September Newsletter

Investors Begin to Think 25X Sales Valuations are "A Bit Rich"


Dear Subscriber,

We will tally up the results of our portfolio (appreciation + dividends) for the last three quarters this week and get out results and updated targets. But the data from S&P says these first three quarters are the best since 1997. I can tell you this: today sure as heck does not FEEL like 1997! Back then I was Group Publisher for Phillips Publishing and in charge of a group of "growth investing" newsletters and had just started my own "ChangeWave Investing" newsletter for friends and family (and my boss the late great Bob King who later funded the spin-off of ChangeWave Research into a separate company. He walked into my office and declared in 1999 "Toby--I have made so many $millions in your internet stocks I'm gonna invest in you next!")

I was also in charge of standing up an internet strategy for the company--and I knew every new start-up in internet space it felt like. Ahhh--the good old days of 1997.

As I shared in last month's newsletter, sometimes events in the finance world are more important symbolically than they are in a purely economic sense. My Exhibit A was the insane WeWork "tech" IPO. I claimed in our last newsletter that if this "Emperor has no clothes" insanity actually prevailed and this insane POS got priced by the investment bankers at Goldman Sachs, Morgan Stanley et all, I was going to call a top for the technology sector and take our 2019 growth profits and run.

Well now we know that actual pre-IPO roadshow was like throwing a small pig into a snake den--and the deal (like the pig) did not escape alive. That the advisors are now warning of a high potential of bankruptcy in February 2020 from this IPO disaster is just perfect: if you ever wanted a way to explain the greed and hubris in 90% of the Investment Bankers I know/have met/have sat in on IPO pricings with--the WeWork shit show illustration will work for a few lifetimes.

The lessons I take from this debacle are really lessons I have used for decades plus a new lesson about what happens when the private capital markets get so out-of-whack versus the public equity investors (in the late 90's it was the reverse). Now clearly $hundreds of billions of dollars sloshing around in the Softbank "Vision" funds had the same effect as 1500 internet IPOs in 1996-2000--way too much money chasing too few great companies capitalizing on great ideas and business models.

But the lesson I want to make sure you never forget is the one I learned from famed hedge mogul Leon Cooperman back in the 80's "Toby--don't make this stock market thing too complicated. Stocks are priced by the perception of the marginal buyer (and in the stock market, the marginal buyer is the price-insensitive buyer with an open-till-filled market order bid). In Economics 101, the marginal buyer is the price-sensitive buyer who would leave the market first if the price were any higher--but the stock market today does not run on Main Street economics.

With 4.7 $trillion in index funds mostly market-cap-weighted (and "only $4.25 trillion in actively managed funds that are supposed to beat the market) some days indexers ARE the marginal buyer of stocks (forced to buy shares to maintain their market cap weighting.) And of course, the perception of the marginal buyer is not always correct--just ask the "value investors" who percieved great "value" in bank stocks in 2008 or low p/e stocks 2010-2019. And today the marginal buyer in growth stocks may not be a person at all--if that stock is a price momentum stock and the algorithmic marginal buyer is a buy high sell higher momentum fund or trader. Remember momentum investment strategies are typically buying shares of companies that have risen the MOST in the last 6-12 months and sell relative underperformance losers. They are not buying based on "valuation" or price sensitivity--they are betting against financial gravity--i.e., the relative outperformance will last long enough for them to profit.

Many of you I have chatted with via social media have also confused the "FAANG" stocks (Facebook, Apple, Amazon Netflix and 'Google) as "momentum names" when in fact they have all been way too volatile according to DataTrek that identifies "momo" stocks heavily owned in the momo trading world. Case in point: the momentum meltdown from July has been in fact the e-payment platform stocks (Visa, Paypal, Square, Mastercard) and the enterprise business process platforms SaaS, IaaS and PaaS players Spotify, Zscaler, etc. The only mega-cap "momentum" name still rocking is...wait for it...Microsoft!

My point? #1 Secular growth FAANG is starting to look attractive again (despite regulatory and headline risks--remember when you are giving something away for free like Facebook and Google or have monster global competition like Netflix/Apple/Amazon a "monopoly" case from the FTC is extremely hard to win--see Microsoft. ) And don't forget--AAPL AMZN GOOG FB and MSFT deliver 12% of pre-tax profits for ALL non-financial firms and 30% of the S&P 500 R&D budgets--amazing.

So what started the momentum meltdown in enterprise SaaS/PaaS/IaaS stocks with nose bleed 15-20-25 times sales valuations? Glad you asked.

Positive Unit Economics

The Silicon Valley "Unicorn" bubble is a tale of two markets--the firehose of $400 billion in dry VC powder aimed at a relatively small universe of tech, healthcare, and biotech firms (with some direct-to-consumer aka DTC companies thrown in.) Look--if you are an institutional investor and you can borrow money for 10 years at 3-4% and can invest in a VC fund that has been achieving 20-30% a year for 5+ years, that is an irresistible offer for many institutions and pension funds seriously underwater to their actual liabilities. Throw in oil-rich countries like the Saudi's and Norway into the VC game and they became the price-insensitive private capital marginal buyer.

But as noted, starting with 40% hits to Smile Direct Club and Slack Direct IPOs and then the Lyft/Uber/Peleton melt-downs and then the straw that broke Wall Streets back the WeWork fiasco, it suddenly dawned on the private capital markets that the public markets on Wall Street does not have an endless appetite for Unicorns and does not want GANC--"growth at any cost."

One of my VC heroes Bill Gurley from Benchmark Capital says it best--that shockingly public market investors want "positive unit economics" where the cost of adding a new customer produces a positive ROI. I mean really--how picky can you get!" If I sold newsletter subscriptions where I lost nearly 80-100% of my acquisition costs in the first year but made it up on renewals, I would have to have at least have a 70% renewal rate to justify losing 100% of my marketing investment in customer acquisition costs.

Key point: The return to reality valuation discipline is GOOD for the public stock markets and for our aging 11-year bull market. The correction of the momentum enterprise software stock valuations from nose-bleed valuations that I have been long forecasting is GOOD for the growth stock market.

Bull markets don't die of old age--they die when 1) The Fed kills them with rate hikes with low inflation and 2) when rational price and value discovery die and the momentum mob takes over chasing "a new paradigm of valuing companies." Dude--been there, done that and have the scars to prove it.

2019--A Tale of Two Investors and the Growth/Utilities Paradox

So riddle me this--how can it be that utility stocks and growth stocks are both having a banner year so far? And are value stocks "back?"Look at the data: the answer we really have two distinct investors in the market today--secular revenue/earnings growth investors and bond proxy investors who have moved money they previously had in bonds into higher yields because they can't make their pension liability payments with 1.4% yielding 10-year bonds (or the $17 trillion in negative yields bonds, either).

These are the stocks by group trading within 5% of 52-week highs--see anything? The scariest part of the market I find is how so few stocks are leading this "best 3 quarters rally" since 2007.

Banks 130 748 0.17
REITs 125 274 0.46
Utilities - Regulated 90 176 0.51
Conglomerates 70 134 0.52
Consumer Packaged Goods 63 230 0.27
Application Software 57 414 0.14
Communication Services 45 170 0.26
Industrial Products 43 242 0.18
Asset Management 41 176 0.23
Computer Hardware 39 210 0.19
Autos 38 184 0.21
Semiconductors 35 136 0.26
Transportation & Logistics 33 172 0.19
Real Estate Services 31 117 0.26
Drug Manufacturers 28 186 0.15
Retail - Defensive 27 88 0.31
Business Services 26 110 0.24
Engineering & Construction 26 98 0.27
Chemicals 25 119 0.21
Retail - Apparel & Specialty 25 202 0.12
Medical Instruments & Equipment 23 82 0.28
Building Materials 23 79 0.29
Insurance - Property & Casualty 22 60 0.37
Homebuilding & Construction 21 40 0.53
Manufacturing - Apparel & Furniture 20 86 0.23
Travel & Leisure 20 150 0.13
Entertainment 19 100 0.19
Metals & Mining 19 191 0.10
Brokers & Exchanges 18 86 0.21
Biotechnology 16 477 0.03
Utilities - Independent Power Producers 16 33 0.48
Restaurants 14 73 0.19
Communication Equipment 14 94 0.15
Insurance 13 45 0.29
Insurance - Specialty 13 34 0.38
Oil & Gas - E&P 12 151 0.08
Credit Services 11 66 0.17
Medical Devices 11 104 0.11
Beverages - Alcoholic 10 48 0.21
Aerospace & Defense 10 71 0.14
Consulting & Outsourcing 10 53 0.19
Online Media 9 95 0.09
Medical Diagnostics & Research 8 84 0.10
Insurance - Life 8 46 0.17
Beverages - Non-Alcoholic 8 29 0.28
Waste Management 8 28 0.29
Forest Products 7 42 0.17
Steel 7 47 0.15
Oil & Gas - Midstream 7 60 0.12
Oil & Gas - Services 7 86 0.08
Health Care Providers 6 55 0.11
Advertising & Marketing Services 5 28 0.18
Oil & Gas - Refining & Marketing 5 32 0.16
Industrial Distribution 5 35 0.14
Packaging & Containers 5 33 0.15
Employment Services 4 31 0.13
Personal Services 4 13 0.31
Airlines 4 42 0.10
Farm & Construction Machinery 3 26 0.12
Agriculture 3 21 0.14
Publishing 3 26 0.12
Education 3 37 0.08
Oil & Gas - Integrated 2 49 0.04
Medical Distribution 2 13 0.15
Coal 2 19 0.11
Truck Manufacturing 1 12 0.08
Oil & Gas - Drilling 0 14 0.00
Health Care Plans 0 12 0.00
Tobacco Products 0 17 0.00

We not only have a tale of two investors, but we also have a concerning top since early 2018 where three times stocks have broken out to new marginal highs only to fail. In contrast, in 2013 to 2017 when we broke resistance we stayed above and made new highs.


Moral: It has paid EVERY TIME for us to WAIT and buy the dip where Relative Strength dips to 30--MACD dips to 20 and Slow Stochastics dip to 20 or lower. That is the market we are in--like it or not--and especially since the trade war was started by the USA with China in January 2018. NOBODY is making money buying great stocks at the TOPS--the blue lines. The money we have made is buying into the technical damage at support lines while our MacroMarket Index is positive

Transformity MacroMarket Index: 15.8 or less than 10% chance of US recession in the next 4-6 months (unless tariffs go to 25%--all bests off!). Q4 2019 GDP Forecast: 1.8% GDP Growth--Bull Market Still Alive and Well (but we are buying the DIPS and not chasing stocks).

The GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the third quarter of 2019 is 2.1 percent on September 27, up from 1.9 percent on September 18. After last week's and this week's data releases by the National Association of Realtors, the U.S. Census Bureau, and the U.S. Bureau of Economic Analysis, an increase in the nowcast of third-quarter real gross private domestic investment growth more than offset a decrease in the nowcast of third-quarter real consumer spending growth.


In other words, 17-18 times estimated forward 2020 earnings, the overall market needs another jolt of go-go juice--either from the Fed or from some Federal fiscal stimulus spending in 2020. Given the open warfare in DC for at least the next 3-4 months, that is not going to happen. With a $1 trillion 2020 deficit already locked in--it seems a stretch that a polarized Congress and White House will come up with a magical $1 trillion infrastructure plan (badly needed!) by say selling $1 trillion of 100-year bonds?

So our strategy remains: 1) Buy the best secular growth companies for 2020 near the BOTTOM of their price ranges 2) Earn 10-25% yields on the other side of our "barbell" strategy and 3) Be opportunistic scavengers of secular growth in our six 21st Century Disruptor spaces
1) AI/Big Date Machine Learning Technology
2) IaaS/PaaS/SaaS cloud-based computing
3) 21st Century Semiconductor Tech & Enabling Equipment
4) Early 5G and iOT Winners
5) Highly Valuable IP companies facing $100 Billion+ TAM ("total addressed markets).
6) New category--Renewable energy power where ROI is now BETTER and lower cost than hydrocarbon-based power
7) Major Corporate and Regulatory Transformations

But the triumph of software and key enabling technologies that drive that software is still amazing. My old Newscorp. colleague Grep Ip captures the triumph of enterprise software in a recent report he sent me:

"Toby at the peak of the tech bubble in 2000, Microsoft Corp. jockeyed for the title of world’s most valuable company with Intel Corp., which made microprocessors; Cisco Systems Inc., which made communications gear; and General Electric Co., which made locomotives and turbines.
Nearly two decades later, Microsoft is once again atop the market-value rankings. Cisco, Intel, and GE are—combined—worth about half of Microsoft.

This is the profound shift in the economy in recent years. Productivity and economic growth increasingly flow not from equipment, buildings or computer hardware, but from instructions, processes, coding and data: in other words, software.
Nearly eight years ago, venture capitalist Marc Andreessen wrote: “Software is eating the world.” Software programming tools and internet-based services such as cloud computing, he argued, enabled startups to displace incumbents by digitizing everything from phone calls and cars to retailing and film distribution.

Like-minded technological evangelists have long argued artificial intelligence, machine learning, big data, and other technological advances were about to unleash a new boom. But the boom refused to show: growth in productivity—the best measure of how technology enhances worker output—remained mired near generational lows.

Recently, however, there have been intriguing signs a boom may be in the offing. In the first quarter, American companies for the first time invested more in software than in information-technology equipment. Indeed, outside of buildings and other structures, software surpassed every type of investment, including transportation equipment such as trucks and industrial equipment such as machine tools. Software spending is even higher if the cost of writing original software programs, now classified as research and development, is included.

Adjusted for inflation, software investment grew 11% from the first quarter of 2018 through the first quarter of 2019. By contrast, investment in equipment grew less than 4% and in structures, just 1%. (Revised data are due out Thursday.) The headwinds buffeting capital spending broadly, whether the waning tax cut, trade war or slumping commodity prices, have largely spared software. Meanwhile, productivity growth has picked up to 2.4% in the past year, the fastest since 2010.

Whether that can continue is debatable: business investment and productivity growth appear to have slowed in the current quarter. Nonetheless, a recent survey by Morgan Stanley & Co. found chief information officers planning to boost software budgets this year by 5%, and hardware budgets just 2%. Their main target is cloud computing, under which businesses pay external providers to host their data and supply tools to analyze that data."

The digital transformation of business is non-stop. It does not care about China tariffs. If a company's transformative technology and its business model creates value in such a way that incumbents or up-and-comers have a difficult competing AND has recurring or repeat revenues and/or digital transformation enabling semiconductors, they are in our wheelhouse. And technology lets enterprises unlock the value of their data. That is a competitive differential; that's the crown jewel of strategic differentiation. Technology today does not just support the business; it must become the business.

So that is where we are in this start-stop-correct-bottom market for growth and high-income paying securities. And remember--IF YOU WANT to reduce the stress and strain of the "what will the next tweet say"--do what I AM doing--hold 30% of my risk money in our favorite very LOW risk Preferred Stock ETF PFFA. It is a beautiful thing to see on these 400-600 points down days that are NOT bottoming opportunities but just another knee jerk risk-off day.

To whit: Look at PFFA and compare it to the S&P 500 loop-to-loops: Man if we EVER get a year-end Flash Crash like Dec 14-30--I will go in deeper with serious leverage. Nearly 10% yield and you don't need to open your account on a 600-point day--its going to up or down a penny or two. Ahhhh!
PS: If you recently sold some major real estate and sitting on a bunch of cash, THIS is the place to store it for the inevitable NEXT tradable correction.


Updated Portfolio/Targets and a few October surprises out this week.


PRO NewslettersTobin Smith