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The Weekly Summary

The election is all over except the inevitable recounts and legal challenges in jurisdictions where no clear winner can be announced yet. One way or another, half of Wall Street is somewhere between happy and relieved. A week ago, nobody was happy. Now, while half the people are still frustrated with the results, the world has yet to end. In fact, futures are up sharply in overnight trading as we write this. Neither party pulled off a commanding lead or is likely to capture all branches of the government. We are probably going into a period of incremental change, fierce resistance and something like gridlock.

In many ways, that's the best possible outcome for Wall Street. Stocks thrive on an equilibrium between disruption and stability. Too much disruption creates volatility and exhausts us. We lose our patience and our nerve. Too much stability deadens the economy and risks stagnation. Investors evidently appreciate the way the votes stacked up because our stocks and the market as a whole spent much of last week rallying in relief. No matter how disappointed or frustrated you might be, the way money is flowing demonstrates that many people are pleased to see that the results weren't worse. They can live with this.

And one way or another, with the election out of the way, we can all get back to work on challenges like the pandemic, where a consistent containment strategy will be welcomed and a little more economic stimulus will definitely not hurt. People are tired of shifting rules and rolling shutdowns. One day we will have a real mass-market vaccine. Until then, lawmakers no longer have the election to distract them and can work together in the national interest. We aren't quite cynical enough to assume that they won't. At least they have the opportunity now.

Meanwhile, our stocks make their own luck. Despite everything that has happened this year, the BMR universe is now up 30% YTD. In a normal year, that would be huge. In the face of a pandemic and a shadowy recession, it's a towering achievement. And with the holidays coming, the year is winding up. We're now only two months from the next earnings cycle . . . and this one should bring clarity on what every company on Wall Street considers its "new post-pandemic normal."

As bizarre as it may sound, we have now been in this twilight state for nearly nine months. Once the full year is over, the comparisons get a whole lot better and all investors will be able to gauge progress again on a company-by-company basis. It's going to feel good. And that day is not far away.

There's always a bull market here at The Bull Market Report! We're doing something different in The Big Picture by providing more strategic notes on what the Fed's easy money is doing to traditional asset allocation. Stocks have cheered at the support but Treasury debt does not look attractive here. The High Yield Investor has plenty of alternatives to bonds if you agree with our logic. Otherwise, we have many stock updates and if you're wondering about what the election results mean, Gary Jefferson is on point.

As always, please write Todd Shaver directly at Info@BullMarket.com with any questions you have about our stocks. His goal is to respond quickly.

Key Market Indicators

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BMR Companies and Commentary

The Big Picture: Treasury Or Trash?

Investing is all about playing the cards the world deals you. Sometimes the opportunities fall right into your hand. In other seasons, you draw nothing but obstacles that need to be overcome. And occasionally you just need to fold. That’s the position Treasury bond holders are facing. After all, Jay Powell is going to run the Federal Reserve for the foreseeable future. The election didn't change that. This is a real problem for the traditional 60% stock / 40% bond portfolio, where the bonds effectively serve as ballast, paying a few percentage points in annual interest while promising to return your initial capital in full when they mature.

No risk. Minimal real returns. We usually accept the terms because the 60% stock allocation does most of the long-term work. Stocks simply make more money than bonds. Unfortunately, they’re also a lot more volatile. We love stocks. Overall, our recommendations have gained 130% apiece since we inaugurated coverage on each one. On that basis, the 60% end of a conventional portfolio is doing just fine.

The problem is on that other side that Jay Powell effectively controls. We don’t have anything against Powell. He’s doing heroic work supporting the markets while we all recover from the pandemic. On that level, the Fed is every investor’s friend. But because the Fed’s support takes the form of massive bond buybacks, Powell’s flood of free money has pushed Treasury prices beyond rational levels. And since rising prices depress the associated yields, these securities now pay less income than any sane investor would tolerate.

All government debt now carries a lower effective interest rate than ambient inflation. In other words, while you’ll get your money back when those securities mature, it will buy less than it does now. Buying bonds today is a guarantee that you will lose purchasing power throughout the holding period. You’re locking in a slight but significant loss.

And if 40% of your portfolio follows that best-case-scenario math, your stocks need to work even harder just to keep up with the minimal inflation we see now. If the Fed’s heroic efforts erode the value of the dollar, inflation picks up and your bonds will do even worse. So much for “safety.” Powell said it again last week: Interest rates will not rise until inflation trends well above 2% for an extended period of time. We don’t anticipate Treasury debt becoming interesting again to retail investors before 2022 at the earliest.

However, you don’t need to play the Fed’s game. Banks and insurance companies need to buy Treasury bonds to meet regulatory capital requirements. They can’t own stock under those terms. You, however, are not a bank. What you need from your portfolio is a good long-term growth profile and current cash flow to smooth the rough patches when selling stocks would only lock in a loss.

When your bonds mature, don’t buy new ones. Roll that money over into high-yield dividend stocks instead. Remember, Johnson & Johnson and Microsoft formally have better credit ratings than the federal government. If they default, we all have bigger problems to worry about, and the yields are a lot better than just about anything you'll find in the Treasury market right now. Johnson & Johnson even pays more than ambient inflation . . . and unlike bonds, there's always the chance that these stocks will gain value over your holding period. World-class companies have management teams constantly working to enhance shareholder returns. Not all succeed, but there's a better shot here than with bonds.

Once you have a reliable income base in place, you can reach for incrementally higher yields from companies that have the cash flow to pay quarterly dividends in good times and the reserves to cover their obligations in the event of economic disaster. That's all it takes. Their stocks can go up and you'll be happy. They can go down and it really isn't your problem until you decide, for whatever reason, that you need to liquidate. As long as the checks keep coming, patient investors can lock in even bigger yields in perpetuity.

Think of these stocks as bonds with no guaranteed return when they mature. But over a long enough holding period, the dividends can more than compensate investors for substantial volatility along the way. We choose our High Yield and Real Estate stocks on this principle. Even in an economic catastrophe like the COVID pandemic, most find a way to maintain their shareholder distributions. A few falter a little along the way, but we've seen that they have what it takes to get back to work once a crisis recedes.

The stocks have had a bad year because some investors aren't able to trust the companies to pay for the long haul. But we believe the worst is over. Many of our recommendations rely on the yield curve to borrow cheap and lend the cash back out at higher rates . . . the curve looks a lot healthier now than it did a year ago. And Real Estate companies have come out the other side of the pandemic rent crisis. If tenants didn't default on their leases over the summer, Congress is going to make sure they don't default in the coming year.

The stocks have a lot of hard work to do before they recover pre-pandemic levels. They've been a drag on our overall performance, keeping the BMR universe from matching (or exceeding) the Nasdaq's unexpectedly spectacular YTD return. A lot of trust needs to be rebuilt, which takes time. But that's an opportunity. Many of these stocks currently carry a discount to their balance sheets. You're getting a slice of those assets at a bargain price.

Over time, we know the market resolves discounts and stocks generally achieve fair value. In that scenario, the stocks will pay back more than what you put in now. And in the meantime, unlike bonds, the dividends will hold up a whole lot better against whatever inflation is waiting for us.

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Okta (OKTA: $233, up 11%)  

This year the stock has nearly doubled. Since its 2017 IPO, you would have seen your investment increase by 14 times. We were a bit late, adding the stock to our coverage in 2019 at $96. Yet, we couldn’t be happier with the performance. Allowing employees to sign in to their companies’ network with a single login, its revenue growth has been astounding. Fiscal 2Q21 (ended July 31) revenue grew 43% versus a year ago to $200 million, from $140 million. Typically, we like to see profitability follow the same path. That wasn’t the case here, with the loss widening from $45 million to $60 million. Since this was due to a higher interest cost, we aren’t overly concerned. As long as the company continues to execute on the top line, profitability will follow and there’s every indication that that is going to happen. Just look at management’s guidance, which calls for third-quarter revenue to grow 32% to $200 million. Our $220 Target Price and $175 Sell Price is outdated. With our strong conviction in the company, we are raising them to $270 and $205.

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Twitter (TWTR: $43, up 4%)  

The stock cratered on the last trading day of October, falling from $52 to $41 after the company reported 3Q20 results. Revenue rose 14% compared to last year, to $935 million. This didn’t lead to higher profitability, with income dropping to $30 million from $35 million. We aren’t phased by this since this was due to higher interest and other costs, and lower interest income. In other words, these are not core items related to the company’s operations. What the Street didn’t like was the slowing user growth. Its average monetizable daily active users were 187 million, an addition of only 1 million users from 2Q20. It had added 10 million in 2Q20 during the pandemic. Even with that, the Street was expecting another 10 million additions this quarter. Clearly, the pandemic skewed the numbers, so we’ll wait to see how things shake out in the coming quarter.

Management wasn’t too helpful, only stating that the U.S. election makes it hard for them to predict ad spending. Activist investor Elliott Investment, that had called for the ousting the company’s chief executive, Jack Dorsey, is involved, (this time in a constructive manner) and Twitter formed a committee to look at the company overall. Some governance issues were hashed out, such as ditching the classified board structure and working on a CEO succession plan. We have a $44 Target Price, and our Sell Price is $34.

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Universal Display (OLED: $212, up 7%)  

The stock has been on a tear since March after it dropped to $105, a 52-week low. On Friday, the company reached $215, putting the $222 all-time high within reach. Trading at $190 on October 28th, the latest catalyst was its 3Q20 results. A leader in organic light emitting diode (OLED) technologies, revenue grew 20% over the prior year to $115 million. The company is profitable, with the bottom line increasing 10% to $40 million. (Note that a $40 million profit on $120 million in sales is very strong.) The quarter saw a nice rebound from 2Q20 when revenue dropped by 50% to $60 million due to the pandemic hurting demand for its products.

The recent results show that the company is as strong as ever. It is producing next-generation products, transparent OLED screens that are already being used, and management expects its usage to widen to different markets as diverse as homes and airplanes. Its existing products are used in many applications, including Apple’s new iPhone 12. The stock has more than doubled since we first recommended the company in 2018 when the price was $95. Our optimism in the company is as high as ever. That’s why we aren’t hesitating to raise our $173 Target Price to $240. Our new Sell Price is $183, up from $145.

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Akamai Technologies (AKAM: $102, up 7%)  

 The market sent the stock down from $107 to $96 after the company reported 3Q20 results in late-October. It dipped further over the next couple of days, down to $94, before coming back part of the way. This just creates a more compelling valuation. Revenue rose 12% year-over-year to $795 million. This drove its EPS 13% higher to $0.95. We don’t find anything to complain about with these results. The company’s solutions allow companies to secure and deliver online content - an important area that companies need. Hence, we believe Akamai’s growth rate will stay strong for the foreseeable future. Nonetheless, the stock is below our $104 Sell Price, so you could decide to cut bait. Our Target Price is $118.

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Roku (ROKU: $253, up 25%)  

The stock had a big run in the prior two days before it reported 3Q20 results on Thursday evening, going from $197 to $227. On Friday, the company hit $256, an all-time high, closing up another 13%. It just keeps on executing its plans, which continue to show up in strong results. Revenue rose 73% versus a year ago to $450 million. Plus, it flipped to a $15 million profit versus last year’s $25 million loss. Roku will undoubtedly sustain its profitability. It generates 30% of its revenue from selling players with the balance from advertising. Both posted impressive growth, with device sales up 62% to $130 million, and advertising revenue increasing 78% to $320 million.  The key metrics, active accounts (46 million, up 43% year-over-year), streaming hours (14.8 billion, 54% higher), and average revenue per user ($27, 20% higher), continue to grow strongly. This has been a huge winner for us since we recommended the company in 2018 at $35. Now well above our $170 Target Price, we are raising it to $290. In keeping with our practice, we are simultaneously increasing our Sell Price from $145 to $225.

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ServiceNow (NOW: $535, up 8%)  

 The stock continues its amazing run, hitting a record of $537 on Friday. The company has had a nice gain since we initiated coverage a year ago at $283.  It reported 3Q20 results at the end of October, which were strong, as usual. Revenue was $1.2 billion, 30% higher compared to a year ago. This bested management’s 27% guidance, or $1.1 billion. When a company beats aggressive projections, we take notice. Their 4Q20 revenue expectation is 28% growth to $1.2 billion from $950 million. Profit did shrink to $15 million from $40 million, but we aren’t troubled by this since it was mostly due to the company seeing some increased expenses which aren’t recurring. In other words, this doesn’t measure the company’s operating performance. The firm continues to ink clients, including 41 deals worth over $1 million annually. Only 2% below our $545 Target Price, we will raise it when (not if) it goes past this level. Our Sell Price is hereby raised $50 to $480.

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Splunk (SPLK: $201, up 1%)  

After a rough September that saw Tech stocks sell off, the company has rebounded in a big way. Down to $171 in late-September, it is up 17% since then. We aren’t surprised since the cream always rises to the top. When the company reports fiscal 3Q21 results (ended October 31) in a month, management expects revenue to come in at $615 million versus $625 million a year ago. As a reminder, 2Q21 revenue fell 5% to $490 million. Results are hard to judge right now since the company is transitioning to a cloud platform. With exciting products and upgrades that allow companies to use data in decision making, and acquisitions to expand its cloud capabilities, the company still has huge growth potential. We have a $230 Target Price and our Sell Price is $175.

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Spotify Technology (SPOT: $276, up 15%)  

We’ll take a 15% gain like this any week. At $276, it is heading back towards its all-time high of $300. We hope you have enjoyed the ride since we recommended the stock at $149 in 2018. Reporting 3Q20 results at the end of October, revenue was $2.3 billion, 14% higher than 3Q19’s $2.0 billion. However, it flipped to a $120 million loss compared to a $285 million profit. This was due to higher Sales & Marketing spending, which went from $210 million to $300 million. Management has proven its ability to grow revenue, so spending for the future should pay off down the road You can see the effectiveness via continued subscriber growth. Monthly active users grew to 320 million, 29% higher than last year, and 7% more than 2Q20. With the stock higher than our $265 Target Price, we are raising it to $325. Our new Sell Price is $240, up from $200.

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Square (SQ: $198, up 28%)   

The company posted 3Q20 results on Thursday evening, driving the stock from $175 to an all-time high of $201. For those of you that bought the stock when we first recommended the company in 2017 at $17 and stuck with the name, congratulations on your huge gain. We’ve racked up another 10X return for you! Revenue grew to $3.0 billion from $1.3 billion in the year-ago period. Most of the increase was due to Bitcoin revenue going from $150 million to $1.6 billion – quite extraordinary. That’s not the entire story, with transaction-based, subscription, and hardware revenue all higher. Combined, the three areas went from 3Q19’s $1.1 billion to $1.4 billion. Profit grew to $35 million from $30 million. Well above our $160 Target Price, there is a lot more room for the stock to run. Our new Target Price is $230. We are also amending our Sell Price to $175 from $120.

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Twilio (TWLO: $292, up 5%)   

The stock certainly had a nice week. In fact, for those of you that bought the company four years ago when he added it to our coverage when it was trading at $52, you’re sitting pretty with nearly a six fold gain. You undoubtedly use its technology, which is used to improve communication in texts, phone calls, video, e-mail, and chat, without even knowing it. Real-time communication has obviously taken on increased importance during these times, and it won’t go back to slower methods. Last month, Twilio reported 3Q20 results, and you won’t hear us complaining. Revenue was $450 million, a 52% year-over-year revenue gain. Once again, this beat management’s guidance by a wide margin, which called for $400 million. Looking to next quarter, they are forecasting 36% year-over-year growth to $450 million versus 4Q19’s $330 million. 3Q20’s loss did widen to $115 million from $90 million. The good news is that the company is starting to leverage operating expenses*, which increased 35% from a year ago, to $345 million. This is the way it’s supposed to happen. Eventually, it will lead to sustained profitability. With the stock now above our $285 Target Price, we are raising it to $335. We are also updating the Sell Price which was $215, to $255.

* leveraging operating expenses: higher sales, with expenses not increasing by as much (fixed costs spread out, economies of scale, etc.)

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A Word From Gary Jefferson

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

The last few weeks have been tough for investors who could have picked from any one of the daily headlines: the election, the pandemic, gridlock in Washington. Everything has been cloaked in uncertainty and fomented in fear. Even though we saw financial results from four of the biggest technology companies in the world which were mostly at or above expectations, all four suffered considerable declines until the election results started coming in.

Blame investors' lack of nerve. Because the election and the pandemic made economic conditions in the current quarter less certain than usual, companies across the spectrum have been reluctant to provide anything concrete in the way of financial guidance. Consequently, the range of analyst estimates is uncharacteristically wide. In a nutshell, nobody knows, and the lack of guidance is causing a major case of the jitters.

But individuals and institutions are holding record amounts of cash. Money market fund balances are currently just shy of $5 trillion. All that cash could be the fuel for a tremendous rally in equities when the investing public regains confidence. And we might be seeing it now. We are fine with a slower pace of recovery, because it is simply unrealistic to think we can continue to have the explosive numbers we saw last quarter. Our economy remains on solid footing, the fundamentals are all there and the fact that it may be somewhat harder and slower to reach our goal is no reason to suddenly flip and expect the worst.

Many analysts make the argument that the eventual winner of the presidential race will not be all that significant to the equity markets. Though the GOP is often seen as more business-friendly and the Democrats are associated with higher taxes, the history of stock market performance during all the presidential terms since World War II doesn’t support the idea that party affiliation has much to do with stocks. While it seems different this time, for sure, we believe history  should not be totally ignored due to only the fear and emotions swirling about.

The more important issue may be whether there is an orderly and uncontested election and a smooth transfer or continuation of power in the oval office. No matter how the election turned out, a large number of voters on one of the sides were going to be disappointed. What we wanted to see is widespread recognition that the democratic process worked as designed and that the election results were fair. This could be as important as the outcome, and so far, investors seem cheerful.

Unfortunately, it can be easy for investors to be influenced in this heightened period of uncertainty by some common “myths." One is the myth that the stock market and economy are somehow disconnected. Remember, the stock market is a leading indicator for the economy. We anticipate. What the market sees is significant unsatisfied consumer demand, a recovery from the pandemic-induced economic impact and an abundance of liquidity flowing through the capital markets. The market is not ignoring the economy. We're simply ahead of the pandemic and looking toward a vaccine.

Probably the biggest myth today is that the election will make or break the economy or the stock market. As we have pointed out again and again, history simply says otherwise. We aren’t making the argument that politics or policies do not matter. But, historically, one can make the best case for forming an investment strategy once policies are known and appear poised to be enacted into law. In other words, it’s better for investors to watch what politicians do, not what they say.

The market has always favored “gridlock” in Washington because one way or another, private enterprise prospers when the government is unable to make decisive moves in any direction. Depending on your political orientation, you may think a victory for the other side will have damaging consequences for the economy and the market. Fortunately, history does not provide the same conclusion. Yes, elections have consequences, but we look forward to a little gridlock. Maybe we'll see compromise, negotiation and win-win policies.

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The High Yield Investor
By Larry Rothman
VP High Yield Investments
The Bull Market Report 

Three of the investments that we are looking at this week fall at the higher end of the risk spectrum, which their yields reflect, of course. We present the opportunities, along with the potential pitfalls, and ultimately you decide how much risk you want to bear. Our fourth name is at the other end of the scale: lower risk, but also paying lower rewards.

Annaly Capital Management (NLY: $7.22, up 2%, yield=12.2%)

Investors bid up the stock of this REIT, which mostly holds Mortgage-Backed Securities (MBS), from $6.98 to $7.16 immediately after it reported 3Q20 earnings on October 28. Annaly posted revenues of $450 million for 3Q20, compared to year-ago revenues of $150 million. The company has topped consensus revenue estimates two times over the last four quarters. Quarterly earnings hit $0.32 per share, beating the Street estimate of $0.26, compared to earnings of $0.21 a year ago, an earnings surprise of 23%. In the second quarter, the Street expected they would post earnings of $0.23 per share when it actually produced earnings of $0.27, delivering an upward surprise of 17%. Over the last four quarters, the company has surpassed consensus EPS estimates three times.

Book value increased from $8.39 to $8.70, 17% below the current price. They bought back $200 million in stock over the past six months.  The cost of funds this quarter was 93 basis points versus 1.29% in the prior quarter, as the company continues to benefit from the zero interest rate policy. Management has a keen eye on the market and has renegotiated all debt agreements possible to take advantage of the optimal financing environment. They reduced leverage to 6.2 times from 6.4 times quarter over quarter. The portfolio generated 205 basis points of Net Interest Margin, up from second quarter of 188 basis points, driven primarily by the decrease in cost of funds. Annaly ended the quarter with an excellent liquidity profile with $8.8 billion of unencumbered assets, an increase of almost $1 billion from the prior quarter, including cash and unencumbered agency MBS of $6.9 billion.

Most of its portfolio is in Agency Securities, which are packaged residential mortgages guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae. The company uses leverage, borrowing for the short-term to invest in these longer-term securities. That makes the yield curve very important to Annaly. With the 2/10 spread at 67 basis points, that puts the company in a good position. We always keep an eye out for any flattening and lately the curve has been solid, as the Fed is doing everything it can to hold rates low. It cut its July dividend from $0.25 to $0.22, which is still a 12.2% yield. Our Sell Price is $6, and Target is $9.

Apollo Commercial Real Estate Finance (ARI: $8.64, down 1%, yield=16.2%) 

This REIT invests in real estate debt. This encompasses First Lien Mortgages, Subordinated Loans, and other Commercial Real Estate debt.  There are 70 loans outstanding with a $6.7 billion balance. On average, these mature in about three years. In terms of property type, Office (28%), Hotel (24%), and Residential (16%) total 68% of its portfolio. Urban Retail and Healthcare, at 10% and 6% of its assets, are also significant. New York City is the largest geographic area, representing 37% of the portfolio.

The pandemic has taken a toll on the company. 3Q20 revenue was $70 million, down from 3Q19’s $85 million. Income was $50 million versus $30 million due to an accounting adjustment that reversed a loan loss provision this year, adding $5 million to income versus a $35 million expense. Apollo Commercial Real Estate Finance (Target Price: $10) has slashed its dividend a couple of times this year. Its July payment was $0.35, down from $0.40. This provides a 16.2% yield. So, if you can wait it out, assuming no further dividend cuts, there is a lot of reward for the risk. Our Sell Price is $7.

Ares Capital (ARCC: $14.65, up 6%, yield=10.9%)

Ares is a Business Development company that invests in Middle Market companies. These are smaller firms that typically have a higher risk than larger, more established companies. Management mitigates this risk by investing in safer securities. With $15 billion of investments, $6.8 billion was placed in First-Lien loans, and another $4.3 billion was invested in Second-Lien loans. They also diversify across 16 sectors. Healthcare (19%), Software & Services (14%), and Commercial & Professional Services (9%) are the top three. Ares also spreads its investments geographically across the U.S. The company (Target Price: $18) has a 10.9% yield. Our Sell Price is $12.

BlackRock Income Trust (BKT: $6.09, down 1%, yield=6.8%)

This is one of the more conservative income investments in our universe. At least 65% of its assets are invested in mortgage-backed securities. The mandate also calls for a minimum of 80% placed in securities guaranteed by the U.S. government or agency, or rated AAA. As of September 30, more than 100% of its portfolio was invested in Agency Mortgages due to the use of derivatives. More than half mature within five years. Blackrock Income Trust (Target Price: $6.50) has a 6.8% yield, which is 640 basis points more than the five-year Treasury yield. Our Sell Price is $5.50.

 

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