While October is often a cruel month, it is off to a strong start for value stocks, with the Russell 3000 Value Index up 5.4%.
Value stocks have been buoyed by the hope for more economic stimulus and the potential for a vaccine for COVID-19. The index is still down 7.5% for the year, but it is good to see the slow erasure of the COVID-19-related losses. Meanwhile, our companies are also participating in the rally. In fact, despite a few severe losses during some difficult months, my picks, on average, are now down less than 1% for the year.
Have we now turned the corner for good and left the recession and COVID-19 in the rearview mirror? Are we headed higher through 2021? I believe that it is certainly possible that the Russell 3000 Value Index could be over 10% higher a year from now.
The performance difference between value and growth, with the Russell 3000 Growth Index up over 30% this year, approaches on absurd. This gap is simply not sustainable, and I anticipate that more money will go into value names once confidence in the economy is restored, and once sales growth in many of the current highfliers inevitably slows. At some point, the valuation multiples on value stocks will expand, largely due to the fact that we will see very low interest rates for an indefinite period of time. Indeed, this process has already benefited growth stocks this year.
However, before we get to the nirvana for value stocks that growth stocks have already experienced, there are a couple of obstacles to clear. First, there is the economy, with the chief concern being the large number of first-time unemployment claims. Companies are still continuing to adjust the number of their employees to get costs in line with current demand, especially as the positive impact of the first round of stimulus wears off. While it will take a few more months to determine the ultimate significance of these layoffs, they are currently limiting gains in many names.
The other obstacle is the potential for a corporate tax hike,is a little trickier issue should former Vice President Joe Biden be elected president. A rise in the corporate tax rate from 21% to 28% would lower after-tax earnings for most companies by nearly 10%, and this is not reflected in current earnings estimates. Given the strong recent run in stocks, the realization that a cut in estimates is inevitable will likely lead to a setback for most stocks.
In my review of each of our companies, I do my best to estimate what the impact of a tax hike next year may mean for earnings in 2021. While I would naturally prefer that estimates not end up being lowered, the risks seem manageable, given the low price-earnings (P/E) ratios most of our companies sell for.
While the economy is a trickier issue to navigate, I do believe that a rapid economic recovery is baked into estimates. A recovery is inevitable at some point, and our companies are well-positioned to benefit from it.
While some patience, and the ability to withstand some market volatility, is required, our companies should realize good long-term gains. I will adjust my targets where necessary, take profits when prices look full and add at least one new name a month that offers solid value. Solid dividend yields in a time where cash yields nothing will add A Street That Leads to Gainsto total returns. Things have gotten a lot better for our stocks recently, and more gains will inevitably come.
A Street That Leads To Gains
State Street Corporation (STT) is a Massachusetts-based financial holding company. However, State Street is not your typical bank and does not generate the bulk of its revenues through lending. Instead, it provides investment servicing and investment management services.
The company’s Investment Servicing line of businesses performs core custody and related functions and provides institutional investors with clearing, settlement and payment services. This allows large institutional investor clients to execute financial transactions daily in markets across the globe. Services in this line of business include securities accounting, settlement and custody, daily pricing, cash management and foreign exchange services. Through the 2018 acquisition of Charles River Development, State Street enhanced its portfolio services offerings and software capabilities.
Investment management services primarily include offering index funds to clients, but STT also offers exchange-traded funds (ETF), enhanced investment strategies and socially responsible investing funds.
Investment Servicing is the much larger of the two businesses, contributing 87% of pre-tax profit in 2019.
The company was a model of consistency in recent years, with earnings per share (EPS) growing from $4.25 in 2012 to a peak of $6.48 in 2018. However, EPS fell to $6.17 in 2019, as pressure on fees and lower interest income in client activities drove a 3% decline in revenue.
However, there are some signs of stabilization this year. Revenues increased 5.2% in the second quarter and were flat if you take out the volatile foreign exchange business.
One encouraging sign continues to be the company’s software and processing business, acquired in the Charles River transaction, which improved 45% over the course of the quarter. This business is now 10% of total fee sales and will have a bigger impact on results as it becomes a bigger part of the overall business.
STT will report revenues on Friday, with expectations low on continued fee pressure and lower interest income, with revenues expected to drop 4.6% and EPS to fall to $1.41 from $1.51. However, I believe that these estimates are conservative. While foreign exchange results are difficult to predict, I think the remaining businesses should be stable. Aided by strong foreign currency results in the first half, EPS should improve to $6.40 this year from $6.17 in 2019.
As STT traded above $107 in January 2018, I believe that the stock looks attractive at its current price. Even if EPS were to fall to $5.50 next year due to an increase in tax rates, the stock is a solid value at 12X this conservative estimate. It is also selling at 1.1X book value and offers a dividend yield of 3.1%. Buy State Street under $70. My target is $80.
Review of Our Positions
3M (MMM) will report third-quarter earnings before the market opens on Oct. 27. Expectations are for EPS of $2.23 vs. $2.58 on a 3.2% gain in revenue to $8.25 billion. Sales will be lifted by the fact that the company made up much of the revenue that was lost during the shutdown. However, margins will suffer from an unfavorable revenue mix as the company’s transportation and electronics segment remains under pressure. Given that revenues for the first two months of the quarter have already been reported, I do not expect the top line to differ too much from expectations.
Assuming that the economy remains stable, an improvement in EPS from $8.30 this year to $9.10 next year seems reasonable, although I estimate an increase in the corporate tax rate could shave $0.45 a share from earnings. Given this outlook, I remain comfortable with my $175 target. Hold 3M in front of earnings.
Cognizant Technology Services (CTSH) will report third-quarter earnings after the market closes on Oct. 28. Expectations are for EPS of $0.90 vs. $1.08 on a 2.4% decline in revenues, with global economic weakness weighing on results. However, the company has beaten estimates over the past several quarters, and I would not be surprised if that happens again, given its recent cost-cutting efforts and better-than-expected sales results regarding new services. With these favorable trends, and new orders strong, I believe EPS could rebound from $3.55 this year to $4.00 next year. Even though the company generates most of its income outside the United States, a higher U.S. corporate tax rate could result in a $0.15 a share headwind. With a lot of improvements going on under the surface at CTSH, the stock is a buy under $65. My target is $80.
Genuine Parts (GPC) will report third-quarter earnings before the market opens on Oct. 22. Expectations are for EPS of $1.38 vs. $1.50 on a 12.8% decline in revenues. However, given recent improvement in the industrial economy and the positive impact of the company’s efforts to streamline its industrial product offerings, along with continued improvement in the number of driving miles helping the auto parts division, I think that there is a good chance that the company will surpass expectations. EPS should improve from $4.85 this year to $5.50 next year, and even with the potential $0.28 a share headwind from a higher corporate tax rate, I believe my $105 target is achievable. Genuine Parts is a buy below $92.
HP Inc. (HPQ), which will report fiscal fourth-quarter earnings in November, has been trading rather steadily. While the growth that the company has been seeing in laptops is not sustainable, improvement in the company’s printing department, as the economy reopens and HPQ initiates aggressive cost-cutting measures, should compensate for lower computing sales. HP Inc. is a buy below $19. My $23 target is 10X EPS estimates of $2.30 for the October 2021 fiscal year. The 3.6% dividend will add to total returns.
Ingredion (INGR) will report earnings before the market opens on Nov. 2, with expectations of EPS of $1.47 vs. $1.82 on flat revenues of $1.47 billion. Weakness in South America and institutional food services will continue to pressure profitability. Although the stock has struggled, I believe that, as the global economy reopens, results in food services will improve. Thus, we should get a bounce in EPS to at least $6.10 from the $5.70 expected this year. The company generates much of the income outside of the United States, and I believe a higher U.S. tax rate will only impact EPS by $0.10 a share. With expectations low, I believe that there is a good chance of a rally after earnings. Buy INGR under $82. My target is $95. The 3.2% dividend yield adds to the attraction of the shares.
Our new pick last month, Kronos Worldwide (KRO), is off to a fast start for us, as material stocks have done well in hopes of a better economy in 2021. The company will report earnings in the first week of November, with expectations for EPS of $0.08 vs. $0.16 on a 12.5% decline revenues to $382 million reflecting weak volumes and pricing for titanium dioxide (TiO2). While the timing of the company’s earnings recovery will be difficult to pin down, due to the volatility of TiO2 pricing, the company’s earnings power will remain in excess of $1 a share when times are good. The anticipation of this recovery should keep the stock moving higher. KRO is a buy below $13.50. My target is $17.
MSC Industrial Direct (MSM) will report fourth-quarter earnings for the fiscal year that ended in August on Oct. 27. Sales have already been announced as falling by 12% to $747.7 million, and with the company also reporting gross margins close to expectations, EPS estimates for the quarter of $0.96 vs. $1.30 in the prior year will be close to the actual results. The company faces tough earnings comparisons for the first two months of fiscal 2021, and EPS is expected to decline slightly from $4.57 to $4.50 in 2021. A higher tax rate could clip results by $0.20 a share, but we have to keep in mind that the company will have the tax increase only impact its results from the second half of the fiscal year. MSM is a buy below $60. My target is $72.
Old Republic (ORI) will report third-quarter results before the market opens on Oct. 22. Expectations are for EPS of $0.43 vs. $0.51 as premiums are expected to decline by 4.6% on weakness in worker’s compensation results due to an increase in unemployment from the prior year. However, with the unemployment picture improving, we should see better results in future quarters. Although the stock has been disappointing, the shares remain very cheap at less than 10X expected EPS for the year at $1.70 and at only 0.8X book value. These metrics are too low, especially when considering the company’s long and profitable record. I expect a much better stock performance over the next year. ORI is a buy below $18. My target is $22. The stock has a safe and very attractive 4.75% dividend yield.
Safety Insurance (SAFT) will report third-quarter earnings sometime in the last week of October, with current expectations for EPS of $1.45 versus a weak EPS of $1.02 last year. The stock has been under pressure on the continuing impact of COVID-19 on auto insurance in Massachusetts, as much of the state’s economy activity remains restricted. And, although they will not impact third-quarter earnings, the severe storms we saw in Massachusetts last week could pressure the stock as well. However, I think that the stock will recover. The company has a solid operating history that is driven by careful underwriting and pricing. While EPS will be volatile at times, it should average over $5.50 per share over the long-term. At $1.26, the stock’s price to book value is at historically low levels. My new buy price for SAFT is $75. My target is now $88. The 5.3% dividend yield adds to the attraction of the shares.
Valvoline (VVV) will report fiscal fourth-quarter results in the first week of November, with expectations for EPS of $0.36 vs. $0.40 on a 2% decline in revenue to $617 million, as the number of driving miles in the third quarter remained below levels from a year ago. This has cut demand for the company’s lubricants division. Results in the Quick Lube division should still show some growth and will be aided by the acquisition of more franchises.
The stock has struggled somewhat since the start of August after outperforming strongly from the market bottom in March. I believe that there is some skepticism on the expected EPS increase to $1.55 from $1.38 in the next fiscal year, given that the number of COVID-19 cases remains stubbornly high in the United States and Europe. In addition, a higher corporate tax rate could lower EPS by $0.10 in fiscal 2021. However, even if current estimates for the September 2021 year are slightly too optimistic, I believe that earnings will still be higher and that there will be a vaccine that will end the COVID-19 crisis. This will be enough to drive the stock higher. VVV is a buy below $20. My target is $26.
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