Cabot Growth Investor Issue: June 13, 2024

Simplicity Is the Ultimate Sophistication

Twenty-five years ago this week, a young whippersnapper got a lucky break, getting hired straight out of college to follow his passion: Researching, writing about and recommending growth stocks (and market timing) for a small, former family business that was starting to expand. The market (super strong bull phase) and company (great team and system in place) environment were perfect fits—and today, I’m still at it, enjoying the challenge of the markets just as much as I did back then. I wanted to say a quick thanks to all of you, who in the end have allowed me to make a career doing what I love ... and I’m looking forward to following the same script for many years to come.

I’m not big on looking backward (not my thing), but I have been thinking about some stuff from the early days, including a lot of time spent during the first two or three years going down the research rabbit hole for market timing, looking at wild stuff like derivatives of indicators (rates of changes of moving averages!) to come up with a secret sauce. But like most at this game, you eventually come back to the fact simple usually works best—as the saying goes, simplicity is the ultimate sophistication.

I bring that up today because of the current environment, which is very tricky and divergent, not just market-wide but even within individual sectors and themes, with a few choice names and areas acting well while the rest of the market slugs it out in a trading range. Indeed, our mixed indicators tell the story, with our Cabot Trend Lines bullish, Cabot Tides neutral and Two-Second Indicator negative. A couple of decades ago, I’d likely dive into the minutiae and try to figure out exactly what it means and when something will play out.

Today, though, I realize it’s better to keep it simple: If the environment is mixed and narrow, then we want to hold and nibble on what’s working while putting out fires in the portfolio when they appear. And because a mixed/divergent environment has an elevated risk of staging a sharp change in character (be it a market decline, a vicious rotation or something else), we’re holding a decent chunk of cash, too. That’s the path we’ve been following in the Model Portfolio the past few weeks.

Now, this week has been interesting—yesterday’s tame inflation report made it seem possible investor perception was changing for the better, with interest rates again threatening to break down and some growth measures test new high ground ... though today didn’t exact show any real follow through. Still, if the buyers appear, we could floor the accelerator, but right here, the evidence says a cautiously optimistic approach makes sense.

What to Do Now

The day after the last issue was sent out, we pruned the portfolio further, selling one-third of our stake in AppLovin (APP) and cutting bait on our half-sized position in Toast (TOST). We’ve stood pat since then, though we are making one move tonight—filling out our stake in Pure Storage (PSTG), which is acting great after a post-earnings shakeout. Still, our cash position will be around 30% after the new buy, which we’ll hang onto tonight as the buyers and sellers fight it out.

Model Portfolio Update

With the market remaining narrow and with leading growth stocks remaining mostly hit or miss, we’ve been walking the tightrope in the portfolio, aiming to hold onto and do some buying in relatively resilient (and ideally fresher) names, but also putting out fires among stocks that go south and holding some cash.

Now, as we explain later in this issue, while the market’s narrowness has been crazy extreme (see more on that later in this issue), things have been mostly sideways, so a few good days could make all the difference. Yesterday’s initial reaction after a tame inflation report looked like it could potentially be the start of that, as some growth measures started to poke out to new highs, but we need more confirmation as the sell-on-strength vibe that’s been around of late is continuing.

Tonight, we are putting a bit of money to work—averaging up (buying another 5% stake) in Pure Storage (PSTG)—and while ruling out another small move here or there, we’re holding about 30% in cash while we wait for more growth stocks (and ideally, all stocks) to kick into gear.

CURRENT RECOMMENDATIONS

AppLovin (APP)—We decided to sell one-third of our position in APP a couple of weeks ago, partly for portfolio management reasons (it was our largest position) and partly because the stock had been hitting resistance and was beginning to take on water. That proved timely, as the stock has since come under pressure due to a supposed advertising rules change from Apple that some think could affect AppLovin’s business … though at least two analysts have come out and said it’s basically a run-of-the-mill update and that AppLovin indicated they haven’t seen anything there that would have a significant impact on its business. (One analyst also relayed that there’s no potential lockup of close-held shares, as some have feared.) If you haven’t sold any, we do think trimming is a good idea; regardless of the fundamentals, APP had been rejected in the 85 area many times and has now seen some real selling. For our part, having already sold some, we’re holding the rest for now but, we are watching things closely and could trim a bit more if the stock remains weak—and, bigger picture, a move all the way back down toward key support in the mid/upper 60s would be a red flag in our view. Right here, though, we’re sitting tight but remaining flexible. HOLD

Cava Group (CAVA)—As we wrote last week, CAVA has been all over the map since its quarterly report, and while we expect more ups and downs, the stock has begun to settle down a bit as it’s moved back toward its highs, which is obviously a good sign. At a conference last week, the firm relayed some interesting statistics about its business: It’s very well balanced in terms of customers (55%/45% female/male), meals (54%/46% dinner/lunch) and geographically (southwest, southeast and mid-Atlantic all 25% to 30% of sales; the Northeast is just beginning to be penetrated), though customers are higher income (59% make more than $100k annually), which should be a good thing (less affected by economy and inflation). Our thoughts on the stock haven’t changed much—it’s had a big move and the closely-held shares for sale (no confirmation if they’ve been dished out yet or not) are likely to cause further near-term volatility, but the big picture (story, numbers and chart) all look good. Hold on if you own some, and if not, we’re OK with a small buy here or (preferably) on dips of a few points. BUY

CrowdStrike (CRWD)—CRWD was on the edge for us just over a week ago, having been dragged down by the general software sector weakness and poor action from many cybersecurity peers, too. But the quarterly report was essentially steady-as-she-goes, which the market liked given the ill tidings seen in other reports—essentially, top-line growth was solid in the low 30% range (sales and recurring revenue), while new business adds were strong as more clients took more of the firm’s offerings. Earnings-wise, most metrics beat estimates by a bit, with free cash flow again coming in well ahead of reported earnings ($1.25 per share or so, up 42% from a year ago), meaning the near- and longer-term outlook (for $10 billion of recurring revenue by 2027, up from $3.65 billion now) is intact. That got CRWD off its duff, and then last Friday it was announced the stock would be added to the S&P 500, which has caused a rush of buying this week—driving the stock to new highs! If you own some, we’d certainly hold on; the recent action (including what now looks like a shakeout pre-earnings) is all to the good. That said, for new buyers, it’s trickier—as we’ve written before, these S&P 500 moves tend to help for a couple of weeks and then lead to a bit of a hangover after the stock is added to the index, which will come June 24. (To be fair, UBER was an exception to that general rule late last year.) Because of that and the overall mixed environment, we’ll stay on Hold here, looking for a higher-odds entry in the days or weeks ahead. HOLD

On Holding (ONON)—ONON has been acting just fine, refusing to give up hardly any of its post-breakout run and even notching new highs earlier this week. On the marketing front, the firm signed a multi-year deal with popular actress Zendaya, who’s also known for top fashion and more; we’re not marketers so we won’t go there, but the deal should help On expand its reach and buzz. Back to the stock, there are no sure things, but after a lot of false starts, the evidence suggests ONON has finally gotten going on the upside—and given its growth outlook and long-term potential as another major footwear/athletic brand, we think the move could be a sustained one as big investors build positions. BUY

PulteGroup (PHM)—Frankly, we were close to pulling the plug on PHM late last week when interest rates ramped up and homebuilders took a hit—but the two-steps-forward, one-step-back advance in recent months was still intact (higher highs and higher lows since February), and this week’s tame inflation report helped the stock bounce somewhat. It’s a good sign, and at some point the odds favor a more sustained resumption of the overall upmove as earnings remain not just elevated but continue to advance (nearly $13 per share this year, up 10% from 2023 and likely conservative). Thus, we’re hanging on, but given that the stock is still whipping around in a range, we still favor new buying being focused elsewhere. HOLD

Pure Storage (PSTG)—One place for that new buying could be Pure Storage—we’re going to fill out our position, thinking the firm’s top-notch offerings, semi-subscription model and, of course, the accelerating AI push should all play into its favor. Indeed, while some disagree on the timing (one analyst downgraded shares this week, thinking the AI-induced bump in demand could take a while), most see a multi-year upcycle emerging, with Pure itself saying it saw more and higher-quality discussions with hyperscalers last quarter about replacing their hard disk drive environments with flash (like Pure offers). Of course, trends in technology can change quickly, so there are never any sure things, but this has always been well-run outfit and the environment appears to be accelerating—we’ll buy another half position here (another 5% stake) and use a stop for the combined stake in the mid-50s, under the rising 50-day line, which keeps our risk in check. BUY ANOTHER HALF

Toast (TOST)—TOST had a solid chart, good numbers and a great story, so buying a half-sized position in a rebounding market on a nice breakout made sense—and has worked for some other positions. But this breakout failed, with a solid Investor Day (including higher long-term margins) actually bringing in the sellers, who have remained in control of the stock. At some point, these payment stocks like Toast (and maybe Shift4) will get going, as the growth is superb, but the fact is big investors aren’t interested yet. We cut bait on TOST two Fridays ago in the 24 range. SOLD

TransMedics (TMDX)—TMDX hasn’t been immune to the growth stock chop of late, with some sloppy day-to-day action and selling on strength appearing in the 145 area a couple of times—and yet, shares are within shouting distance of new highs and hugging their 25-day line, so the sellers haven’t been able to do much here. The story remains as good as ever, and one thing that has us optimistic is the sea change in the bottom line—three months ago, it was assumed that TransMedics would grow rapidly but still lose money well into 2025, but after two surprisingly profitable quarters, analysts see the bottom line remaining in the black and growing nicely going ahead, and even current estimates ($1.20 or so next year) could easily prove conservative. As a smaller-cap medical firm, gyrations are to be expected, but the potential here is big given that the company is revolutionizing the organ transplant business. We filled out our position two weeks ago and will stick with our buy rating today. BUY

Uber (UBER)—UBER’s 23% drop from March through late May was anything but pleasant, and we trimmed our position a couple of times because of that. But now we’re seeing some intriguing action: Shares tightened up a bit in the low 60s, saw some buying after peer Lyft released an enticing longer-term outlook, and now UBER has popped above its 50-day line on good volume on the post-inflation rally ... though, like most things, it gave up a chunk of that today. The stock is only halfway back from its tedious decline and there is resistance at this area, so there’s certainly more to prove, but we’re holding on and seeing if the still-strong free cash flow story here will gradually bring in some fresh buying. Hang on. HOLD

Watch List

• First Solar (FSLR 292): FSLR is clearly the liquid leader in the solar space, which has long been on its back—but now seems to be awakening, thanks in part to views that plunging panel prices will be arrested via tariffs and other factors. The stock is very strong, and while subsidies are a big part of the story, the net effect is that earnings should be out of this world for years to come.
• Freshpet (FRPT 125): We’ve been watching FRPT on and off for a while; the story is outstanding, though trading volume can be an issue … though with sponsorship increasing (527 funds own shares vs. 434 nine months ago), that might be changing. See more below.
• Halozyme (HALO 50): Old friend HALO might be back from the dead—business has been strong and some clarity surrounding patents is helping investor perception. See more below.
• Hims & Hers Health (HIMS 24): We’re not chasing HIMS after the recent move, but the underlying business has been solid for a while, and its move to sell compounded GLP-1 weight-loss treatments for a (somewhat) reasonable price has supercharged the stock. The next rest period of a couple of weeks could be buyable.
• ProShares Ultra Russell 2000 Fund (UWM 37): We wrote about interest rates and small caps in the last issue, and after this week’s tame inflation report, UWM bounced nicely … though it never got out of its never-ending range (40 to 41 has been a ceiling) and fell back today. Still, if things go well, this long-neglected batch of stocks could be ready for a sustained move.
• Robinhood (HOOD 23): HOOD continues to see business surge as the markets remain overall healthy and attract more investors from the sideline—in May, assets under custody rose 9% from the prior month and 65% from a year ago, while net deposits of $3.6 billion were healthy (miles above any month last year) and margin and cash sweep amounts were up nicely, too. The stock remains volatile but strong.
  

Other Stocks of Interest

Halozyme Therapeutics (HALO 50)—In mid-to-late 2022, even as growth stocks were circling the drain, Halozyme was hitting new highs and had a story that promised huge growth ahead, but shares proceeded to fall apart due to patent issues ... but at long last the outlook there might be clearing up. The big idea here is the firm’s Enhanze drug delivery “system,” which uses an enzyme to break down cellular lining, allowing drugs to be safely given in bulk subcutaneously—in minutes instead of hours, not only saving patients time but boosting the number of patients that can be treated at infusion centers (can see more patients with the same number of nurses and seats). The firm has inked deals with many big players in the industry, making money from royalty (usually mid-single digits) and milestone payments; for the past year or two, a couple of drugs were the big drivers of that revenue (one from Janssen of J&J, one from Roche), but that’s set to change, as many Enhanze-enabled drugs have gotten approval in the U.S. and elsewhere (Argenx’s Vyvgart, expanded indication for Takeda’s Hyqvia, Roche’s Tecentriq in E.U.), with another handful likely getting approval starting this month and all the way into early 2025, with more beyond that. The approvals should keep milestone revenue healthy ($145 million annually, give or take) while royalties boom, from $450 million in 2023 to an estimated $1 billion by 2027! (Via acquisition, Halozyme also has an auto-injector business that should bring in about $300 million in revenue this year and grow 8% to 10% annually for a few years.) So why was HALO flat on its back the past year and a half? Basically, patent-related fears, with many thinking the royalty projections would prove way too bullish due to possible patent expirations on some of its most important drugs within a couple of years. Some of those worries still exist, but it looks like they’re being pushed out at the very least: Last week, Halozyme received a newly issued patent from the E.U. that extends royalty rates for Darzalex (a big seller from J&J) through March 2029—which caused management to hike its long-term forecast (it now sees earnings easily north of $7 per share in 2027, up from $3.86 estimated this year) and caused the stock to surge out of a long bottoming formation, reaching 16-month highs. Of course, the fear here is what happens in 2030 and beyond if royalty rates fall off, but a lot may have been discounted; even after the bump, HALO trades at 13 times 2024 earnings estimates. Put it all together and we’re intrigued, as you have a firm with a unique technology that many industry giants approve of, with many years of huge earnings and cash flow growth coming. HALO is a bit thinly traded, but it’s on our watch list as we see if it can “grow up” further.

Freshpet (FRPT 125)—Let’s face it: You’re not going to brag to your spouse or spout off at a neighborhood get-together about the latest and greatest dog food stock. But Freshpet has long been on our radar, as it has an excellent growth story that, after some hiccups post-pandemic, is firmly back on track. The firm was a startup in 2010 but today it dominates the fresh pet food segment of the market, with its offerings of U.S.-raised local chicken and beef (the #1 ingredient), whole ingredients and no preservatives (the offering needs to be stored in a fridge), fillers or powdered meat proving very popular; the “humanization of pets” (in the firms’ words) has more families spend extra to keep Fido healthier and living longer. Marketing (including national advertising campaigns) and distribution (it’s found in more than 27,000 stores, 20% of which have a second fridge) are big here, and that’s been attracting more customers (12.3 million households, up 20% from a year ago, a growth rate the firm thinks is sustainable), all of which has contributed to a whopping six straight years of 25%-plus revenue growth—and yet, overall, Freshpet has just 3% of the U.S. dog food market, so the long-term upside is gigantic. Thus, demand has always been excellent, but the issue here during the post-pandemic period was mainly costs, which got out of whack on many fronts, leading to sizable price hikes, some restructuring, and some investments in new capacity. Because of those convulsions, the bottom line sank and volume growth actually slid to “only” 14% in early 2023 (because of price hikes), but since then everything has gotten back on track: Volume growth (revenues gains not from pricing) came in at 31% in Q1, accelerating for the fourth straight quarter, while logistics, quality control and input costs have all come down nicely, with margins already eking above their longer-term targets. That’s resulted in solid sales (up 34%), EBITDA ($31 million, up from $3 million a year ago) and earnings growth (38 and 37 cents per share the past two quarters) of late, and the bottom line should be able to accelerate higher for many years to come. FRPT itself broke free from a long bottoming effort (which followed a horrific 80% drop in the bear market) in late February and has crept higher since. Trading volume can be an issue here, especially early in the day, but we think this story has long-term growth written all over it.

Valaris (VAL 76)—While almost all of our work is spent researching growth firms and new stories, we do run some screens on the entire market just so we’re up on what’s going on outside of the tech, retail, medical and the like. One thing we like to look for is a weak group that historically has the ability to trend, and then identify the strongest name in that group—with the idea being, if the group does turn up, that stock could be a fresh leader just starting a big run. That brings us to Valaris, which is one of the few remaining offshore drillers out there; in fact, this week’s news that Noble (NE) is buying Diamond Offshore (DO) only serves to lessen the investable options. The underlying story for the sector here is simple: After many years of underinvestment (really since the 2014-2015 boom when oil prices were triple digits), capacity is relatively tight when it comes to offshore drilling rigs (especially for deepwater, though the market for everything is improving) despite modest oil prices as big players look to secure supplies for longer. That’s led to a steady advance in charter rates, which is only just starting to be seen in the results. As for Valaris itself, it’s one of the bigger players, with the largest fleet of high-specification offshore rigs out there, both jackups (shallower water) and deepwater, and with the environment improving, results have been perking up, with revenue growth accelerating (22%, 12%, 4% the past three quarters) and earnings leaping into the black. But the best is yet to come: Valaris’ backlog has expanded six straight quarters and ended March at north of $4 billion (by comparison, this year’s revenue estimate is $2.3 billion), a figure that was up 43% from a year ago. Along with future re-contracting at higher rates, that has Wall Street expecting boom times, with earnings rapidly lifting to about $4 per share this year and possibly $10 per share in 2025—and with that surge, the top brass expects to return nearly all of its free cash flow down the road to shareholders. Despite a soft sector, VAL is showing nice relative strength—shares are near the top of a 16-month consolidation, with the 80 level looking like key resistance. Oil stocks aren’t our favorite, but a breakout would be tempting here.

Under the Market’s Hood: Very Narrow, but Fresher Leadership Emerging

It’s been a couple of years now that the “Magnificent 7” have been much talked about, with the mega cap-weighted indexes far outperforming the broader market starting last spring (when the AI craze began), and after a broad rally late last year, this year has seen a return to that narrow trading. We can see that just by looking at returns for the major indexes—while the S&P 500 is up about 12% since the calendar flipped, the equal-weight S&P is up just 4% while small caps are down for the year!

Amazingly, the situation has become even more split of late: Once again, the market’s rally off the April bottom started very broadly (there were three straight days of NYSE breadth greater than 3:1 in early May, which usually portends good things), but lately, as the big-cap indexes have notched new highs, the narrowness has gotten ridiculous. Shown below are short-term charts of the S&P 500 (on top), the number of stocks in the S&P 500 itself hitting new highs, and the percentage of S&P stocks above their 50-day lines.

You can see that for this week’s push to a new S&P peak, new highs within that very index was just over 40, down from 83 in May and nearly 120 in March, while more than half of stocks in the index currently sit south of their 50-day lines! Admittedly, we haven’t looked at all the data going back a few decades, but in our mind’s eye that’s certainly one of the more extreme situations we can ever recall.

That wide divergence is bearish, right—likely to result in a market downturn since the generals are leading but the troops aren’t following? That’s definitely possible but we wouldn’t say it’s close to a sure thing: To us, this is a classic “descriptive vs. predictive” situation, where it tells you that, right now, the big-cap indexes are painting a misleading picture, and if a couple of stocks turn down, the gains could quickly recede. However, there are two reasons why we’re not looking at this bearishly (at least not yet).

The first being, simply, that even the lagging indexes and growth measures aren’t exactly weak, just simply treading water. Take a look at the charts of the IBD Mutual Fund Index (real-money measure of growth funds) and the iShares Momentum Fund (MTUM)—the first is a stone’s throw away from virgin turf, and MTUM actually nosed to new highs earlier this week. Said another way, if we get a few good days, key growth measures (and a lot of other indexes) could quickly be “in gear” with the S&P and Nasdaq.

Probably more important to us, though, is what we’re seeing in leadership names. It’s definitely mixed, but not awful—while some leaders that had enjoyed extended runs have decisively broken down (Nutanix was one of the bigger examples), there are some newer names picking up steam.

As we’ve written before, retail has seen many fresher names pick up steam, including growth-oriented restaurants (including Dutch Bros, BROS, shown below), some turnaround-type chip names with decent growth angles (like Teradyne, TER), a select few solar names (First Solar, FSLR, is the biggest player), bull market issues (Robinhood, HOOD, as well as others) and some random issues (Hims & Hers Health, HIMS, is an example).

All in all, it’s easier to invest when everything is lining up—obviously, on the upside, that means buying and being heavily invested, and when most of the evidence is weak, it’s not hard to hold a lot of cash (especially if you’re getting paid to do it like nowadays).

When looking at the near and intermediate term, though, the evidence above, as well as our market timing indicators, reinforce a mixed environment, which is why we’re in our current stance: Holding a good chunk of cash and kicking out weak performers, but also sharpshooting some entries in resilient, fresher names that have good potential should the buying pressures spread.

Cabot Market Timing Indicators

Simply put, the evidence remains mixed, and that goes for whether you’re looking at the major indexes, individual sectors or growth stocks, where there’s plenty of sideways action. With both pockets of strength and many air pockets out there, picking your spots and managing your positions is key.

Cabot Trend Lines – Bullish
It’s now been about 17 months since our Cabot Trend Lines last gave a signal—which is part of why it’s our most reliable indicator, keeping us on the right side of the market’s larger, longer-term trend. Today, that green light remains intact, with the S&P 500 (by 10%) and Nasdaq (by 14%) both holding far above their respective 35-week lines. Near-term factors aside, the odds continue to favor higher prices when looking months down the road.

Cabot Tides – On the Fence
While the longer-term trend is clearly bullish, the intermediate-term trend is still on the fence: Our Cabot Tides are mixed, with the big-cap indexes positive but the other three indexes we track (including the NYSE Composite, shown here) basically stuck in the middle of a two-plus-month trading range. We would point out our Growth Tides are in slightly better shape after the recent action, but overall the path of most stocks and indexes is sideways.

Two-Second Indicator – Negative
Our Two-Second Indicator has been ping-ponging since April, and at this point we have to call it negative—just three of the past 16 days have seen sub-40 new low readings, which is obviously a yellow flag given that the popular big-cap indexes are at new highs. There are some signs the late-week dip in rates could be helping just in time, but we have to see more than a day or two of sub-40 readings to conclude that after the recent wave.

The next Cabot Growth Investor issue will be published on June 27, 2024.

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