has a 4.4% dividend yield. BUSE is a buy below $20. My target is $25.

Newell Brands (NWL) has been range-bound since reporting second-quarter earnings. However, the stock is still cheap, and NWL has returned to profitability. Earnings comparisons should be easier next year since retailers have finished reducing inventories, and new management has a greater focus on key products and markets. So, I think the stock can continue to recover. NWL is a buy under $10. My $16 target is 14.5X next year’s EPS estimate of $1.10.

Occidental Petroleum (OXY) has been volatile with the price of oil, but it has been trading firmly. If the global economy avoids a recession, the stock should continue to rally. Low-cost production growth from the company’s Permian Basin assets sets OXY up well for long-term earnings growth. Buy OXY under $65. My target is $75.

Patterson Companies (PDCO) will report fiscal first-quarter earnings in late August or early September. Expectations are for EPS of $0.40, vs. $0.32 last year, on a 3.4% gain in revenues, as the company tries to continue the operating momentum it exhibited in the previous quarter, which sent the stock significantly higher. Both the dental and animal health segments should produce growth. Management believes it has just started to benefit from the investments it has made in previous years, and if there is another big upside surprise in earnings, my $35.75 target could be raised. Buy PDCO below $30.

Phibro Animal Health (PAHC) will report fiscal fourth-quarter earnings on August 30, with expectations for EPS of $0.40, vs. an easy comparison of $0.26 from the fourth quarter of last year. Revenues are expected to rise 1.3%. Earnings should rebound in the next fiscal year for PAHC, with EPS able to reach $1.35 in fiscal 2024 from the expected $1.24 in current year, as cost pressures decline and the company benefits from a weaker dollar. I also continue to believe the sales of the company’s animal health and veterinary products will be relatively resistant to any potential recession. PAHC is a buy below $16. My target is $20.

Sonoco Products (SON) gave back the gains that it made after its second-quarter earnings report. However, it is still a major positive that the company has lowered its earnings guidance for the year, as lower estimates have been priced into SON stock for a while now. So, the stage is now set for an improvement in 2024 when customers are done reducing inventories. The stock is now trading at around 10X next year’s EPS estimates with a 3.53% dividend yield. SON is a buy below $60. My target is $70.

Sysco Corporation (SYY) was not able to hold its post-earnings rally, which I believe reflects the fact that the stock got a little extended technically. However, the stock of this high-quality food distributor is still a sound value at 17X this year’s EPS estimates, which is well below where the stock has traded historically. SYY is a buy below $80. My $92 target is close to the company’s high of 2022.

WEC Energy (WEC) has come under some pressure as interest rates have risen. However, even if rates rise further, I still think the company’s valuation and consistent growth put it in a better position to handle rising rates than many other stocks. If we have an economic slowdown, utilities stocks could do very well. In the current uncertain market, I view WEC as a good “all-weather” pick. Buy WEC under $93. My target is $100.