The Nasdaq Collapse and What’s Next for Value

It continues to be a tough road in 2020 for value stocks, as the Russell 3000 Value Index started the day down 10.23% for the year. On the bright side, the Index reached its best level since June last week, before falling victim to the Nasdaq-driven selling Thursday and Friday.

However, perhaps last week’s Nasdaq selling will be the start of better times. The Russell 3000 Growth Index is up 23.79% for the year, as growth stocks have become invincible as investors believe the pandemic will only increase investments in technology to enable remote communications, while the ultra-low interest rate induced by the Fed has allowed valuations to reach levels unimaginable in the past.

However, this growth trading is now overdone. The level of outperformance versus value is not sustainable, and I think a reversal has started. Although there is some controversy surrounding last week’s selling in Nasdaq, it appears to be caused at least in part by the winding down of a trade where big call option buying in stocks such as (AMZN) forced the sellers of those options to buy the underlying stock as a hedge, which drove the stocks even higher. Therefore, an element of speculation and gamesmanship that has driven growth stocks higher may have been removed for now.

Also, economic data keep improving, and COVID-19 is looking like less of a threat in terms of crippling our health care system. This is going to encourage more risk-taking in stocks that have more leverage to the improving economy and the normalization of life in a post-COVID-19 period. Finally, while financial theory suggests that very low-interest rates benefit growth stocks more than value stocks, they do benefit value stocks as well, but this is not yet reflected in the prices of many strong companies.

So, I am confident that once the current overall market selling ends, value stocks are in a good position to outperform, and that stocks on our Buy List can do exceptionally well.

Kronos-Pigments for Profits

Kronos Worldwide (KRO) has been producing and marketing titanium dioxide (TIO2) pigments since 1916. TIO2 is a white inorganic pigment used in paint, plastics and food and cosmetics. Kronos was formerly owned by publicly traded NL Chemicals (NL) but was spun out as an independent entity in 1989. A great technical achievement of the company was the development and commercialization of the chloride process technology in the late 1970s. This process has become the standard in most production of TIO2 today.

The company has over 4,000 customers in 100 countries, with 46% of sales coming from Europe, 34% from the United States, 10% from the Asia Pacific and the remaining 10% from the rest of the world.

KRO has six production facilities it either owns outright or as part of a partnership; two in Germany and one each in Belgium, Norway, Canada and Lake Charles, Louisiana.

The company is the fifth-largest producer of TIO2 worldwide with a market share of 7%. The company’s management estimates that TIO2 demand will grow by approximately 3% a year, driven by overall economic growth and applications that improve the quality of life. The company believes that there will not be a dramatic increase in industry capacity worldwide, as KRO and its competitors should be able to meet increased demand by improving bottlenecks at their own facilities. I view this as favorable for KRO, as it will help keep capital spending down and it lowers the risk of a sharp decline in pricing.

Given that their product is a commodity, Kronos will have a lot of volatility in sales and earnings. The company’s cyclical peak in results came in 2017, with sales of $1.72 billion and earnings per share (EPS) of $1.93, aided by firm pricing and good demand. Even though the company lowered production in the first quarter of 2018 due to the installation of a new Enterprise Resource Planning (ERP) system, KRO still had a good year, with EPS of $1.74 and revenues of $1.66 billion, as pricing remained firm.

Last year was a difficult one for KRO, as EPS declined to $0.73 on weaker pricing and higher raw materials costs could not be passed onto customers. However, what I am encouraged by is the fact the company remained solidly profitable through the recession, as the company earned $0.16 a share in the second quarter even with volumes down 20% due to the lockdown. It appears likely the company will remain profitable through the remainder of 2020, perhaps earning close to $0.60 a share for the year. KRO is then set up for a much better year in 2021, with EPS recovering to $0.90 as the economy improves. Keep in mind that recent manufacturing statistics suggest a recovery in that segment, which is critical to KRONOS, is already underway.

The fact that the stock traded close to $30 when earnings were at their peak in 2017 and 2018 is indicative of the potential price recovery in KRO’s shares. While earnings will be cyclical, the company is sound and strong financially, with interest expense earned over 10X, and cash flow generation equal to earnings, which allows for a generous dividend payment, with the shares currently yielding 5.9%. I believe with the stock still depressed, but with business conditions likely to improve, now is the time to buy KRO. Buy KRO below $13.50, my target is $17.

Review of our Positions.

3M (MMM) had a good August, helped by the strong market, and a good sales report for July. The company will shortly announce sales for August, and I will have an update at that time. MMM is a solid collection of businesses holding up well in the recession, and I believe the company and the stock will continue to do well as the economy improves. The company in the past has sold for as high as 20X forward earnings versus its current 18X, and I believe it can do that again given the very low rate environment. Buy MMM under $160, my target is $175.

Cognizant Technology Solutions (CTSH) had a quiet month, and while I was disappointed the shares could not move higher considering CTSH’s better-than-expected second-quarter earnings, I believe the stock will work its way higher. Strong orders in growing businesses and cost controls in legacy businesses are helping the company stave off the impact of the recession. Once the economy improves, CTSH will be in position to grow earnings meaningfully. CTSH is a buy below $65, my $80 target is based on a reasonable multiple of 20X next year’s earnings.

The weaker dollar has given a slight lift to shares of Ingredion (INGR) in the past week. Although the slumping restaurant industry will cause earnings to decline over 10% this year, look for a recovery in 2021 as the economy reopens and aids restaurants.

Continued growth in specialty products will also contribute to the expected improvement. INGR is a buy below $82, my $95 target is just over 15X next year’s EPS estimate of $6.50. The 3.1% dividend yield will add to total returns.

Genuine Parts (GPC) has been trading near my $100 price target, and I am bumping up my target to $105. The company’s efforts to streamline its industrial offerings paid off with better-than-expected second-quarter earnings, with operating margins higher despite a 14% decline in sales. Sales for the Automotive divisions were higher in July, and the combination of an improved cost structure and recovery from the economic shutdown should allow EPS to improve from $4.80 this year to $5.45 next year. I believe GPC is a good example of a company with a solid franchise whose current valuation does not reflect the sharp decline in interest rates this year, and I feel the 19.5X PE ratio implied by my target is very reasonable. I am also raising my buy under price to $92.

HP Inc. (HPQ) reported fiscal third-quarter earnings of $0.49 vs. $0.57, which was 6% better than expectations. Revenues declined 2% to $14.3 billion which was $1 billion better than expectations, thanks to strong laptop demand during the economic shutdown. However, this strength was offset by weakness in printing, which saw sales decline 20% and operating income fall 37% due to closed offices reduced printing usage.

HP believes it can eliminate over $1 billion in costs in printing over a three-year period and maintain its goal of having 16% to 18% operating margins in the segment. While this is uncertain in my opinion given the ongoing industry pressures, the good news is that the company does not have to achieve this goal to still have earnings power of over $2.00 a share. Meanwhile, while the personal systems segment will slow from the 7% revenue growth achieved in the quarter, results should remain relatively steady and help HP Inc. maintain its status as a cash flow generating machine. Free cash flow generation has helped the company retire 6% of its shares so far this year, and this will continue into the future and help EPS comparisons.

HP Inc. remains a buy below $19; my $23 target is just 10X a reasonable fiscal October 2021 EPS estimate of $2.30.

MSC Industrial Direct (MSM) shares have stabilized but still trade off their highs from earlier in the summer following recent disappointing sales. Manufacturing activity has shown signs of picking up, however, and I am hoping for some improvement in August sales which will be reported in a few days and bring the stock closer to my $72 target. MSM is a buy below $60.

Old Republic (ORI) stock has lagged despite the company’s strong second-quarter earnings and the strong stock market which should lift the company’s equity portfolio. Soft pricing in certain states’ workmen’s compensation insurance rates may be scaring some investors, but I believe the company will still realize earnings per share (EPS) of $1.60 this year with improvement next year. At just 10X earnings and .84X book value, the stock’s valuation is compelling considering the company’s long and favorable underwriting history. ORI is a buy below $18; my target is $22. The 4.75% dividend yield will add to long-returns.

Public Service Enterprise Group (PEG) is off its recent highs as greater confidence in the economy has lifted interest rates to put pressure on the utility sector. However, the increase has not been meaningful, and the company’s 4.1% yield is much better than the typical utility. A sale of the company’s non-nuclear power generation business will also be favorable for the stock, as it would remove an element of volatility to the company’s earnings. PEG is a buy below $53; my target is $60.

Safety Insurance Group (SAFT), last month’s new pick, has struggled as financial stocks sold off in the middle of August. However, the stocks are beginning to stabilize, and I believe they will recover shortly. The company has a history of solid profitability and has limited exposure to large catastrophic losses. Valuation of 12X 2020 EPS estimates and 1.3X book value is very low by historical standards, while the 5.0% dividend yield adds to the attraction of the shares. Buy SAFT under $82; my target is $95.

Universal Health Services (UHS) shares have traded in a relatively tight range. However, new COVID-19 cases are on the decline again, and with progress being made on vaccines, the chances remain good the hospital company will return to normal operations sometime in 2021. Meanwhile, the company remains profitable and will return to annual EPS of above $10 a share as soon as next year. UHS is a buy below $100; my target is $120.

After a period of significant outperformance since the market bottom in March, shares of Valvoline (VVV) retreated in August. While there was some concern in last quarter’s earnings conference call that lower costs for lubricants, which benefitted the company’s second quarter, would be passed to consumers, I believe the company will still be close to flat EPS comparisons by the fourth quarter, which would be a good accomplishment considering vehicle miles driven has declined 7% since March. The company will then be set up for a strong 2020, with QuikLube franchises continuing to provide growth. VVV is a buy below $20; my $26 target is 16.8X 2021 EPS estimates of $1.55.