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The Weekly Summary

As we mentioned in our News Flashes, last week was all about rotation on Wall Street. Money rolled away from high-growth stocks with valuations to match and into slightly more defensive or at least “cheaper” themes, leaving Technology in particular at a tactical disadvantage.

We welcome the turn as a sign that investors remain alert and cautiously optimistic about the economy. Despite all the fretting about interest rates and whether the Federal Reserve now needs to take back a tightening move or two, institutional fund managers didn’t retreat to the sidelines. They simply adjusted their bets, pushing major indices up 1% to 2% in the process. As a result, the BMR universe as a whole gained ground despite a few volatile names pausing their giddy YTD climbs to shift into reverse.

You know the stocks we’re talking about. We talked about them in the News Flashes and a few of you have written in to express your confidence that the stall will be temporary. As far as you’re concerned, this is a buying opportunity. We tend to agree. And in the meantime, for every BMR stock that fell, we had another that soared 5% to 20%. That is not a typographical error, either. If you were reading the Flashes, you know that stock too. Hint: SYNA.

So what happened to drive this rotation? In our view, it really revolves around a sense that the S&P 500 is running out of easy upside here within sight of last year’s peak. The market ran 13% last quarter and our stocks are up 19%. That’s a big bull run in a short period of time, so a pause was in the cards sooner or later.

From here, earnings season starts in two weeks to separate the companies that still have fire in their belly from those that were simply running on post-tax-cut fumes. Our recommendations are the most dynamic players in the U.S. economy so we’re looking forward to a lot of good news in the coming cycle. Other investors may not be so lucky.

Rate fears have receded as well. The partial yield curve inversion didn’t end the world, and like the pilots say, any landing we walk away from is a good one. Fear mongers need to find another target for their angst and the rest of us can return to doing what we love: Watching and participating as U.S. companies dazzle the world and make more money than ever before. That growth curve may be fast or slow, but it’s unlikely to go negative any time soon.

There’s always a bull market here at The Bull Market Report! This week's Big Picture takes a last look at a rollercoaster couple of quarters before we shift back into earnings mode. Gary Jefferson discounts political anxiety while The High Yield Investor deflates those yield curve anxieties from a fresh angle. Which of our holdings are the most rate-resistant of all?

Then there’s fresh news from Apple, the once and future juggernaut of Wall Street. Talking about that company gives us an opportunity to review a few of its rivals (Roku, Spotify), suppliers (Universal Display) and theoretical peers (Twilio, in our opinion). Let’s get to it.

Key Market Measures (Friday’s Close)

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BMR Companies and Commentary

The Big Picture: Is The Correction Finally Over?

Exactly six months ago, the S&P 500 hit a peak and promptly spent much of the rest of 2018 in a steep decline. Right after Christmas, the mood recovered, but it’s taken stocks an entire quarter to heal their wounds and get back to work. Even now, it’s going to take the market as a whole another 3% before it breaks any fresh records — which is the definition of the Bull Market philosophy we live by.

Six months is a long time for investors to wait for tangible returns. We aren’t thrilled with the rate at which the market is moving ourselves, but at least the BMR universe has moved up a collective 2% over that time frame while our dividend stocks have kept pumping cash into subscriber accounts. We’ve easily beaten the index funds’ miserable performance. Granted, we’d always like the absolute numbers to be bigger, but unlike the index funds, we made sure the bases were covered.

The market as a whole lost money in the last six months. BMR made money and depending on your allocations, you might be looking at an average 4% six-month cash return from the High Yield side. That’s good news. And the fact that we parlayed that success into a string of new recommendations during the downswing is a great omen for the future.

We bought great stocks on the dip. Out of our 10 recommendations in the last six months, only one — Dropbox (DBX: $22, flat) — has yet to turn into profit during our coverage period. Some like CyberArk (CYBR: $119, up 5%), Workday (WDAY: $193, up 1%) and Alteryx (AYX: $84, up 2%) are up as much as 70%. Even Tesla (TSLA: $280, up 6%) is back in positive territory since we swooped in on October’s weakness.

As far as we’re concerned, the correction that matters ended a few weeks ago when our stocks collectively passed their 3Q18 peak. Recommendations like PayPal (PYPL: $104, up 3% to a new all-time high) and Dollar Tree (DLTR: $105, up 4%) are joining CyberArk at their highest level since before market went south. A lot of our other stocks are within 3% striking range of joining them. But as we like to point out, barely 20% of the S&P 500 are in a similarly bullish position while many more stocks even in that elite group are still somewhere between correction and full-fledged bear market territory.

Half of all stocks in the S&P 500 are down at least 10% from their pre-correction peaks. One in three are down 20% or more. They still have a lot of work on their plate before the market as a whole can confidently rise to new records. Several of our key recommendations are in that category, as even a casual look at Amazon (AMZN: $1,781, up 1%), Apple (AAPL: $190, down 1%) and friends like Roku (ROKU: $65, up 1%) and Square (SQ: $75, flat) reveals.

In these cases, the fundamental picture has been stirred but not necessarily shaken. They have gifted management teams pivoting as necessary to get back on the track they were following before the 4Q18 confessions and guidance cuts. We’re confident that they’ll recover all lost ground and more, and in that scenario even the S&P 500 should find the strength to rally beyond its peaks.

After all, that correction was savage, even tipping the entire S&P 500 into the bear market zone for a moment. From that perspective, we may not be starting the second decade of one of the longest bull runs in history after all. We may be in the earliest stages of the newest and youngest bull to come — and as those of you who remember previous rebounds remember, the first steps in that kind of cycle are the sweetest.

We’re excited. Our universe rolled with the worst decline in a decade and came back smiling in a matter of months. Now it’s time to keep that defense tuned while we reach for the real upside that lies ahead.

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Apple (AAPL: $190, down 1% -- all returns are for the week)

With the introduction of a trio of new products this week, Apple has cemented its place at the market’s commanding heights by clarifying its long-term growth ambitions. The rollout of Apple Card, Apple News+, and Apple TV+ will all squeeze incremental revenue out of existing customers and entice millions to join the company’s ecosystem.

The Apple Card is revolutionary in that it solves credit card theft, theoretically eliminating conventional magnetic swipe or PIN verification entirely. The “card” is really just a tangible symbol you can hand a merchant to interface with existing transaction systems. The real brains are stored on your phone, where you’ll be able to monitor spending and shut the physical card down if necessary. In the meantime, the system exists to drive more retail activity into the Apple Pay network, where the company is already routing 20 million transactions a day and volume is doubling year over year.

Apple News+ and Apple TV+ reflect a serious push into content delivery. The former affords access to over 300 news publications for $9.99/month and the latter is Apple’s new streaming service for TV shows and movies, effectively a revamped version of the iTunes video store. The frontal assault on Netflix made headlines here, as there is plenty of room in the rapidly expanding streaming universe for multiple players to grab a slice.

Then there’s Apple Arcade, where the company will support over 100 games that can be accessed across the spectrum of Apple’s hardware devices. While Apple Arcade likely won’t have as big an impact on the bottom line, the goal here is to keep young children entertained and bring them into the corporate ecosystem, creating the next generation of Apple Faithful. That will pay dividends as those kids grow up and start buying the devices for themselves as well as using Apple News+ and Apple TV+, paying with their Apple Card.

The goal is retention now. Remember, this is still a company that owns 16% of the North American mobile phone market; operates at 40% gross margins; maintains an enormous stockpile of cash that keeps growing (practically $250 billion at the end of 4Q18, up 3% from the prior quarter); and buys back stock at a continued huge pace. A juggernaut like that doesn’t need to sell vast numbers of iPhones every single year*. It simply needs to ride its own momentum to bigger and better things.

*But they WILL sell millions and millions of iPhones each year.

We can’t help but notice that Apple just hired the head of Tesla power train engineering. Why would they do that unless they have truly transformational ambitions? In the meantime, an evolutionary approach keeps the wheels turning while we wait for the next revolution from the company that brought the world the personal computer, digital music and smartphone.

BMR Take: Concerns about slightly lackluster iPhone sales are so last year. . . It’s a new year and a new ball game now. Apple is far from a one-trick pony. The company is as innovative and dynamic as they come, with this latest slew of service launches proving that there’s still a lot of money to carve out of the world-class brand even if phone sales have plateaued for the time being. We didn’t give up on the company when iPod sales peaked. Why would we bail out now? It only takes a 1% lift for Apple to once again dethrone Microsoft at the top of the Wall Street food chain. From there, $1 trillion is back in sight. (Microsoft sits at $905 billon. Apple at $896 billion. Amazon is still in the running at $875 billion.)

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Spotify (SPOT: $139, flat)

Some say there’s only room for one company in the streaming music marketplace. If that’s the case, they need to explain why Apple’s big push into Music Services left Spotify practically unmoved. What’s really going on here is the way New Media providers as a group are transforming the way we consume entertainment and information. Until that process is complete, there’s no reason to assume competition will be a zero-sum game with one winner and a lot of losers.

We saw more proof of that this week with Spotify making fresh inroads on conventional Talk Radio through a second high-profile purchase in the podcasting space. Following up on its $230 million acquisition of Gimlet Media, the digital music pioneer bought niche podcast platform Parcast.

Parcast hosts mainly True Crime and Paranormal programming, two genres of online chatter with loyal followings and lots of room to grow. Clearly, Spotify is making an aggressive push into the space and we like the long-term diversification thrust here. After all, sound is sound. If people get tired of playing their favorite songs, there’s always News and Talk. Sell the audience unlimited access or pursue a more conventional advertising-supported model. Either way, the end of terrestrial radio opens up a lot of room for next-generation business models.

And the Spotify audience is already huge: 100 million global subscribers, up 35% over the past year. That big reach has already translated into $5.3 billion in annual revenue. We’re looking for that top line to expand another 25% this year as the audience keeps growing on its current trend. Either way, with $900 million in cash and zero long-term debt, management literally has cash to burn building its listener base and the variety of content it can serve.

BMR Take: Spotify’s CEO predicted that soon 20% of all content consumed through its channels will not be music. That means audiobooks, webinars and existing broadcast radio formats, as well as Web-only podcast talk and drama. This company would be great as simply the biggest music streaming service on the planet. With the push beyond music, the path to replace existing commercial radio becomes clear. We’ve always been here for the power of the advertising platform. This is how it happens.

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Universal Display (OLED: $153, down 1%)

This stock had a monster quarter, rebounding 63% as it became clear that the business is a lot more than smartphone screens. Even though revenue dropped nearly 30% last year (to $250 million) due to a sluggish iPhone upgrade cycle, management is pushing Organic Light-Emitting Diodes into new applications like wearable computers, tablets, laptops, TV screens and even smarter automotive instrument panels.

It’s working. This year we expect to see sales rebound to 2017 levels and grow at least 20% annually for the foreseeable future. Universal Display could easily be twice its current size by 2022, and that’s worth both our attention and a little patience. Meanwhile, the business is astoundingly lucrative, generating 70% gross margins even in a bad year and handily supporting Research and Development activities.

Granted, only $1.24 per share made its way to investors last year as profit, which is one reason Universal Display fell so far from its all-time $208 peak before we grabbed the chance to add it to the Special Opportunities list at $95 11 months ago. But all these numbers discount the smartphone market, where Organic Light-Emitting Diodes are becoming the standard in high-end screens. This company has “OLED” as its ticker for a reason. Its technology is the global standard here, so any acceleration on the phone side will be huge.

BMR Take: The next generation of high-end Apple devices is at most six months away now and with 5G networking becoming a reality, a lot of people are going to need new phones. When they upgrade, that means Universal Display screens that are brighter, stronger and even flexible. Who doesn’t want a tablet that can fold into a phone or simply fit into a smaller pocket? BMR subscribers have booked a 60% return here since we launched coverage back in May. Compare that to the market as a whole and the power behind this stock speaks for itself.

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Roku (ROKU: $65, up 1%)

This is another of our champions, up a stunning 85% for BMR subscribers who bought our initial Research Report just 10 months ago. The stock is short move from recapturing last year’s $78 peak, and of course a larger Technology company could easily decide to simply buy it out as a way to control the Streaming Video universe.

Roku is on fire. The user base expanded by 40% last year and now stands well above 27 million. Revenue per subscriber expanded 30% as well, so between the larger audience and more lucrative relationships, we saw overall sales surge nearly 50% to within sight of $750 million.

Management forecasts over $1 billion in revenue this year, which looks conservative given the way Roku is monetizing its platform and the rate at which U.S. households are cutting the TV cable. As for the bottom line, remember: This is still a growth play, with no plans for sustainable profitability at this scale. The goal here is to become the go-to platform translating “online” video content to the big TV screen where so many families still look for their home entertainment experience.

BMR Take: Roku has been a rollercoaster since going public nearly two years ago. Right now the stock is on the upswing and we’re nearing the highs we reached last year. As investors figure out the company’s long-term business model and subscribers keep signing up, we suspect the good times will continue. After all, this isn’t just an upstart gadget maker like TiVo was decades ago. The Roku stick itself is practically a loss leader, the company’s way to bring its advertising into millions of households. That’s where the real money is.

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Twilio (TWLO: $129, flat)

We’ve listed a couple of stocks today that have roughly doubled in the last three months. But why settle for 100% when Twilio has been moving at roughly that rate for the last full year? This was a $37 stock last April. Here we are at $130 with no end in sight.

Twilio revolutionized communications via its messaging software. Big names like Uber, Lyft and WhatsApp (now owned by Facebook) are on board as customers and the client base keeps broadening out as new companies sign up. The 10 biggest Twilio customers accounted for 30% when it went public three years ago. Now they only add up to 20% of the sales base, leaving a lot of room for newcomers.

And since that sales base is tracking to come in quadruple its 2016 level this year, the math is attractive across the board. The original anchor customers have practically quintupled what they spend on Twilio technology over the last three years. If the companies coming to the platform now follow a similar trajectory, the future here is even brighter than the past.

The beauty of Twilio’s business model is that the company hasn’t even penetrated the small business market yet. As more and more entrepreneurs reach out to their own customers via text messages, Twilio is here for them. There’s no way a small business could develop this on its own. We could be looking at the next truly ubiquitous name of the Technology sector.

BMR Take: Add it all up and we expect another 65% growth year to take Twilio to a $1 billion run rate over the next 12 months. We admit that the stock is no bargain on an earnings basis, but what do you expect from a company that just grew into positive margins last year? Twilio has crossed the breakeven frontier now and it’s time for the bottom line to surge alongside the top.

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A Word From Gary Jefferson

Jefferson Financial Group
First Vice-President, Investments
UBS Financial Services, Inc.

The Mueller investigation is done. What does it mean for investors? Our latest research on this subject shows that political biases can significantly hamper investors’ ability to make prudent investment decisions. This can be particularly damaging when we allow political disappointment or exuberance to shape our decisions.

But as we’ve learned, political and geopolitical events — even the ones that have shaped history — have rarely overridden the economic and financial drivers of market returns. As a result, we recommend against making any major investment decisions based on political forecasts or beliefs alone.

We think long-term investors are inherently smart enough to realize this and would answer the Mueller question by simply saying, "Probably little, if anything.” The real question for investors is," Are the economic and financial drivers of the market still intact?"

We are seeing evidence of slowdowns in German and French manufacturing, and the U.S. 3-month/10-year yield curve has inverted for the first time since 2007, which is often seen as a recession indicator. While the inversion was as usual seized on by many media pundits as a signal for a looming recession, we don't see cause for alarm. This is not an inversion of the 2-year/10-year yield curve and even if it were, it would likely be a temporary one.

After all, most of the other relevant indicators of economic health in the U.S. are doing quite well, even though corporate earnings growth rates are definitely slowing down. Even so, total earnings for the S&P 500 index are still expanding, albeit at a diminished rate of 2% compared to last year’s 23% tax-driven surge.

There is no doubt that the immediate impact of the tax cut was significant and the growth created was substantial. However, lower tax rates are still in place and will continue to offer at least some momentum for earnings growth. In other words, we don't see the 2018 tax reform as a one-and-done or boom-to-bust event. The main challenge for investors will be to find companies that continue generating solid profits even as wage pressures rise, credit markets tighten, tariffs weigh and broad GDP growth levels off.

The bottom line: It’s all about the comparisons. Strong growth in 2018 was primarily due to the lower corporate tax rate, which represented a one-time boost to corporate bottom lines and this will make earnings growth in 2019 look weak comparatively. However, while economic growth is slowing as GDP begins to level off, a recession is impossible as long as corporate earnings and revenue are still expanding.  We would take another look at this issue if economic growth outside the U.S. turned particularly bad or growth expectations here at home incurred serious downward revisions. For the time being, we want to stay focused on growth opportunities.

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The High Yield Investor

By John Freund
VP of High Yield
The Bull Market Report 

So what was once a tentative partial inversion between short- and long-term interest rates has deepened and now Treasury debt maturing a month from now pays a higher effective yield than bonds due in 2029. Since we deal with yields here at The High Yield Investor, this is our business. Should investors panic? Which of our stocks are most vulnerable and which will actually benefit if the curve keeps moving against its normal tendency?

Let’s start by defining what we mean by an inversion. The yield curve illustrates the different interest rates paid by fixed-income investments. When most people talk about it, they mean the interest rates paid by Treasury securities like 10-year note and 30-year bonds or 1-month and 3-month bills. Normally the longer out you go to maturity, the larger the annualized interest payments get as compensation for locking up your money for longer periods of time when either something could go wrong or you could be invested in theoretically better-performing instruments.

However, there are times when the yield curve flattens and then, under rare circumstances, reverses its normal upward slope as longer-duration yields decrease, shorter-duration yields rise or both. When short pays more than long, we say that the yield curve inverts.

Strict definitions matter here. The middle of the curve started to invert in December when the normal relationship between 1-year and 3-year yields flipped. Since then, other points on the curve have followed suit, leaving the 1-month bill paying 2.43% while the closely watched 10-year bond only pays 2.41%, and the 3-year debt in the middle only pays 2.21%. Even so, the economy has clearly not gone over any immediate cliff.

Most economists prefer to watch the relationship between 1-year and 10-year yields or, in some cases, where 2-year rates are going compared to the 10-year bond. In this framework, the last few weeks have skirted a 1/10 inversion while a 2/10 flip remains relatively remote. We’d need to see demand for 2-year bonds decline in order to complete that process, and that’s probably not going to happen unless the stock market rallies first.

That’s right. Bonds and stocks usually move in opposite directions as money flows from one asset class to the other. For 2-year bond yields to rise above their longer-dated counterparts, we’d need to see investors flee those bonds for other assets. Stocks are the best game in town right now unless people suddenly become content with 2% Certificates of Deposit barely paying enough to keep up with inflation.

Interestingly, the last time this type of inversion took place (between 3-month and 10-year) was in 2007, a year before the Great Recession. The echo has some investors especially anxious, but a recession takes time to gestate. Considering the unemployment rate, GDP growth, consumer spending and a host of other macro-economic indicators, we’re a long way away. Even the Fed says conditions in the bond market have more to do with Brexit, tariffs and the slowdown in China than anything happening in the domestic economy. As those conditions improve, the yield curve heals.

In the meantime, some stocks in the HYI portfolio are especially rate resistant, largely insulated from developments inside the yield curve. One is New Residential (NRZ: $16.91, up 2%, Yield = 11.8%), the largest non-bank owner of mortgage servicing rights in the world. That’s not a business that relies on interest rates either way, but if the economy weakens, homeowners will stop paying down their loans early and the business of servicing the mortgages will become even more lucrative in the long term.

Whatever the Fed does, New Residential is in excellent shape for the year ahead. In last week’s newsletter we outlined how their extraordinary yield is safe. That doesn’t change here. Rates could rise or fall and the business of mortgage service remains unchanged.

Municipal bonds are another traditional haven from dislocations in the Treasury market. The reason is simple: As the Treasury curve flattens or inverts, bondholders feel the squeeze. A year ago 10-year Treasury bonds paid nearly 3.0% a year. Now that interest rate is 2.4%, and on an after-tax basis it’s even worse. But because muni bonds pay their interest tax free, they look better as Treasury yields are compressed.

As it is, muni investors are still obtaining better rates than short term investors, and they’re not paying taxes on their dividends. That spells good news for muni funds like Invesco Municipal Trust (VKQ: $12.05, flat, Yield = 5.1% tax free or the equivalent of 7.8% taxable), which invests most of its assets in municipal bonds.

One other stock we’ll take a look at in relation to the yield curve is Annaly Capital Management (NLY: $9.99, down 3%, Yield = 11.7%). Annaly is the largest Mortgage REIT in the world. The company’s bread is buttered by borrowing at short-term rates, purchasing mortgage-backed securities paying attractive longer-term interest and pocketing the difference.

As we mentioned in last week’s newsletter, Annaly’s dividend is safe. How do we know? Well for starters, the Fed has been tightening monetary policy for the last three years, yet the company’s operating results have held firm. And an expert management team has been diversifying into targeting residential, commercial and corporate credit assets.

While all companies are vulnerable to an economic slowdown or recession, some, like New Residential and muni funds actively outperform during a yield curve inversion. Others like Annaly are properly prepared and therefore protected against significant downside risk. While investors should always be wary of a potential recession down the road, we don’t see it happening now. Instead, it’s always a good time to cash dividend checks while we can.

Good Investing,
Todd Shaver, Founder and CEO
The Bull Market Report
Since 1998