Jarvis™ Newsletter: Markets in Turmoil, How Best to Respond
-Brian Dress, CFA,
Director of Research, Investment Advisor
Overview:
Seriously, what a week.
We have cross currents throughout both the economy and the markets alike, including continued inflation/deflation push and pull, rising interest rates, strength in the US dollar, pronounced weakness in crypto, and sustained selling in small and mid-cap technology names. And if that wasn’t enough, we wake up this morning greeted with the news of a new (Nu?) Covid variant, which has roiled markets with many Wall Street traders away from their desks for the Thanksgiving holiday. As you can see from the chart below covering 11/18-11/26, volatility now appears to be the order of the day as we move into year end (S&P 500 in red, NASDAQ in blue).
With the short holiday trading week and plenty of negative storylines in play that are undoubtedly causing confusion and concern among the investing public, we want to take a step back from the usual Jarvis data interpretation and speak more broadly about how we approach portfolio management strategy at times like these. When markets become unexpectedly and suddenly volatile, this is when we generally see a spike in client calls seeking out our advice on how best to manage risks and emotions, in the context of a long-term planning strategy. In this week’s Jarvis newsletter, we want to provide you a flavor on how best to respond when things seem haywire.
In today’s letter, we will digest more fully what happened over the past five days and share with you our views on how to interpret these developments. Finally, we will give you some simple strategies to respond rationally to short-term turmoil to benefit your long-term strategy, which should ultimately be your entire focus. Our observation is that investors often respond rashly to short-term disruptions in a way that damages the long-term plan. Our hope is that we can give you a few easy tips on how best to avoid making crucial mistakes. Additionally, market pullbacks like these can provide great opportunities to purchase excellent businesses at discounts to form cornerstone positions in your portfolio.
Remember, in the Jarvis newsletter, we cover a 7-day market cycle from Friday to Thursday. We had a short week this time around due to the Thanksgiving holiday, but no shortage of market action. During the period between 11/18 and 11/24, the S&P 500 fell 0.06%, with the NASDAQ falling 0.93% and the economically sensitive small cap index, the Russell 2000, the worst performing index losing 1.35% in value. Crude oil prices appear to have made a short-term peak and fell 0.78% during the period. However, note that crude oil prices have fallen as much as $9 per barrel in overnight trading in response to the new Covid variant. There is plenty to interpret as we dig deeper below the index level, which we will cover throughout this week’s letter.
As we stated above, we often see a flurry of inquiries in times like these as investors grapple with market turmoil. Whether you handle your own investments or currently work with an advisor, we are happy to provide you with a second opinion to determine whether your portfolio is appropriately positioned given recent developments. Fill out our form for a Free Portfolio Review and a member of our Investment Advisory team will contact you to set a meeting.
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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’s Happening?
When we see market activity and volatility kick up, we like to take a broad accounting of what is actually happening. Then we dig deeper into the numbers to understand better how macro factors and investor sentiment are impacting individual positions. After all, Left Brain is a bottom-up investment shop and, ultimately, we care most about the prospects of individual businesses.
Over the last two weeks, we have seen significant pullbacks, particularly in growth stocks. In the five days covered by this report, we have seen roughly 5% pullbacks in a number of growth-oriented ETFs including: iShares Expanded Tech-Software Sector ETF (IGV) and Invesco NASDAQ Internet ETF (PNQI), while we also saw 6-8% negative return in cryptocurrency-related funds such as Grayscale Bitcoin Trust (BTC) (OTC:GBTC) and Grayscale Ethereum Trust (OTCQX:ETHE). Crude oil has begun to reverse rapidly, as well, with West Texas Intermediate crude oil falling from $84/barrel on November 9 to $69/barrel.
With respect to oil, we noticed an interesting divergence this week. Despite the nearly 1% pullback in oil prices in the reporting period for this week’s letter, the SPDR Series Trust - SPDR S&P Oil & Gas Exploration & Production ETF (XOP) advanced by nearly 2%. We think there is a growing understanding among investors that the major oil companies will be profitable even if the sale price of the commodity modulates.
Considering the weakness exhibited in growth stocks and energy-related investments in the context of their rallies in October and early November, it is clear these were “crowded trades”. When particular investments gather strong momentum, they attract widespread investment, which can unwind quickly and we have witnessed that phenomenon over the past week. At the same time, this phenomenon can create opportunity for smart, long-term investors to buy coveted stocks at a discount. This so-called “buy the dip” mentality has been successful since the beginning of the Covid crisis and is especially powerful for relatively young investors in “accumulation mode.” However, there must be nuance here, as not all dips should be viewed equally. In the next section, we will give you some insight on how to separate the good opportunities from the “traps.”
We need to take a bit of a step back and understand the bigger picture of growth investing in 2021. Not all tech stocks have moved equivalently this year. While the tech-heavy NASDAQ Composite index has gained nearly 24% in value this year, certain pockets in technology have really suffered, especially companies that delivered triple-digit gains in 2020. Some great examples of this are Zoom Video Communications (ZM) (down 35% year-to-date), Peloton Interactive (PTON) (down 69%), and Chegg (CHGG) (down 72%). Significant money has rotated from the so-called “Stay-at-Home” stocks in 2021 to “reopening plays” as you can see in the chart below from the New York Times.
We have been struck by the narrow nature of the tech rally in 2021, which we read as a sign of overall market weakness. Consider the YTD returns of the following stocks: Microsoft (MSFT) (up 48%), Nvidia (NVDA) (up 141%), and Alphabet (GOOGL) (up 62%). There has certainly been a separation between the mega caps and some of the other growth stocks in the market, like those listed above.
Despite the growth sell-off over the past couple weeks, we have identified a pocket of strength: semiconductors. One of the big themes across a wide array of industries has been the scarcity of semiconductor chips, which are used in many applications. The VanEck Vectors Semiconductor ETF (SMH) advanced 1.0% in the period covered by this week’s letter, despite the overall negative tilt of the NASDAQ. Looking for divergences like this help us to find clues of how best to proceed when we face market turmoil.
How Should Investors Respond?
When any market turmoil occurs, we take a step back to reassess. Falling stock prices do always give us some information. This is why we always follow technical and quantitative factors through our Jarvis system, in additional to our deep fundamental analysis of our target companies.
But at the end of the day, things all come back to fundamentals for us. There are dozens of growth stocks that have experienced significant pullbacks in 2021, only exacerbated by the action we have observed over the past two weeks. Where stock price fails as an information source is that price never tells the story of “Why?” Sometimes stocks fall because they were “overbought” and sometimes they fall because business has deteriorated. It is our job as investors, advisors, and analysts to study the story in a deeper way to determine whether the cause of a stock price slide is purely technical or more fundamental in nature.
A quick word about growth stocks informs our viewpoint. It is often said that growth stocks are “overvalued” because they carry price-to-sales ratios in excess of 10x, 20x, or more. However, it is not unusual or inappropriate for growth stocks to trade at these high valuations, when they are growing revenue at 25% annually or higher. In our experience, it is very unusual to see a true high-performing growth stock trading at a low valuation. As we often say around the office “the best merchandise rarely goes on sale”.
Because growth stocks often carry such lofty valuations, expectations amongst investors are high. This means that the valuations of growth stocks are ripe for contraction when fundamentals deteriorate. In simpler terms, if the revenue growth trajectory decelerates, investors should expect stock prices of high valuation growth stocks to fall violently. We call stocks like these “broken growth stocks” and the market often punishes holders of these securities with 50%+ declines and long periods of underperformance. Broken growth stocks are the types of names we want to avoid on pullbacks like this one.
Naturally, investors want to know in these situations “Should I buy the dip/pullback?” From our point of view, one can only answer that question by taking a deep look at the fundamentals and determine whether a stock price drop is warranted by a change in business trends or if the stock has been “unfairly” punished in a wider market correction. We think when growth stocks correct, making a shopping list of strong businesses is appropriate, but we would emphasize that investors must be cautious to purchase shares in companies that having slowing growth and/or are unprofitable.
In the following section, we will give you some examples in both categories, with the intention of teaching you more about a way to handle a widespread market dip.
What is a “Bargain” and What is a “Trap”?
By now, you likely can anticipate that our answer to this question. In a period of indiscriminate selling, “bargains” are stocks associated with healthy and growing businesses and “traps” are companies with deteriorating business prospects. Here are the stocks/sectors we think should go into the “bargain” and “trap” categories at this time:
Bargains:
Large Integrated Oil producers: The thesis here is fairly simple. Oil prices have been relatively high for most of 2021, as seen in the chart below showing oil prices between December 2019 and November 2021:
As you can see from the chart, the price of crude oil has been above $50/barrel for a full year now. Given that the breakeven price to produce a new barrel of oil is roughly $47 in the US, we can make the conclusion that the oil companies with the greatest scale have been operating profitably for quite some time and could do so, even if the price of oil were to drop. There is also the option for companies to hedge future production and lock in positive and predictable cash flows 2-3 years forward.
Additionally, large oil companies have been stingy with capital expenditures, in an effort to improve their financial situations, large oil companies have limited capital investment, as you can see in the chart below. This leads directly to higher profitability.
All of these factors mean that we will be looking for ways to add exposure to oil producers, the likes of which you will find in the SPDR Series Trust - SPDR S&P Oil & Gas Exploration & Production ETF (XOP). For those looking for individual stocks to choose, we would recommend Exxon Mobil (XOM) and Occidental Petroleum (OXY).
Cybersecurity/cloud computing: ever since the pandemic took hold, cybersecurity shares have been in high demand. The market is growing rapidly and is expected to be a nearly $2 trillion industry by 2025. Cloud security spending is pegged to grow by 42% alone. One company we have identified as a key beneficiary of these trends is Arista Networks (ANET), which sells hardware and operating systems that cloud computing and cybersecurity firms use to power their businesses. ANET has grown its revenues by roughly 25% over the past year, as companies continue to invest in critical infrastructure to undergird rapidly expanding cloud networks. ANET shares have pulled back by around 7% since making a high of $133/share on November 7 and we think this presents an attractive opportunity for long-term investors.
Semiconductors: as we mentioned above, we have noticed that semiconductor stocks have held up well while other growth stocks struggle. While much of this outperformance derives from Nvidia (NVDA), one of our favorite investments, many other companies in this industry are benefitting from market trends and the crucial chip shortage. Qualcomm (QCOM) is one that stands out for us. While the VanEck Vectors Semiconductor ETF (SMH) index has risen by 41% year-to-date, QCOM shares have only gained 15% in 2021, so there is some opportunity for catch up here. Qualcomm produces chips for cellular handsets and is a major beneficiary of the 5G upgrade cycle, which is far from over. Over the past 12 months, QCOM has grown revenues at a strong 43%, showing the type of acceleration we look for in a business. Like ANET, QCOM shares are down just 6-7% since the November 9 high, but we think a nice opportunity is developing for long-term investors.
Traps:
Teladoc Health (TDOC): Teladoc Health operates a platform that allows patients to connect with doctors and other medical professionals remotely. This was one of the biggest beneficiaries of the pandemic, with the stock gaining nearly 300% from December 2019 to the peak in February 2021. However, the stock has lost more than 60% of its value since the February peak, as the “stay-at-home” type stocks have suffered and business has decelerated. The stock dropped sharply last week after the company’s investor day, when management told investors to expect just 25-30% revenue growth in 2022 (growth rates have been roughly 115% over the past 12 months). This deceleration, coupled with concerns about competition from Amazon (and others), has weighed on the stock. With growth decelerating and competition on the horizon, TDOC is an example of a potential “trap” that we would recommend avoiding until there is a change in business trajectory.
Zoom Video Communications (ZM): Zoom Video has become a household name over the past two years, as people all over the world have used the service both for personal and business communications. This stock rose in value by more than 800% before also peaking in February 2021. Market participants appear to be concerned that the business has a limited moat, as many business customers have turned to Microsoft Teams as a replacement product. Zoom has had revenue growth in the double digits for more than two years now, so the stock has long carried a premium valuation. However, in the last earnings call, management projected just 35% sales growth for 2022, which represents a major deceleration. ZM shares are more than 60% lower than their February peak, so logically investors want to know if this is a buying opportunity. We think those investors should look elsewhere from Zoom until something changes on the business side here.
Takeaways from this Week
The growth rally of October and early November appears to be a thing of the past, with many of these growth stocks dropping violently over the past few weeks. We see pronounced weakness in software and crypto, as well as in energy, while we see pockets of outperformance underneath the surface, including oil exploration companies and semiconductors. These sources of outperformance are the starting point as we separate the potential opportunities from the market pullback from the potential traps.
We know that times like this can be some of the most difficult to navigate in financial markets. Having a plan and a framework are crucial as investors make decisions on how best to take advantage of lower share prices across the board. Our view is that purchasing strong businesses on dips can be the opportunity to bring cornerstone positions into the portfolios of patient, intelligent long-term investors. Contact me directly on the number in the “Announcements” section below if you are looking for guidance on how best to proceed for your own portfolio.
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 rest of your Thanksgiving weekend!
Announcements:
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.
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 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. Enjoy the weekend!
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Disclosure: I/we have a beneficial long position in the shares of QCOM, XOM, OXY, ANET either through stock ownership, options, or other derivatives.