Jarvis™ Newsletter: Earnings, More Inflation Talk, Risk On
By Brian Dress, CFA, Director of Research, Investment Advisor
Overview:
Since the beginning of September in this space, we have shared with you our observations that stock markets were slipping, amid a strange brew of elevated inflation expectations, interest rates creeping higher, and profit taking in some of the high-flying names of 2020-21. Last week we began to see signs of life in growth stocks (and the market more broadly), as earnings season began with traditional money center banks like Goldman Sachs (GS), Morgan Stanley (MS), and Bank of America (BAC) all reporting strong quarters.
This week we saw sustained momentum across the board, as positive earnings reports continued to trickle in. Those earnings reports brought optimism to the overall markets, with the S&P 500 advancing 2.52% over the 5 days covered in this report, along with a 2.65% rise in the NASDAQ Composite, and a slightly less optimistic 0.97% increase in the Russell 2000 Index, which covers small cap stocks.
In the face of the September sell-off, we encouraged investors to remain constructive on the overall market and avoid selling core positions into the fears of last month. As markets continue to recover in October, we are again reminded of how difficult it is for investors to sell positions into a market downtick, while subsequently finding a way to reinvest those funds profitably. Rallies in some growth stocks over the past 2 weeks have been aggressive in some corners of the market, further emphasizing the point we were making in September. Long-term investors’ patience through times of market strife tends to be rewarded and the growing momentum in growth stocks is further evidence of this view
We have been in the thick of the earnings season this week, which many of you will know is the most important time for investors to get a gauge on business and financial progress on the company level. Also, by reading a wide array of these reports, we have the opportunity to draw broader conclusions about the US economy, as businesses continue to cope with challenges from supply chain backlogs, to labor and input cost inflation, and the continued pandemic. Later in this report, we will share with you our thoughts on two mega-cap tech firms: Netflix (NFLX) and Tesla (TSLA), who both successfully navigated the challenges to deliver excellent 3rd quarter results. Beyond that, we will provide you with our preview of earnings next week: there are more than a dozen earnings releases we will be following closely to answer some of our investing questions that have been developing over the past months.
US Treasury rates continued to creep higher this week, with the ten-year bond trading at a yield of just below 1.68% at the time of writing. We note the break in linkage between higher rates and weaker performance in growth stocks. Our thesis continues to be that an orderly increase in long rates should have limited long-term impact on the types of growth stocks we often favor. Additionally, in the context of commodity and labor cost inflation, businesses in the tech and software areas, have the chance to take advantage of rising prices. These companies tend to be less labor and capital-intensive than the average public company, while still holding some pricing power. We saw shades of this idea in the Tesla (TSLA) report, which we cover below.
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With that all being said, let’s get into it!
Interpreting the Jarvis Data (week of 10/15-10/21):
Best/Worst Performing:
Best/Worst Performing is a list driven by technical factors, like relative strength and stock price relative to moving averages. To learn more about how we use the “Best/Worst Performing” lists and the criteria Jarvis uses to choose stocks for each list, visit our Jarvis page and read the section entitled “Interpreting the Jarvis Outputs.”
In last week’s letter, we saw one of the most positive Best/Worst ratios we have seen in months, with 21 Best Performing stocks to just 7 in the Worst Performing column. This week, the momentum continued, as the Jarvis output showed us a 24 to 9 Best/Worst Ratio. In our experience, a Best/Worst ratio moving above 1 to 1 is an indicator of momentum in the overall stock market. Over the coming weeks we will continue to monitor this relationship.
Over the past couple months, energy has dominated the Best Performing list, as oil prices continued their march higher into the $80+ range. This theme is still in evidence this week, with 8 of 24 Best Performers still coming from the energy space. As we mentioned in the October 8 newsletter, we still see opportunities for investors to gain exposure to the energy space, despite the already significant moves higher in the industry.
Repeat readers know that we track which stocks from the “Best Performing” list appear for multiple weeks in a row, as we consider this a good indicator of short-term momentum. In this week’s list, 12 of the 24 names are repeat entrants to the list.
Some of the energy names we saw make a repeat appearance on this week’s Best Performing list: Devon Energy (DVN), Hess (HES), and oil service provider Oceaneering International (OII). For the third straight week, we saw the appearance of two pipeline operators in Antero Midstream (AM) and Enlink Midstream (ENLC). Western Midstream (WES) made a second appearance. Note also the repeat appearance of solar company Sunpower (SPWR). It has taken some time for solar companies to gain strength in the face of higher fossil fuel prices, but momentum is starting to build. More on the move in the solar business later.
Horsetrack and gaming operator Churchill Downs (CHDN) has continued to be one of the best performing stocks over the past month. We are beginning to do some work on this name on Jarvis’s urging and we will report back after next week’s earnings report. Yet again, Digital Turbine (APPS) makes the list, which is a company that helps app developers/operators monetize their applications. APPS stock has rallied more than 80% since it made a low on August 19 of this year.
Worst Performing continues to favor small/mid cap companies, with none of the nine companies on this week’s list having an enterprise value in excess of $13 billion. One notable name on the list this week is Doximity (DOCS), a social platform for medical professionals. We have been intrigued by this company over the past couple months and will be monitoring closely.
Left Brain Logic: At the risk of repeating ourselves, energy continues to be one of the major themes of 2021. While the commodity price of oil and gas may be volatile in the near term, we think prices have been high enough for long enough to create a positive free cash flow situation for businesses in this space. Look below to our earnings preview section to understand what we want to hear from some of the natural gas producers, as they report earnings next week.
The Worst Performing list and the relative underperformance of the Russell 2000 this week suggest that small caps are out of favor. This is something worth monitoring over time, since these small cap stocks are economically sensitive. Our hypothesis is that these businesses are the biggest victims of rising input and labor costs.
ETF List -- Most Risen/Dropped:
The ETF List is the way we follow sector trends. In Jarvis, we rank roughly 300 ETFs on a weekly basis and track which of these rose and dropped the most over the past week. Though we focus more on the micro than the macro, it is important to recognize which sectors are strongest at any given time, to help us identify opportunities that exist in our blind spots.
ETF List - Most Risen: It would be hard to follow the news this week and miss the significant move in the crypto space, as Bitcoin made a new all-time high. The three strongest ETFs in our list were Bitwise Crypto Industry Innovators ETF (BITQ), Grayscale Bitcoin Trust (BTC), and Grayscale Ethereum Trust (ETH), all of which advanced over the past five days by more than 8%.
Beyond crypto, we saw movement in strategies betting against US Treasuries like Direxion Daily 20+ Year Treasury Bear 3X Shares (TMV) and ProShares UltraShort 20+ Year Treasury (TBT). More importantly to us, there is momentum building in the growth stock/tech space, with the SPDR S&P Semiconductor ETF (XSD), Renaissance IPO ETF (IPO), Invesco DWA Momentum ETF (PDP), and Invesco S&P 500 Pure Growth ETF (RPG) all among the top performers this week.
As we mentioned above, solar stocks are beginning to respond to high fossil fuel prices. We saw iShares Global Clean Energy ETF (ICLN) make the list this week.
ETF List - Most Dropped: Natural gas has been one of the top performing sectors over the past few months. Over the last two weeks we have seen some loss in momentum in the commodity price here. The United States Natural Gas Fund, LP (UNG) was down more than 7% this week. We saw some weakness in the metals space also, with Aberdeen Standard Physical Palladium Shares ETF (PALL), VanEck Steel ETF (SLX), and iShares MSCI Global Metals & Mining Producers ETF (PICK) all among the 10 worst performing ETFs this week.
As we mentioned above, fixed income related ETFs are struggling in recent weeks, particularly in the higher quality credits like Treasuries and Municipal Bonds. Worst performing ETFs this week in this category include iShares 20+ Year Treasury Bond ETF (TLT), Pimco Municipal Income Fund III (PMX), and BlackRock MuniHoldings Quality Fund II Inc (MUE).
Left Brain Logic: The momentum in Crypto is undeniable. We have favored playing the trend indirectly through companies like Square (SQ), who have partial exposure to the crypto asset class. We will be deepening our research into cryptocurrencies over the coming months. Keep an eye for that.
Growth and momentum names are gaining steam and the ETF List this week is just another data point to support this observation.
With respect to fixed income and especially high-quality bonds, we think there is significant risk to the downside, as interest rates continue to creep higher. We think investors should at least consider backing down their exposures to high-quality fixed income instruments like US Treasuries and Municipal Bonds, as interest rate risk is real in the current environment.
Earnings Reviews from This Week
Netflix (NFLX)
On Tuesday of this week, we were able to listen to the insights from Netflix (NFLX) executives, who announced earnings from the 3rd quarter. Netflix has been a steady performer in 2021 (up 16% year-to-date at the time of writing), a year that has been marked by significant pullbacks in the information technology stocks that had dominated in 2020. The stock had been trapped in the 500s for some time, but appears to be breaking out, with the first close above $600/share on October 1 of this year (see chart below).
(Source: Factset)
Netflix has been a controversial name in our office over the past two years, given that the growth trajectory of the business appeared to be leveling off and the company’s strategy related to original programming caused the company to burn significant cash. All the while, co-CEO Reed Hastings and his management team have steadfastly persisted with the strategy. In our reading of this quarter’s report, we think management’s patience has been rewarded with strong business results and positive guidance for the future.
For the 3rd quarter, Netflix announced year-over-year revenue growth of 16.3%, which represents a deceleration in growth. However, this must be put into the context of the pandemic, which accelerated results for Netflix in Q3 2020. More important than the Q3 results to us was the company’s guidance for next year, which is for a slight acceleration to 19% on a $30 billion revenue base, as well as the expectations that margins will grow 3% per year on a going forward basis. With that said, management was clear that forecasting results coming out of COVID has proved challenging.
For the quarter, Netflix added 8.5 million new paying subscribers, which is in line with trends over the past few years. For comparison, over the last 24 months, the company has been adding subscribers at an annual rate of roughly 27.5 million net adds per year.
Co-CEO Hastings stated that the company is coming near to the end of COVID-related choppiness, which was marked by relatively high levels of customer churn. For the 3rd quarter, churn was down relative to the levels in both 2019 and 2020, though viewing hours per member were down versus 2020 levels (though up from 2019). According to Hastings, the company’s strategy for reducing churn is a continued emphasis on producing original content in all regions.
Most anyone who follows pop culture will know that the Netflix original series “The Squid Game” has been a runaway hit. More than 142 million viewers worldwide viewed the series in just the first few weeks of release. Hastings stated that determining the next series to go viral is very difficult, but that the effects for the overall business are “super powerful when it happens”. The company continues to work hard to create the next viral sensation: producing content on a global basis now gives Netflix a great opportunity to continue developing high performing content like The Squid Game and Tiger King. Hastings noted that the company’s foray into movies has been slightly less successful that the established television division, but noted (1) that the film division is many years behind TV in its development and (2) the film division has produced 5 Oscar Best Picture nominees over the past 3 years. Hastings seemed optimistic about the film division’s prospects.
What piqued our interest on the call were a couple initiatives in the company’s pipeline: (1) mobile gaming and (2) consumer products. Since the vast majority of Netflix members engage in some part with the platform with a mobile device, the production of mobile games is a logical step forward for Netflix. The company has begun to produce mobile games this year and Hastings expects to have a competitive edge in a growing field due to his plan not to use ads or in-app monetization within the company’s games. He mentioned that 3 years from now, a series release like The Squid Game will be accompanied by an array of interactive games, designed to increase engagement with the platform. Hastings also mentioned that Netflix is open to an acquisition in the space to speed up the development process, though he seemed to indicate that Netflix is not aggressively pursuing a purchase.
We also like Netflix’s move into e-commerce for consumer products. Now that the company has a working film division, pairing toys and other products with theatrical releases is a logical step forward. Note that Netflix has built a new website for e-commerce and has recently partnered with Walmart to market the company’s products.
All in all, we thought Netflix delivered strong results in the 3rd quarter. We will be watching in Q4 whether revenue growth begins to accelerate again as the company begins to lap the incredible results from the early days of the pandemic. We remain convinced that Reed Hastings and his management team are persisting with a well-considered corporate strategy and that this stock should continue to perform over the near to medium term.
Tesla (TSLA)
On Wednesday of this week, we heard from Tesla executives (sáns Elon Musk), who reported quarterly revenue for the electric vehicle maker of $13.76 billion, a 56.9% increase over the same quarter in 2020. It was good to hear from the executive team beyond Musk for a couple reasons: (1) it gives a good indication of the company’s strong management team and (2) the call was focused on the substance of the business rather than Musk’s personality, which is sometimes off-putting for investors (myself included).
The Tesla team reported that the company delivered 240,000 cars in the 3rd quarter, which is up 20% over last quarter and 70% versus Q3 2020. At the end of the quarter, Tesla crossed a crucial threshold, which means that the company now is producing vehicles at an annual run rate of 1 million. This has been driven by the ramp in production of the Model Y in the company’s Shanghai factory, which has been in operation since 2019. The Shanghai factory, along with factories under construction in Austin, TX and Berlin, will allow Tesla to supply more cars to the North American market, as well as to introduce the Model Y to the European market.
According to management, Tesla’s Model 3 is now the bestselling luxury sedan worldwide and the Model Y “is poised to be the bestselling vehicle in the world.” With such impressive growth, there are considerable challenges, one of which is charging infrastructure. Tesla has doubled its network of charging stations over the past 18 months and intends to triple network size again over the next 2 years, which is a considerable acceleration. Access to charging stations is a key consideration for prospective purchasers of electric vehicles and Tesla is addressing the question aggressively.
Those who follow business news will be fully aware of the supply chain challenges that are impacting businesses of all types, but especially automakers. Despite the difficulties automakers have had with obtaining semiconductor chips, Tesla has been able to maintain previous production forecasts, which sets it apart from others in the industry. Supply chain challenges, coupled with higher commodity (rare metals that are inputs to Tesla batteries) and labor costs have created cost headwinds for the business, but high demand for electric vehicles (and Teslas in particular) have empowered the company to adjust vehicle prices higher to compensate. Tesla generated operating cash flow (CFO) of $3.1 billion for the quarter, implying an operating margin just under 15%, in excess of the company’s long-term guidance for profitability.
We thought the company’s quarterly results were impressive, as the often tend to be, but what really excites us are Tesla’s future plans. The company’s medium to long-term goal is to grow production by 50% per year. Tesla’s ultimate aim is to produce 20 million units per year (roughly 20% of current worldwide auto sales) by expanding the fleet to include small, medium, and large sedans, SUVs, trucks, and robotaxis.
The company’s next product launch will be the Cybertruck, but the release schedule is currently up in the air. Tesla hopes to launch the Cybertruck at some point in 2022. Beyond this, Tesla plans to begin production of a $25,000 model in the year 2023. These plans are somewhat uncertain at this time based on progress in the Austin and Berlin production facilities. Management expects to build its first units in each of the new facilities by the end of 2021, but cautioned investors not to expect delivery from either factory by the end of 2021. As these factories get up and running, investors should expect operating margins for the overall business to suffer slightly over the coming quarters.
The future is bright for Tesla. As the company’s self-driving features become more ingrained into each vehicle, management expects considerable upside to the company’s profitability. This is because software is a much less capital-intensive product to produce, relative to the underlying hardware in the vehicles. With the proviso that high input costs and delays in standing up the factories in Austin and Berlin could temporarily weigh on profitability, we like the growth trajectory in evidence at Tesla and we remain bullish on the company’s prospects.
Earnings Preview for Next Week
We spoke last week about our method for digesting earnings calls and how that fits in with our investment philosophy. We have had a steady trickle of earnings over the past two weeks, but we will be following a deluge of earnings next week from some of the largest and most important tech firms in the US. Here are the reports we will be watching most intently next week:
· FAANG: Facebook (FB) – Monday, Alphabet (GOOGL) – Tuesday, Apple (AAPL), Amazon (AMZN) – Thursday: Next week we hear from many of the heavy hitters in the tech space, with the other 4 components of FAANG reporting after this week’s Netflix report. Though 2021 has been a year of muted returns for many companies in the software sector, the FAANG names have been the clear bright spot in the NASDAQ. Growth rates among these powers have remained steady in 2021. We will be watching closely to see whether there is acceleration in results for the 3rd quarter. Additionally, reading through the earnings calls of these firms often reveals trends in other businesses under our coverage. The way these calls go will likely dictate the mood of the overall markets next week.
· Advanced Micro Devices (AMD) – Tuesday: We have been bullish on the semiconductor space over the past few years, as many of you have heard our consistent praise of Nvidia (NVDA) and a number of other chipmakers. The worldwide shortage of chips has given firms like AMD strong pricing power in the marketplace. We are enthusiastic supporters of CEO Lisa Su, who has turned this business around since she entered the role in 2014. We will be looking to AMD for clues on the global supply of chips, along with how the company is performing relative to other key competitors in the space, specifically Intel (INTC).
· Natural Gas: Range Resources (RRC) – Tuesday, Antero Resources (AR)/Antero Midstream (AM) – Wednesday: Over the past few weeks, we have alerted readers to considerable strength in the natural gas futures markets. We followed a number of natural gas producers over the years, but specifically as it relates to their outstanding bonds. Those bonds have appreciated well over the past two years, so we are turning our attention to the common stock of these producers. RRC and AR are exploration and production firms with drilling rights in the Appalachian region, which derive the bulk of their revenues from natural gas. We know these two companies to be disciplined stewards of capital who came through a decade of low natural gas prices as two of the few not to file bankruptcy. We will be looking for a few key factors in their reports this week: (1) trajectory of known reserves, (2) average production cost, and (3) hedging strategy. Since natural gas prices have become elevated in 2021, we are looking for low-cost producers to hedge some portion of their future production in order to lock in predictable streams of cash flow.
· Enphase Energy (ENPH) – Tuesday, First Solar (FSLR) – Thursday: Energy prices have been on the rise for most of 2021. Traditionally, alternative energy companies like ENPH and FSLR are beneficiaries of higher fossil fuel prices, as consumers and power plants look for alternative energy sources. These two stocks have been relatively slow to participate in this historical pattern, but we have seen signs of life in recent weeks. We will be looking to ENPH and FSLR to see if the higher energy prices have led directly to increased sales and profits over the past three months of results.
· Others to watch this week: Spotify (SPOT), Boeing (BA), ServiceNow (NOW), Twilio (TWLO), Ford (F), Churchill Downs (CHDN) – Wednesday, Dexcom (DXCM) – Thursday.
Takeaways from this Week
This week, the recovery in growth stocks continued in earnest, especially as earnings reports began to trickle in. As we read the NFLX and TSLA reports, we became more convicted in our view that the underlying businesses related to growth stocks are doing well.
The energy sector is still showing significant strength, but natural gas prices pulled back by 7% this week. This feeds into our view that the way to play the energy markets is through the common stocks of the best run entities in the space, rather than to own the commodity directly. We will be watching the AR and RRC reports this week intently to see how producers are changing their approaches to respond to a long period of higher prices. By the end of next week, we will have an exclusive report on a natural gas producer for subscribers.
Earnings season is our focus next week and we will be watching 12-15 reports closely. We will report back our findings in next week’s letter, so make sure to read the newsletter next Friday to get our views on those reports.
Thanks again for your continued support of Left Brain and the Jarvis newsletter. Again, if you found value here, we would humbly ask that you pass the newsletter along to friends or colleagues with interest in investment strategy. Have a great weekend and we will speak with you again soon!
Announcements:
(1) We are just 15 days out from the next installment of our Fortune Makers webinar series. On Sunday, November 7 at 4 pm Eastern/3pm Central, we will host our free webinar on Income Securities. Our investment team will speak briefly on the role of income securities in a balanced portfolio, while also providing you two actionable ideas for investors looking for sources of income in their holdings. Please visit our Eventbrite page for details on how you can sign up for the event. Note also that attendees will receive our e-Book which details the way Left Brain looks at income securities, including bonds, preferred stocks, high dividend stocks and more!
(2) We hope the insights of the Jarvis newsletter are helpful to you as you get ready for the next week of stock market action. Please share this newsletter with your network if you found it of use. That’s the best way for our work to be found! For more details on Left Brain, Jarvis™, or anything else investing related, please reach out to us at www.LeftBrainIR.com. Feel free to contact me directly at briand@leftbrainwm.com or at (630) 547-3316 with any questions. We would love to receive your reader feedback on how we can make this weekly letter more useful to you, as you manage your portfolio and/or choose an advisor to help you accomplish the task.
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Thank you and we wish for you another week of profitable investing. Enjoy the weekend!
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