Cabot Growth Investor Issue: November 16, 2023

More Positives Emerging

If you’re all about fundamentals, your life in the market is centered around data, much of it outside the stock market—inflation reports, economic growth, movements in things like the U.S. dollar and oil prices, maybe even geopolitics. There’s no question the majority of big investors and Wall Street focus on this sort of analysis, which is why you see it on TV and in articles all day every day.

There’s nothing wrong with that at all, but the other way to look at things is as a student of the market, focusing on the market’s own evidence, both primary (trends of the major indexes, action of leading stocks and sectors) and secondary (sentiment, breadth, etc.). Essentially, a big part of this type of analysis is to know what is “normal” behavior for a stock or market—to know what it usually does when it starts a fresh uptrend, for instance—and to see if that lines up with what’s happening now.

And the good news today is that, while not perfect, the market’s evidence is indeed acting as it “should” if the bulls are truly taking control. When it comes to the secondary evidence, you can read much more about later in this issue; suffice it to say here that much of it began to perk up in recent weeks (one reason we wrote a month ago that the market had a nice setup) and the pieces continue to fall into place, with interest rates exhaling, breadth improving and more.

Even more important, of course, is the rubber-meets-the-road primary evidence: If the market is starting a sustained uptrend, you’d expect the longer-term trend to remain positive through the recent correction (it did, by the skin of its teeth). You’d expect the intermediate-term trend to turn up within a couple of weeks of the rally starting (it did this week). And you’d expect the ranks of leadership to grow, with pullbacks limited early on as big investors rush to build stakes and re-position their portfolios (again, that’s what we’re seeing).

Now, are things perfect out there? Nope. Our Two-Second Indicator, while showing improvement the past couple of days, is still negative. Similarly, broader indexes, while also showing improvement, are still in the lower to middle part of their multi-month ranges. And, on the growth side of things, the list of potential targets is broadening but still has limitations—right now, some traditionally lucrative areas that usually spawn growth leaders like retail and medical remain in rough shape.

What to Do Now

Now, if the rally continues as it has, those imperfections could easily be erased, which prompt us to accelerate our buying spree. But given what we see now, we’re continuing to step into leading names at a measured pace as we take things on a day-to-day basis; the rally is just two weeks old at this point, so if it’s the real deal there will be plenty more to come. We put a little money to work earlier this week, and tonight we’re going to add a half-sized position in super-volatile Duolingo (DUOL), which will leave us with around half the portfolio in cash, give or take.

Model Portfolio Update

The market has continued to take steps in the right direction, with our Cabot Tides flipping to positive this week and more pieces of secondary evidence clicking, too. (See more on that later in this issue.) Moreover, leading and potential leading growth stocks have also acted well, with a few moving straight up during the past couple of weeks—possible an early “thrust” that should portend good things down the road.

Now, to be fair, growth stocks aren’t exactly crazy powerful, with most of what’s working in the mega-cap and (software, AI and chip stocks)—other traditional growth areas (especially retail and medical) are still struggling, which makes it a bit more difficult to uncover lots of leadership.

That said, it’s still early—we’re about two weeks into this rally phase, and while there are many good signs, there’s no question much of the market is still in the early stages of rebuilding the damage from the past three-plus months, as well as the past couple of years.

Thus, we’ve been putting a little money to work, including a chunk on Tuesday, and we’re taking another small step into things today, adding a name we’ve been watching forever—Duolingo (DUOL), which is very volatile but also very big potential. The half-position buy will leave us with a hair over 50% in cash.

CURRENT RECOMMENDATIONS

CrowdStrike (CRWD)—CrowdStrike will report earnings on November 28, the week after Thanksgiving, which will probably tell us about the stock into year’s end. That said, to this point, the action has been pristine, with shares marching over 200 and holding today despite a poor earnings reaction from peer Palo Alto (PANW) as investors see not just rapid but increasingly profitable growth (earnings and free cash flow) for years to come thanks to its new-age cybersecurity platform and offerings. We still have just a half-sized stake, and while we’re not expecting any big correction (if the market rally is the real deal, the leaders may not let many people for a bit longer), with the stock temporarily extended (15% above its 50-day line) and with earnings coming up, we’ll continue to hold off adding more for now. If you don’t own any, try to start a position on a retreat of a few points. BUY A HALF

DraftKings (DKNG)—DraftKings hosted an Analyst Day on Tuesday of this week, and basically all the news was good in terms of financial projections, market size and even new initiatives. The firm now sees the total opportunity for online sports betting and iGaming (online casino) of $30 billion in 2028 (up from $20 billion this year) in states that have already legalized gambling, with potential upside of course as more states give the thumbs up. As for DraftKings itself, its share continues to grow and accelerate (33% for sports betting and iGaming combined), while new users are turning profitable more quickly (five-quarter payback on average for those in states that approved gambling in 2022 and 2023) as handle is increasing and marketing spend is fading. All in all, the firm sees EBITDA lifting from a $100 million loss this year to $400 million next year to $1.4 billion in 2026 and then to $2.1 billion in 2028—while longer-term forecasts obviously involve some guesswork, the company has had a great history of topping its outlooks. Indeed, some analysts think a few of the embedded assumptions the firm used are conservative (its hold rate should get a boost from new offerings, such as its progressive parlay), which means further beat-and-raise quarters are likely. We filled out our position last week and DKNG remains super strong. Hold on if you’re in, and if not, you can buy a small position here or (preferably) on dips of a couple of points. BUY

Duolingo (DUOL)—Everyone is looking for stocks that can go up a lot, of course, but one of the “secrets” is to find stocks you can also hang onto with a good-sized position—which was a problem with Duolingo for much of this year. After blasting off in March, the stock had a good few weeks, but then started the first of three 20%-plus corrections, leaving the stock with no net progress over a seven-month stretch. However, we think the Q3 report (and the prospects for expansion) and massive upside reaction may be helping the stock to “grow up” by attracting more strong hands (498 fund owns shares now, up from 317 at the start of the year). The general story is the same as we’ve been relaying for months: Duolingo’s app is by far the top grossing in the education category, allowing a whopping 83.1 million monthly users (a figure that’s up 47% from a year ago) to learn various languages. And this isn’t a boring online college course but instead is game-like with goals and quests and even digital gadgets you can buy for yourself. Still, to this point, just 5.8 million of those users (up 60% from a year ago) pay money each month for added features (the others do see ads, which bring in a bit of revenue), which is great growth but leaves plenty of upside if Duolingo can convert more of its free user base into paid subs. Moreover, all of that growth is falling to the bottom line, with EBITDA margins of 16.3% in Q3 (free cash flow margin of 24%!), up from 2.2% the year before. The language-related growth story, then, should have plenty of legs and result in lots more rapid, consistent top- and bottom-line growth ahead (revenues have advanced between 42% and 44% each of the past four quarters)—but what could be a game changer, at least for investor perception, is Duolingo’s move into new areas. The firm has or will soon offer math and music on its main app, and while revenue from these will be tiny for a while (the firm will be testing out what works best and keeps users engaged for months), many are thinking that Duolingo’s proven model will result in it having a general learning platform rather than “just” a language learning app. Not totally surprisingly, the stock went vertical on the news, lifting to new all-time highs on its heaviest weekly volume ever before getting hit yesterday. As mentioned above, volatility here is still crazy (the stock moves 5% a day, on average!), but it’s also one of the more powerful names out there. We’ll buy a half-sized position and use a liberal stop in the 170s. BUY A HALF

Noble (NE)—NE had a very encouraging earnings report (including a dividend hike) and initial reaction, but the energy patch has been just about the worst thing out there over the past couple of weeks as oil and natural gas prices have nosedived (oil plunged to four-month lows today) due to various economic and supply fears. That said, when it comes to deepwater drilling, nothing much has changed fundamentally, of course, with demand for these kinds of rigs continuing to gradually increase, absorbing some sidelined capacity (rigs out the water) that’s come on-line all while pushing dayrates up (and while contracts are beginning to lengthen); barring a total collapse, 2024 should see more of the same, which should benefit Noble as it re-charters a few floaters next year. All that said, we’re just taking our cues from the stock: NE was ugly today was it returned to its recent low, which believe it or not is better than many peers. There’s support nearby (40-week line, prior lows, etc.), so we’ll hold on tonight, but if all’s well, we’d expect to see NE start to rebound right quick. HOLD

Nutanix (NTNX)—We started a half-sized position in NTNX two weeks ago, and we filled out that position earlier this week as the stock acts properly. Obviously, we’re willing to change our mind if something goes awry—a drop below the October low (and 50-day line) near 34 would be very iffy, but while some near-term wobbles are possible, the main trend here is up. Earnings are due November 29, which will be key, but we’re thinking the solid story (the go-to IT platform for many big enterprises), free cash flow story and powerful breakout in September (along with a healthier market) should lead to good things. BUY

Uber (UBER)—UBER remains very powerful, with the snap back before and after earnings taking the stock out to new highs (and above resistance near 50)—the action is so powerful that we added some shares back (a 3% position) earlier this week. “But Mike, you sold some at lower prices!” Yes, we did, but we have two things to say about that. First off, of the sells this year, even in great-potential stocks, so many have fallen sharply since (MTZ, INSP, even FOUR before the recent snapback), so we’re not regretting taking action when things were weak. Second and more important, the market doesn’t care whether you bought or sold XYZ weeks ago—while you don’t want to constantly chase your tail (being whipped in and out of a name), you don’t want to be shy about making whatever move you think will pay off. All that said, we’re talking about a relatively small change (a 3% position), so our main point is that UBER looks like a real institutional leader that may take aim at its all-time highs in the low 60s down the road. BUY

Watch List

• Arista Networks (ANET 213): Arista released OK guidance at its Analyst Day last Friday, with “double-digit” revenue growth this year (though it did say 15% sales growth was likely through 2026), which caused some hesitation—and analysts do see earnings up just 10% next year. Even so, the stock doesn’t seem to believe it, hitting new highs this week.
• Eli Lilly (LLY 589): LLY got official approval for its weight-loss drug in the U.S. last week, and since then the stock’s been up and down, which was half expected (sell the news, etc.). Let’s see if it (and peer Novo Nordisk (NVO)) can hold support and break out on the upside.
• Nvidia (NVDA 495): Mega-caps have been the early leaders of the rally, and NVDA is clearly one of those, marching back to its prior highs (and round-number resistance) near 500 before a brief breather. Earnings are due next Tuesday (November 21), which will obviously be key.
• Palantir (PLTR 20): It’s definitely volatile and speculative, but what got PLTR going in the spring—Its AI platform, which appears to be well ahead of others—is already starting to be adopted by U.S. commercial players. See more below.
• Vertiv (VRT 43): VRT is in an in-between stance for us—it looks fine, has great numbers and a great story, though it’s not exactly racing higher and is still extended after such a big move this year. We’re watching it because we’re thinking the next big move is up, but at this time, VRT is more being pulled up by the market than leading it.
  

Other Stocks of Interest

Palantir (PLTR 20) – We wrote about Palantir in July, a firm that’s long had its hands in advanced software for many big outfits (including U.S. and overseas government and military agencies; it was founded as a counterterrorism player) to improve operations. And that knowledge and years of work have put Palantir in pole position to be the AI platform of choice for large clients: It appears to be way ahead in terms of having an offering that can integrate proprietary or public language models (or a few of them at once), having those models “work” on only certain data in a secure way to produce real advice and unique data points. (Interestingly, it’s well known now that Ukraine is using Palantir’s AI systems to help in various aspects of its war efforts.) Despite no lack of excitement from management (which does tend to talk a boisterous game), the question was whether the early interest and inquiries would turn into “real” growth—the Q2 report left that an open question (one reason the stock got whacked in August), but after the latest update, big investors are thinking everything is lining up. While the company’s Q3 numbers (sales up 17%, earnings of seven cents up from a penny a year ago) were solid, the conference call revealed many bullish tidbits such as Palantir’s U.S. commercial business (which is the first place the AI platform should gain traction) growing 33%, with contract value inked rising 55% and customer count up 37%. Part of that growth is due to the firm’s “boot camps,” where it can get a partial offering up and running on a potential client’s real data in five days or less; Palantir is on track to do 70 in November alone, which is more than all of the pilots that took place for U.S. commercial clients last year! In total, nearly 300 organizations have used the AI platform since it was released just five months ago, with users almost tripling in Q3. Now, for perspective, U.S. commercial revenues are only about 21% of the total, but (a) that should change as the segment is expanding rapidly (the top brass believes this part of the business can double between now and the end of 2025) and (b) it’s not like international and government agencies (it only supplies products to western allies) aren’t eager to adopt Palantir’s AI offerings, either. Growth estimates here remain good-not-great (20%-ish sales and earnings next year) and the valuation is big, but many are thinking the company is going to be a big winner in the AI movement, driving business higher for a long time to come. The stock is very volatile, but it etched higher lows in the summer and fall and gapped up on the Q3 report—and is now challenging its summer highs. It’s back on our watch list.

Expedia (EXPE 130)—Logic is often a bit overrated in the stock market, which looks ahead and moves up and down at least as much because of psychology and investor perception than due to cold, hard facts. Expedia is a good example of that: The firm is one of (if not the) largest travel firms out there, operating many popular sites (including Expedia.com, Hotels.com, VRBO, Orbitz, Travelocity and many others), and anyone who’s traveled at all in the past couple of years knows it’s been boom times, with flights and hotels full (and prices up). Indeed, Expedia’s bottom line has recovered in a big way since the pandemic and should notch a new high near $8.50 per share this year while free cash flow comes in even larger, likely around $15 per share for 2023. That’s thanks to industry-wide conditions, yes, but also some company-specific offerings, including a rapidly growing business-to-business platform (revenue up 26% in Q3; that segment made up one quarter of the total business) and a unified loyalty offering (dubbed OneKey, where people can earn and spend rewards on/with any of Expedia’s brands; all brands have now been migrated to a similar looking app)—which means the benefits of a couple of years of hard work should boost things even more going ahead (analysts see earnings up another 26% in 2024 to $10.66 per share). Despite all that, the stock had been completely waterlogged—it fell more than 60% from peak to trough in 2022, but even as results have cranked ahead, shares were sitting in the low 90s three weeks ago, well within the long bottoming effort it put in for more than a year. But since the Q3 report, the stock changing character in a big way—EXPE gapped up 19% on the report and has rallied hugely since then, blowing through resistance in the 120-125 area. Clearly, this is a turnaround-type situation—top-line growth is likely to run in the single digits while EBITDA expands in the low/mid-double digits. But we see this as more of a special situation, where a stock was effectively left for dead despite great results and outlooks, and management isn’t sitting still, buying back a ton of stock (share count down 8.7% from a year ago) and it has billions more dry powder to put to work on corrections.

Howmet Aerospace (HWM 52)--We’ve written a few times in the past how aerospace can be a sneaky good growth group, especially when it comes to the supply firms that provide much of the precise machinery and workings that go into various aircraft; trends in the industry are usually long lasting and there aren’t a million players, so when times are good, the leaders thrive. With that in mind, Howmet is a steady Eddie that should see sales, earnings and margins lift nicely for at least a few years to come. Advanced metal products (aluminum and titanium) for aerospace engines are the main driver here, making up just under half of revenue in Q3 and 57% of EBITDA. (The firm was spun off from Arconic, which itself used to be part of Alcoa, back in 2020.) Then come fastening systems (bolts, rivets, latches, fluid products and more), making up around 20% of sales, with forged aluminum wheels and engineered structures (solid and hollow beams and bars) making up the rest. About half of business comes from commercial aerospace, with defense, transportation and other industrial making up the rest, with both new and spare parts demand looking good--and given increasing demand for new, more fuel-efficient aircraft, the wind is definitely at the company’s back and should remain so for a long time to come. The numbers have been great for a long time, with sales expanding between 12% and 21% each of the past six quarters, while earnings are up 28%, 26% and 35% during the past three quarters, and Wall Street sees no sign of that changing, with a 20% earnings gain in 2024 expected (and likely conservative). It’s not a household name, but the steady performance and outlook is a reason why nearly 1,600 mutual funds own shares, and the stock itself is just powering out of correction: HWM had a nice run to the low 50s before getting slowly dragged down by the market into late October--but since earnings, the stock has recouped all of its lost ground on many days of big-volume buying. It’s not going to be a stock you likely brag about, but if this market rally persists, we think the odds are strong that HWM will put on a good show.

Secondary Pieces Are in Place

We got a few “What are you talking about?!?” questions and comments a few weeks back when we opined that the market had a good setup—and that if something went right in the world, the market could respond. We’ve obviously seen that start to happen during the past two weeks as more and more secondary pieces talked about below click into the bulls’ favor.

First and foremost, bonds, the tail that’s been wagging the market for the past two years, seem to have given up the intermediate-term ghost. The initial crack two weeks ago was encouraging, and most Treasury rates (like the five-year note yield, shown here) have decisively fallen below their 50-day lines on this week’s inflation report … a good thing for stocks.

Second, big-picture sentiment remains awful, which is not a surprise after two years of bad news and sluggish market performance for even the “strongest” indexes. Here’s a chart from Bank of America’s monthly survey of institutional investors (who manage something like $500 billion in total) that combines everyone’s economic growth projections, cash level and equity exposure (read: how confident and how much exposure these big investors have), and then charts it on a relative basis to other readings from the past 23 years. You can see that, while up from March (when SVB went bankrupt), this measure is actually still sitting near many major low points since 2000, telling us many remain cautious and there should be tons of buying power on the sideline.

Third, the initial move off the low two weeks ago saw an old-time blastoff indicator flash. Called the Zweig Breadth Thrust (invented by the late, great Martin Zweig), it measures times when market breadth goes from very bad to very good in a short period of time (just two weeks). According to Rob Hanna of Quantifiable Edges, it’s flashed 12 times since 1957, and six months later, the S&P 500 was up every time by an average of 17.8%, while the gains a year out averaged 24% It’s worth noting, given that so many of these usually reliable blastoff measures have fallen flat since 2022, we’re not putting a huge emphasis on this one—but right now, it does fit with other evidence that the market has started a major rally.

Last but not least, we’re seeing some follow-through from individual stocks—Tuesday’s CPI-induced moonshot in the market saw the largest number of new highs on the NYSE and Nasdaq since July, with the figures about the same on Wednesday. Near-term, that can mean a bit of an exhale is possible, but more things pushing through resistance is a good thing.

Elephant Tracks in Housing

We’ve been seeing “elephant tracks”—signs of big, institutional buying—in more and more stocks and sectors during the past two weeks as the market has rallied. But nowhere have we seen more than in some of the housing and housing supply stocks; it’s not a total surprise given the drop in interest rates, but the action is intriguing and suggests lots of big institutions are thinking positively.

On the homebuilder front, Toll Brothers (TOL) and Pulte (PHM, shown here) look like the two leaders. After dipping for two and a half months, a stock like PHM has made up all that ground and more in just two weeks, with three major upside gaps (including this Tuesday) on big volume. If big investors thought those gaps were overdone, they could have easily sold into them (a pattern we’ve seen countless times in recent months) at various times in recent days—but instead, they actually bought more after the move. Very impressive.

From the supply side of the sector, look at a name like TopBuild (BLD), which has a similar price pattern—though in this case, the elephant tracks occurred right off the bottom, as the stock’s persistent decline ended with four straight days of big, accelerating buying volume after earnings. The upside gap this week was also great.

Obviously, we mention these two names not just because of the charts—both look to have the potential to follow a pattern we’ve seen many times in recent years among cyclical-type names, where earnings go bananas after the pandemic, but instead of profits falling back to “normal,” they continue to push higher—which eventually turns investor perception back up as valuations adjust. Using PHM as the example, earnings moved from $3.63 per share in 2019 to an estimated $11.51 this year (7x earnings even after the latest upmove), and analysts see that figure remaining elevated next year … though many think it could actually grow if mortgage rates come down.

Obviously, these aren’t “growth” stories per se, but housing stocks do have a history of trending once they get going, and if rates have finally started to cool off after a two-year rally, such a trend could be starting. It’s not near the top of what we’re looking at, but we do think housing can surprise on the upside in the months ahead.

Cabot Market Timing Indicators

The setup was solid in late October, and the liftoff to this point, while brief (just a couple of weeks old), continues to see more pieces of evidence fall into place—with our Cabot Tides buy signal this week a sign to continue putting money to work. There are still some yellow flags out there, so we’re not cannonballing into the pool (yet), but there’s no question the arrow is pointed up.

Cabot Trend Lines: Bullish
Our Cabot Trend Lines just had a major test, and the buyers showed up just when they needed to—both the S&P 500 and Nasdaq closed north of their respective 35-week lines two Friday’s ago and have continued nicely higher since, which keeps this indicator situated in the bull camp, as it’s been since late January of this year. Successful tests usually lead to good things for the market, so we’re optimistic the longer-term uptrend is starting to resume.

Cabot Tides: Bullish
Our Cabot Tides have turned bullish—the S&P 500 and Nasdaq went positive last week, but it took this week’s CPI-induced market rally to bring some broader indexes (like the NYSE Composite, shown here) to the positive side of the ledger; you can see the lower (25-day line) has turned up here, and same is starting to happen with small- and mid-cap indexes. Translation: The intermediate-term trend is now up.

Two-Second Indicator: Negative
Our Two-Second Indicator is still lagging, though we’ll see how it goes—today was the third straight day of fewer than 40 new lows, so a few more days of that could sound an all-clear. As always, though, we don’t anticipate signals; a sustained bull move will almost definitely need a healthy broad market, so this remains a fly in the ointment of the rally.

The next Cabot Growth Investor issue will be published on November 30, 2023.