Value Is Looking Good, But Some Caution Is Warranted

Value has become all the rage of the investing world this year, with the Russell 3000 Value Index up 9.63% for the year going into today, versus a 4.1% decline in the Russell 3000 Growth Index.

While this hardly reverses the massive outperformance of growth stocks in 2020, it does bring a certain sense of gratification to value investors that choosing stocks based on careful business analysis and paying the right price for that business remains a sound and financially rewarding strategy.

To some extent, the valuation of value stocks still does not reflect the fact that interest rates are likely to remain low for years to come, even with the occasional jump in rates like the one we are currently experiencing. However, I would caution that some of the more aggressive value sectors, namely industrials and financials, now feature extended valuations, as momentum investors who are fleeing growth and tech stocks are looking for alternative ways to achieve quick gains.

This aggression could be misplaced, as we are approaching some risks. Namely, I am concerned what may happen with forbearance programs on mortgages ending, as 5% of homeowners are still not making their payments. In addition, now that the stimulus plan has passed, the Biden administration may turn to revenue-raising measures, such as a promised increase in the corporate tax rate. This would lead to meaningfully lower earnings estimates for most companies.

In response to this, some of our recent picks have been more defensive in nature. I believe that this will prove to be the correct strategy, as I believe that there will be a chance to enter more aggressive names at better prices later in the year. Meanwhile, our newest picks are doing well.

Our latest pick operates dollar stores, which have historically been stable businesses. There are also growing indications that improvements in the company’s stores are starting to produce improved earnings. Let’s take a closer look.

A Tree That Looks Poised to Grow

From a single variety store that was opened in Norfolk, Virginia, 60 years ago, Dollar Tree (DLTR) has grown into a chain of more than 15,600 retail discount stores in 48 states and five Canadian provinces.  The company’s operations are conducted in two reporting business segments: Dollar Tree and Family Dollar.

The Dollar Tree segment is an operator of discount variety stores that offer merchandise at the fixed price of $1. The Dollar Tree segment includes operations under the “Dollar Tree” and “Dollar Tree Canada” brands, 15 distribution centers in the United States and two distribution centers in Canada.

The Family Dollar segment was acquired through the company’s 2015 acquisition of Family Dollar Stores for $9 billion. This segment operates a chain of general merchandise retail discount stores that provide consumers with a selection of competitively priced merchandise in convenient neighborhood stores. The Family Dollar segment consists of four operations under the “Family Dollar” brand and 11 distribution centers.

In the just-completed fiscal year, Dollar Tree accounted for 61.6% of gross profit, while Family Dollar accounted for 38.4%.

Since the Dollar General acquisition, the company has enjoyed good sales growth and has opened additional stores. However, it has struggled to translate these two factors into improved profitability. Many Family Dollar stores have struggled, and the company had a difficult time driving down costs.

However, there were signs of improvement in the fiscal year which ended in January 2021. Sales increased 8%, driven primarily by a 6% increase in same-store sales, with Family Dollar same-store sales up 10.5% and Dollar Tree same store-sales rose by 2.0%. While the pandemic helped the company over the past year, as its stores were allowed to stay open as essential businesses, Family Dollar sales were also rejuvenated by two new store formats.

One of these formats, called a combination store, as it combines the best of Dollar Tree and Family Dollar in one location, saw comparable store sales increase 20% in the latest year. The other format, called H2, features more freezers and coolers and a wider selection of products.

Gross margins expanded on the improved Family Dollar results, and administrative expenses were flat as a percentage of sales, despite additional expenses for COVID-19 safety measures. Earnings per share (EPS) for the year increased to a record $5.75 from $4.76 the prior year.

There are some headwinds for the company in the current fiscal year. February sales in Texas were challenging due to the severe weather and sales comparisons will be difficult the next few quarters as the company has to compete against strong numbers while many retailers were locked down. DLTR also faces higher costs for wages and freight transport.

However, I believe that these will be offset by the success of the new Family Dollar formats, lower COVID-19 safety expenses and continued cost-cutting initiatives. I believe that the company will earn at least $6.10 a share in the current year.

In conclusion, DLTR is one of the dominant players in its segment of retail, along with its rival Dollar General (DG). The company is seeing improved results from its Family Dollar segment, and this should drive improved profitability with the steady sales the company has enjoyed. The dollar store industry should remain a stable one, and the improved profitability should drive a higher price-to-earnings (P/E) multiple. Dollar Tree is a buy below $110. My target is $125.

Position Review

Although shares of 3M (MMM) are trading lower than their Jan. 27 high of $187, when the stock spiked post-earnings due to short covering, they are still trading steadily. At 19X this year’s EPS estimates and steady earnings growth going forward, I believe that my $190 target is very realistic. 3M is a buy below $172.

Despite the rise in long-term rates since the start of the year, Black Hills (BKH) has performed well since my Jan. 11 recommendation. Please keep in mind that utilities did well during the Fed tightening in 2018, and as long as the yield in the 10-year Treasury note stays below 2%, I expect this to be the case again. Favorable rate actions and investments in infrastructure will keep earnings and dividends growing at a steady pace. BKH is a buy below $62. My target is $67. The 3.8% dividend yield will add to total returns.

Cognizant Technology Solutions (CTSH) have been stuck in a range between $72 and $76, and this will likely be the case until first-quarter earnings are reported. At this point, the company will hopefully show that the project that it had to terminate at the cost of causing poor fourth-quarter results was a singular event that will not recur. Aside from this issue, CTSH is succeeding in rejuvenating its growth, and its strong pipeline suggests this trajectory will continue into the future. Buy CTSH under $75. My target is $85.

General Mills (GIS) is expected to report fiscal third-quarter earnings on March 24, with expectations for EPS of $0.84 vs. $0.77 on a 6.2% increase in revenues. The company continues to benefit from more eating at home due to the pandemic. While this trend will start to reverse in the fiscal fourth quarter as the company laps the start of the pandemic and will have to undergo difficult comparisons, I do not expect a sharp decline in earnings for the May 2022 fiscal year due to the company’s well-balanced product portfolio. I look for EPS to fall to $3.65 from a projected $3.75 in the current fiscal year. The stock has not done much since last month’s recommendation. However, GIS has the same defensive qualities as utilities do. This should help it in times of rising interest rates. GIS is a buy under $59. My target is $65. The 3.6% dividend yield will add to total returns.

Ingredion (INGR) has continued to see its stock rally strongly after better-than-expected fourth-quarter earnings, as money managers are scrambling to find names that still look inexpensive. At less than 14X this year’s EPS estimate of $6.60, I believe that there is still room for the stock to go higher. If better results from the company’s institutional food business, as the pandemic winds down, enables the company to earn over $7.00 a share next year, my $100 target could be conservative. Ingredion is a buy under $85.

Keurig Dr Pepper (KDP) has been a steady, but not spectacular, performer since my Dec. 7 recommendation, as investors have chased more aggressive names that are tied to an improving economy. However, with the company growing its units steadily, and the stock trading at less than 20X this year’s EPS estimates, I believe the stock should perform well in most environments. KDP is a buy below $31.75. My target is $36.

Kronos Worldwide (KRO) should report fourth-quarter earnings later this week. As I discussed last month, EPS is expected to decline to $0.05 from $0.08 a share. However, the bigger news is that titanium dioxide prices are continuing to rise, which should lead to higher earnings and a higher stock price. KRO is a buy below $13.50. My target is $17. I will have more on KRO after the company releases its earnings report.

Old Republic (ORI) continues to perform well and is not far from my $22 target. I believe that there is a good chance that the target can be raised. I even believe it can be surpassed if the economy stays healthy and the company can earn over $2.00 a share again in 2021, even as its title insurance division declines from its extraordinarily strong results that allowed ORI to earn $2.24 a share last year. Although the stock is not as cheap as it once was, it still sells close to expected year-end book value, and its conservative underwriting polices should continue to drive long-term value to shareholders. ORI is a buy under $18.

Safety Insurance (SAFT) is currently benefitting from an expected rise in interest rates. A decline in interest income cost the company roughly $0.25 a share last year, so a rise here will help compensate for an expected increase in claims expenses as the pandemic winds down. The first two quarters of 2020 still figure to be unusually strong for the company due to lower-than-normal claims, which should allow SAFT to earn over $7.00 a share this year. Buy SAFT under $78. Provided that the financial segment remains favorable, my $88 target should be obtainable. The 4.7% yield adds to the attraction of the shares.

Valvoline (VVV) shares have been range-bound since January, but I believe that they can break out of the range and move higher. Trading at just 15.3X fiscal September 2021 EPS estimates, investors do not appreciate the fact that Quick Lube has become a major growth driver of the company. In fact, it is becoming the majority of VVV’s operations. If the company can show that its growth will not let up over the next few quarters, my $27 target could be raised. I am raising my buy under price for VVV to $23.50.

P.S. I’m excited to be part of the Mad Hedge Fund Traders and Investors Summit, which is a free online event taking place on March 9-11. I speak on Thursday at 10:00 a.m. Eastern. Please join me and many other great speakers by clicking here now to register. It’s going to be a great event, and I can’t wait to see you there. (Well, “see” you virtually!)