The Weekly Summary
Lingering Fed relief was enough to push the Banks and other once-neglected market groups up last week, leaving a lot of BMR stocks in the shade. After so many weeks of outperformance, we are willing to let the laggards narrow the gap . . . all in all, our universe is still 5% ahead of the S&P 500 YTD and a full 10% ahead of the market over the trailing 12 months. As long as the aggregate numbers keep moving in our favor, we're still well ahead of the game.
Of course that score depends on which BMR stocks dominate your portfolio. Performance on a position-by-position level has been volatile over recent months as investors debate whether to keep pivoting into recession-resistant income sectors like our REITs or crowd back into high-growth themes like Technology. From what we've seen on the economic front, there's no reason to head for shelter yet. You should already have your High Yield allocation in place generating current income. If not, we suggest waiting until recession fears recede to establish your defensive positions.
In the meantime, the real buying opportunity now seems to be growth stocks. We know how valuable Wall Street thinks dynamic companies can become. We've seen these stocks hit levels that reflect a lot of hope and even more conviction that the underlying businesses are expanding a lot faster than the market as a whole. These are the hot spots in any economic environment. When broad growth slows and earnings for many sectors stagnate, forward-thinking investors want to be in these stocks. And when the hot spots are also the pain points, it's a buying opportunity.
There’s always a bull market here at The Bull Market Report! We dig a little deeper into the rotation away from growth in The Big Picture, only to conclude that it takes more than a 30% decline to shake our conviction, especially when you're looking at stocks that can soar 100% or more between those dips. The High Yield Investor takes a look at the opposite end of the market with updates on a few of our most defensive income recommendations, and Gary Jefferson chimes in with a fresh take on what's poisoning sentiment around a fundamentally sound economy.
With the bulk of the 3Q19 earnings season behind us, it's also time to start our quarterly review of all positions, starting with several of the core Stocks For Success: Alphabet, Amazon, Apple, PayPal, Microsoft and Visa.
Key Market Indicators
BMR Companies and Commentary
The Big Picture: Weighing the Pain Points
Over time, the BMR universe as a whole has outperformed the S&P 500 by a wide margin, but the market’s latest rotation has been unusually cruel to our Aggressive and High Technology portfolios. We aren’t thrilled to see so many great stocks retreat so fast after soaring so high, but it will take more than this to push us to the exit.
Let’s start with the statistics. Seven of our positions have dropped 30% or more from their YTD peaks: two in High Technology, three in the Aggressive portfolio and one each in Special Opportunities and Healthcare. Several other BMR stocks are down at least 20%. In all, about a quarter of our active universe is in bear market territory.
That’s a lot of downside to digest in the last few months, especially when the S&P 500 keeps nudging from record to record. But we’re far from alone here. While the S&P 500 has held up relatively well, a staggering 50% of all smaller stocks have descended into the bear market zone right alongside several of our favorites. Investors are crowded into a handful of winners, seeking safety in size and leaving just about everything else to swing in the wind.
We’re buoyed by the preponderance of strength across our universe. The drag on Aggressive and High Technology has been significant, but our core Stocks For Success (containing most of the most defensive Silicon Valley giants) have kept outperforming the market, giving us 5% since the end of June. Our REITs and High Yield recommendations have soared 7% collectively over that period while the Special Opportunities are still making money as well.
And even our pain portfolios have rallied so hard this year that it’s going to take a much bigger retreat to even bring them back to where the S&P 500 is now. Our Aggressive stocks are down 27% from their collective peak but are still up 37% YTD, well ahead of the market as a whole despite the recent downswing. High Tech has done even better in the long view, hanging onto a 63% YTD profit after absorbing a 21% slide. When these stocks are in favor, they fly.
They’ve flown before. The question now is whether they’re permanently grounded, and that’s why we focus on the underlying business each stock embodies. After all, Wall Street’s moods ebb and flow, but cash flow is eternal and objective. Our calculus is simple: if the business has deteriorated, it’s going to take a long time for the stock to justify any upside. In that scenario, it’s time to think about taking profit and moving on.
However, when the quarterly results prove that the business is meeting our expectations, there’s no logical reason to change course simply because other investors either lose their faith or their nerve. They were willing to buy a growth curve at a certain price. And when the growth curve shapes up even better than they anticipated, sooner or later the stock will climb even higher. All it needs is for the market to recover either its faith or its nerve.
We can’t control the market. All we can do is weigh the fundamentals and police our own reactions when the market goes in what we consider the wrong direction. Right now, in terms of BMR stocks, ZScaler (ZS), Dropbox (DBX), Workday (WDAY), Splunk (SPLK) and Okta (OKTA) haven’t even reported their 3Q19 numbers yet, so there’s no objective reason to pull the plug without confirmation that they’ve hit a wall.
As far as we can see (and the weight of Wall Street agrees), these are all slightly better companies than they were at their peak. Maybe that’s not the case. We’ll know in a few weeks. But at this point it’s going to take an enormous disconnect between our models and corporate reality to justify keeping any of these stocks down. Over time, they’ll go back to breaking records.
Similar logic applies across most of our other pain points. Roku (ROKU) has confirmed that the most aggressive revenue forecasts are still coming true . . . if anything, the business is ramping up 4% faster than we hoped. That’s not worth a 30% decline. The company hasn’t weakened. The only thing that’s wavered is Wall Street’s will.
Exact Sciences (EXAS) and other BMR stocks are in roughly the same place. The numbers are good and the outlook is better. When the mood swings back in their favor, they’ll hit fresh peaks. Until then, this is a buying opportunity.
And when the numbers actually indicate that our expectations were too aggressive, the shortfall is almost always cosmetic while the punishment is severe. Twilio (TWLO) is a great example of this. Guidance only came down a few pennies per share and revenue is accelerating faster than we hoped. With the stock down nearly 40% from its peak, this is a buying opportunity that we could also extend to companies like TPI Composites (TPIC), Shopify (SHOP), Expedia (EXPE) and Square (SQ).
Maybe it will take a little time for all of these stocks to push past their historical highs. It doesn’t matter. At these levels, there’s a substantial amount of money to be made here, even in the face of slightly softer fundamentals. When they’re flying, they go fast. And when money shifts back in their favor, we want to make sure BMR subscribers are in position to ride the wave. Defense won’t dominate the game forever.
Alphabet (GOOG: $1,311, up 3% last week)
Alphabet is having a great year, up 25% YTD and having just set a new all-time high. The company’s 3Q19 was strong, with revenue increasing 20% YoY to $40 billion. Although EPS of $10.12 missed estimates by $2.34, that’s not the important metric here, as management previously noted that continued foreign exchange headwinds would ding the earnings for the quarter. Wall Street responded in knee-jerk fashion by selling off the stock, until cooler heads quickly prevailed and the bulls came charging back, sending the stock to new heights.
There are too many growth stories here to ignore. With the company purchasing FitBit at a valuation of just over $2 billion, Alphabet is taking a proactive approach to the wearables market, which is sure to grow in size over the coming years as new technology increases the speed and efficiency of data delivery from wearables and the internet-of-things. And Google has launched its mass-transit app Pigeon into five more cities after launching it in New York. Pigeon may eventually be folded into popular traffic app Waze, or it could serve as a standalone product. Either way, Alphabet is slowly but surely working its way into all aspects of the consumer’s life.
BMR Take: How can you not love Alphabet? This is the most innovative and pioneering company in existence. The brand is so strong, Hollywood made a Vince Vaughn and Owen Wilson movie about two guys who interview for a job there. Is there anyone who thinks Alphabet won’t be more valuable one year, three years and five years from now than it is today? We’re certainly in Alphabet for the long term, and we’re reiterating our $1,450 Target Price.
Amazon (AMZN: $1,786, flat)
Although the stock is down from its 52-week high, Amazon is still up 20% YTD, and we believe there is more to come before year-end. The company is investing $40 million into a new robotics hub, where 200 technicians will build the workers of the future. Meanwhile, the company is investing a further $600 million into its Indian subsidiaries, as it expands its footprint in that fast-growing economy. Amazon is battling Flipkart in India, and the company has pledged to invest $5 billion in the near-term to win that fight.
Like Alphabet, Amazon’s 3Q19 was a revenue boom but earnings miss. Revenue of $70 billion was up 24% YoY, but EPS of $4.23 missed by $0.32. Again, there are some macro-economic headwinds at play here. Plus, the story with Amazon is product expansion and market share capture, both of which are on full display. Like Alphabet, the company keeps expanding into every single aspect of our lives.
BMR Take: Amazon is another company that is sure to be in a stronger position over the coming years, given its dominant market position and endless string of innovative product launches. Cashier-less retail stores, Amazon Pay, Whole Foods, a variety of Healthcare startups… there is a lot going on at Amazon. Just know that this e-commerce business is rapidly shifting into a full-blown conglomerate, and we expect the stock to continue to produce hefty returns for the foreseeable future.
Apple (AAPL: $260, up 2%)
With a 64% YTD return, Apple exemplifies the Stocks for Success portfolio. The company produced a stellar quarter, with revenue of $64 billion improving 2% YoY, and EPS of $3.03 beating consensus estimates by $0.19. Non-iPhone revenue was up 17% YoY, and wearables revenue was up 50%. If you’ve been reading our newsletters, you know we’ve been covering how Apple is converting itself from a pure hardware maker into a company with a much broader suite of products. Already that diversification is paying off.
Apple currently has 450 million subscribers across all of its platforms, a 30% YoY increase, which is truly astounding. A lot of that has to do with the iPad, which grew revenue 17% YoY thanks to the popularity of the new iPad Pro. This huge customer base gives Apple an entrenched pool of prospects to pitch their new product launches to, in the areas of credit cards, gaming, news applications and more.
BMR Take: With the stock blowing past our $238 Target Price, we’ve raised our new target to $300. And of course we’re reiterating our ‘Would Not Sell,’ given how revolutionary this company is. Apple is right up there with Amazon and Alphabet when it comes to innovation and pure market dominance, and we’re convinced both the company and stock will thrive and excel for many years to come.
Microsoft (MSFT: $146, up 1%)
Microsoft’s $10 billion Pentagon JEDI contract win is being hailed as a ‘game changer,’ with analyst Wedbush declaring that the contract adds an additional $10/share to Microsoft’s stock. Rival Amazon was expected to prevail, but the Department of Defense went with Microsoft, and the stock responded by reaching a new all-time high.
Microsoft was already having a strong year, even without the JEDI contract. The company’s 3Q19 revenue of $33 billion improved 14% YoY, with EPS coming in at $1.38, beating consensus estimates by $0.14. The company also continues to improve its cloud-based operations, acquiring cloud file migration provider Mover, which will be integrated into the 365 platform. In the previous months alone, Microsoft has acquired Blue Talon, jClarity and Movere, so the company is getting aggressive as it pursues further market share in the red-hot cloud-computing space.
BMR Take: The stock is up 44% YTD, and there seems to be no stopping it. Our $166 Target Price is getting closer and closer, and we’ll be sure to raise once the stock crashes right through, given how promising the future looks for Microsoft. This is an industry pioneer that’s as innovative as any emerging Tech platform.
PayPal (PYPL: $101, down 4%)
Although PayPal is off about 20% from its 52-week high, the stock is still up 19% YTD. The company has some major opportunities on the horizon, including the growth of peer-to-peer mobile payments system Venmo, and expansion into the Chinese market.
Venmo currently owns about 5% of the $100 billion peer-to-peer payments market in the U.S. And the company is doing all it can to attract new users. With free transfers to and from bank accounts, and a branded debit card offered to customers, Venmo is rapidly earning strong brand awareness. Plus, the company is on the verge of launching its own credit card. Venmo’s $27 billion in total payments volume last quarter was a 64% YoY increase. So all of the perks are catching on fast.
And China represents an even larger potential market for PayPal than Venmo does. Asia-Pacific peer-to-peer payments volume is expected to reach $60 trillion – yes that’s trillion, with a ‘T’ – by 2027. PayPal earns about 2.4% on every dollar of total payment volume. So if the company captures just 1% of the Asia-Pacific market, that translates to $600 billion in total payment volume, or about $14 billion in revenue. That’s seven-times what the company generated in international revenue last quarter. So there’s a lot to get excited about here.
BMR Take: PayPal had a strong 3Q19, with revenue of $4.4 billion improving 19% YoY, and EPS of $0.61 beating market expectations by a penny. The company has a lot of tailwinds, and the Venmo and China opportunities are too big to pass up. PayPal is a dominant industry pioneer, with plenty of innovative technology that will carry it through the next decade.
Visa (V: $179, down 1%)
Visa has been having a fabulous year – up 35% YTD and currently hovering at its all-time high. The company’s recent partnership with Chinese giant TenCent on a mobile wallet is a huge step forward. Visa holders will now be able to use their Visa card anywhere in China that WeChat Pay is accepted (which is a lot of places).
Visa has been aggressive about global expansion and technological innovation, not acting like the Blue Chip industry laggard many expect, but rather like an innovative Tech upstart. The company recently acquired Rambus’ tokenization technology, improving the company’s token services and helping it reach new markets. The company is also courting small businesses with its new Visa Infinite Business, a credit line with high limits for growing enterprises.
Visa had a strong 3Q19, with revenue of $6 billion increasing 13% YoY, and EPS of $1.47 beating consensus estimates by four pennies. The company also announced a 20% dividend hike to $0.30/share. All great things for this prominent credit card company.
BMR Take: Visa is a name that everyone knows, but the company is playing a very different game than most expect. Global expansion and technological innovation are what Visa is focused on, so don’t expect the same old “it’s everywhere you want to be” company. Visa has a go-forward strategy that positions it more as a Tech company than credit card manufacturer. We’re reiterating our $200 Target Price.
A Word From Gary Jefferson
Jefferson Financial Group
First Vice-President, Investments
UBS Financial Services, Inc.
Going back to last October, the S&P 500 is up 14% over the trailing 12 months. Remember, last year we experienced a very real stealth bear market in which over 50% of all stocks went down 20% or more. This year has made up for most of last year's damage. In addition to the jobs and China news, the Fed is now our friend. Following the FOMC meeting, Chairman Powell stated that "a material reassessment of our outlook is what would be needed for the Federal Reserve to next change its rate path . . . its current rate path seems appropriate."
Thus, rates will be lower for longer and that has always been a plus for stocks. In this case, it also has been a plus for bonds because they go up in value as rates go down. So despite all the incessant doom and gloom that has inundated the media this entire year, investors have seen account values go significantly higher than where they were at the end of last year.
Of course, as we have come to expect from the mainstream media, the doom and gloom rhetoric has only been ramped up despite all the good news. Listening to several of the business news networks this weekend we heard comment after comment like "this stock market is a crash waiting to happen . . . this stock market has nowhere to go but down . . . this market can't go any higher, but it can go a great deal lower."
So, here's a recap: Volatility is under control and markets are proving resilient in sustaining their bullish outlook. Earnings are coming in above their targets. China talks are progressing. The Fed cut rates. The jobs report was better than expected. That's the real news and the idea that these are all red flag signals of impending doom is utter nonsense. We sense that professional investors are actually seeing just the opposite and are acting accordingly.
One new catalyst that totally defies the media's global recession narrative is the sudden high-volume breakout in the deep cyclical sector. Stocks belonging to steel, materials, mining, chemicals, railroads, heavy equipment and machinery companies charged higher . . . led by a 17.3% spike in U.S. Steel. These are "deep cyclical" stocks that are normally abandoned well in advance of global slowdowns but which gather momentum when the perception is for global expansion. Our impression is that moves higher by these sectors could be a reflection of an emerging investor perception that the domestic and global economies are in the process of picking up speed in the fourth quarter and into 2020. These sectors would move to the downside if investors believed the economy was headed into a recession.
And let's revisit the "yield curve." Historically, the yield curve had to be inverted from six to nine months in order to reliably indicate a recession was imminent. Our yield curve inversion lasted about a week or so, and because it has not kept inverting for the past several months, the message from the bond market is clear: there is no recession headed our way.
Could all this be derailed because of a blow-up with the China trade talks or some other black swan event? Of course it could. Volatility could easily get out of control. But the fundamentals of the market, the jobs, the consumer confidence, the bond market and the ever-important earnings all point towards investors staying the course and letting the market step its way higher rather than worrying about it falling off of a cliff.
The High Yield Investor
By John Freund
VP of High Yield
The Bull Market Report
This week, we’re going to take a look at a trio of stocks that don’t follow the traditional earnings cycle, which means they don’t report with the rest of the market.
First up is AllianzGI Equity & Convertible Income Fund (NIE: $23, up 3%, Yield = 6.8%). Allianz is an actively managed closed-end fund (CEF), which is different from a traditional mutual fund in that CEFs don’t issue and redeem shares on the open market. That means they don’t need to maintain the capital reserves that traditional mutual funds keep in place in order to protect against a massive selloff, which in turn means that CEFs can take additional risk and make investments that traditional mutual funds cannot. That can lead to outsized returns.
Management takes advantage of the CEF structure by investing in convertible debt investments typically associated with startups and early-stage companies that issue short-term debt to investors that converts to equity once a valuation benchmark is hit. For example, an investor may loan a startup $10 million at 7% interest until the company reaches a $100 million valuation, at which point the debt converts into a percentage of equity. The investment is risky because if the company fails, the debt is worth zilch. However, if the benchmark is indeed hit, the investment can turn into a home run. Convertible debt investments allow AllianzGI to essentially act like a Venture Capital firm, investing in riskier assets while also providing a fixed income.
AllianzGI also operates a covered call strategy that generates significant revenue for the fund. A covered call revolves around the owner of a stock issuing options to sell it at a fixed price in the near future. People buy those options and AllianzGI gets the cash up front. The approach here is conservative. The fund owns and issues options on a diverse portfolio of large dividend-paying companies like Microsoft, Google, Apple and Visa. Add the cash collected on those options to the dividends and management can pay shareholders a substantial amount. Of course there's risk here. Covered call strategies can lose money if the underlying stock price declines, but the returns are worth it in more bullish scenarios.
The beauty of AllianzGI is that it offers exposure to blue-chip companies while providing a hefty dividend payout to investors – much larger than the aggregate yield of the stocks in the portfolio itself. So if investors were to buy into each of AllianzGI’s holdings individually, they’d be earning much less than the 6.8% annual yield that the fund is offering. Allianz also charges a low 1% expense ratio, providing a relatively conservative means of participating in some unique investment opportunities like convertible debt investments and covered-call strategies.
The fund is up 22% YTD. It’s not often that a CEF beats the broader market index, but the asset class has had a fabulous year, bouncing back from last year’s struggles. And with the dividend remaining as stable and dependable as ever, we’re extremely comfortable with our position here going forward.
Next up, Pimco Dynamic Income Fund (PDI: $34, up 1%, Yield = 7.9%). Most of the portfolio is comprised of non-agency mortgage-backed securities (MBS). Non-agency means the MBS is not backed by the federal government, making the assets a riskier investment class than agency MBS. The good news here is that interest rates are on the decline. Lower interest rates buoy the broader economy and help augment the overall housing market, which is already coming off a strong 2018.
Last year, MBS-focused CEFs including this one outperformed the broader CEF market, thanks to rising home prices and income levels, coupled with a low mortgage delinquency rate and unemployment rate. While housing starts slowed slightly during the Fed’s period of interest rate hikes, that period is now over . . . so look for housing starts to pick back up as we head into 2020. (Although housing starts fell 9% in October from the prior month, September represented a 12-year high for housing starts, so we’re still in historically strong territory and expect to stay that way through the rest of this year and into next).
Management here is also having a wonderful year, with shares rising 16% YTD and still paying out that hefty 7.9% annual yield. And that dividend is well covered. This fund generates 10% more cash than it needs to pay the dividend, which means there is plenty of wiggle room to cover quarter-to-quarter wobbles in the numbers. And the coverage ratio is actually increasing as we head into 2020. At this rate, by next summer this fund will have a 150% coverage ratio, creating plenty of room to raise the dividend. Additionally, management maintains a half quarter of income in reserve, so even if cash flow slips, shareholders keep cashing checks while the portfolio repositions.
While it’s true shares of this fund are currently 23% above the fund's Net Asset Value, the underlying holdings are poised to make some serious gains next year. We believe the portfolio will appreciate and shrink that premium. In the meantime, this is a fund that always trades at a premium, averaging 15% over the past year. And with Pimco being one of the most reliable CEF sponsors when it comes to income production and covering the dividend, investors should feel comfortable holding this fund until the portfolio catches up.
One final stock we’re taking a look at this week is a recent addition the BMR portfolio: BlackRock Income Trust (BKT: $6.10, flat, Yield = 6.8%). BlackRock isn’t a fund that moves very far in either direction. Over the last five years, the trading range has been from $5.50 to $6.50. The stock is up around 9% YTD and sitting right in the middle of that range. We believe BlackRock will head to the higher end of that range thanks to lower interest rates which support the MBS industry. (BlackRock is a brand name CEF that invests in investment-grade MBS.)
On the financial side of things, BlackRock is in good shape, as the company only carries about 30% leverage on its $600 million portfolio. With a healthy operating margin (83%), income production should remain high for the foreseeable future. Most (80%) of the assets are invested in the U.S. and 76% in agency MBS, so BlackRock operates a very conservative investment strategy.
Of course, the real reason we are in this stock is the stable dividend. BlackRock’s payout has been stable all year, and since investment-grade bonds are among the safest investments on the market, this makes a great cornerstones for any portfolio. Investors can park money here for stable, dependable fixed income returns without much concern over a dividend slash or severe price depreciation. BMR subscribers should be in BlackRock for the long haul. As long as we stay within that trading range of $5.50 to $6.50, we’re fine with that. We just want to keep collecting the dividend year after year.
Todd Shaver, Founder and CEO
The Bull Market Report