Cabot Growth Investor Issue: February 8, 2024

Leaders Superb, but Short-Term Risk Growing

We sat at our desk for a solid 30 or 40 minutes today wondering exactly what to write on this page, looking for something witty or an old story to share that reminds us of the current environment. But instead, we’re falling back on simply sharing what we see—and right now, we have three main thoughts in our mind.

First and foremost, after two-plus years in purgatory, leading growth stocks are lighting up the sky, putting on their best performance since the aftermath of the pandemic crash in 2020. We’re happy that we own a few of them, and we’re impressed that during the past two or three weeks, we’ve seen an avalanche of earnings gaps—including more than a few that occurred on overwhelming volume, which is as good a sign as any that big investors aren’t hesitating to hit the buy button (a sharp contrast to 2022 and 2023, where strength was sold into). Going along with this, the other primary evidence we harp on (the trends of the major indexes) is also up—and given the setup, we’re optimistic this super strength will continue over time.

Our second thought is that, outside of leading stocks (the majority of them growth-oriented), most of the market is just sitting there—not terrible action, but so far this year most broad indexes (of small caps, mid-caps, equal-weighted big caps) are flat to down even as the leaders race ahead. Thus, a divergence is beginning to take hold, though our favorite measure of such things—our Two-Second Indicator—tells us selling pressures aren’t really picking up as much as buying power is concentrated.

And finally, our third thought: Things have gotten near-term frothy and extended in both price (extended above support) and time (many names have been running for three months or more, as has the market itself).

When you put those three together, you actually have a relatively straightforward take: The market is strong, leaders are leading, and the big picture is bright—you can never be sure, but it continues to look like last November marked a major turning point, especially for growth stocks. That said, near term, risks are growing that we could see some sort of sharp move, be that a general market and leadership dip or a rotation of some sort.

What to Do Now

Thus, at least the way we do things (intermediate- to longer-term viewpoint), that means riding the primary evidence higher … but also engaging in a little risk management should some names start to come back to earth. In the Model Portfolio, we sold two small positions that were lagging earlier this week—Duolingo (DUOL) and ProShares Russell 2000 Fund (UWM)—and are holding the cash, leaving us with around 30% on the sideline. Tonight, we’re holding onto that, though we may do a little buying soon as earnings season rolls on.

Model Portfolio Update

The market environment has become narrow, with most of the market meandering (or a bit worse) since late December while the big-cap indexes—and leading stocks, of which we own a few—perform very well. And of course, this is happening as interest rates rise to test key levels and regional bank stocks (which were the market’s bugaboo a year ago) act suspiciously. As we explain later in this issue, this dynamic does raise risk, which is why we’re holding a bit more cash—but it’s not necessarily as predictive as many make it out to be, with divergences often persisting for weeks or months ... and sometimes they simply resolve themselves over time.

Overall, then, we have pulled in our horns a bit more, dumping our two worst-looking positions (DUOL and UWM) earlier this week, and tonight, we’re holding onto a decent cash position (about 30% of the portfolio). That said, stay tuned: We’re monitoring a ton of names right now, and if we see any reasonable wobble (in a strong stock like, say, PLTR) or lift-off (after earnings, like possibly in EXPE), we could put a little cash back to work. Tonight, though, we’ll sit tight and see what comes.

CURRENT RECOMMENDATIONS

Arista Networks (ANET)—Arista’s earnings are due next Monday (February 12), with analysts looking for sales to rise 20% and earnings of $1.71 per share (up 21%). To us, though, we’re more interested in any bump to the 2024 outlook, which admittedly right now looks mundane (earnings up just 11%, probably conservative), as well as any talk about AI-related demand and when that might kick into gear—if the top brass starts talking about a ramp in the second half of this year, buyers should stay interested. All told, we’ll take it as it comes: We have a solid profit on our position and ANET continues to act great, riding above its 25-day line with the occasional pothole along the way. We’ll stay on Buy, but you should keep any new positions on the small side this close to the report. BUY

CrowdStrike (CRWD)—CRWD stagnated near round-number resistance in the 300 area during the past couple of weeks, but Tuesday evening’s well-received quarterly report from one peer (Fortinet), along with continued reports of an increase in cyber threats (a recent release claims Chinese hackers compromised thousands of Internet-connected devices and infrastructure like navel ports and utilities in the U.S.) prompted buyers to pounce, driving the stock to higher highs. All in all, our feelings with this stock are similar to that of leading growth stocks as a whole: Big picture, we think CrowdStrike’s unique positioning as the leader in new-age cybersecurity should lead to plenty of rapid, reliable growth over time—but, for the here and now, the stock remains somewhat extended in time and price, so we’re not pounding the table at the moment. If you own some, sit tight, and if you want in, we advise keeping it small and looking for dips of 10 or 15 points to start a position. BUY A HALF

DraftKings (DKNG)—DKNG looks great, motoring higher nearly every day of the past three weeks to new price highs, and even the relative performance (RP) line, which isn’t shown on this chart, was also able to reach virgin turf this week. Interestingly, the parent of its closest peer (FanDuel) just began trading in the U.S. recently, and this morning, MGM Resorts said that its BetMGM arm saw revenues up 36% in 2023 as a whole; that said, neither event had much of an effect on DKNG or the sector as a whole. As with many leading stocks, earnings are approaching—due next Thursday, February 15, with analysts looking for a 45% revenue bump and a small profit, though just as much attention will be paid to competitive-related metrics like revenue per user and churn in the wake of ESPN’s launch late last year. We’re optimistic the best is yet to come, especially if management is confident it can meet or exceed its own user and EBITDA targets that it put out at last year’s analyst day, but as always, we’ll see what comes. Right now, we’re holding on tightly to our position. HOLD

Duolingo (DUOL)—Duolingo has a great story, and it’s always possible the stock gets going again down the road (earnings are due February 28) if the firm’s newer offerings (music and math) catch hold. That said, there’s no question that the stock is a big laggard these days, not only falling in early January but then skidding further on some competition-related fears and being unable to bounce much even when the market does. We sold half a few weeks ago, pulled the plug on the rest this week and are looking to redeploy the proceeds into a stronger situation. SOLD

Elastic (ESTC)—ESTC obviously isn’t one of the big-cap tech plays that’s on everyone’s lips, and the firm has been all quiet on the news front for a couple of months, but the stock continues to act well, with next to no big-volume selling in stock since its huge earnings move in December despite continued upside progress. The core business here is solid, with the firm’s corporate search products embedded in many big outfits’ observability and security apps, which should keep sales and earnings moving up—but the big added draw is that, since AI essentially needs to be able to search massive reams of data quickly, Elastic’s search offerings are perfectly suited to quickly be integrated in tons of new AI systems. We’ll see how it goes and remain flexible, but so far, so good with ESTC. We’ll stay on Buy. BUY

Nutanix (NTNX)—Nutanix has many fundamental winds at its back, perhaps the biggest of which being that it’s the go-to technology platform for hybrid cloud environments (big firms with lots of assets have some stuff in the cloud but still retain lots of technology on-premise—hence the hybrid label), where its so-called hyperconverged infrastructure allows on-prem equipment to have the same efficiency as the stuff in the cloud. Moreover, as the AI revolution takes hold, a lot of that equipment should be on-premise, driving more business Nutanix’s way. As for the stock, it’s slowed down a bit of late, but that comes after a monster run (the 50-day line is still down around 49.5). We took partial profits a couple of weeks ago and continue to advise holding on to the rest and giving it room to breathe. HOLD

ProShares Ultra Russell 2000 Fund (UWM)—We haven’t really changed our big-picture thoughts when it comes to small caps—the unusual strength seen late last year as well as the many years of underperformance (not to mention the likelihood of Fed rate cuts later this year, which is usually catnip for small caps) should align to create a sustained uptrend … eventually. But right now is not that time, with the Russell 2000 down so far this year. We’ll keep an eye on UWM going forward, and if we see a decisive trend emerge, we could jump back in the pool—but right now, given the environment, we think it’s best to ditch some laggards and UWM was definitely one of those. SOLD

Pulte Homes (PHM)—As rates have backed up, homebuilders have started to struggle—no real surprise there. Indeed, PHM saw some volume selling a couple of times as it tried to move higher in recent weeks. Even so, the weekly chart (shown here) certainly doesn’t look bad at all, with a straight up run in November and the first half of December and zero giveback since then, even with rates testing key levels. (Remember, mortgage rates are still down a bunch from their peak; analysts see PHM’s earnings remaining elevated in 2024 and new orders were buoyant in Q4.) Obviously, this isn’t a true growth situation, so our antennae are up—a drop much below 100 would have us going to hold and possibly selling some of the position—but right here, we’ll stay on Buy, thinking new buyers could start small on this multi-week sideways area while the long-term trend is still up. BUY

Shift4 Payments (FOUR)—FOUR hasn’t been able to make progress of late, with yet another poor earnings reaction from PayPal (PYPL) hurting the cause today. (PYPL has little to do with Shift4’s business, of course, but short-term sector swings can have an impact.) Even so, we remain optimistic the next big move is up: There’s little doubt business is great, with earnings estimates (up 29% for 2024) looking solid as a lot of deals inked in the second half of last year go live (not to mention thousands of new restaurants likely coming on board this year in Europe thanks to its Finaro acquisition), and the stock has traded very tightly in recent weeks (four straight weekly closes between 75 and 76.5), which is usually a constructive sign. (There are also some buyout rumors still floating around, which doesn’t hurt.) There’s no official date yet for earnings, but they’re likely out around the turn of the month—in the meantime, we’ll take it as it comes. If you own a small stake, sit tight, and if not, we’re OK buying a little around here. BUY A HALF

Uber (UBER)—Uber’s business remains in fifth gear, with the Q4 report and outlook topping expectations and tons of sub-metrics impressing: Bookings for Rides (up 28%) and Delivery (up 17%) were very solid, while EBITDA boomed 92% overall and total trips lifted 24% (and the number of trips per active customer continued to rise as well). Then, on the conference call, the top brass shared some enticing nuggets on newer businesses—grocery delivery is now at a $7 billion annual run rate in terms of bookings, while the advertising business, which was expected to reach $1 billion in 2024, already reached a $900 million run rate in Q4, with about 550,000 entities advertising on the platform (up 75% from a year ago). Perhaps as important as the results will be next Wednesday’s Investor Update, when management may lay out some intermediate-term profitability goals that could move the stock. For now, UBER remains in great shape, shaking off a minor wobble yesterday morning and hitting new highs today. We’ll stay on Buy, but we advise keeping new positions small and/or looking for dips, especially ahead of next week’s event. BUY

Watch List

• AppFolio (APPF 237): APPF is a cloud software outfit focused on property managers, a huge and growing sub-sector, and the stock just changed character on earnings. See more below.
• Arm Holdings (ARM 114): ARM has been around awhile, known mostly as a provider of advanced chip technologies to many of the big producers out there. The firm came public again in September and had been doing fairly well—but went absolutely bananas today after its Q4 report blew away estimates. It could be a liquid leader in the chip space.
• Eli Lilly (LLY 735) and Novo Nordisk (NVO 118): Both LLY and NVO reported very solid Q4 results, with good (not amazing) 2024 outlooks, partly due to constrained supply of their weight loss offerings. Even so, both stocks look great as they accelerate higher.
• Expedia (EXPE 160): If EXPE didn’t have earnings due out tonight after the close, we probably would have already started a position—the setup is great, and while it’s not changing the world, there’s still decent growth, monstrous free cash flow and possibly upside to expectations as the economy remains strong.
• GitLab (GTLB 76): GTLB continues to look like a potential emerging blue chip—the DevSecOps platform (basically allowing faster, better more secure software development) looks to be best-in-class for a sector that’s set to mushroom over the next few years as firms look to standardize on one platform. Shares remain in a firm uptrend.
• Intra-Cellular Technologies (ITCI 72): Intra-Cellular has event risk, with trials underway for its drug Caplyta (for major depressive disorder; some results due Q1, more in Q2), but early indications have been favorable and the drug is already selling like mad for bipolar indications. Shares are set up nicely here; earnings are due February 22.
• Palantir (PLTR 25): It’s definitely wild and woolly, but PLTR is finally leaving a multi-month dead period behind thanks to a Q4 report that showed its AI platform for U.S. businesses is in big demand. See more below.
  

Other Stocks of Interest

AppFolio (APPF 237)—Now here’s a good story. AppFolio is a cloud software firm, but instead of trying to have something for everyone, the firm is laser-focused on one industry, and it’s a big one: Real estate, and more specifically, property management, which touches more than 50 million units that house north of 120 million people, and where many regular functions are very inefficient and make up most of the overall costs. AppFolio’s platform does it all for owners and managers of any type of property—single or multi-family homes, commercial, student or affordable housing, etc.—with a centralized hub to track and manage everything from billings to payments to vendor activity and work orders, while also providing help with needed functions like maintenance, utility management, marketing, leasing, package management and more, thanks in part to an expansive partner network, where dozens of specialized apps are integrated. AppFolio is the leader overall, so it’s not surprising it looks to be ahead in the AI push as well, with the firm already piloting a conversational AI module (dubbed Realm-X) that could bring huge productivity improvements with everything from communications, billings, information gathering and more, all by just uttering a few words. (Broader availability of Realm-X should come later this year.) The company has a traditional subscription-based business model, and growth here has been both rapid and reliable, with sales rising between 25% and 39% each of the past eight quarters, while earnings, free cash flow and margins balloon (free cash flow margin is expected to be 18% for all of 2024, and that should prove conservative) as the firm inks more customers that have more renters (up to 8.2 million units managed, a 13% increase from a year ago) that are using more services. The runway of growth is large, too, and investor perception is on the upswing—APPF spent the second half of last year resting and correcting, but the Q4 report brought a massive gap up that shares have held onto despite the narrow market environment. Liquidity here isn’t great, but we think the stock could be growing up as sponsorship has steadily improved. We’re intrigued.

Palantir (PLTR 25)—This will be the third time we’ve mentioned Palantir on this page, and we’re thinking that the third time will be the charm for the stock: Ever since the AI boom arose last spring, Palantir has been in the news, as the firm’s history of advanced software (in large part for the U.S. and friendly armed forces and government agencies; one of its original focuses was counter-terrorism) meant it has been working on many AI-type functions for years—and that put it in the lead to develop an AI platform not just for government clients, but for commercial clients as well. Indeed, the firm actually was testing out its platform with select clients last summer, with an ability to integrate public or proprietary large language models and have them use only certain data in a secure way (another specialty of the firm given its roots in the military field). The question was when results would actually start to show up; the stock went nowhere (net-net) from early last June through last week as the quarterly reports showed promise but not a lot of cold, hard business—but it’s likely the Q4 report changed that. While the overall results were solid (sales up 20%, earnings up 100% though off a low base), the under-the-hood numbers are starting to show the potential of the U.S. commercial side of the business: Revenues in that area rose 70% while contract value more than doubled, billings were up 54% and the sum of all money under contract that’s due in the future was up 47%, in large part because of AI-related adoption. To be fair, the government side of the business (which is still more than half the total) and non-U.S. commercial area (a quarter of the total) aren’t growing very fast, which led to some good-not-great guidance for 2024 (revenues and free cash up about 20% or a bit more), but, even there the top brass expects a little acceleration, and there’s no question big investors are keying off of the forward-looking U.S. commercial metrics anyway. As mentioned above, the stock has been all over the place for months but hasn’t made any progress, but this week’s (on Tuesday) gap up came on enormous volume (one of many we’ve seen of late like that—see more later in this issue), and the upside follow-through since has been jaw-dropping. The AI group is hot and heavy right now, so PLTR could hit a pothole at any time, but the odds favor the next big move being up.

Shockwave Medical (SWAV 235)—Like most investors, we tend to keep an eye on some old winners, not just for memory’s sake, but because, at heart, they’re great companies—and in the past decade or even two, many giant winners see their stocks take a couple of years off … but then eventually reassert themselves as the growth story continues, the market rights itself and/or the firm comes out with some new products. We think that has a chance to play out with Shockwave Medical, which made its mark a few years ago with a much better mousetrap for atherosclerosis, where arteries are narrowed by plaque buildup, especially with big calcium buildup making things even harder to treat: The firm’s IVL systems (stands for intravascular lithotripsy; it has a few systems that attack the problem for different areas of the body) has been near-revolutionary, using soundwaves to break apart calcified deposits without affecting healthy tissue. Results have been excellent and far better than the prior standards, so not surprisingly, growth has been fantastic for years, with Shockwave making headway in coronary and periphery atherosclerosis procedures. That alone would be enough, but a new product should help down the road. Dubbed Reducer, the system is targeted at the few hundred thousand patients each year in the U.S. and E.U. who have already had vascular surgery but still suffer from angina (chest pain). Shockwave says Reducer has been shown to help 80% of patients meaningfully reduce angina (!) and the FDA granted it Breakthrough status. (To be fair, full approval is likely a couple of years away.) All told, the overall addressable market for IVL and Reducer should be north of $14 billion annually (compared to $730 million-ish of revenue last year), so there’s clearly a long runway ahead if management pulls the right levers. Not surprisingly, growth has slowed some—in fact, earnings were actually flat in Q3 (higher sales and R&D expenses, along with taxes now being paid) and sales growth has decelerated, but analysts see a pickup to the mid-20% range for both this year (and those are almost always low-balled). Moreover, the stock may have already discounted the slowdown and is looking ahead to a consistent, reliable growth wave. After falling nearly 50% from late 2022 to last November (and making no net progress for two and a half years), SWAV has rallied all but two of the past 13 weeks. But what we’re really interested is in the quarterly report next Thursday, February 15: A very positive reaction could mean investor perception is truly back on the upswing after a long digestion period.

Many Noteworthy Volume Skyscrapers

The market rally crossed the three-month mark last week, and while there’s never a set time limit to a rally phase—great environments can trend above the 50-day line for months—it’s also a fact that even many strong upmoves (like those seen in 2003, 2007, 2009, 2013, 2017, etc., etc.) often will run into some turbulence.

That said, we consider stuff like that “don’t leave your brain at the door” evidence—good to be aware of and it can provide a solid guide for what could happen, but except for a small move here or there (like maybe a partial profit or two in an extended name), it’s not enough to trade on. We almost always make meaningful moves (buy or sell) based on what is actually going on—which, in turn, tells us what big investors are doing.

And on that front, it certainly seems institutional investors are still active on the buy side based on one encouraging fact: We’re seeing more than a few stocks rally not just on overwhelming volume, usually after earnings or some major news that breaks. “But Mike, aren’t earnings-induced upmoves almost always on big volume?” Yes, but we’re talking about exceptional volume, and not just for one or two days—recently, we’ve seen many launch higher on some of their highest weekly volume totals in years, if not ever!

ASML Inc. (ASML), which has something of a monopoly on super-high-end chip equipment, is a good example. It wasn’t one of the early chip leaders of the post-October upmove, but it rebounded nicely after an early-January shakeout and then exploded higher on earnings, challenging its old 2021 high—on its heaviest weekly volume since 2013!

Also in the chip equipment space, Taiwan Semiconductor (TSM) is a gigantic foundry that had been struggling some as the chip cycle has been weak, but its recent earnings report included a great forecast that brought in the buyers—while it’s further below its all-time high than ASML, the move was clearly powerful, and the weekly volume was the third heaviest since 2015.

Western Digital (WDC) is an old-school hard disk drive and flash storage player, and business has been horrible for a while as the cycle was pointed down. But, again, the latest earnings report caused a pop, with shares pushing to 18-month highs on the heaviest weekly volume since at least 2009.

There are many more, like AppFolio (APPF), which saw all-time record volume, and Palantir (PLTR), which is doing the same this week (we wrote about both earlier in this issue, as well as WillScot Mobile (WSC), a provider of mobile office and portable storage solutions along with furniture and appliances (basically making it a play on non-residential construction), which soared on a huge buyout announcement last week (biggest real weekly volume since mid-2021, fourth heaviest in six years).

Obviously, there are no guarantees, but one of the big missing pieces in 2022 and 2023 was so-called “elephant tracks,” which are big, outsized price gains on huge volume in key stocks, all of which signals that institutional investors are active. We saw plenty of that in November as the market took off—and the fact that we’re still seeing this in big, liquid stocks that weren’t necessarily the leaders of the past few months is an encouraging sign.

Divergences: What It Does and Doesn’t Mean

When you dive into market history, you’ll see that when the market is moving in unison, it tends to be in a strong position, but, conversely, when many stocks and sectors start to swim in different directions, the market’s underpinnings are weaker. Indeed, near major market tops, you almost always see a divergence in breadth vs. the major indexes—with the generals leading but the troops not following along.

However, the tricky part about divergences is (a) sometimes they right themselves, with the broad market rebounding, and b) even if they don’t, they can last varying amounts of time before the market keels over. For example, take a look at the NYSE Advance-Decline line (one of the most common measures of breadth) here before two major tops, 2000 and 2007 (the Nasdaq’s progress is shown in the bottom panel). In the first case, the A-D Line fell for more than a year before the top in March 2000 (and when the selling really picked up that fall)—but before the financial crisis, the divergence was “only” four months.

Just as important, these two divergent markets were actually some of our most profitable, with leading growth stocks gobbling up most of the money flows and soaring before the market topped out.

In terms of when a divergence starts to bite, our key to that puzzle has been our Two-Second Indicator—the A-D Line might be sluggish or the percent of stocks above certain moving averages might be unimpressive, but if the number of new lows on the NYSE is fewer than 40 on most days (especially if it’s fewer than 20), history says the broad market is in good health. Conversely, when the readings get above 40 (and especially when they really expand) as the major indexes are hitting new highs, it often tells you the sellers are beginning to swarm. Today, we’re still in decent shape on that indicator, with some plus-40 readings here and there, but nothing consistently out of the ordinary yet. (See chart later in this issue.)

All that said, a better way to think about divergent environments is in terms of risk: The more divergent things are after a big advance (it’s different if the market is on its knees), the greater the risk that there’s some sort of major change in character coming up—either via a broad market correction (or worse) or that there’s some sharp rotation out of the small set of leaders and into other areas.

Right now, that risk is rising but not enormous—hence our current stance of being more discerning on the buy side and holding a chunk of cash, all while sticking with most of our winning names ... and keeping an eye on the Two-Second Indicator and leading stocks to see if the divergence is starting to bite.

Cabot Market Timing Indicators

The market’s primary evidence remains in good shape, with the trends of the major indexes up and the action of leading stocks (especially leading growth stocks) very strong. To be fair, the risk of a character change is growing given the divergence in the market, but even on that front we’re not seeing red flags from our Two-Second Indicator. All told, we’ve pulled in our horns a bit, but remain overall bullish and could do some fresh buying soon.

Cabot Trend Lines: Bullish
The big-cap indexes are the strongest out there, which means our Cabot Trend Lines remain firmly positive—as of this morning, the S&P 500 (by 10%) and Nasdaq (by 12%) stand miles above their respective 35-week lines, which obviously keeps the longer-term trend pointed firmly up. Of course, at some point, the spread between the indexes and the 35-week lines will tighten (probably because of a market retreat), but bigger picture, the odds favor this bull move carrying higher in the months ahead.

Cabot Tides: Bullish
Our Cabot Tides are seeing some of the effects of the recent divergence, with the small- and mid-cap indexes testing key intermediate-term levels—but we look at five major indexes, and at this point, four are clearly positive. The NYSE Composite (shown here), which is broader than the big-cap S&P 500 and Nasdaq, is one of those, notching new highs this week and remaining nicely above its 50-day line. As has been the case for weeks, the intermediate- and longer-term trend of the market remains up.

Two-Second Indicator: Positive
Our Two-Second Indicator has been on-again, off-again of late with the broad market’s wobbles, with four straight days over 40 in January … then nine straight sub-40 days … then another three straight north of 40 … before another couple of quiet readings this week. As we wrote about earlier, the market’s divergence does raise risk levels, but the fact that new lows are still relatively tame tells us selling pressures are mostly under control.

The next Cabot Growth Investor issue will be published on February 22, 2024.

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