Cabot Growth Investor Issue: September 7, 2023

Gray Skies (With Some Rays of Light)

It was about one month ago that the current correction phase began in earnest, with the sellers really showing up and cracking (first) a lot of growth stocks and (shortly after) the major indexes. There was an encouraging snapback that started late last month, but it never got enough momentum to flip some of our key indicators—and now, as the calendar has turned to September, the sellers have re-appeared, hitting the broad market and even some sacred cows like Apple and Nvidia.

All in all, then, the correction remains in force: Our Cabot Tides came this close to a shakeout buy signal but couldn’t get it done—and now the indexes are back below their 50-day lines. It’s a similar story with our Two-Second Indicator, which has seen three straight plus-40 readings after a solid stretch. And more generally, 70% of all stocks are south of their 50-day lines and very few names are hitting new highs.

Thus, right now, it’s gray skies out there so we advise staying close to shore—we’re holding a good-sized cash position and remaining mostly patient until the buyers can retake control. However, even beyond the still-positive bigger picture (Cabot Trend Lines bullish, tons of studies pointing to higher prices in the months ahead), there are some legitimate rays of light shining through, especially when it comes to growth stocks.

Last week, for instance, saw a handful of powerful earnings moves from stocks we’re watching—a stark contrast to the July/early August earnings horror show. Our Aggression Index(es) also continue to put on a solid show, with the equal-weight Nasdaq 100 vs. consumer staples hitting new recovery highs on Tuesday. And, shorter term, there’s a good amount of resilience among growth titles this week, even as the Nasdaq has gotten hit.

Of course, none of that is enough to ignore the primary evidence listed above, but it backs up the overall view that the correction likely has longer to run, but there should eventually be another leg up with some high-potential leadership. For now, though, we advise patience and caution as the market works its way through a series of unknowns (Fed, interest rates, China, U.S. economy, etc.) and tries to emerge from the downturn.

What to Do Now

In the Model Portfolio, we’ve made a series of small moves during the past week: We averaged up on Noble (NE), started a half position in CrowdStrike (CRWD), cut bait on our remaining shares of DoubleVerify (DV)—and tonight, we’re putting our ProShares S&P 500 (SSO) position back on Hold. After those moves, we’ll be holding on to a cash position of around 43%.

Model Portfolio Update

Despite the renewed selling this week, we think the past three weeks have been generally encouraging for growth stocks, with a lot of names we’re watching bottoming out and starting to round out their launching pads—and, for the first time in months, there have been a good number of positive earnings reactions, too.

With that said, there remain many flies in the ointment out there, not the least of which are our own indicators—the longer-term trend remains firmly up, but our Cabot Tides and Two-Second Indicator couldn’t click into gear before this week’s broad market selling. Even beyond that, few stocks were able to hit new highs—and let’s not forget about interest rates, which continue to lurch higher.

Put it together we’re comfortable holding cash while making small changes in the Model Portfolio—we did do a little buying last week, but then we sold our remaining small position in DoubleVerify (DV) on Tuesday’s special bulletin, leaving us with around 43% in cash. We’re also placing SSO back on Hold tonight to respect the recent selling.

We’re not ruling out a nibble or minor reshuffling of the portfolio if the market finds its footing and growth stocks remain resilient, but there’s not likely to be much money made until the market really gets going. Thus, be patient for now, but be ready to make some moves should things click into gear.

CURRENT RECOMMENDATIONS

Celsius (CELH)—CELH continues to impress, rallying most days despite the market’s renewed weakness environment—perception is clearly coming around to the view that, with Pepsi in its corner, growth could remain rapid for many years as it grabs share from Monster (that firm’s revenues are nearly five times as large as Celsius) and others. In fact, in the 12 weeks ended June 18, one industry group said Celsius was the leader in unit growth for all refrigerated beverages! Interestingly, the energy drink market itself is still growing double digits, which obviously helps the cause, and we think the potential internationally could be gigantic—while the overseas business is more of a 2024-and-beyond story, management said that, way down the road, international sales could make up 35% to 40% of total sales (similar numbers to mature competitors), vs. less than 5% today. Now, with all of that said, the stock has had a big run and is extended to the upside, with the 200 level possibly being an area of round-number resistance; throw in an iffy market environment and a pullback is likely at some point. We’re sitting tight with what we have, but if you’re starting a position, keep it small and aim for dips of a few percent. BUY

CrowdStrike (CRWD)—As we wrote about in the last issue, we’ve been following CrowdStrike for years, as the firm’s ever-broadening cybersecurity platform continues to attract giant clients and produce excellent growth. And while earnings and free cash flow have been strong for many quarters, margins are now leaping far above expectations—the firm thinks it will achieve a 30% free cash flow margin this year, nearly up to its long-term goals (30% to 32%), which means profitability should end up being much larger down the road than expected. The stock had been basing in a sideways pattern for four months but popped to the top of that range after earnings last week—we bought a half-sized position (5% of the Model Portfolio) and will look to average up if the market improves and CRWD continues to act well. BUY A HALF

DoubleVerify (DV)—We still think DoubleVerify’s long-term story is solid, but there’s no question that big investors aren’t believers, at least right now—the stock is broken and wasn’t able to bounce much before another wave of selling hit it in recent days. (The fact that its closest peer, Integral Ad Sciences, IAS, acts similarly confirms the picture.) Maybe DV can repair the damage over time, but that will likely take a couple of quarterly reports and, of course, a better market. But near term, it’s not in position to be a leader and could fall further if something pops up. We sold our remaining shares on a special hotline earlier this week. SOLD

DraftKings (DKNG)—As opposed to DV’s lackluster bounce attempt, DKNG is putting up a fight, lifting about halfway back after its ESPN- and market-related weakness in early August. That said, shares aren’t out of the woods, as there’s plenty of resistance above here, and fundamentally, we’re thinking the stock may need some sort of positive update (could be earnings, or an update after ESPN launches in the fall) for big investors to pile in again given the competitive fears. (There’s been a dearth of company news or analyst commentary since the Penn National announcement a month ago.) At heart, we’re optimistic: DraftKings is the leader, and the sports betting industry, while still having great potential, isn’t in the land-grab phase anymore, so top brands aren’t easy to displace. A dip back to its recent lows (25 area) would be a bad sign and probably would have us moving on, but right now we’ll continue to practice patience, holding our half-sized stake and giving it a chance to gain momentum. HOLD (1/2)

Noble (NE)—Cyclical stocks have been hit hard this week, likely because of the continued march higher of interest rates (causing economic fears) and, today, some China wobbles; combined, that’s slapped NE around after its stretch higher last week, albeit on light volume. Even so, oil prices remain strong above $85 per barrel, and the stock has done nothing wrong, trading back into its prior range. We’re not complacent, and should the market and cyclical names go over the falls, we’ll make sure any loss remains reasonable. But the combination of booming earnings and cash flow coming up, as well as a nascent shareholder return program, should keep investors interested—we filled out our position last week and are staying our Buy. BUY

ProShares Ultra S&P 500 Fund (SSO)—SSO has pulled back along with the S&P 500, diving back below its 50-day line yesterday. While that’s not good, of course, the overall picture hasn’t changed much—with our Tides still neutral-to-negative, the market is still in a correction phase that probably has more consolidation to do … but with the Cabot Trend Lines positive and many big-picture bullish studies out there, the correction should eventually give way to another leg up. Obviously, we’re not going to stubbornly stick to that view if the market totally falls apart, so we’re simply following the plan we laid out last week—a drop back to the correction lows (near 55 on SSO) would be a yellow flag and probably would have us trimming our fairly large position, and if you started a new position last week, that would also be a logical stop level. We hate to ping-pong between ratings, but while the selloff isn’t disastrous (the S&P 500 is 3.5% off its peak), we’ll respect the recent downturn and go back to Hold. HOLD

Uber (UBER)—UBER looks like most growth stocks, with a correction in July and early August and a rally back near the end of the month before sloughing off in recent days. The company had been quiet on the news front but the top brass spoke today at a conference and relayed some good tidings, saying it was “quite optimistic” about demand trends; sees delivery growth of at least 14% in the second half of this year and revealed that 13% of Uber Eats customers have ordered grocery, up from 10% or so a year ago; and it said the nascent ad business is at a $650 million run rate today and is on track to exceed $1 billion in 2024. Plus, management said shares buybacks are possible over the next couple of years as free cash flow grows. Thus, the story remains on track, and the stock’s action looks normal; if that changes, we could change our thinking, but right here we’re keeping our Buy rating in place. BUY

Watch List

• Axcelis (ACLS 180): ACLS snapped nearly all the way back to its old highs before getting nailed today ... raising the prospect of a double top. Even so, we’re putting more emphasis on the super-strong snapback, keeping it on our watch list.
• Confluent (CFLT 33): CFLT is now seven weeks into a normal base-building effort, but it hasn’t been able to rally at all. We still think it’s worth watching, but it should perk up soon if all’s well.
• Duolingo (DUOL 156): Duolingo is the top-grossing education app, with a huge opportunity as it monetizes its user base. See more later in this issue.
• Freshpet (FRPT 75): We still like the FRPT story and chart—but volume remains a bit too light for our tastes. If that doesn’t change, we’ll look elsewhere.
• Monday.com (MNDY 174)—MNDY continues to set up reasonably well, chopping around in the middle of its three-month range. The growth and profitability profile here is outstanding, and big picture, there’s been very little selling in recent weeks as the stock consolidates.
• Pure Storage (PSTG 39)—PSTG had a shakeout the day after reporting a solid quarter (annualized recurring revenue up 27%; earnings of 34 cents per share beat by six cents) and then took off, briefly hitting new highs before being yanked down a bit by the market. We like it—see more later in this issue.
• Samsara (IOT 31)—IOT was maybe the biggest earnings winner last week, soaring after another excellent report that saw free cash flow turn positive and recurring revenue rise 40%. The stock is moving out not just above its three-month rest period but from a giant post-IPO base, too.
• Splunk (SPLK 125)—SPLK has turned very powerful since earnings, and while it’s not growing the top line at lightning-fast rates, free cash flow is beginning to soar and should continue to for at least a couple of years. See more below.

Other Stocks of Interest

Splunk (SPLK 125)—Splunk isn’t a new name, having been one the early pioneers of a software platform that helps firms do more with their data—today the firm has one of the leading offerings that allow clients to view and act on data and perform analytics in real-time, with observability (making sure every piece of IT and every app is working together as it should) and security (detect and respond to threats, automate repetitive tasks, user and behavior analytics) being the big draws. Despite the stock’s action (more on that in a second), business has always been solid and the installed base is growing and is very sticky; more than 90 of the Fortune 100 use Splunk in some way, shape or form, and it has 834 clients that pay it at least $1 million a year (up 15% from a year ago) as it continually rolls out new products (including integrating more AI capabilities into its offerings). However, Wall Street never truly fell in love with the stock, as costs were elevated, competition appeared during the pandemic and, most important, Splunk had a long transition to a subscription business model, which marred the numbers for a couple of years. (See more on this later in this issue.) But now the benefits of that transition are paying off in a big way: In the quarter ending July, Splunk’s annualized recurring revenue (ARR) lifted 16%, but cloud-based ARR (which makes up about half the total and accounts for two-thirds of total bookings) rose 27%, and all this happened while operating expenses actually fell 3%! The result is a gusher of cash flow, with $805 million total in the past 12 months, more than triple that of a year ago and totaling north of $4.75 per share (miles ahead of earnings)—and most analysts see that figure rising 40%-plus next year and 25%-plus in 2025. The one not-great point here is actual growth, as ARR is likely to grow in the low to mid-teens percentage-wise this year and next; in other words, this is no hypergrowth startup. But big investors seem more attracted to the rapid and (importantly) reliable cash flow growth that’s coming down the pike. SPLK bottomed last fall with everything else but never really got moving, gyrating for six months even when the market was doing well. But it’s looking like the quarterly report two weeks ago was a perception changer, with not just a big-volume gap but persistent buying ever since.

Royal Caribbean (RCL 97)—We’ve seen the following pattern play out many times in recent years, often due to the pandemic and its aftereffects: A relatively cyclical firm has been plodding along for years and got hit badly during the pandemic—but then, as the world turned right-side-up, business not only rebounded but soared to new highs … and stayed there for much longer than expected, with earnings at elevated levels since so much fat was cut during the dry period. We think the cruise sector could be next in line for that, with Royal Caribbean the clear leader in the space. A lot of it has to do with the travel boom underway, as people are prioritizing leisure travel, and supply is clearly being outpaced by demand; in the past two quarters, Royal Caribbean’s load factor was north of 100% (because more than two people would stay in some rooms), returning to pre-pandemic 2019 levels, and at rates far higher than they were four years ago (gross margins dollars are up 13%, capacity adjusted, vs. 2019). Plus, while capacity is increasing (up a big 13.5% this year, with another 8% planned in 2024), there’s zero sign of any slowdown in demand—in its Q2 report, in fact, the company said not only that bookings are up from 2019, but that 2024 bookings are up “significantly versus all prior years and at record prices.” Just as important is that, after the dry times, management has cut to the bone, so much so that all of the revenue increases are falling to the bottom line, including the growing onboard revenue component. As a result, earnings expectations are going through the roof—two months ago, analysts expected earnings of $4.73 and $6.96 per share this year and next (respectively), but now those figures are $6.22 and $8.49, the latter of which would be the highest level in years. “But Mike, don’t we see this all the time with cyclical names—and now that business is good the stock has already discounted most of it?” For most of my career, yes, that’s been the case; it’s often been better to buy cyclical stocks when they’re losing money, actually. But as written above, in recent years that hasn’t happened, with earnings remaining at nosebleed levels for far longer in groups like commodities, homebuilding, shipping and more; Royal’s top brass thinks $10-plus per share is coming in 2025, but given the revisions, who knows how high the bottom line can get. Moreover, the stock is at an interesting point—RCL took off on earnings in early May and rallied to multi-year highs before pulling in with the market since late July. We don’t pick bottoms, but it’s set up a potential resumption-type pattern; if the stock rallies nicely from here (say, into the low 100s on good volume), it should produce a good risk/reward situation if you’re looking for cyclical exposure.

Duolingo (DUOL 156)—We’ve been watching DUOL since the start of the year, and we came close to buying some when it blasted off at the beginning of March, but it actually peaked just as most growth stocks started to move in May and sagged for the next three months. Now, though, shares are perking up, and the story is as good as ever: Duolingo has become the most popular way to learn a language, boasting the top-grossing education app out there. The scale here is impressive, as seven times as many people Google “Duolingo” than search for “learn Spanish;” there are more people learning a language on Duolingo than there are people in the U.S. learning a foreign language in school; and there are more people learning certain languages (like Irish and Hawaiian) on the platform than there are native speakers of those languages! The offering allows learning that’s bite-sized, on-demand and fun, with a game-like system that keeps people motivated, and with hundreds of millions of exercises completed, Duolingo has what it says is the largest learning dataset that it uses to test and improve the platform. The firm has a freemium model—as of the end of June, there were 74.1 million monthly active users (up 50%), but most don’t pay anything (see ads at the end of each lesson; ads bring in 10%-ish of total revenues). The real money comes from paid subscribers, which totaled 5.2 million (up 59%; subscriptions make up three-quarters of revenues), so there’s plenty of growth potential just from monetizing the current user base. There’s also a small English language testing business (for admissions and the like), and all together, growth has been terrific: Currency-neutral revenues were up 46% in Q2, the bottom line actually turned a profit and free cash flow was around 80 cents per share, with plenty of upside to come if the top brass continues to pull the right levers. All in all, this is a great non-tech growth story, and while the stock has more work to do on the chart, it’s begun to march back after its tough correction. DUOL is back on our watch list.

Business Model Transitions Provide Opportunities

When looking for potential winners, it’s usually helpful to put yourself in the shoes of an institutional money manager, one that’s directing hundreds of millions if not billions of dollars. When you consider the time it takes to get into and out of meaningful positions, these investors are going to want companies with certain characteristics—specifically, stocks that have enough liquidity to trade in and out of and companies that have a long-lasting story to minimize the chances of a blowup.

That’s where we came up with our “Three R’s” of stock picking: We want to look for firms with Rapid and Reliable growth, along with a long Runway of growth. Of course, some of that is subjective and dependent on other factors (the runway depends on competition, etc.), but while many stocks will sport one or two of these, it’s the combination of all three that can be like catnip to a lot of institutional investors—and in turn drive prices higher.

All of that brings us to a big business model change seen in recent years—the rise of subscription-based pricing which, instead of charging larger one-time prices when updates are released, relies on smaller, recurring monthly or quarterly charges in exchange for always providing the latest and greatest offerings. And, while firms can always cancel, in reality, it’s difficult for a big client to untangle itself from a key technology platform from a leading provider. And that means there were a lot more rapid, reliable growers out there, especially during the cloud boom of 2017-2020.

Of course, other firms have seen the benefits, and some have undertaken the big, costly switch over from one-time sales to a subscription business model—without getting into all of the accounting, such a switch hurts revenues and especially cash flow for the first couple of years, but if the top brass executes properly, cash flow eventually soars … and big investors usually pounce.

We’re seeing that potentially play out with a few firms of late. One is Splunk (SPLK), which we wrote about earlier in this issue—it’s been a couple of dry years as it transitioned to a recurring subscription model, but now free cash flow is going crazy and should continue to surge the next couple of years.

Another is Pure Storage (PSTG), which we wrote about in the last issue—it’s the leading flash drive storage provider out there (12,000 total clients, including 59% of the Fortune 500), and while earlier in its transition than Splunk (less than half of total revenue is subscription-based), the firm is well on its way to big things. In the just-reported Q3 last week, total revenue was up just 6%, but annualized recurring (subscription) revenue lifted 27% and remaining performance obligations were up 26%, while free cash flow in the first half of the fiscal year totaled 55 cents per share (vs. 42 cents of earnings). PSTG is trying to emerge from its tight consolidation of the past couple of months.

And a third tech player that’s well into its business model transition is Nutanix (NTNX), which, admittedly, has a story that can give you a Popsicle headache: It’s the number two player in hyper-converged infrastructure (HCI), offering software that can be used with off-the-shelf servers and hardware that effectively combines a firm’s networking, computing and storage resources, replacing the standard of separate servers, storage networks and the like. There are big benefits associated with HCI, including a smaller footprint and easier design of a firm’s data center assets, its much easier to scale, to develop in cloud environments and leads to better reliability.

Business has been solid for a while (24,050 clients, up 9% from a year ago), but again, the transition to a subscription model hurt results, with the bottom line being in the red the past few years. But things are starting to ramp—earnings have been in the black the past four quarters, and in the July quarter (reported last week), billings rose 17%, annualized recurring revenue was up 32% (and made up about three-quarters of revenue) and free cash flow was 49 cents a share in the past two quarters (vs. 39 cents of reported earnings). NTNX catapulted out of an eight-month base last week, with an upcoming Investor Day (September 26) potentially providing more of a catalyst.

Checking in on the Growth Tides

In recent years, the correlation between growth stocks and the broad market has lessened; as time has gone on, we’ve seen more times when growth stocks dance to their own drummer—heck, some of the best growth stock time periods have been very narrow markets, with 1999 itself coming to mind, as well as 2007 (First Solar, Crocs were bonanzas for us) and, of course, 2020.

Don’t get us wrong, top-down evidence is vital, but the above is why we’ve been paying a lot of attention to some other measures that correlate more closely with the growth stocks we favor. One is our Aggression Index, the action of which is very encouraging.

And, while we don’t write about them in every issue, we’ve also been watching a loose collection of growth-oriented funds that we refer to as the Growth Tides—things like the ARK Innovation Fund (ARKK), the Renaissance IPO Fund (IPO) and others, along with their 25-day and 50-day lines (just like the Cabot Tides). Looking at these, we can see there’s still a bit more work to do on an intermediate-term basis—most have rallied very nicely off their lows but are still south of their 50-day lines and might need more time for the 25-day line to turn up.

When it comes to our next buying spree, we’ll be looking at many things, but the Growth Tides will be key—if they all burst above resistance and more individual stocks show big-volume buying, it could be “go time.” For now, more patience is needed.

Cabot Market Timing Indicators

There’s been some positive vibes during the past two to three weeks, with the market rallying for a time, growth outperforming defense and many individual stocks beginning to percolate. But our indicators didn’t quite improve enough for fresh buy signals and are now backtracking. All told, we’re remaining relatively cautious until the buyers take control.

Cabot Trend Lines: Bullish
Our Cabot Trend Lines don’t give signals often, which is part of the reason they’re so valuable, keeping us on the right side of the market’s major trend. Today they remain clearly bullish, as both the S&P 500 and Nasdaq (by 5% and 8%, respectively) stand well above their 35-week moving averages. The near term could certainly see more wobbles, but the Trend Lines (along with many market-based studies in recent weeks and months) tell us the next major move should be up.

Cabot Tides: Negative
Our Cabot Tides came close to a buy signal last week, but never quite got there—and this week’s renewed selling (especially in the broad market) keeps the indicator in negative territory as all the indexes (like the NYSE Composite, shown here) are at or below their lower (50-day) moving averages. If you want to call the intermediate-term trend neutral, that’s fine, but either way there’s no green light yet—which argues for a cautious posture.

Two-Second Indicator: Negative
Our Two-Second Indicator is very similar to the Tides, as there was a marked improvement for a couple of weeks—but, as the broad market has come under pressure this week, any all-clear signal will have to wait, as we’ve now seen three straight 40-plus readings, with today (not shown on this chart) being the largest reading of the correction. That’s not necessarily a death knell, but it does confirm what we’re seeing elsewhere—that the market’s correction isn’t over.

The next Cabot Growth Investor issue will be published on September 21, 2023.