The six months of November to April are typically the strongest months of the year for small-cap stocks. But that has not been the story in 2023.
While 2023 has been a year of recovering stock prices for many companies so far, small-capitalization, value companies have been left behind. The small-cap Russell 2000 Value Index (IWN) has declined 4.73% so far this year, and it is now down 25% since its November 2021 peak. Meanwhile, the S&P 500 is up 7.8% year-to-date, and it is now down 14% from its all-time high in January 2022.
The significant weakness in small-cap banks has played a major role in this underperformance this year, but there is also more going on here. There seems to be almost a universal consensus that a recession is coming, even though most economic data remains firm. This has led money to flock back to the largest companies, especially the mega-cap technology companies that dominate the S&P 500. The hope is that larger-cap stocks’ earnings will be more resilient in a recession.
The large-cap dominance so far this year has not been limited to value stocks. The Russell 100 growth index is up an eye-popping 15.82% this year, while the Russell 2000 Growth Index, which was down 26% last year, has recovered only 4% this year.
You’re probably aware that more than half of the companies on our Buy List have capitalizations under $6 billion and can be considered small-cap names. This includes Brady Corp. (BRC), First Busey (BUSE), Newell Brands (NWL), Old Republic (ORI), Patterson Companies (PDCO), Phibro Animal Health (PAHC), and Sonoco Products (SON). The market has been less forgiving to any hiccups these companies may have had compared to their large-cap peers.
While this has been a tough time for smaller companies, I am sticking with them for now. They are inexpensive with good cash flows, and in many cases, they also have attractive dividend yields. Eventually, fundamentals and value will win out, and I think we will see a better performance from these names between now and year end, even if we should experience economic weakness. It is not always easy to take a contrarian stance, but it is generally profitable over a long period with a well-diversified list of stocks.
OXY: Greater Efficiency Will Drive the Stock Higher
Occidental Petroleum (OXY) has been a hot stock as Warren Buffett has been a big investor in the company over the past year. The stock pulled back on Monday after Buffett revealed he has no intention of taking over the company during Berkshire Hathaway’s annual shareholder meeting last weekend. This dip gave us a good opportunity to buy the stock on Monday.
Occidental is primarily a producer and marketer of oil and natural gas, with exploration activities domestically in Texas, New Mexico, Colorado and the Gulf of Mexico, and internationally, in the Middle East, Africa and Latin America. Its exploration unit accounted for 72% of total revenues in 2022.
The company also manufactures related chemicals through its chemical unit, OxyChem. The chemical unit produces basic chemicals, like caustic soda and chlorine, and vinyls, such as PVC used in piping and building materials. This business accounted for 18% of total revenue last year.
Occidental also has a marketing and midstream unit that supports and enhances the company’s exploration and production activities. It operates or contracts for services on gathering systems, gas plants, co-generation facilities and storage facilities. And its marketing business accounted for 10% of total revenue in 2022.
I like Occidental Petroleum as it is doing the main thing oil companies need to do to be successful: Replace its production and do so at a reasonable cost. Occidental has replaced more than 100% of its production for 18 out of the past 20 years. 2015 and 2020 were the two exception years, as that’s when the price of oil collapsed.
While costs have been a problem for OXY in the past, the company is on the right track now, thanks to the company’s proprietary service models, drilling dynamics, and the high quality of its Permian Basin (located in West Texas and New Mexico) reserves. The company was able to replace its reserves last year at a cost of $6.50 per barrel, well below the company’s depletion and amortization cost of over $14.00 a barrel. This has positive ramifications for future profitability even if earnings are pressured by the recent decline in oil prices.
OXY earned $9.35 a share last year when oil prices were elevated, as the company realized $94.23 per barrel of oil sold. While these prices are not sustainable, OXY can still remain very profitable at more normal pricing levels.
We will get a better idea of how OXY will do in the current oil price environment tonight, when the company posts first-quarter earnings after the close. Expectations are for EPS of $1.24, vs. $2.12 last year, with revenues declining 13.6%. However, given the company’s operating efficiencies and likely strength from the chemical unit, I think there is a pretty good chance earnings will be better than expectations. For the full year, the company should earn $5.50 a share barring a collapse in oil prices, which I do not believe will happen.
I will be back with an update on the quarter later in the week. In the meantime, keep in mind the big picture at OXY. This is a company replacing its reserves at a very good cost, with plenty of reserves still available from its Permian Basin operations to keep its recently improved efficiency going for the long term. Buy OXY under $65. My target is $75.
Position Review: Positive Picks for an Uncertain Environment
Brady Corp. (BRC) will report fiscal third-quarter earnings before the market opens on May 18. Expectations are for EPS of $0.92, vs. $0.78 last year, on continued growth from both the Identification Solutions and Workplace Safety segments. The stock has pulled back from its recent highs due to economic concerns. However, even if the economy pulls down EPS in the July 2024 fiscal year to $3.20 a share from an expected $3.80, Brady’s valuation remains reasonable. A more accommodative Fed in this recession scenario will bid the stock higher even before earnings make their inevitable recovery. BRC is a buy below $50. My target is $62.
Fidelity National Information Services (FIS) saw its post-earnings rally end last week when fears about the banking sector re-emerged. However, as the company pointed out on its recent conference call, their customer base is well diversified with no bank accounting for more than 1% of revenue. The company’s cost-cutting measures are also set to kick in, which will set the stage for a recovery for the earnings and the stock. FIS is a buy below $60. My $72 target is just 11X 2024 EPS of $6.50 a share.
First Busey (BUSE) shares continue to feel pressure from concerns surrounding narrowing interest margins. While the company has lost deposits since the Fed started raising interest rates, the rate of decline has slowed in the first quarter. Earnings estimates now reflect the likely decline in interest margins, and the stock is very inexpensive at 8X a reasonable EPS estimate of $2.20 next year. BUSE is now a buy below $19. My new target is $24. The 5.3% dividend yield is secure and should support the shares.
Lowe’s (LOW) will report fiscal first-quarter earnings on May 23, with expectations for EPS of $3.48, vs. $3.51 last year. An expected revenue decline of 8% from the weaker housing market will be largely offset by the company’s share buyback program. I believe the expected revenue decline is perhaps too pessimistic, which could set the stock up for an upside earnings surprise. Aside from the short-term, LOW is a strong franchise selling at just 15X EPS estimates depressed by the current macro environment. LOW is a buy below $215. My target is $260.
Newell Brands (NWL) pulled back after initially rallying following its first-quarter earnings report. While the stock is very cheap based on its earnings projections, the current decline in sales due to inventory adjustments has investors sensitive to any further weakness in consumer spending that would further delay NWL’s recovery. We’ll continue to carefully monitor any potential adverse developments. For now, I want to stick with the stock. NWL should return to profitability next quarter, and I believe management is doing a good job at lowering expenses in this difficult environment. NWL is a buy under $13.50. My target is $17.50.
Old Republic International (ORI) continues to trade steadily. It is impressive the way the company’s profitability has held up despite the decline of title insurance sales, which should recover with housing at some point. ORI remains reasonably valued at 11X this year’s EPS estimates, with earnings having a good chance to rise next year as the title insurance business improves. The 3.85% dividend yield, which will likely be enhanced by a special payout in September, helps make the stock a good choice for the current uncertain environment. ORI is a buy below $24. My target is $27.
Patterson Companies’ (PDCO) fiscal fourth quarter ended on April 30, and the company will not report results until late June. Although the shares have struggled over the past 12 months, I do not think the flat EPS the company is expected to report for the year is too bad of a result considering the company did face difficult COVID comparisons in its dental business. We will know more when the company reports in late June, but I am confident that we will EPS growth in the 2024 fiscal year, and the stock should do well from its current depressed price. PDCO is a buy below $29.50. My target is $33.
Last week, Phibro Animal Health (PAHC) reported fiscal third-quarter EPS of $0.29, vs. $0.33 last year, which was also $0.04 below expectations. Revenues grew 3% and gross profit increased by 5%. However, an increase in employee expenses and interest expenses more than offset these positives.
The stock moved lower after earnings due to not only the earnings miss, but also the company saying that it sees recessionary pressures in its mineral nutrition business. Sales declined 3% in this business for the quarter. With one quarter left in the quarter, the company retained its EPS guidance for the year of $1.21 to $1.31. I believe the low-end of this range is much more likely.
With cost comparisons easier next year, and the overall company relatively recession resistance, I believe EPS can improve to $1.30 next year, which should lift the stock from its current price. PAHC is a buy below $16. My target is $20.
Sonoco Products (SON) reported first-quarter EPS of $1.40, vs. $1.85 last year, which was slightly stronger than the company’s previously pre-announced guidance. Sales were down 2%, as strong pricing was offset by lower volumes. A negative revenue mix also hurt operating margins as more profitable industrial packaging volumes declined.
The good news is that the company’s supply chain situation continues to improve, which allowed SON to raise the high end of their annual EPS guidance by $0.10. The company now expects EPS of $5.70 to $6.00 for the year.
The company used its strong cash flow in the quarter to reduce its debt by $67 million, buy back $10 million in stock and pay its dividend, with the stock currently yielding 3.4%. While the market is not rewarding shareholders, the company is doing well in a challenging environment, and I think the stock will turn higher as the macro outlook improves. Buy SON below $65. My target is $75.
Last week, Sysco (SYY) reported fiscal third-quarter EPS of $0.90, vs. $0.71 last year, on a 14% increase in revenues. Results were $0.02 below expectations, which, along with the cautious comments from the company on the economy, caused an initial negative reaction in the stock. However, the overall the results were solid, and since many of the industries that the company serves are recession proof, the shares recovered a lot of the lost ground.
Growth will slow next year, as the easy comparisons are now over since the company has now raised prices. However, EPS should still grow to $4.50 in the June 2024 fiscal year from $4.00 this year. My $92 target is 20.5X this estimate, a reasonable multiple for SYY given its steady, historical, long-term growth. SYY is a buy below $80.
U.S. Bancorp (USB) has been hurt by concerns the company will be forced to raise capital following the company’s acquisition of Mitsubishi Bancorp’s U.S. assets. However, if we stay out of a recession, the bank should be able to raise its capital to pre-acquisition levels in a little more than a year. Meanwhile, deposits have been steady, and the bank will be able to raise rates on savings deposits and remain highly profitable. USB is a buy below $37. My target is $42.