-Brian Dress, CFA,
Director of Research, Investment Advisor
We’ll say it again for the second straight letter: “seriously, what a week.”
The harsh reality is that growth stocks have been “smoked” this week (in popular parlance) and it is time for investors to take stock of their positioning. In the long term, there are likely to be stocks that are phoenixes rising from these ashes. However, we think it is prudent for everyone to take a step back from the chaotic market action and make some distinctions of what’s working and what isn’t and why. In the second segment of today’s letter, we will describe some patterns that are emerging in the current selloff that we think you can use to protect your investments in a difficult moment.
As we have mentioned over the past few weeks, there continue to be significant cross currents in the global economy that are weighing on both sentiment and business results. We are all familiar with the bottlenecks that are driving inflation expectations across the globe, as well as concern about potential for rising interest rates only bolstered by Fed Chair Jerome Powell’s testimony to Congress earlier this week. We will speak a bit more about rates further down in the letter.
This morning’s non-farm payrolls report was mixed, at best, with jobs created in November coming in at a disappointing 210,000, despite upward revisions to the September and October figures and a fall in the overall US unemployment rate to 4.2%. This appears to have triggered another wave of selling early in the Friday session.
For the five days covered in this report (November 26 to December 2), the major averages have fallen significantly. Over that period, the S&P fell 0.37%, NASDAQ Composite receded by 0.71%, and the small cap Russell 2000 dropped by 1.78% (this is excluding the Friday movement, which will be reflected in next week’s report). The movement in the indices fails to tell the whole story, with dramatic down moves especially in the iShares Expanded Tech-Software Sector ETF (IGV) (down 3.34%), which covers many of the high-growth software type names that we have historically favored and recommended. The trend has become undeniable: market participants are selling first and asking questions later. At times like these, sometimes fundamentals are thrown out the window and selling can become indiscriminate. Our aim in this week’s letter is to help you determine how best to proceed, given the current volatility.
In times of market turmoil, it is natural for investors to feel angst and wonder what exactly they should do: should they aggressively sell positions or look for opportunities to take advantage of what appears to be indiscriminate selling. Whether you manage your own portfolio or currently work with an investment professional, we want to extend our hand to you and offer you with a second opinion to help you assess whether your portfolio is appropriately positioned, given recent market movement. Fill out our form for a Free Portfolio Review and a member of our Investment Advisory team will contact you to set a meeting.
If you like what you see in the weekly Jarvis update, please share this newsletter with other investors, friends, and colleagues. The success of the Jarvis newsletter depends on your word-of-mouth recommendation to other like-minded investors. Just in case you are not receiving the newsletter into your inbox on Saturday mornings, make sure to visit our website to get yourself on the mailing list. The Jarvis Newsletter is a great way to get your weekend started, as you use your time with the markets closed to do deeper research and prepare for the next week of investing.
Thank you, again, for your support in the early days of the Jarvis newsletter!
With that all being said, let’s get into it!
What (The ****) is Happening?
Bad Reactions to Good News
As mentioned in this week’s overview, growth stocks selling off precipitously, pretty much regardless of whether news at the micro level is good or not. Down in the “Earnings Review” segment of this week’s letter, we will cover what we view as a very positive earnings report from Cybersecurity leader, Zscaler (ZS). As you can see in the chart below (source: TradingView), the stock fell sharply the day after the earnings report (which is delineated in the chart by the blue shading), despite very positive results and guidance. This suggests to us that there is little rhyme or reason to the recent action.
Broad-Based Selloff in Growth
The nature of the selloff has been relatively broad-based across the spectrum of growth stocks, a point which is illustrated by the table below, showing the 5-day stock price change of 20 selected growth stocks sorted by market capitalization.
We think a couple of patterns are beginning to emerge. First, it appears that the larger market capitalization companies have been faring better in the recent selloff. But second, take a look at the column marked “ROIC”, which stands for Return on Invested Capital. Broadly speaking, this is a measure of profitability. If you scan through the chart, you can get the sense that the companies with a low or negative ROIC (DOCU, ROKU, CRWD) have been most punished by the selling in the market, while companies with solid profitability metrics like AAPL, MSFT, ADBE, and NVDA have held more strongly. As we look to do some portfolio hygiene to cope with the current market dynamics, identifying relatively smaller, unprofitable companies could be a wise way to proceed, especially for investors that need to raise cash, for whatever reason.
Another point of weakness we have identified has come in the payments space, whether it be in traditional payment processing firms like American Express (AXP), Visa (V), and Mastercard (MA) or in emerging Fintech powers like Square (SQ) and Paypal (PYPL). Take a look at the following chart to get a sense of the action here over the past 30 days:
There has been some news flow around these businesses, including news that PayPal is losing business from eBay, along with a potential delay in Square’s acquisition of “Buy Now, Pay Later” firm Afterpay. With that all being said, this space is growing rapidly, particularly for PYPL and SQ and these stocks should be the beneficiaries of gradual economic reopenings. Sometimes we have to throw our hands up in wonderment here. We think this is a potential opportunity over the coming weeks, but we are, by no means, calling a bottom.
As we mentioned briefly above, Fed Chair Jerome Powell signaled this week that the Federal Reserve will slow the pace of its bond buying program more quickly than investors seem to have imagined (also known as “tapering”). This, coupled with the continued fears of inflation, has given investors some concern for growth stocks. Without getting too into the weeds about how investors value growth stocks, many market participants put values on companies based on future earnings discounted back to present value, based on long-term interest rates. In theory, as long rates increase, the present value of future earnings decrease. This especially penalizes companies not set to earn profits until years in the future, while advantaging companies with robust profits in the present. Thus, we can expect multiple compression in unprofitable growth companies. We think this phenomenon has a lot to do with the recent market action. At Left Brain, we do not try to forecast the direction of future interest rates, but we must be aware of how others view growth stocks through this prism.
What’s Working (And What Isn’t?) What Should We Do?
We did address in the section above what seems to be holding up best in the current market, at least as far as growth stocks go: larger and more profitable companies seem to be holding value relatively well, while smaller, money-losing companies are feeling the brunt of the market’s wrath.
Data for this claim is only beginning to emerge, but we are studying a new theory to guide investment strategy. The theory is that mega-cap technology companies seem to be the new “Blue Chips,” replacing the IBMs, GMs, and GEs of yesteryear. Looking back to the table up on page 3, you begin to see strength is concentrated in the behemoths like MSFT, AAPL, GOOGL, AMZN, NVDA, etc. Year-to-date, the S&P 500 has advanced by nearly 20%, but prosperity has not been shared broadly by any means. Microsoft, Google, and Nvidia are all up more than 50% this year (NVDA more than 100%) and are huge drivers of the index performance in 2021.
As always, our view is that investors need to dig deeper into the fundamentals at times like these. With the interest rate expectations that are taking hold in the market, it is crucial to take stock of positioning and understand that there could be continued selling in the growth arena, particularly in small, unprofitable companies. The new “flight to safety” appears to be in the mega-cap names we have mentioned throughout the letter here.
There were quite a few earnings reports, particularly in the cloud software space. Investors heard from such major firms as Salesforce.com (CRM), Okta (OKTA), Crowdstrike (CRWD), and Docusign (DOCU). DOCU’s report after the bell on Thursday was met with extreme selling, with the stock down more than 40% in Friday’s trading, after the company reduced guidance for the 4th quarter and admitted the company has not been executing well. The Left Brain view on DOCU is to liquidate shares, with no clear sense of where the bottom might be for a relatively small, unprofitable company like this. We put companies like this in the “penalty box”, meaning that there will need to be a significant improvement in business fundamentals (and share price action) for us to reconsider investing.
In today’s letter, we will give you formal writeups on two more positive earnings reports from this week from two of the most quality cloud software names on the board, Snowflake (SNOW) and Zscaler (ZS). As we mentioned above, the share price action has not been especially positive for either company this week, but these are examples of companies that investors should consider when they are building a “shopping list” to take advantage of the market pullback (after the selling stops).
Snowflake is a company whose earnings we have previously covered in the Jarvis newsletter, with glowing reviews. They announced their most recent earnings (3rd quarter FY 2022) this week and they painted a picture of a continued growth trajectory, currently unmatched by companies in similar phases in their growth curve.
For those unaware, Snowflake is a cloud-computing data warehousing company, which many corporations are using to store and analyze data. They stand centrally in one of the biggest growth industries anywhere in the world, data science.
On the earnings call, CEO Frank Slootman announced Q3 revenue of $312.5 million, implying an annual growth rate of 110%, an acceleration over last quarter. This was driven by 128% growth in accounts booking $1 million or more in annual revenue (to 148). Growth is even more impressive in the international context, with growth in Europe at 174% and in Asia of 219%. Dollar-based retention rate measures the ability of the company to retain customers and induce them to increase the amount they spend on a company’s products. Snowflake’s retention rate came in at 173%, meaning that Snowflake is not only retaining existing customers, but also those customers are spending 73% more on average than they were one year ago.
Our view is that Snowflake is in the right industry, which is growing rapidly and the company’s leadership in that sector is getting stronger each quarter. Beyond that, we like what we see in terms of profitability here. For the first time this quarter, Snowflake delivered positive operating margin (+2.5% of revenue) and generated $6.40 of free cash flow for every $100 in revenue. For a visualization of progress in profitability, see the graphic below from the company’s investor presentation.
Not only that, CEO Slootman announced revenue guidance for next quarter of $345-350 million, which would imply annual growth of 94-96%. In terms of the future, Slootman had some interesting quotes that suggest that the company is still in the early stages of growth: “we sort of haven’t reached that tipping point yet where sort of the floodgates are open and things are just exploding at a meteoric rate” and “we are just seeing the tip of the iceberg” in reference to the fact that many corporations are still in the process of modernizing legacy data systems. Since Slootman entered the CEO job, the company has been aggressively adding sales personnel to go after the largest companies and it has been working, with 223 of the Fortune 500 companies now counted among Snowflake’s customer base (up 30% year-over-year).
On the current trajectory, there is plenty of more room for growth here. We remain enthusiastic about Snowflake for the coming years.
Zscaler is another cloud computing leader, whose business focuses on cybersecurity with a “zero-trust” architecture built to protect corporate networks in the context of a work-from-home and cloud computing world. We have followed this business for a number of years now and we rated CEO Jay Chaudhry one of the best CEOs in our CEO Profiles series. The company checks many of the Left Brain boxes: accelerating revenue growth, quality management, and strong positioning in a growing industry.
This week Zscaler reported earnings, delivering 62% revenue growth, along with record operating profit and free cash flow for the quarter. According to CEO Chaudhry, the company showed strong growth across all business verticals and geographies, and recently achieved the milestone of $1 billion in annual recurring revenue. Chaudhry struck an optimistic tone for the future, stating that the company is building toward the next milestone, which is $5 billion in annual revenue.
Based on some of the qualitative statements on the call, there is certainly reason for optimism. Said Chaudhry, “In my recent dialogues with Chief Information Security Officers and Chief Information Officers, 8 of 10 are looking to phase out legacy networks in favor of zero-trust”. Chaudhry reports that there has been a 300% year-over-year increase in threats hidden in the so-called SSC-encrypted traffic, the current protocol that secures most internet traffic. Zscaler’s zero-trust architecture is designed to inhibit threats passing through a network, which is a huge improvement over legacy systems like Firewalls and VPNs. In 2021 alone, Zscaler has blocked some 20 billion threats and the system uses machine learning and artificial intelligence to process some 300 trillion data points daily to improve the system on an ongoing basis.
The future is bright for this business: Zscaler has Remaining Performance Obligations (RPOs), which are future revenues of $1.71 billion (up 97% year-over-year). Management estimates a 6x growth opportunity to upsell new products to current customers. Note that ZS now has 224 customers of $1 million in annual revenue or more (up 87% in a year) and signed 550 new customers of over $100,000 annual revenue in 2021 to bring the total to 1,616.
For the next quarter, management projects revenue of $240-242 million (53-54% growth) and $1 billion in revenue for the current fiscal year (49-50% growth). The company is moving toward profitability despite being in a major growth phase, with a free cash flow margin of 36% of revenue.
We think Zscaler is a best-of-breed company in a fast-growing business (cybersecurity) that has been unfairly caught up in the indiscriminate selling of this week. We think investors should give this one strong consideration when markets stabilize.
Portfolio Strategy: An Alternative Tax-Loss Tactic
We have spoken over the past few weeks about tax optimization, mainly by selling losing positions to offset any realized capital gains taken in the 2021 tax year. With the continued selling in the market, we would suggest that investors continue to scan their portfolios for unrealized capital losses to reduce tax burden for this year. Take a look at one of our previous letters to read more on this strategy here.
This week we wanted to give you another wrinkle. One concern many people have with tax loss selling is the wash sale rule, which holds that an investor must refrain from buying back shares with realized capital losses for 30 days to retain the tax benefit. One way to manage that issue is to take up another stock that gives you a similar risk exposure. Think of this concept as a “pairs trade”, selling one stock to realize the capital loss and buying a competitor stock. Below are some examples of stocks you might sell and the stocks you can use to replace the exposure.
Implementing this tactic is one way to optimize taxes without significantly changing one’s portfolio composition.
Takeaways from this Week
Growth stocks have clearly reversed their trend violently. The selling does seem indiscriminate at some level, but we do see a pattern emerging. Companies with some largess (in terms of market cap) as well as with profits in the present, seem to be faring better than their counterparts under $50 billion in market cap that are currently unprofitable. The current worries about higher interest rates are a driver here, as well as some profit taking, along with many other factors.
We think this is a great opportunity to assess all positions in a portfolio. This sort of selling may continue in growth stocks over the coming weeks and months, so it is not too late to make appropriate changes to protect yourself. Since we are getting close to the end of the year, it is time to take lemons and make lemonade by realizing capital losses strategically and this week we shared a simple tactic to do so and maintain portfolio exposures.
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. Make sure you sign up to receive the newsletter weekly in your inbox, if you haven’t already. Have a great weekend!
Don’t forget to sign up to receive the Jarvis newsletter in your email inbox every week. Make sure to check your spam/promotions folders if you don’t receive it after signup. Note that we will begin charging for the newsletter beginning in early 2022, but we will be offering a special price to our current loyal readers, so look for that in the next few weeks.
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 email@example.com or at (630) 547-3316 with any questions. We would love to receive your reader advice 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.
With the markets showing increased volatility over the past few months, we know that many investors are wondering if they need a “second opinion” on their investment positioning, whether they manage their own money or use an advisor. We stand ready and willing to help and we are thus offering a complimentary portfolio review to interested investors. Just reach out to us on the link provided and we will contact you within a few days to help you assess whether your portfolio is well-positioned to take advantage of business and market trends!
Thank you and we wish for you another week of profitable investing. Times like these can be difficult, so take some time to decompress, think carefully about your strategy, and we will get back at it on Monday. Enjoy the weekend!
DISCLAIMER: This report contains views and opinions which, by their very nature, are subject to uncertainty and involve inherent risks. Predictions or forecasts, described or implied, may prove to be wrong and are subject to change without notice. All expressions of opinion included herein are subject to change without notice. Predictions or forecasts described or implied are forward-looking statements based on certain assumptions which may prove to be wrong and/or other events which were not taken into account may occur. Any predictions, forecasts, outlooks, opinions or assumptions should not be construed to be indicative of the actual events which will occur. Investing involves risk, including the possible loss of principal. The opinions and data in this report have been obtained from sources believed to be reliable; neither Left Brain nor its affiliates warrant the accuracy or completeness of such, and accept no liability for any direct or consequential losses arising from its use. In addition, please note that Left Brain, including its principals, employees, agents, affiliates and advisory clients, may have positions in one or more of the securities discussed in this communication. Please note that Left Brain, including its principals, employees, agents, affiliates and advisory clients may take positions or effect transactions contrary to the views expressed in this communication based upon individual or firm circumstances. Any decision to effect transactions in the securities discussed within this communication should be balanced against the potential conflict of interest that Left Brain, its principals, employees, agents, affiliates and advisory clients has by virtue of its investment in one or more of these securities.
Past performance is not indicative of future performance. The price of securities can and will fluctuate, and any individual security may become worthless. A high or favorable rating, rating outlook, gauge, or similar opinion is not indicative of future performance, and no user should rely on any such rating, rating outlook, gauge, or similar opinion to predict performance or potential for return. Future performance may not equal projected or forecasted performance or potential for return. All ratings and related analysis, as well as data, statistics, analysis and opinions contained herein are solely statements of opinion and are not statements of fact or recommendations to purchase, hold, or sell any security or make any other investment decisions.
This report may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will materialize. Reliance upon information herein is at the sole discretion of the reader.
THE REPORT IS PROVIDED ON AN "AS IS" AND "AS AVAILABLE" BASIS WITHOUT REPRESENTATION OR WARRANTY OF ANY KIND. Left Brain Investment Research LLC DISCLAIMS ALL EXPRESS AND IMPLIED WARRANTIES WITH RESPECT TO THE REPORT, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE.
The Report is current only as of the date set forth herein. Left Brain Investment Research LLC (LBIR) has no obligation to update the Report or any material or content set forth herein.
LBIR is an affiliate of Left Brain Wealth Management LLC, an investment advisor registered with the Securities and Exchange Commission. LBIR is an affiliate of Left Brain Capital Appreciation Fund, L.P., Left Brain Capital Appreciation Offshore Ltd, and Left Brain Capital Appreciation Master Fund, Ltd., all of which are hedge funds managed by Left Brain Capital Management, LLC. The general partner of these hedge funds, Left Brain Capital Management, LLC, is an affiliate of LBIR.
© 2021, Left Brain Investment Research LLC. All rights reserved. Reproduction in any form is prohibited.