The Time For Cloud Stocks May Be Now (Episode 44)

Yeah. Hey Kate, good to be with you. I think there were, there were three issues coming into this year that set up a bad first half. Of course we had the worst first half since 1970 for stocks and also the worst first half for bonds in over a hundred years. And, and coming into last year, I mean in over 30 years of doing this, I've never seen a more perfect bullish storm than we had coming into last year. We're coming off of the worst recession since the thirties with the pandemic and, uh, earnings rebound. Typically they did, they rebounded 70% last year. We saw that and anticipated it, but it was being supercharged by record government spending and money printing. I mean the fed through 5 trillion at the market and the government spent 5 trillion to make sure we got through the pandemic. So you had, you were in the sweet spot to own stocks and being supercharged by 10 trillion of government spending.

So it was a fantastic set, but I think valuations got away from themselves. You know, we were over 27 times on the S and P 500, all that money flowed into cloud companies and they got up to 40 times sales and it reminded me of, um, dot com in 2000 oh three, when you just had crazy valuations and the so-called, you know, yuck young unprofitable companies that don't know when they're gonna make money. And they were just dealing with a speculative bubble that was bursting. And the, the catalyst for that was the fed ending its ACC cycle. In March of this year, they've started raising interest rates and, and long duration tech companies, companies that aren't gonna be profitable for many, many years then are worth less today because interest rates affect the discount rate and their present value of cash flows are worth less.

So, you know, we've seen, we expected this, we thought there was a lot of risk coming into this year. And a lot of those cloud companies, whether it's Twilio or, you know, a whole range of them have, have lost 80 to 90% of their value. And, you know, the broader market, the S and P 500 dropped 25% and the NASDAQ dropped 35%. So we've seen a lot of damage year to date and remember, uh, the typical bear market without a recession is down 25%. And the S and P was down almost exactly that at the June low and then a typical, uh, bear market with a recession is down 35%. You know, that take the S and P down to 3,200 versus the 3636 40 that we saw at the June low. So we've seen a lot of damage. The average stock on the NASDAQ's been cut in half.

So, you know, a lot of bad news is discounted at this point. And I think this rally off the June, we're a really critical juncture here for the market. A really, uh, , it's a good day to be doing this interview because we've had a, uh, you know, about a 16% rally in the S and P 500, it's still down 11% year to date. So I think there's a strong test coming up for the market here. It's over bought on a short term basis. We're now more than two standard deviations above a 50 day moving average, that's classically over bought, we're expecting some pullback. The market's going to get tested next week as a fed has its Jackson hole, a meeting in Wyoming and chairman,

Yeah, there's kind of this battle between, uh, the macro, which is still concerning and kinda scary in some regards and inflation is the highest it's been since the early eighties. And we know the fed is, is not done hiking interest rates. They, they keep coming out and telling you they're committed to raise interest rates and get inflation back to 2% from the 9% we're at. So, you know, as an old adage, don't fight the fed and the Fed's not done. So we've got that as a headwind, but it's interesting if you look at, you know, what the 10 year treasury is telling you, it it's at 3%, you know, out to 20, 24, and then there's implied inflation rates over the next year, two years, three years, five years. And those all have a two handle on them. So the market is telling you, it expects inflation to come down.

It could be some combination of this tighten cycle of the feds going through. They wanna slow demand and what's supply catch up. And also some portion of the inflation is transitory. I mean, these supply lines have been compromised because of the COVID pandemic. And, you know, there's a Bloomberg piece recently that said about 40% of this inflation, almost half is likely to be eventually resolved. And we know that the Ukraine war is compromised at grain corn wheat and created supply disruptions. So, you know, it's not impossible that the fed has a soft landing. Historically the, the odds are about 30% that they pull it off. But, you know, there's several indicators that the implied inflation rates with the bond market is telling you that inflation can moderate and, you know, and in nine months to 12 months from now, the, the market could look very different.

Sure. I think, you know, broadly speaking, we see opportunities. I mean, we were, as I say, we're we're risk managed. So we saw very good setup. We have macro models, that driver process. So last year we were very boss up 27 to 47%. This year, we're down, you know, in our hedge models, less than, uh, two to 3%. And we see a great opportunity setting up. And one of those opportunities is revalued, secular growth companies.

Yeah, there's some really bullish themes that are going on right now. And this is part in part why I'm not an Uber bear in longer term because I think the efficiencies, the us economy is twice as efficient as it was in the 1970s and technologies like 5g are coming. We saw what happened with, you know, obviously the internet coming out of, uh, the late nineties, but 5g is gonna be a game changer. It's gonna reduce latency with mobile devices and open up a massive amount of opportunity. Autonomous driving is one of them all are smart devices, the internet of things. And there's companies that are powering that some, you know, we don't believe in their business models, but some have fantastic business models that were just overvalued. So Arisa networks, for example, ticker a N E T is their switches are integral in the network that will be powering 5g. Another interesting play we think is key site. K I S is a company that does the testing of, uh, 5g networks and, you know, American tower AMT is, uh, they put up the 5g cell stations and 5g is a shorter wavelength. So you need greater density of, uh, cell towers and maybe you start have seen some of them popping up more frequently. Um, certainly out here in Denver, I, I noticed them going out on I 70 quarter, you know, up to bail and, and you know, all over the city,

You're just seeing more towers popping up. And

Yeah. And they're, they're kind of clever sometimes the way they disguise 'em and there there's going down to Colorado Springs. I noticed there's one with bit kinda a foliage and it sort of blends into the, the trees

Yeah. It's handed its ups and downs and these for us were very, you know, objectively and quantitatively driven. So it's some, these are ideas. I think some of them are ahead of themselves and it's valuation dependent and it's price level dependent on whether and where we will own these stocks. For example, with the pandemic crash of 2020, you know, Amazon finally scored well in terms of its valuation on a pre split basis at 1800, we added that to our strategies that then doubled going into last year. So, you know, you do have to pay attention to the valuation of these companies, but I think some of them are getting very interesting and you know, these trends will keep growing. So even though their stocks have been taking a nap, the trends that are driving them or are not going to sleep, then I would point out artificial intelligence is another secular growth theme. And, and Nvidia is a player. N VDA is a player in that market. Cloud computing, I think is another one, you know, in our office, we work remote, uh, Friday and Monday. And we, we, you know, we're not skipping a beat between zoom meetings and just companies that are powering that like Amazon with their AWS division and Microsoft with, uh, Azure ServiceNow, we loved for a long time. It's valuations. Now finally getting interesting for us where we have a value discipline, Adobe, another

Right. We look at a range of valuation metrics, price, sales, price, earnings, market value to EBITDA price, to book. And then those are actually weighted in terms of their explanatory power for each sector. For example, in utilities, you know, yield just dividend yield can be explanatory where in other sectors, you know, market value EBITDA can be more explanatory like it is in technology and, you know, take service now. I mean, this company is not a roll up. I mean, this is organic growth on the bottom line on earnings of, you know, 25% through 2026. So this is, you know, three over three times the average company in the S and P 500. So it deserves a higher multiple. And you know, we also run discounted cash flows on these companies, but, you know, you're getting close to relative to its growth, a reasonable valuation. So it's relative to its peer group. It's relative to its own growth, higher growth companies deserve a higher multiple. And, you know, historically the rest of 1000 growth index sold at 29 times earnings because it's got higher growth where the S and P 500 is sold at 16 times earnings because it's earnings growth is lower. It's, it's like, uh, 7%, seven to 8% a year.

It's relative in terms of growth. And I mean, we also look at the profitability of companies and their business model. Do they have to spend a lot to maintain the business or grow the business, or is it kinda a cash cow company? Like Adobe is a fantastic company, cause it doesn't have to spend a lot to run that business. So it deserves a higher multiple.

And that's correct, Kate. I mean, historically ServiceNow is sold in, in forties in terms of it's multiple, it's now selling it 51 times next year, but it's growing at over 25%. It's also let me inject another piece to this. It's a function of interest rates because interest rates become the discount rate of future cash flows. And, you know, if the fed were, have had to hike interest rates to seven, eight, 9%, then that would mean a lower multiple. But right now, you know, we're at 2.8% on the tenure. And if you go out to 2024, the market is only saying it'll get up to about 3%. So in this kind of an interest rate environment, and given that ServiceNow is traded in the forties and the past, we're approaching a reasonable level in terms of valuation. You go after 2020, it's selling it 40 times.

Yeah, I think cyber is, is you've seen all the cyber attacks. And I think the growth you're seeing with companies like CrowdStrike CWD Palo Alto, P a N w Fort net. I think that's another secular growth market. And, uh, some of those still look expensive to us, but, you know, CrowdStrike is the leader in that and their intelligent network. It within the periphery say of a campus like an office campus, if there's a tax within any touchpoint of that, whether it's mobile phones, whether it's, uh, you know, all the interconnected devices, it alerts the rest of the, the entire network. So really interesting technology and the leader in cyber to us, it still looks, uh, expensive, really

It does fundamentally. And we doesn't mean, you know, expensive stocks can get more expensive, but CrowdStrike for us is not quite there in terms of its valuation. How Alto is closer. I think another interesting theme and, and we're fans of the pick and shovel analogy, you know, back in the gold rush. I mean, if you, if you bet on an Explorer that found the mother load, then of course you, you made a lot of money, but a lot of 'em didn't. So, but it was the companies that sold the picks and the shovels that didn't have the risk of the explorers. So there's picking several plays within EVs, for example, you know, you've seen Rivian and a number of these startups just absolutely implode. And, uh, Tesla of course, is the leader still expensive by traditional metrics. But one interesting way to play it is through copper there's three times the copper needed in an EV than an internal combustion company. And, and, uh, Freeport Macmoran FCX is one way to play that. Another interesting kind of pick and shovel play is active. This is the old Delhi, but ticker a PT, they do the electrical systems and, and needed with electric vehicles and also autonomous as it comes. So looks active, looks really interesting to us right now.

Yeah, I think from a macro standpoint, there's really this battle between the macro and what some of the technicals are telling us. You know, I mentioned the it's almost like the and Manila and I got these look from gen Xers and our office. And of course that was Ali and Frazier, their fight and Manila, the macro we've got these headwinds. One thing I didn't mention is the 600 pound gorilla in the room is oil. I think oil supply demand is tight, but through the end of the year, at least, and want to see how the winter plays out and Europe plays out with, uh, Putin, you know, cutting off, uh, a gas to Europe and, you know, we could have some problems with oil. So I'd like a number of energy companies too, is a way to kind protect or hedge your portfolio to that risk.

But watch this pullback we're going to have, I, I think the market is, uh, ahead of itself. If we have an orderly pullback and it holds at 3,900 to 4,000 versus 4,200 right now, I think from a few viewpoints where the bear market may be, be ending. There's a few technical indicators. We look at the percentage of stocks above their 50 day. Moving average is very close to hitting 90% since 1970, that has a perfect record of calling the end to bear markets. So it's something we're watching very closely and just the we'll be looking at, you know, the breath are we seeing cell thrust. Those are 10 to one or more down volume down issue versus up issue up volume days. If we have an absence of those, if it's orderly. And I think there's a good chance, we we've seen the worst of it.

And the market's telling you then that inflation will moderate that perhaps we get, uh, gridlock in November, which has historically been good for stocks. And, you know, eventually there'll be a resolution to the Ukrainian war. And again, markets look forward six to nine months. So even though it's kind of upsetting and concerning right now, the, the markets look forward. So I would look, let's see how this plays out. Let's see how it handles. The fed is going to be hawkish next week. You know, the regional fed heads have been telegraphing that I think Jerome Powell on Friday, you know, 10 o'clock Eastern is going to have a pretty hawkish message, meaning they're not done in terms of hiking rates. And let's see how the market handles that.

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Thank you very much, Kate.