The Weekly Summary
Last week saw the bulls hit the wall of worry hard, with Apple and other companies confirming that the Chinese viral outbreak is starting to disrupt market chains and make it more difficult to sell products around the world. Over the weekend we saw reports that this is going to cost the Airlines alone $30 billion in lost revenue. People aren't flying. People aren't taking cruises. And they're still getting sick.
For investors obsessed with hints of a slowdown ahead, this is the latest recession trigger they've been hunting. We remain skeptical. The outbreak seems to be largely contained in China and new cases have plateaued. While South Korea and Japan are now discouraging large gatherings as well, both economies remain resilient and, compared to the number of people getting sick, vast. Only a handful out of every million people in these densely populated countries have caught the disease. Those who are getting treatment now are recovering.
However, the market mood is already on the fragile side after last year's massive rally, so investors are less inclined to consider strong statistics than to ponder everything that could go wrong. We saw this last year when the yield curve was apparently a harbinger of an imminent recession despite all concrete economic data to the contrary. The curve healed. No recession emerged.
If anything, the Federal Reserve remains poised to cut interest rates at the first hint of global weakness. Cash is flowing after last year's cuts. While additional relief is unlikely as U.S. inflation picks up speed, we suspect the cash will keep flowing at its current rate. Easy liquidity has been good for stocks. And as brokerage commissions drop to zero, the barrier to anyone with a little money to invest in the market is lower than ever. As a result, even if "smart" money looks at current valuations and cringes, the hottest stocks keep soaring to statistically unlikely and unsustainable levels.
That's why the market as a whole ground in a tight circle last week and BMR stocks actually declined a bit. Our recommendations are solid, but they just aren't the handful of names that drove market chatter in recent days. We're waiting for a better entry point before we add them to our universe . . . if we ever do. Given the choice, we'd much rather trust strong fundamentals than gamble everything on sentiment. Some of the hottest stocks around right now have run up to 1600X revenue. Forget earnings. That's the price speculators are paying for every $1 in sales right now.
Numbers like that are fun while they last, but they don't last. Our blend of Aggressive and more Conservative stocks is a much more sustainable proposition in the long term, which is all we want. On that note, it's great to see earnings across the market are still holding up a little better than they were a year ago. That's long-term progress, between all the headlines, hype and distractions that Wall Street served up over the past 12 months.
We've survived the yield curve inversion, endless political turmoil, the trade war (remember the trade war?), and missiles fired in the Persian Gulf. Our companies will weather the virus and everything else. They'll even withstand the electoral cycle. A few major investors are terrified that Bernie Sanders will win the Democratic nomination and even go all the way. We'll deal with that if it becomes a real possibility.
There’s always a bull market here at The Bull Market Report! Gary Jefferson has the week off but we have plenty to chew on with The Big Picture looking at "guidance" and The High Yield Investor taking a fresh look at a few of our more esoteric recommendations. Warren Buffett has also delivered his annual manifesto, so we need to update you on Berkshire Hathaway's numbers. And even though our Aggressive portfolio took the brunt of last week's nerves, we still love these stocks. This is the kind of dip smart investors buy.
Key Market Indicators
BMR Companies and Commentary
The Big Picture: What About Guidance?
Every recent earnings cycle has played out in a pattern. A great company delivers a stunning quarter, blowing all expectations away. But the stock takes a big step back because investors were hoping for even better things ahead. And when corporate management isn't prepared to feed those hopes, people wrongly assume that the past was as good as it gets. We don't find that logic convincing, but it's how the market operates these days.
The problem with the argument to guidance is that it makes analysts the supreme arbiters of reality. Management's outlook is only half of the picture. You need to compare their numbers to an outside benchmark in order to evaluate whether the future looks better or worse than you initially projected. In most cases, that's what the analysts told you to expect. Unfortunately, there's often a lot of guesswork in those numbers even in the best of times. If all the variables line up right over a three-month period, you've predicted the outcome to a reasonable standard of error. Otherwise, reality is going to surprise you.
We instead, prefer to let the people who know these companies best guide our outlook. When there's a historical track record of long-term guidance, it's easy to see when management is too optimistic or aiming too low. But weighing their expectations against Wall Street is asking for more disappointment than upside. There are a lot of smart people in the investment banks juggling a lot of numbers. They tend to aim high and then when reality gets in their way, it's perceived as disaster: it's not the analysts who were wrong, it's the company that failed.
Furthermore, when everyone aimed too low and a company beats expectations, long-term targets rarely rise in response. Quite a few of our stocks had an outstanding 4Q19, delivering 17% stronger earnings than we predicted as risk factors simply didn't materialize. That 17% upside raises the base on any comparison to a hypothetical future. Unless expectations rise along with it, the ultimate effect is to depress implied growth rates ahead. The future starts to look less dynamic than the recent past. Expansion curves flatten out.
That's rarely what happens in reality. The companies we look at build on a rising revenue base and translate that expanding cash flow into profit. They don't simply book a windfall in one quarter, fire their sales team and settle for what they have. But that's what the math dictates when you match a better-than-expected historical period against unchanging expectations for the future. Logically a win in one quarter means raising the bar for the next.
That hasn't happened here. As a result, while nearly all of our recommendations have confirmed or raised guidance, their implied growth rates for 2020 have come down sharply . . . if you spend all your time worrying about "consensus," that is. When management provides an outlook, it's been to raise our sights. They're excited about the future. Once the analysts pick up on that, the ceiling on hope will rise again.
To be fair, we're happy that consensus is on the grudging side. When they aim too high, it opens up opportunities for BMR subscribers to buy the dips that follow. The stocks recover. Only those who sold the "miss" are out of luck.
Alteryx (AYX: $138, down 13% last week)
Alteryx has certainly been volatile in the last year, going from $74 to $147 in September before dropping to $87 at the end of October. Since then, the stock has rocketed back, reaching $158 on Friday, an all-time high. The stock had a rough week though, falling 13%, making it is reasonable to ask where Alteryx goes from here. Quite simply, we continue to see good things for the company.
Many companies are talking about using data in the decision-making process. Alteryx’s solutions allow this to happen. Users can quickly and easily transform the data to permit better decision making. There is a lot of data out there these days. Alteryx allows a streamlined process since its solutions are not aimed solely at IT professionals and those with an advanced mathematical degree, who then decipher the data before sending it to the decision makers. Alteryx designed simple, easy-to-use products that incorporate visuals and drag-and-drop functions. The customers, numbering over 6,000 globally, is up 30% from 2019. These include 700 of the Global 2000 with impressive companies such as Chevron, Federal National Mortgage Association Netflix, Salesforce.com, Siemens, Toyota, Twitter, Uber, and Xerox on board.
Management’s strategy, which is to increase the number of customers and expand the number of users within its current client base, is working. When it reported year-end results earlier this month, 2019 revenue showed a 65% year-over-year increase, from $255 million to $420 million. We are particularly impressed that the company, which had losses before 2018, grew the bottom line again. Income increased from $30 million to $50 million.
BMR Take: We are pleased that the company delivered when it reported 4Q19 results. Hence, after crashing through our $120 Target Price, we are raising it to $158. Our new Sell Price is $121.
Anaplan (PLAN: $60, down 5%)
Over the last four months, Anaplan has risen by 38%, from $43. Over a year, the stock has nearly doubled from $33 and this week tested the record level of $63 reached earlier this month before pulling back.
This is another company aiming to improve businesses’ decision making. It has pioneered the Connected Planning category. This is an exciting opportunity. Traditionally, planning for most companies is done in the Finance department using outdated and slow tools. Anaplan is revolutionizing the process through Connected Planning, which allows an integrated approach across the entire organization. Anaplan does this through its proprietary Hyperblock technology that gives access to the data across the organization, which could number in the thousands since Anaplan is targeting large global firms. This makes the planning process much more efficient, robust, and less prone to error.
For those concerned about the risk of this new area succeeding, you can take comfort in the results. These should allay your fears. Anaplan’s 9M19 revenue rose 45% year-over-year, from $170 million to $250 million. The loss slipped to $115 million versus a $100 million loss in the year-ago period. This was due to higher expenses for Sales & Marketing, which rose from $125 million to $180 million. We are not overly concerned since this is being done to support a rapidly growing top-line. But we would like to see better results on the bottom line in the next few quarters. Its balance sheet is in good shape, with $310 million of cash and $55 million of debt but with losses like these, the numbers could turn around pretty quickly. The company is scheduled to report 4Q19 results on February 27.
BMR Take: There aren’t many companies that are revolutionizing the way business is done. Anaplan is clearly one of them. It is changing financial planning from a cumbersome, multi-department endeavor to a unified, simplified approach. We have a $70 Target Price and our Sell Price is $45.
Okta (OKTA: $134, down 3%)
The stock rose from $62 at the end of 2018 to reach a record of $141 in July or an eye-popping 128%. It headed down to $97 two months later before renewing its ascent. The stock, which pulled back in the latter part of this past week along with the overall market, is still much closer to that all-time high than October’s level. You just can’t hold a quality company down for long, and Okta fits the bill.
This Identity Management Service provider, which is done via a cloud platform, is in a good space. Think about all the data breaches over the last few years. Providing its products to businesses allows users to securely sign into applications. This means customers and employees can trust that their information won’t wind up in nefarious hands.
The Okta customer base, which is all different size companies, numbers 6,000. As the company has grown, bigger customers are becoming more important. They are scheduled to report 4Q19 results on March 5. So far, growth has been phenomenal. Its 9M19 revenue grew by 48% year-over-year, from $285 million to $420 million. The loss widened from $95 million to $160 million due to management boosting expenses, including increasing headcount. The combined cost for R&D, Sales & Marketing, and G&A rose from $295 million to $445 million. With revenue growing at these rates, this makes perfect sense. With sales continuing to grow, we expect the company to become profitable in the next 12 months.
The $1.1 billion of debt isn’t great but there is $1.4 billion in cash, offsetting immediate concerns about the balance sheet.
BMR Take: Okta is just getting started. We believe its market opportunity is vast. As long as there are people trying to steal information, Okta’s business is sustainable. The stock is bumping up against our $135 Target Price. We anticipate raising it soon. Our Sell Price is $113, which we are raising now to $121.
CyberArk (CYBR: $121, up 2%)
CyberArk Software hit $147 in July, which was an all-time high. After pulling back to $99 in September, the stock has resumed its upward climb, rising 22%. As with Okta, CyberArk protects businesses. The company’s privileged access management software is involved in thwarting external hackers and internal threats. Want proof that this is the real deal? More than 50% of the Fortune 500 have signed up for Okta’s solutions. If there’s a better testimony, we can’t think of one.
Okta continued to roll in 4Q19. Revenue increased by 18%, from 4Q18’s $110 million to $130 million. Profit slipped from $25 million to $20 million. This was caused by management raising R&D spending from $15 million to $20 million, and Sales & Marketing expenses from $40 million to $55 million. These are investments for the future, and we remain confident these will lead to future revenue growth.
The company also generates a nice amount of cash flow. For 2019, its operating cash flow was $140 million, a 9% increase over 2018’s $130 million. The balance sheet is healthy, too. There was $1.1 billion of cash and $485 million of debt.
BMR Take: There is beauty in the simplicity of the business. CyberArk does an excellent job of filling a void with its customers and meeting a need. The sales growth is there and we believe profits will turn upward soon. We have a $151 Target Price and a $121 Sell Price. (Remember, the Sell Price is for YOU to decide what to do. This is not for US. We want you to think about your own risk levels and make decisions that work for you.)
Paycom Software (PAYC: $300, down 4%)
Paycom shareholders have enjoyed quite a remarkable run over the last four months. The stock has risen from October’s $191 to the current $300, a 57% increase. This is down from the all-time high of $342 reached three weeks ago following the company’s 4Q19 earnings report.
We have analyzed 4Q19 results, and these were strong. Revenue rose 29%, from $150 million to $195 million. This drove a profitability increase from $30 million to $45 million, 44% year-over-year growth.
Paycom generates a growing amount of cash flow, $225 million in 2019 compared to $185 million in the year-ago period. The balance sheet is in good shape with $135 million in cash and $60 million of debt.
Some were disappointed with 1Q19 revenue guidance, which management expects to come in at $240 million. This figure is depressed by the timing of a bank holiday that management expects to recover in 3Q20. We note that 1Q20’s revenue is 20% above 1Q18’s $200 million. We believe the Street used this as an excuse to sell off and we expect this is just a little breather before the stock resumes climbing upward.
Started more than two decades ago, Paycom provides a cloud-based comprehensive human capital management solution. It is a turn-key, user-friendly application that allows organizations to better manage their HR function in a more efficient and cost-effective manner. It empowers employees to use it to manage their activities, reducing a company’s administrative burden.
BMR Take: Paycom’s gaining market share and growing revenue. Better yet, its driving profits higher. The stock was above our $315 Target Price earlier in the week before selling off with the overall market. Our Sell Price is $270.
Zscaler (ZS: $55, down 12%)
After Zscaler reported fiscal 2Q20 (ended January 31, 2020) results on Thursday after the market closed, the stock traded down from Thursday’s $65 to close the following day at $55. Before that, the stock was having a good week, running up 5%.
For starters, the earnings report was solid. Revenue rose 36%, to $100 million versus the year-ago period’s $75 million. This was slightly better than management’s guidance. True, the loss widened from $5 million to $30 million. With the company increasing costs to go after the large market opportunity, this was expected. Specifically, management spent more on Sales & Marketing (50% higher, to $60 million) and G&A expenses (upped to $30 million 3x higher).
Management hiked its revenue expectation for FY20, from $410 million to $415 million and they anticipate billings of $515 million compared to their original $505 million guidance. Management is looking for $105 million in revenue, 33% higher than 3Q19’s $80 million. Some investors were disappointed with 3Q20 bottom-line guidance. They expect earnings per share to come in at $0.02, a little lighter some on the Street expected.
Zscaler’s noble mission is to “provide fast, secure and reliable access to information no matter where it lives.” The company provides a cloud security platform that protects data.
BMR Take: Our $95 Target Price may seem ambitious right now. It is important to remember that the stock reached $88 in July, an all-time high and the growth story remains intact. The upshot here is that the fundamentals remain compelling. We have a $52 Sell Price.
Earnings Review: Berkshire Hathaway (BRK-B: $229, up 1%)
Warren Buffett has spoken. He can't find anything he'd rather buy than his own stock, and with $128 billion in cash to deploy, it's a real problem. Berkshire Hathaway earned another $29 billion in profit last quarter so there's plenty of cash coming in. The days of shock losses from bad investments in companies like Kraft Heinz are over.
In theory, Buffett could simply buy back 25% of his company and replenish his cash hoard at a rate of $300 million a day. However, he's always been a grudging fan of his own stock, preferring to buy other companies that offer real organic growth opportunities. Throughout last year he only spent $5 billion on buybacks. He'd much rather keep his powder dry otherwise.
He's waiting for a big dip to put serious money to work. That's how he scooped up massive amounts of Apple, Amazon and the big Banks in addition to the Consumer and Insurance companies that made his initial fortune. When the financial crisis roiled the market in 2008, he grabbed blue-chip stocks at a deep discount, calling it a once-in-a-generation opportunity.
We can all learn from his discipline and optimism. He's buying into Biotech and Grocery chains now and doubled his stake in Occidental Petroleum, which we now recommend as well. It's all about balance and seizing the day. You have to push the button when you get the right entry point, and the fact that Buffett hasn't seen a lot of great entries lately doesn't mean that his methodology or the market is broken. It only means that the day is coming when he'll strike again.
For now, it's business as usual. We expected $66.5 billion in revenue to turn into $2.40 per share in profit on the "B" shares. We got roughly those numbers, maybe a little light on the top line and a little better than predicted on the bottom but nothing to get upset about. When you're dealing with a behemoth, even $100 million here and there is practically a rounding error. We love this stock.
The High Yield Investor
The equity market’s concerns about the coronavirus entered a new phase this week. Previously, there were rumblings about the disease’s impact on economic growth. No one really knows the extent, but in the last few days we got some answers. Apple (a company that remains one of our favorites) warned it wouldn’t meet its 2Q20 revenue guidance due to the virus outbreak in China. Due to the company’s size, its suppliers are also going to feel the effects. China’s GDP, already feeling the impact from the trade war with the U.S., could further slow.
Right now, the U.S. economic data was generally upbeat. Leading Economic Indicators rose 0.8% in January. The real estate market remains strong with higher building permits and starts. One metric, the producer price index (PPI), a measure of wholesale inflation bears watching. It was up a sharp 0.5%, and it is important to monitor to see if a trend develops and filters down into higher consumer prices. Right now, there is not too much to get excited about. Later in the past week IHS Purchasing Managers Index came in weaker than expected.
The Federal Reserve released minutes from its meeting. There were no surprises, with the central bank mentioning the coronavirus as a potential source for trade uncertainty. Overall, the Fed raised its GDP projections, and said that it was less concerned about downside risks. It does expect inflation to move up, closer to its 2% target. All said, it appears the Fed continues in a holding pattern regarding short-term interest rates. Later in the week, the equity market took it on the chin as fears about the coronavirus intensified after concerns were raised that it was spreading, following fatalities in Japan and South Korea.
The stock market’s losses were the bond market’s gains with yields falling across the curve, with the 2-10 spread narrowing from 17 basis points to 12 basis points. Why would investors turn to the U.S. Treasury market? Because it is considered a safe haven since there is zero credit risk. The two-yield Treasury yield ended the week at 1.34%, down from 1.42% while the 10-year yield contracted to 1.46% from 1.59%.
For us, the feel-good U.S. story remains. The economic data is compelling, showing positive growth, and, notwithstanding a one-month spike in the PPI, low inflation. The Bull Market Report continues our hunt for attractive yields for all types of investors.
More conservative investors in higher income tax brackets should find Nuveen AMT-Free Municipal Credit Income compelling. Climbing the risk scale, PIMCO Dynamic Income Fund offers a higher yield by investing in mortgage bonds and other fixed-income instruments. Finally, New Residential Investment, a REIT, offers the highest yield out of the three investments we discuss this week, and of course, has the highest risk.
New Residential Investment (NRZ: $17.44, down 1%, yield = 11.5%)
New Residential Investment is a REIT, and thus it must pay out 90% of its taxable income as dividends. The company invests in residential real estate mortgages and mortgage servicing rights (MSRs). The latter results in a typical 0.25% to 0.50% interest payment for servicing a pool of mortgage loans. The company gets this fee for collecting the mortgage payment and passing it along to the entity holding the loan.
There is a large market for these loans since the institutions that grant the mortgages generally do not hold on to the majority of them. The lenders sell the loans, which are pooled together mostly by Government Sponsored Entities (GSEs) into residential mortgage-backed securities. Between purchasing residential mortgages and servicing them, New Residential has a large market from which to choose.
The company reported results earlier this month. For 4Q19, interest income was $215 million versus 4Q18’s $200 million. Profits fell to $230 million from $245 million primarily due to “other” income turning into a $55 million loss compared to $105 million income mostly due to changes to the fair value of assets.
New Residential Investment (Target Price of $18, Sell Price of $16), offering an 11.5% dividend yield, is for the more risk-tolerant investor. Its residential investment mortgages include a sizeable portion that is not guaranteed by the government or agencies. Thus their investments face more credit risk. There is also the risk that lower interest rates cause refinancings and accelerate prepayments. Given the economy’s state, growing modestly without igniting inflation, and the Federal Reserve currently in a holding pattern we do not foresee an issue on either front.
Nuveen AMT-Free Municipal Credit Income (NVG: $17.04, up 1%, yield = 4.6%)
The firm’s objective is to provide income that is exempt from federal taxes. It invests in municipal bonds and looks for undervalued securities. But there is some risk involved since it employs leverage (37% as of October). While most of the fund's asset are in highly rated credits, with 70% invested in A-rated bonds or better, the managers can invest more in lower-rated bonds. Should they choose, they can place up to 55% of the assets in BBB-rated bonds or below (BBB- or lower is the high yield category). Currently, non-rated and high-yield bonds represent just 11% of the fund's assets.
A closed-end fund with a net asset value per share of $17.64, the $16.97 represents a 4% discount. In October’s shareholder letter, the fund stated it was taking a more conservative approach given the mature economy.
The portfolio is diversified, with nearly 1,100 holdings. Its top 10 investments account for 20% of the assets. Most of these are not in a municipality’s general obligation bonds. It is in places such as Metropolitan Pier, Buckeye Tobacco, Chicago Board of Education, and Toll Revenue bonds. It is overweight in Healthcare (21% of assets) and Transportation (18%), underweighting General Obligation bonds. Illinois represents the largest state holding, with 14% of the fund’s assets. This is followed by Texas, California, Colorado, and Ohio.
In November, the fund combined with Nuveen Connecticut Quality Municipal Income Fund. The 2 funds merged in November to streamline the offerings. Through the end of October, common shareholders’ total return was 23%, trouncing the S&P Municipal Bond Index’s 9%. Over 10 years, shareholders received more than a 6% annual total return, besting the Index by over 150 basis points.
Nuveen AMT-Free Municipal Credit Income (Target Price: $19, Sell Price: $14) offers a 4.7% yield. Since the income is free of federal income tax, you'll want to compare what the yield would be if it invested in taxable assets. To do that, take the fund's yield and divide it by (1 minus your income tax rate). If you are in the highest tax bracket, 37%, your tax-equivalent yield is 7.5%.
PIMCO Dynamic Income Funds (PDI: $33, flat, yield = 8.0%)
This is another closed-income fund that invests with income as the primary objective (capital appreciation is secondary). It accomplishes this by investing globally (although three-quarters of the assets are invested in the United States) in different areas of the fixed-income universe. This means the fund can invest in any type of fixed income security (e.g. mortgage-backed securities, investment-grade and high-grade corporate bonds, and sovereign (i.e. government bonds from different countries).
Typically, the fund allocated a minimum of 25% in non-agency mortgage securities. These have more credit risk than those whose mortgage payments are guaranteed by the government (Ginnie Mae) or an agency (Fannie Mae and Freddie Mac). It also usually invests up to 40% of the assets in the sovereign and corporate debt of emerging markets.
Currently, 50% of the portfolio is invested in mortgage securities, with the overwhelming majority of this placed in non-agency mortgages. High yield bonds were the second largest component, at 19%. The assets are spread across sectors, with the biggest weighting, 6%, in Banks. Utilities, Healthcare, and Aerospace each account for 2-3% of the fund’s assets. The majority of assets, two-thirds, mature within five years. The largest portion, 27%, comes due within a year. The shorter maturity lowers interest rate risk since longer-dated paper is more sensitive to rate changes.
PIMCO Dynamic Income Fund (Target Price: $33) attempts to minimize interest rate and credit risk through shorter-dated bonds and diversifying across sectors. It does invest in the riskier end of the bond pool. With that in mind, an 8% yield is well above the risk-free Treasury rates at the lower end of the Treasury curve. Shorter-dated Treasury yields range in the 1.4% to 1.6% area. Note also that book value is $28.26, so the stock is trading at a large premium. The stock has traded at a premium for years, so it may continue. Then again, watch this closely as this fabulous 8% yield will mean nothing if the stock reverts to book.
Todd Shaver, Founder and CEO
The Bull Market Report