Jarvis™ Newsletter: Tech Strong, Energy Weak; Earnings: Nvidia and more; End of Year Tax Strategy
-Brian Dress, CFA,
Director of Research, Investment Advisor
Overview:
As the year winds down and the 3rd quarter earnings season moves toward a close, a few key themes appear to be emerging in the financial markets. First, and most importantly from the Left Brain point of view, there is clear momentum in the technology sector, driven by a strong set of Q3 earnings (with some notable exceptions). More broadly, as you can see in the graphics below, the earnings season has been largely positive for companies of all shapes and sizes. This has created significant positive momentum in markets since the beginning of October (the S&P 500 has advanced 9.22% since 9/30/21). This comes despite inflation concerns that have permeated the minds of many investors.
If Q3 earnings are any indication, the US economy is moving along quite nicely, even though pricing pressures remain a concern among business owners and consumers alike. The consumer in the US is looking especially healthy, with many households sitting on savings from the 2020 lockdowns and itching to spend on consumer goods, travel, and more. This condition is having ripple effects across the economy, causing supply chain challenges, as the economic system struggles to cope with explosive demand growth, as businesses begin to address a post-Covid world.
In these pages, you have read that while we take the threat of inflation seriously, we do not share the same doomsday view of price levels that you may have seen in other financial media. In this week’s letter, in the ETF List section, we will share with you some of this week’s data points that show some relief in terms of inflation. Our view continues to be that inflation is likely to abate, as businesses ramp back up to more normal levels of production, but it could take some time. It is constructive to see some confirmation of this view in the data, as we have over the past month.
Third quarter earnings are beginning to draw to a close. As you know, we consider earnings season the most important time on the investing calendar. Though earnings reports have slowed to a trickle this week, we can’t let a week of earnings go by without studying and weighing in. This week we give you our thoughts on earnings reports from two of our favorite stocks: Nvidia (NVDA) and Bath and Body Works (BBWI). These continued a clear theme of 2021, which is strength in technology (especially late in the year) and building momentum in omnichannel retail.
The market digested more earnings, lower commodity prices, and falling US 10-year treasury rates positively over the five days covered by this report. Over the five-day period, the S&P 500 advanced 1.18% and the tech heavy NASDAQ gained 1.85% in value. With the 10-year treasury rate falling back below 1.6% and oil down 3.16% for the week, the financial and energy heavy Russell 2000 small cap index fell 1.49% in the same period. As we will address later, cryptocurrencies also fell significantly over the last week.
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With that all being said, let’s get into it!
Interpreting the Jarvis Data (week of 11/12-11/18):
New Ranks Under 50:
“New Ranks Under 50” is one of our favorite features in the Jarvis system. We use the feature to identify stocks with clear upward momentum. We continue to see a reasonable amount of turnover in our top 50 ranking list, which we think is understandable as companies continue to release fresh earnings reports and we see rotation from “reopening” stocks back to growth.
This week we had more than half of the top 50 list turn over, so there were quite a few new names in the list. We wanted to share just a few of those with you in this week’s letter. One company we have been following closely this year, alternative asset manager Blackstone (BX) entered this week’s list as the 14th top ranked stock in Jarvis. We also saw the entry of microchip maker Broadcom (AVGO), as well as another leader in the technology space Adobe (ADBE). Amazon.com (AMZN) entered the list for the first time in a long while, after a challenging 2021 fiscal year.
The last segment we wanted to mention, in terms of a pattern of new entrants to the list, is healthcare. Dental device producer Align Technologies (ALGN) entered the top 50 for the first time this week, as did hospital operator Community Health Systems (CYH) and health insurer Cigna (CI). Healthcare has been one of the top performing sectors this year, as it is perceived as a safe haven in inflationary times (the Health Care Select Sector SPDR Fund (XLV) has advanced roughly 15% year-to-date).
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: The main themes of the “Most Risen” list this week were growth generally and technology, more specifically. Among the strongest ETFs in this week’s data were the iShares S&P 500 Growth ETF (IVW) and the Vanguard Mega Cap Growth Index Fund ETF Shares (MGK). This was driven specifically by strength in the tech sector, with the tech-heavy Invesco QQQ Trust (QQQ), Technology Select Sector SPDR Fund (XLK), and the VanEck Vectors Semiconductor ETF (SMH) all in the most risen category for the week.
Outside of tech, we observed strength in the homebuilder stocks represented in the SPDR S&P Homebuilders ETF (XHB), as well as in the Consumer Discretionary Select Sector SPDR Fund (XLY).
ETF List - Most Dropped: Over the past month or so in the ETF List, we have seen major strength in the crypto asset space. This week there was a significant reversal in the theme, with Grayscale Bitcoin Trust (GBTC), Grayscale Ethereum Trust (ETHE), and ProShares Trust - ProShares Bitcoin Strategy ETF (BITO) all among the worst performing ETFs for the week.
Strength in the energy markets has been a near constant topic in the Jarvis letter over the past few months. We saw reversal in that trend this week, with notable entries to “Most Dropped” from SPDR S&P Oil & Gas Equipment & Services ETF (XES), VanEck Vectors Oil Services ETF (OIH), United States Natural Gas Fund, LP (UNG), and Alerian MLP ETF (AMLP). Since the region depends heavily on energy, Latin American equities showed weakness over the past five trading days, with iShares Latin America 40 ETF (ILF) and iShares MSCI Brazil ETF (EWZ) among the weakest performing geographical ETFs.
Finally, we would mention that cannabis returned to the doghouse, with the ETFMG Alternative Harvest ETF (MJ) down 8.6% for the week.
LB•logic Plenty to dig into here. As we digested some more positive earnings reports and momentum builds into the end of the year, growth and technology stocks have performed well over the past week. The coup de grace was the NVDA report, which sent the semiconductor index higher.
As we have mentioned many times over the past months, the US consumer appears healthy. That theme continues to play out with the strength in home builders and consumer discretionary stocks.
Crypto assets have been strong for weeks, both on the optimism of the technology underlying cryptocurrency and on the belief that the cryptos can be a hedge against inflation. With inflation indicators like oil weak and the US dollar strengthening over the past five days, cryptos suffered. We think there is promise in this nascent industry, but investors have no choice but to expect volatility in the sector. Just comes with the territory so you must be “eyes wide open”.
As stated above, oil fell significantly over the past five days. We would note again the weakness in oil services. With exploration companies seemingly committed to capital discipline, oil service providers the obvious losers in that equation. That segment is a “stay away” from our point of view. We still like oil and specifically through the pipeline and exploration segments. The drop in AMLP may be a chance for investors to add exposure.
Finally, for cannabis, the less said the better. We mentioned last week that strength in the sector was a chance to close any positions that investors were still holding in the space. We are rarely surprised to see weakness in the cannabis sector.
Earnings Reviews from This Week
We are getting a bit downcast around the office, with earnings season beginning to wind down. As we have fewer earnings reports to digest, we begin to feel that same empty feeling that football fans will recognize happens after the Super Bowl ends. Fortunately, we read two very interesting reports this week, the findings of which we will share below:
Nvidia (NVDA)
Nvidia has been one of our favorite stocks for a number of years and has been one of the strongest performers over the past five years (see chart below). We have long considered CEO Jensen Huang one of the best managers in the business and the company is consistently on the cutting edge in a number of different technologies. Nvidia’s Graphical Processing Units (GPUs) have become more widespread across a number of computer applications and the company is always pushing to find new ways to innovate.
(Source: Factset)
Beginning as a company providing computer chips for gaming uses, Nvidia has rapidly expanded to become a leader in data center hardware, Not satisfied with that, Nvidia is pushing into autonomous vehicles, artificial intelligence, and the concept that has become known as the “Metaverse” (Nvidia calls it the Omniverse). In pursuing these new endeavors, NVDA is moving beyond the hardware realm into the higher-margin software business and investors have rewarded Nvidia with an ever-higher valuation. Based on what we read in the most recent earnings report, we think the recent stock move has been justified and we see plenty of room for continued growth.
Nvidia has delivered yet again with a strong quarter of results. For the 3rd quarter, NVDA produced $7.1 billion in overall revenue, up 50% versus Q3 2020. The gaming business generated $3.2 billion (up 42%) and the data center business revenue was $2.9 billion, up 55% versus last year. Though the perception has long been that this is a gaming-driven company, revenue ex-gaming now accounts for more than half of the company’s revenue. This is indicative of the company’s move into ever more business channels.
With respect to gaming, the company’s cloud gaming platform, GeForce Now, is gaining traction, with more than 14 million gamers now active there. New gaming tech in the form of NVIDIA RTX is driving a robust refresh cycle and more than 200 games now support the cutting-edge technology. The data center business occupies a similar space in its market, with 70% of the world’s 500 top supercomputers powered by Nvidia technology. CEO Huang states “Every single server will be GPU-accelerated someday.” Note that just 10% of servers are currently GPU-powered. Therein lies a huge growth opportunity for Nvidia. Says Huang, “Next year is going to be quite a good year for data centers.”
We have long known that gaming and data center are impressive business segments. But what really excites us going forward are the growth initiatives, namely artificial intelligence (AI), autonomous driving, and the Omniverse.[1] GPUs are now being used widely for AI in applications such as technology analysis, speech recognition, computer vision, and anomaly protection. One compelling such application comes in Microsoft Teams. Teams has 250 million monthly active users and uses Nvidia’s AI technology to convert speech to text. Nvidia AI is now widely available to enterprise customers. As CEO Huang says: “It takes software to open new markets” and that explains the company’s changing orientation away from exclusively hardware production.
Omniverse is one of the hottest topics in technology and in finance. The applications of the Omniverse technology are numerous: Omniverse Replicator produces data to help train robots, Omniverse Avatar generates interactive avatars that can be used in automated customer services, virtual collaboration, and content creation. In terms of market opportunity, CEO Huang sees an opportunity to sell the system to $40 million creators and designers at $1,000 per user yearly. Additionally, the autonomous vehicle system (NVIDIA DRIVE) is another $1,000 per year (per unit) annual revenue opportunity (there are roughly 100 million vehicles annually sold worldwide). When we boil all of these opportunities down, what we see is the long-term vision here, which is eventually to convert this company into a software business, which will have higher margins and command a higher price to earnings multiple.
Nvidia is attacking the supply chain issues head on. Inventory is up 68% Year-over-Year, as Nvidia is securing chip supply for 2022 for Omniverse and other applications. Despite cost pressures, gross margins were up 2.6% versus Q3 of last year. Cash flow from operations for the quarter came in at $1.5 billion versus $1.3 billion a year earlier. We think the evolving orientation of the business to data center and software-related segments, along with great execution, are driving margins higher. All in all, Q3 was a great quarter for Nvidia and further bolster our view that the company is on track to achieve a $1 trillion market value in the near term.
Key Risks: Supply chain issues could cause issues for production, profitability. Chip supply is largely in Taiwan, so there is geopolitical risk here given the tension with China. The semiconductor space is competitive (AMD, Intel, and more). The business is economically sensitive and would suffer in an economic downturn.
Bath and Body Works (BBWI)
We have followed Bath and Body Works closely for years, as we have been investors in Limited Brand (LB) bonds for some time (the former parent of BBWI). We noticed in our previous study of LB’s business that the growth engine there was always Bath and Body Works, which was hamstrung by its connection with the lagging Victoria’s Secret (now trading under the ticker VSCO). Since the two companies separated in mid-2021, we have been intrigued by the opportunity in BBWI stock, which is one of the best growth businesses among mall retailers.
Bath and Body Works was one of the few mall retailers that benefited from the pandemic, since the company sells a wide array of soaps and sanitization products. In 3rd quarter of 2021, net sales of $1.68 billion represented a 1% decrease versus the same period in 2020. CEO Andrew Meslow said this was due to an expected pullback in soap sales, which was offset by a rise in body care/fragrance sales. Note also that this sales figure represents a 53% increase versus the 2019 figure, so clearly this is a growth business.
In terms of earnings per share, BBWI delivered $0.92 EPS for the quarter, up from $0.83 from the same quarter last and also exceeding previous guidance of $0.55-0.60. Margins in Q3 were better than in Q2, as management managed the amount of promotional pricing (sale pricing) well in the quarter. However, gains in profitability are decelerating due to the type of inflationary pricing pressures we have observed throughout the economy. Said CEO Andrew Meslow: “[BBWI is] better positioned than most retailers due to our primarily domestic supply chain, we are not immune to [inflationary] challenges.”
For a retail business like this, we are paying particular attention to the impact of inflation and the strategy that management has to tackle the problem. Reading this quarter’s report gave us confidence in the strategy. First, management shared that BBWI has proactively managed both production and promotional pricing in the 3rd quarter and expects its product assortments to be “full and abundant for holiday”. Additionally, BBWI was able to raise some prices to help absorb the impact of input cost increases. For example, in Q2, BBWI raised its prices on all candles by $1. This shows that BBWI has enough pricing power to help cope with any inflationary concerns. Said CEO Meslow: “We’re still very confident in our ability to [sustain merchandise margin pricing power].” Meslow also stated that BBWI “[has] not seen negative customer reactions…to these changes.”
We have been following the shifts in retail closely throughout the past year. Omnichannel businesses, those that have strong presences both online and in physical stores, have been some of the best performers in 2021. BBWI has seen strong growth in dual-channel customers, which is fortuitous, given that these customers spend 3 times more than the average single channel customer. As a result, management mentioned that average customer spend is up in the high 20% region since 2019.
What we will be watching going forward will of course be the impact of supply chain issues and input cost pressures on this business. We are optimistic, given that CEO Meslow stated management is “satisfied with our inventory position as we head into holiday.” However, management expects challenges in the holiday season from the challenges mentioned. With that said, BBWI expects 4th quarter earnings per share of $2.10-2.25, a sharp increase compared to the $1.96 EPS in Q4 2020 and $1.41 in 2019. We think BBWI is well positioned to do well this holiday season and we remain bullish on the company.
Key Risks: Supply chain and input cost increases could weigh on profitability. Any return of Covid-related restrictions could hurt the company’s omnichannel strategy
Strategy Session: End of Year Tax Optimization
As the holidays come around, we know it can be tempting for investors to put portfolio management to the side. However, at Left Brain, we consider this time of year crucial for investors, as it is an opportunity to make some simple moves to optimize one’s tax situation. We have spoken in the past about end of year tax optimization, which is a tactic whereby an investor strategically sells securities from the portfolio that carry a capital loss in order to offset any realized capital gains taken throughout the year.
In the 4th quarter, smart investors should take stock of their portfolios, identifying which securities they hold carry unrealized gains and losses. Taking that inventory can help investors make the best plan to minimize their capital gains tax burden.
Before we go more deeply into explaining another twist on the strategy, we want to set the stage with some foundational points. Note first that we are speaking with regard to investments in taxable brokerage accounts. Given the tax-deferred nature of retirement accounts like IRAs and 401(K)s, this strategy would not be applicable for those sorts of accounts.
According to US tax law, investors are able to use $3,000 of capital losses per year to offset their Adjusted Gross Income (AGI) and the use of realized capital losses to offset realized capital gains is currently uncapped. This structure advantages investors that strategically sell underwater positions toward the end of the tax year.
Another point for investors to keep in mind is the “wash sale rule”. According to the Internal Revenue Service (IRS), a “wash sale” is defined as the sale or trade of a security in which an investor has a loss and the subsequent repurchase within 30 days of that security or another security with a substantially similar risk exposure (think options). Why does the wash sale rule matter? Simply put, if an investor sells a security at a loss and repurchases that security again within 30 days, the ability to use the capital loss to offset capital gains is cancelled.
The wash sale rule complicates end of year tax planning. What we hear most from investors regarding this strategy is their fear of selling a stock they want to hold for the long term, with the possibility of missing out on gains in the 30-day period where the security is out of their portfolio.
It is certainly true that some of the securities that would be eligible to realize as a capital loss are securities we would like to hold for the long term. From the Left Brain point of view, two names jump out as obvious examples of this phenomenon: Roku (ROKU) and Zoom Video Communications (ZM). Both securities have generated losses for investors in 2021, especially for those who purchased the stocks this year, so these are great candidates for realizing losses. The downside to this is that investors who harvest losses from these stocks will not have investment exposure to them for at least 31 days. Given the wash rule, investors have two choices:
The investor can simply sell the security to realize the capital loss on any day before the end of the year. That investor cannot repurchase that security (or a substantially identical security like options on the same stock). The clear downside to this approach is the investor has no exposure to the security’s upside (or downside) for at least 30 days or
Rather than simply selling and terminating the exposure to stocks like ROKU and ZM, an investor can alternatively purchase a second identically sized lot of shares in the same stocks. After 31 days, the investor can then sell the first lot of shares and realize the capital loss, just as in a conventional tax optimization transaction. For securities on which we have a bullish view, we prefer this approach, as it maintains the exposure to the security, while preserving the tax benefit. The second strategy is not without risk: should the stock fall in value, the loss will be double what it would have been if you had just held the stock and not completed this transaction.
*Note: in order to make this strategy work for the 2021 tax year, you must purchase the second block of stock before November 30 to give yourself 30 days to sell this first block before 2021 ends.
A quick practical example: imagine you purchased 100 shares of Zoom Video (ZM) on February 8 at $433/share. At the 11/18 closing price of $255.75, you would be carrying a capital loss of roughly $18,000. This is how you would proceed under the two strategies mentioned above:
You could sell the shares and realize the $18,000 capital loss (short-term) to offset any realized capital gains in your portfolio. If you are in the top capital gains tax bracket, you could save up to $3,600, but you would be without exposure to the stock for at least 30 days.
You could purchase another 100 shares of ZM, leaving you with 200 shares. Then, 31 days after the purchase of your second block of 100 shares, you could sell the first block of 100 shares. You will then realize a capital loss, which you can again use to offset any realized capital gains, in much the same way. The capital loss would equal $433/share minus the share price when you sell the first block, times 100 shares. In the end, the capital loss is likely to be similar (assuming the stock moves minimally in the 30-day period), but you maintain exposure to the stock during that 30-day period. Remember, the downside to this strategy is that if the stock drops while you hold the two blocks of shares, your loss will be twice as much.
To learn more about how best to implement this strategy for your portfolio, please feel free to contact us. Remember we do free portfolio reviews and we would be happy to discuss this and many other strategies with you. Just click this link to contact us and we will reach out to see if we can help!
Note: we are not tax accountants or attorneys. Please consult your tax professional before taking on these strategies.
Takeaways from this Week
Growth stocks were yet again the story of the week, with technology the main driver of that move. NASDAQ stocks led the broader market, simply continuing a trend we have observed since early October. On the other hand, oil and cryptocurrencies were weak, as inflation fears seem to have abated, with the price of crude oil dropping by more than 3%. As we have mentioned ad nauseum, we continue to monitor the inflation threat, but we have a more benign view than some other investors.
Earnings season is grinding to a stop here, but we read reports from two of our favorite ideas in NVDA and BBWI. In the Nvidia report, we saw yet another quarter of explosive growth, with the company innovating significantly and opening new avenues to drive growth. We also see a shift in business model underway at NVDA to the higher margin software business. In the case of BBWI, we saw another quarter of strong performance, which fits with the broader theme that omnichannel retailers are doing well. We saw some signs of inflation coming through in the report, but we also were impressed with the management’s response, in this case.
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 and we will speak with you again soon!
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[1] Going forward we will be using the term “Omniverse” rather than “Metaverse”.