Cabot Growth Investor Issue: August 10, 2023

Down (but not Out)

In the last issue, we said the near-term market outlook was a coin flip given that the market had been cranking ahead for nearly three months and a lot of the worries of the world had been forgotten. As it turns out, that flip came up tails, with the market beginning to retreat since at a reasonable pace—at least for now, the major indexes are looking very similar to how they did in their initial pullbacks after prior bull kickoffs in 2003 and 2009, with mild declines (3% to 5% on the big-cap indexes), especially compared to the prior run-up.

Near-term, more weakness is certainly possible, maybe even likely, as the market works to reintroduce some fear and digest the gains of May and June. But, whether it’s the market’s own trends (still bullish), a continued barrage of encouraging studies or other factors (defensive stocks aren’t outperforming by a giant margin—see more later in this issue), it’s hard to find much in the way of abnormal action when looking at the top-down evidence.

What hasn’t been similar to the past, however, is the action of growth stocks: Be it big-cap or small-cap, speculative or well situated, great earnings reports or sour ones, we’ve seen an avalanche of intermediate-term breakdowns and big earnings-induced declines across a variety of sectors; among the stocks we follow, most sank 15% to 20% or more in three weeks or less! We’ve responded by cutting things left and right and are now holding about half the portfolio in cash.

So what does it all mean, with the market pulling back normally but growth stocks falling apart? Really, we would just take the evidence as it is: For the market, the odds strongly favor that we’re three weeks into a normal pullback and, while it’s likely going further, should resolve to the upside down the road. For growth stocks, however, there’s no question the charts have been damaged and will require some repair work in the weeks ahead.

But that’s looking at the short- to intermediate-term. All in all, things are down right now—but we don’t think they’re out, for the market but even for growth stocks, some of which still look solid and, even among the “bad” ones, few have suffered longer-term damage to their chart. Over time, we think this rolling correction will allow us to better uncover the stocks that can resume their overall uptrends, as well as some new names that can have sustained, multi-month (not just four- or five-week) runs once the market heads higher.

What to Do Now

Right now, though, we’re mostly playing defense, holding a good chunk of cash and homing in the most resilient names—both in growth, but also some other areas as well. In the Model Portfolio, we’ve cut loose MasTec (MTZ), Monday.com (MNDY) and half of DoubleVerify (DV) since the last issue, leaving us with a cash position of around 51%.

Model Portfolio Update

The market’s correction has been about what we thought when it comes to the major indexes—so far, a very reasonable retreat, especially compared to the May/June/early July advance, with our major trend following measures are all still positive.

But growth stocks have been living in a different universe—egged on by one of the worst earnings seasons we can remember, the growth side of the equation has seen tons of names fall off a cliff We’ve even seen some sacred cows getting hit, too.

Obviously, it hasn’t been pleasant, but we’ve responded by paring back in a hurry, selling off anything that decisively cracked while trying to give our more resilient positions a chance. As written in the first section, near-term, we do think more tough action is possible, maybe even for the market as a whole—that said, bigger picture, the odds still favor the market having another good run once this downturn finishes up.

Thus, we’re cautious for now, but despite the knocks we’ve taken, we remain very confident of landing some winners when the selling pressure wears off—likely in some fresher names that few are talking about right now. Tonight, we’ll stand pat with our huge cash hoard, but (a) near-term, we could add a “non-growth” play (Noble looks great), and (b) once we see some decisive strength in growth names, we’ll look to repopulate the portfolio with them. For now, we’re practicing some patience as the dust settles from the recent selling.

CURRENT RECOMMENDATIONS

Celsius (CELH)—Celsius reported second quarter earnings on Tuesday night and they were a classic blowout: Revenue growth accelerated for the second straight quarter, rising 112%, while earnings of 52 cents per share more than quadrupled from last year, and more than doubled estimates! It’s hard to pick amongst all the good news, but here’s a sampling: Celsius is still just the number three energy drink brand in the U.S., with 8.6% market share (double that of a year ago), so there should be huge upside ahead; distribution continues to soar, with a national rollout of BJ’s just starting last quarter (club store sales were up 120% year on year); the firm sees big potential in a variety categories like foodservice (makes up 11% of Pepsi-related revenues), universities, hospitals, casinos and more; and, finally, international revenue was up 76% but totaled less than 5% of revenues, and there should be giant upside ahead (likely early next year, when Celsius should make a push overseas after getting logistics and what-not in order later this year). Maybe the best comparison of all is simply that, in the latest quarter, Monster Beverage had $1.8 billion in revenue, compared to Celsius’ Q2 total of $326 million—that doesn’t guarantee anything, but there’s no doubt the upside with Pepsi is gigantic if the teams execute well. Happily, the stock actually reacted well to the news, gapping up yesterday on huge volume. We’ll restore our Buy rating, but keep any new positions small and ideally look for dips of a few points after the recent surge. BUY

DoubleVerify (DV)—DoubleVerify is one of the poster children for this earnings season so far, as it pretty much had everything going for it, from a new story to solid growth numbers to an uptrend, under-control chart, and even the report itself (and outlook) was solid—but DV nosedived anyway. (One study said that the average earnings reaction of stocks that beat estimates so far this quarter was the worst since 2011.) Of course, it is what it is, so we dumped half our shares on the break, but so far have held onto the rest—mostly because the stock is back into an area of support and, frankly, the growth profile remains solid. Don’t get us wrong, we’re not just going to hold and hope with our remaining small position, but tonight we’ll hold on to the rest and see if and how well it can bounce going ahead. SOLD HALF, HOLDING THE REST

DraftKings (DKNG)—DKNG has been up and then down, though we remain optimistic. First, the good: The Q2 report was a barnburner, with revenues up 88% (crushing estimates by 15% or so) and EBITDA turning positive, with huge gains in market share in the states it operates—all of which led to a big gain in 2023 estimates and expectations that cash flow is likely to be significant in 2024 and beyond. Excitingly, the firm actually saw revenues up 70% in states it entered between 2018 and 2021 (the equivalent of a “same-store sales” metric for DraftKings) even as external marketing spend fell 10%! That’s all to the good and increases the odds that the firm has built a solid competitive advantage—however, that will be put to the test based on Tuesday’s night’s news that Penn Gaming has partnered with ESPN to launch an exclusive online sports book, which caused DKNG to sell off yesterday. The risk here is probably less of a sudden market share loss (or any share loss at all) and more than Disney (which owns ESPN) will re-start a bunch huge incentives to sign up. Big picture, we feel like the leaders in the industry are already established and doubt it will affect business much, but we’ll see how it goes. We never averaged up here, which has proven to be a good move; with “only” a half-sized position we’re willing to see how it all shakes out, but given the growth stock environment and the latest drop, we’ll go to Hold. HOLD

MasTec (MTZ)—"The unexpected happens frequently in the stock market” is one old market truism, and unfortunately MasTec was an example of that on the downside. Heading into earnings, everything was lined up in the right direction (the stock, the story, the group, etc.), but, simply put, the company put up a stinker of a Q2: Whereas some peers were still seeing good demand from clean energy clients, MasTec said projects were being delayed, which caused the backlog to shrink from the prior quarter and had the top brass cutting estimates. And, seeing how these things go, nascent project delays usually don’t right themselves right away (leading to more delays), all of which caused the stock to implode on the downside. We sold half right away and ditched the rest on Tuesday—it’s obviously disappointing, but the money will be better put to use in other names once this growth stock correction finishes up. SOLD

Monday.com (MNDY)—MNDY had a great-looking setup in June and tested new high ground just a couple of weeks ago, but it could never get off the launching pad—and then, as growth stocks turned weak, the stock broke down like many others; we dumped our half-sized position earlier this week. We will say we’re still keeping an eye on the stock: While definitely not in great shape, the long-term picture isn’t horrific (we sold mainly because of our loss), and we’d note that a ton of funds actually bought in during the second quarter (fund ownership was 370 at the end of June, up from 212 three months before), and they obviously weren’t doing that thinking a major top was near. If the stock can really get going in the weeks ahead (earnings are due next Monday), we could revisit it—but we have to go with what is happening in the here and now, and because of the breakdown we were forced to sell. SOLD

ProShares Ultra S&P 500 Fund (SSO)—From a growth stock standpoint, the past three weeks have been a horror show, with more huge earnings gap downs than you can shake a stick at. (SMCI and DDOG were two more high-profile blowups this week.) However, when looking the S&P 500, it’s been a very normal and modest dip, with the index falling about 3% from its peak and still holding north of its 50-day line—and when you throw in the numerous bullish studies in recent weeks and other factors (there’s been no major rush into defensive stocks at this point; see more later in this issue) and we think the odds favor (a) some more near-term tediousness, but (b) a resumption of the uptrend down the road. We’re not complacent, but we’ll stay on Buy, thinking further dips could be an opportunity to buy some shares of SSO if you’re not yet in. BUY

Shift4 (FOUR)—FOUR is again on the edge for us, nearing its support area for the umpteenth time. So why do we bother to hang on? First, because we have a small position, so we’re not living and dying with every tick. But more than that, it’s because the story and numbers remain as good as ever—really, the story is playing out exactly as thought it could many months ago. While Q2 revenue growth slowed to 26%, the top brass sees the second half of the year re-accelerating a bit to 30% as many of the newer deals it’s inked earlier this year begin revving up; indeed, despite all the economic worries, management again hiked its outlook, not just for revenue but for EBITDA and free cash flow (north of $2.50 per year on that metric now expected), too. And with so many big new deals in sports, entertainment and a variety of other newer industries continuing to be signed, growth should remain very solid well beyond 2023. Of course, the stock is not the company, and so FOUR (dragged down by its peer group) hasn’t responded to the good tidings. We’re holding here, but the stock will have to find support or we’ll move on. HOLD

Uber (UBER)—UBER has been steadily losing altitude since earnings because of the market environment, though we continue to think the future is bright. We went over most of the earnings-related positive tidings in last week’s update, so we won’t rehash all of it, but many analysts are seeing next year’s EBITDA target of $5 billion as super conservative (one is looking for $6.2 billion), with free cash flow also buoyant, and don’t forget about Uber possibly getting some cash from its freight business, which is reportedly on the block or could be spun off. Back to the stock, we could sell a piece of our holdings if things really get ugly, but we think there’s a good chance big investors will support the stock as shares approach support (UBER is near its 50-day line here). Thus, we’ll stay on Buy for now, and aren’t opposed to nibbling here if you don’t own any. BUY

Watch List

• Airbnb (ABNB 136): ABNB tried to emerge from a long bottoming effort before the market (and earnings) reeled it in, but shares aren’t in bad shape. Business here is solid (high teens revenue growth), though underappreciated is free cash flow, which totaled about $6 per share in the past year.
• Boot Barn (BOOT 96): Boot Barn has always had a good cookie-cutter story, but after some post-pandemic adjustments, business is starting to turn back up and the long-term view if very bright. See more below.
• Confluent (CFLT 34): CFLT remains wild, with big swings of late, but we’re still watching it because the story is enormous, with real-time data usage becoming core to the operations of many firms; with tens of thousands (including 75% of the Fortune 500) using Kafka, Confluent’s cloud solution (sales up 78% in Q2) is just scratching the surface of its potential.
• Duolingo (DUOL 141): DUOL has been correcting and consolidating since early June and shook out to a lower low this week—before bouncing back nicely after a great Q2 report that saw another big leap in paying subscribers (up 59%), revenues (up 44%), free cash flow and EBITDA (both positive and up more than three-fold). It still has work to do but we’re intrigued.
• Freshpet (FRPT 79): Similar to Boot Barn, FRPT has had a great story for a while, but after many company-related mishaps, things are back on track and rapid, reliable growth is likely for a long time to come. See more below.
• On Holding (ONON 36): We’ve wanted ONON to calm down—and it has, which is a good sign. We’re not going to step in ahead of earnings (due next Tuesday, August 15), but we’re intrigued given the great story, numbers and, if all goes well, the chart, too.
• Noble Corp. (NE 52)—NE is probably the #1 name on our list that we could buy in the days ahead. Not only does the stock continue to act just fine, the fundamentals are great both near-term results (solid earnings and cash flow, along with a growing backlog) bu also long-term. Management went into some detail about the tightness in the market and why the sector is likely near the start of a multi-year upturn on the latest conference call, which will bolster not just earnings but shareholder returns and (likely) investor perception.

Other Stocks of Interest

Boot Barn (BOOT 96)—Boot Barn is by far the largest retail player focused on western apparel and accessories and (mostly blue collar) work wear, two areas that are seeing demand rise over time thanks to the growing acceptance of country-type lifestyles and generally good job markets for things like oil and gas, construction and the like; the firm offers everything from functional goods to fashion apparel and has more than triple the number of stores as its closest direct competitor, though there are tons of small shops in the sector as well. We’ve kept a distant eye on the company for many years, though we’ve never owned it as the pandemic affected things, both good and bad: Business went bananas in 2021 with sales rising 66% (same-store sales were up more than 50% every month from April through December 2021!) and earnings more than tripling as people were doing more at home ... but as the world turned right-side up, things started to self-correct a bit; the June quarter saw sales up 5% and earnings down 12% as same-store sales dipped 3%. Even so, BOOT has turned strong because the expected downturn is looking pretty modest: Same-store sales actually turned positive in June and July, Q2 earnings crushed expectations and, more importantly, there’s a huge cookie-cutter aspect to this story—Boot Barn ended June with 361 locations, up 16 from the prior quarter, with a target of 397 (up 15% from the end of last year) by the end of March, on its way to 900 eventually. (The store economics have improved in recent years, too, with a payback in just 1.3 years of the initial investment.) All in all, earnings growth is supposed to return to the black in the fourth quarter and grow at a solid high-teens to low-20% rate from there, and we think that could prove conservative as margins have been surprising to the upside and many blue-collar economic sectors are percolating right now. (The forward P/E of 20 doesn’t hurt, either.) BOOT went way up during the pandemic, then way down during the bear market, and after rallying into this year, dipped to a higher low in May. But since then, the stock has been not just rising, but doing so persistently, up nine weeks in a row and popping to 18-month highs after earnings last week. We see solid short- and longer-term potential here; we’ve got BOOT on our watch list.

Vertiv Holdings (VRT 34)—One of the issues with the advance of May and June is that so many old, well-known prior leaders were the first that ran—some are still trying to hold up, but new bull phases often thrive from newer names. Vertiv is one of the few newer names that’s shown great power—it’s extended to the upside here, but the numbers are big and the story should persist as it could be a top play in AI infrastructure. The firm’s product line is all about the data center, with a big part of it revolving around power and thermal management: As chips become more advanced and data centers become more condensed, the need to keep things at a set temperature (for optimum performance of the IT machinery) continues to rise. In fact, the issue is getting to the point where air cooling is reaching limitations, which is boosting demand for liquid cooling methods that are far cheaper and more effective—and where Vertiv has one of the best sets of offerings. While it’s early and hard to track, management believes it already secured tens of millions of dollars of AI-related orders (still a drop in the bucket of the firm’s estimated $6.8 billion in revenue this year), with clear signs of an acceleration in demand coming in the second half of the year. In the meantime, Vertiv is benefiting from general demand and better margins (supply chain issues are finally easing)—in Q2, organic top-line growth came in at 20% while earnings more than quadrupled and crushed estimates, leading to a big hike in estimates for the rest of the year. Granted, this is a down-the-food-chain story—if its clients cut back on purchases, Vertiv’s business could dry up in a hurry—but it’s more likely the opposite occurs. The stock has had a monstrous run and was one of the few growth names to gap up on earnings—and it’s held most of its gains even after a share offering. VRT isn’t near an attractive entry point, but we doubt the overall run is over. We’ll keep a distant eye on it for a proper setup down the road.

Freshpet (FRPT 79)—Freshpet is another retailer we’ve watched for a while as it disintegrated during the bear market (185 to 36!) and spent the better part of the last year going straight sideways—but now, finally, it looks like the buyers are in control. The story here is simple, powerful and should be very long-lasting: Freshpet is the leader in providing high-end healthy food for pets (mostly dogs), with fresher alternatives that have been shown to boost Fido’s quality of life, which plays into the theme that pets are becoming part of the family. Its wares are found in something like 26,000 locations, and the firm thinks it’s penetrated just 15% of all dog households and just a quarter of households that order fresh dog food. The biggest issue in recent years came from the company itself, which had supply chain and cost issues during the pandemic all while it was adding capacity to handle growth; it then went on with a series of price hikes in 2021 and 2022 (more than 25% worth!) to counterbalance that, but of course that slowed buying. But the firm has now gotten a handle on things and all the metrics are pointed in the right direction: Sales (up 26% in Q2, which is the 20^th straight quarter of at least 25% revenue growth!) are cranking ahead, and while some of that is from the price hikes, volume growth is actually accelerating (up 18%, 14% and 12% the past three quarters)—and, just as important, margins are improving as all costs (from advertising to logistics to inputs) come under control and more of that should be on the way as a new production plant ramps up. Moreover, while earnings are in the red, EBITDA is positive and growing ($55 million this year likely vs. $20 million last year)—and we like that the top brass is thinking big, aiming for 25% annual sales growth through 2027 while margins leap another few points. Long story short, Freshpet is a firm that’s always had good demand for its products but had some internal and external (pandemic affecting costs) issues to deal with … but now that management has a handle on those, there shouldn’t be much standing in the way of rapid, reliable growth for many years to come. Our one rub here is liquidity, as FRPT trades $45 million of volume per day, and less liquid names have been subject to some wild moves of late, but we wouldn’t be surprised to see the stock “grow up” as the story reasserts itself.

Earnings Season, Trend Following, Buying Earlier and Partial Profits

Starting a little over 20 years ago (when Regulation FD took effect), earnings season became a four-times-a-year lottery in the market for individual stocks, with many names making or breaking their intermediate-term (and sometimes longer-term) future with big up or down moves after reports. That can lead to some thrilling ups, but like the past couple of weeks, also some frustrating gaps down.

We always go back and study all of our trades (usually many weeks later to let the dust and emotions settle a bit), good or bad, but anytime we get whacked we like to look around right away and see if there’s something we can do better. And on that topic, we have a few thoughts.

First, when it comes to earnings season, one of the main things to remember is that it’s mostly a portfolio management topic. If there were some system that picked out the earnings season winners from the losers, we’d all be rich … but, unfortunately, that’s not how the market works. In fact, the “theme” of earnings season usually changes from quarter to quarter—one period will see growth stocks get hit, but the next one could see growth stocks thrive, and so on.

Thus, when it comes to duds like DoubleVerify (DV) or MasTec (MTZ), we’ll get good questions asking whether they were too extended in price, for instance, or whether had they been running too long. The answer is not really—putting a rule like that in place may have helped last week, but it could have had you selling a bunch of stocks in prior earnings seasons just before they took off on the upside.

All of which is a way of saying: You want to be careful not to over-correct based on some recent pain, changing things up that, in the long run, could hurt your edge in the market. (The same goes after you see a couple of bullish gaps up—best not to start piling in ahead of reports.)

“OK Mike, that makes sense, but isn’t there something that can be done to help?” We think there could be, and it addresses a broader issue that earnings season plays into: We know the big money is in the big, longer-term trends, so it’s best to generally hold on to potential big winners—but how do we account for trends (in the market, or individual stocks) that only last a few weeks before turning tail?

Said another way, what do you do with the stock you’ve owned for a few weeks and is up decently (say, 10% to 20%)? We don’t want to cut it all short—the market is a game of outliers, so cutting any potential bigger winner short is a no-no. That said, we also know that, whether it’s earnings or some other factor (a downturn in the market, a rotation out of growth stocks), many modest winners don’t go on to huge runs, eventually cracking and taking away some or all of the profit.

The solution could be two-fold, the first of which is to aim to buy earlier. For instance, this may involve watching a stock that has taken on some water in recent weeks and looking to enter when a stock rallies back above some resistance (maybe its 50-day line) with a little power. It was harder to do that earlier this year as the market was super narrow and not all that far from bear market lows. Today, that’s different, with the next big move likely up, which should present higher-odds plays if/when new leaders resume their upmoves.

The second solution is something we’ve been doing offhand for years: Taking partial profits, which means selling a small-ish portion of your holding to (a) book some profit, which can then be used to (b) give your remaining shares more room to breathe. For the most part, we’ve taken some chips off the table in winning stocks mostly via judgment—based on the chart or market. But now we’re testing out some ideas involving profits being taken either faster or ahead of earnings if we don’t have a certain amount of profit cushion.

Obviously, there’s no free lunch, but in finding the balance between holding onto some big winners but keeping volatility in check and being able to make a little money when trends end relatively quickly, trying to buy earlier in a resumption of the uptrend and cutting selling a portion a bit earlier in the uptrend could help.

We’re still looking at things and aiming to develop some guidelines, but something like this is likely to become part of our playbook going forward.

Still No Rush Into Defensive Stocks (Though Growth Is Floundering)

The correction to this point has been painful for growth stocks, which are clearly bringing up the rear of the market—that’s clear if you’re looking at a variety of individual stocks, but it’s also being seen with growth-y funds. The Renaissance IPO Fund (IPO) and Russell 2000 Growth Fund (IWO) have both quickly nosedived to the 50-day lines.

That said, the overall market really isn’t throwing off any major red flags at this point—and we continue to see big-picture market action that argues for nicely higher prices down the road. The latest came from Dean Christians of sentimentrader.com: The S&P 500’s 200-day line hit a 52-week low earlier this year and has rallied 40 straight sessions since. Going back nearly 100 years, that’s led to average maximum gains of nearly 17% a year later, with an average max loss (from the signal) of just 2%.

Even beyond the countless encouraging studies is some of the under-the-surface action we’re seeing, especially when it comes to defensive stocks—if the market was super worried about recession and doom in general, you’d expect to see something like the Consumer Staples Fund (XLP) powering ahead … but instead it’s been sagging with everything else. Same goes for the Invesco Defensive Fund (DEF), which includes a bunch of sturdy, steady big-cap firms in a variety of industries.

Indeed, shown here is a daily chart of the relative performance of the equal-weight Nasdaq 100 to the XLP (a version of our Aggression Index). Yes, it’s come down, but it’s “only” back to its 50-day line—and, looking back a few month, it’s barely given up any of its gains. (The chart looks similar when compared to DEF, too.)

Obviously, things can change—if, say, interest rates explode higher—but while growth stocks are taking the brunt of the selling, the overall evidence continues to tell us to stay attentive and be ready to put money to work when the sellers run out of ammo.

Cabot Market Timing Indicators

Growth stocks have been hit very, very hard of late, and we’ve been taking action because of it. But the top-down evidence remains in pretty good shape—the intermediate- and longer-term trends are up, defensive stocks aren’t popping much and the broad market is resilient. We continue to think this downturn, while it probably goes on for a bit longer, will give way to another run higher.

Cabot Trend Lines: Bullish
Nothing new here: Our Cabot Trend Lines remain solidly in the bull camp, with the modest decline in the big-cap indexes not threatening the longer-term trend. As of this morning, the S&P 500 (by 8%) and Nasdaq (by 12%) both remain miles above their respective 35-week moving averages, so while more near-term wobbles are possible (even likely), the odds continue to favor higher prices down the road.

Cabot Tides: Bullish
Our Cabot Tides are also still bullish, though it’s been a role reversal—the Nasdaq is the weakest index and tested its lower (50-day) moving average yesterday before bouncing, though the other four indexes we track (including the NYSE Composite, shown here) are all still a couple of percent above their lower lines. Things can always change, but the fact that the intermediate- and longer-term trends are still up tell us the odds favor the market (and growth stocks) will pull themselves out of this funk at some point.

Two-Second Indicator: Bullish
If the market were in deep trouble, we’d expect to see the broad market take a tumble in concert with (or ahead of) the major indexes. But that hasn’t been the case—our Two-Second Indicator has recorded just two plus-40 readings so far, and even those have been relatively tame (max reading of 65). Looking at another measure, there have been more new highs than new lows within the broad S&P 1500 (big, mid and small caps) every day during this pullback. Again, the evidence can change, but so far it looks like a normal dip for the market-as-a-whole.

The next Cabot Growth Investor issue will be published on August 24, 2023.