Cabot Growth Investor Issue: July 11, 2024

Staying Flexible

We’ve seen our share of unusual markets over the decades, but this one is right up there with any of them. Most will assume that’s because of the much-talked-about market narrowness out there—but to us, that’s not really it. As we’ve written before, we’re no strangers to so-called narrow rallies, with the Internet bubble of 1999-2000, the spring/summer of 2007 and even the pandemic aftermath for much of 2020 ... all being great investing environments (while they lasted) for growth stocks.

Those narrow rallies still had many dozen growth stocks in a couple different sectors that were lighting up the sky; we still held some cash given the risks of a change in character, but it wasn’t hard to find leaders going on sustained runs. This time, though, has been a different animal, with growth indexes mostly stuck in neutral, more stocks hitting potholes than breaking out while a few mega-cap and one-off names have advanced.

That means you had a situation where extended stocks (including some that are extended longer term, so lower odds entries) were running, while names that were setting up have had trouble getting going—with many actually heading south. Taking things on a stock-by-stock basis, that’s the reason we’ve gradually built up cash, having been forced to cut or trim some positions, while most of the names we’ve been wanting to buy have simply meandered, and hence unable to really “pull” us in.

To us, the key going forward is staying flexible. Long term, the odds continue to strongly favor higher prices, but near term it’s more of a coin flip: It’s possible the narrow rally and signs of complacency lead to a “real” market correction (possibly the typical summer sag), or maybe it’s possible (as we saw today) that a coalescing of opinion of easing inflation/future Fed rate cuts will kick off a rotation. Or maybe, just maybe, the buying pressures broaden and everything goes up together.

As always, we’re not going to predict but just follow the plan: Today, the evidence remains mixed, so we’re staying close to shore—but our watch list has actually been expanding as more stocks set up (a product of the sideways market; see more on that later in this issue). If they can break out, we will put some money to work soon—but should growth stocks remain stuck in the mud (or worse), we’ll be glad to have cash on the sideline.

What to Do Now

Right now, volatility remains extreme among individual growth stocks, yet progress as a whole remains hard to find—not the best environment to be putting money to work. This week, we trimmed Cava Group (CAVA) as it was among many growth stocks that took hits earlier this week, leaving us with around 41% in cash. That’s more than we’d prefer, and if some names start to get moving (possibly as earnings season ramps), we’d like to put a good amount back to work. But once again tonight, we’ll grit our teeth and hold a good-sized chunk of cash as well as our remaining stocks.

Model Portfolio Update

The highly unusual environment continues, with the big-cap indexes being carried by literally a couple handfuls of stocks, while the rest of the market (even among big caps themselves) languishes—before today, when we saw a sharp bout of rotation after a “good” inflation number. Overall, the top-down evidence remains mixed: Our Tides are neutral, the long-term trend is up and, as we write later in this issue, the bobbing and weaving activity in recent months has produced more and more setups that could get going during earnings season.

That’s something we’ll be watching closely—we haven’t seen a spate of breakouts across the growth complex really since November/December, so if that is seen in the week ahead, we could do something of a cannonball back into the market’s pool.

That said, we have to deal with the here and now, and we’re still seeing more growth stocks break down than break out, which has us treading carefully. Having sold one-third of CAVA earlier this week, we’re sitting with 41% in cash—which we’ll hang onto tonight. However, our watch list is expanding along with the number of setups out there, so if the buying pressures spread/rotate to these names, expect action soon.

CURRENT RECOMMENDATIONS

AppLovin (APP)—APP pretty much has the classic chart among most growth stocks of late—shares hit a peak in early May, nine weeks ago, were briefly torpedoed on what turned out to be superficial news (the Apple advertising “changes”), then rebounded back to and into new high ground … which immediately attracted sellers, with shares quickly retreating back into the middle of its recent range; lots of movement, but no real progress one way or the other. The risk here is that APP, which was left for dead at the end of the bear market, has had such a big run since that oversold low that maybe a deeper retreat is in the offing—but, to this point, the down-up-down action is normal, the major trend is up and, of course, business remains solid by all accounts (and, while not key to our analysis, the valuation seems fair, too, with free cash flow likely in the $4 to $5 per share range this year). Having sold a third of our shares a month ago, we’ll continue to hold on, giving APP some room to breathe and, ideally, resume its longer-term advance, which we think could be big if things go according to plan. Q2 earnings are due August 7. HOLD

Cava Group (CAVA)—You won’t find many long-term stories as enticing as Cava inside or outside of retail, with a leading position in Mediterranean fast-casual fare, along with proven management that has a history of creating huge players in this industry (the founder and CEO started Panera) and tons of white space for expansion over the next eight years (aiming to increase the restaurant count to 1,000 from 325 in April—simply put, the company is a good bet to get much, much bigger over time. The stock, though, has had a good-sized run this year and, as has been the case for so many names, stalled out for many weeks (resistance near 95), and now the sellers are stepping up, driving shares down to their 50-day line on a pickup in volume. We decided to sell one-third of our stake on a special bulletin earlier this week given the action (and the iffy environment), and like other situations, we’ll aim to give our remaining stake some wiggle room. SOLD ONE THIRD, HOLDING THE REST

CrowdStrike (CRWD)—We’ve kept CRWD on Hold even after shares surged to new highs following its addition to the S&P 500, and so far that’s proven to be a good move, as the stock (stop us if you’ve heard this before) has made no net progress since the pop in early June. However, while our trust level in this divergent market environment isn’t super high, we’re thinking this could provide a decent entry point ... if the stock finds support soon. Fundamentally, CrowdStrike continues to extend its reach, boosting its distribution in Latin America and striking a deal to integrate its Falcon platform with Hewlett Packard Enterprises’ (HPE) observability solution and AI workloads—and, more broadly, the top brass continues to mention the $10 billion target for annualized recurring revenue within five to seven years (up from $3.65 billion in the latest quarter), so they’re thinking big. All in all, we view this week’s dip as normal—we’ll stay on Hold for now but a show of support could have us restoring our Buy rating. HOLD

On Holding (ONON)—One of the characteristics of the market of late is that not much is sticking on an intermediate-term basis—a stock or group might run for a couple of weeks, but it usually runs into some trouble soon after. Retail stocks are a classic example, with many starting to emerge in May and early June from a variety of areas (restaurants, apparel, payments etc.), but now consumer-related names have turned weak, with the selling kicked off by Nike’s horrid earnings reaction two weeks ago. ONON has been caught up in this, with what was basically a picture-perfect breakout and follow-through leading to a few down weeks, as the stock is now testing key support. If shares can hold up (which many names have been doing even in this tricky environment), we still think the potential is as good as ever—but we went to Hold last week, respecting the action, and will stay there here with a stop in the 35 range, give or take a few dimes. HOLD

PulteGroup (PHM)—Long term, homebuilders are one non-growth area we’re going to keep an eye on—there’s the potential for a sales boom (even if prices don’t keep rising) should rates come down and the consumer shape up. That said, in recent weeks we had something of a recession trade, with more economically sensitive areas coming under pressure no matter what rates are doing—though today was certainly much more encouraging on that front, with PHM and other homebuilders moving up strongly after today’s tame inflation report. Even so, the bottom line is that PHM and the group have been living under key levels for weeks (even today’s rally could only get the stock back into key resistance) and it dipped to multi-month lows last week. We sold the rest of our stake last week, taking our modest profit off the table, and will be looking for stronger situations when growth stocks kick into gear. SOLD

Pure Storage (PSTG)—PSTG looks good overall but is gyrating around with most everything else, with a recent downgrade (from an analyst that was already bearish) pulling the stock into its 50-day line, a rebound that briefly challenged new closing highs after that, and then today’s wobble as AI-related stocks hit a pothole. We’ll see if today is the start of a major rotation out of some AI names or just a bump in the road; at this point, the evidence tells us to remain optimistic, with business very likely to pick up steam and, perception-wise, we think any news/rumors of the firm landing a big hyperscaler deal (for AI or not) could be big. We’ll stay on Buy, but like most things, expect near-term ups and downs. BUY

TransMedics (TMDX)—TMDX was yet another growth name that took on water this week, falling sharply yesterday to its 50-day line. The action obviously isn’t fun, but the move “only” took shares down to their prior range, and shares found some very solid support today, so at this point, it doesn’t look abnormal. Like a lot of stocks, we’re trying to give TMDX a little rope given the very unusual market environment—and, of course, nothing’s changed with the bullish fundamental story. The wild card is the market, as any tidal wave of rotation could toss around a lot of names, but just taking it at face value, this is the stock’s first test of the 50-day line since the breakout in early May, which is often a solid entry point. We’re not complacent, but we’re hanging on here, and if you don’t own any, we’re OK grabbing some shares on this weakness. A drop back into the lower 120s would be a different story. BUY

Uber (UBER)—After a shakeout with most everything consumer-related yesterday, UBER found some big-volume buying today on news/rumors that Tesla is delaying its robotaxi reveal into October (from early August), which removes some near-term event risk for the stock. Of course, earnings (likely due around the turn of the month) will also be key, especially after a so-so Q2 outlook three months ago; investor perception likely hinges on whether the slight slowdown in bookings that was forecast is the start of a trend, a one-quarter hiccup—or whether it simply turned out to be overly cautious guidance. Stepping back, the reason we’ve held a piece of Uber is that it smacks of being an emerging blue chip, with a dominant position and huge, growing sales, earnings and free cash flow. If you own some, we advise sitting tight, albeit with a stop in the mid-60s near the 200-day line. HOLD

Watch List

• Arista Networks (ANET 359): ANET has clearly moved out to new highs, so the latest dip could be buyable if it goes further. The stock isn’t in the first inning of its advance, but perception has really changed regarding Ethernet’s use with the AI buildout, which should be super bullish for Arista.
• Credo Tech (CRDO 31): CRDO has a bit of a baby-ANET flare to it, and the stock is fresher, powerful and has huge growth ahead, albeit mostly from three big customers. See more below.
• GE Aerospace (GE 163): While the symbol is old and stodgy, GE Aerospace looks like the liquid leader in the aerospace field with a huge recurring revenue business and free cash flow that’s solid (around $4.50 per share this year) and should grow nicely for many years. The stock has been in a tight 10% range since early May, which is superb given the giant prior run.
• Halozyme (HALO 53): HALO looks fine as it attempts to extend its gains, though like everything else, it’s running into a little selling on strength. Still, this is the type of fresher story with big earnings growth that could go far if the broad market kicks into gear.
• Neurocrine Biosciences (NBIX 147): After a super-tight consolidation that’s been in place since February, NBIX is making a run at new highs. The firm’s biggest drug (Ingrezza) is selling well, and most expect approval for Crinecerfont (treating certain genetic disorders) by year-end; sales and earnings are both growing nicely.
• Palantir (PLTR 28): We’ve been watching PLTR for over a year without pulling the trigger, but after another run to (marginal) new highs, we’re thinking a sustained run could be in hand for what could be a gigantic story. See much more later in this issue.
• Pinterest (PINS 42): PINS has a great setup (tight chart in recent weeks), a good story and excellent, accelerating growth numbers—now the question is whether it can get moving on the upside. We’re watching.
• Robinhood (HOOD 22): HOOD has tightened up nicely during the past six weeks—yes, lagging the big-cap indexes, but we find the action encouraging given the wobbles in crypto and growing expectations of Fed rate cuts.
  

Other Stocks of Interest

AppFolio (APPF 253)—Cloud software is firmly in a long-term growth phase, but that wasn’t enough for the sector to avoid getting hit in recent months; in fact, the group, which slid with everything else during the market’s April correction, proceeded to get clobbered in May when Salesforce.com (CRM) and Nutanix (NTNX) were destroyed on earnings. Both of those names still look suspect, but interestingly, the group has rebounded, and some names have set up good-looking multi-month bases. (Actually, a lot of stocks have—see more on that later in this issue.) AppFolio is a name we first noticed in February when it emerged on earnings, and while the stock has meandered for a few months, the story is as good as ever: The firm is the leading provider of cloud software for the property management sector, with solutions that run the gamut, serving all size operations and all different types of properties (single- or multi-family residential, commercial, student housing, affordable housing, etc.), allowing managers to centralize data, orders, renter requests, payments, billing and much more, as well as providing a portal for communications between managers and renters or owners, and even offering marketing and staffing help. At the end of Q1, it served nearly 20,000 clients that were managing 8.3 million units (up 11% from a year ago), but there’s plenty of upside from there, as AppFolio has just a few percent of the overall market and, like many software firms, clients continue to sign up for more (and more premium) offerings, especially surrounding bigger clients as the company pushes upstream. Revenue growth came in at 38% in Q1, though some of that was due to some one-time factors (it stopped waiving eCheck fees); low 20% revenue growth is more likely when looking out during the next few quarters, but that will be enough to see earnings ($1.05 per share in Q1, up from a loss last year) and free cash flow (should total $4.60 per share or so this year) surge going forward. As one analyst said recently, it’s a “boringly good” story as the number of rental units slowly expands and as AppFolio upsells many current clients. Like so many stocks, APPF isn’t bad (in fact, the big-volume rally in April is a bullish clue) but has been unable to get up through resistance in the 250 area … so far. A decisive breakout would be tempting, though be aware that trading volume can be low. Earnings are likely due in early August.

Credo Tech (CRDO 31)—Credo quacks like a new (public only since early 2022), fresh idea in the AI space, so if the latest dip there doesn’t get out of control, it should do well. To be honest, the details of the products here can make you cross-eyed, but suffice it to say that the company’s active electrical cables (which have quickly become very popular in the sector), chips, IP licenses, line cards and optical processors are seeing growing adoption in data centers, helping connect servers to things like switches and routers, with some of the highest-speed and lowest-power solutions in the market. The firm’s unique technology (dubbed SerDes), in fact, optimizes the balance between top speed and power consumption, while its LRO architecture also uses far less power than the prior standard (dubbed LPO)—all of which means the firm’s offerings are perfectly suited to the AI boom. Indeed, Credo looks like a high-risk, high-reward pure play on the data center buildout among hyperscalers, with three-quarters of the latest quarter’s revenue (ending in April) linked to AI … and the top brass expects AI-related revenue to double in the coming year! The risk here is mostly a common one in this industry: Customer concentration, with its top three customers (Microsoft and Amazon are reportedly two of them) making up nearly two-thirds of revenue, so obviously this is a down-the-food-chain story to some extent. But, frankly, these purchases aren’t snap decisions but are tested out in detail, so to us it looks like Credo’s rapid growth phase is just beginning and could entice more big clients to buy. After a few sour quarters, the April report was the firm’s coming-out party, with revenues up 89% and earnings of seven cents per share up from a loss a year ago—and analysts see growth soaring from here, with the top line up 62% this year and another 51% in fiscal 2026 (ending April of that year) while earnings crank ahead. The stock wasn’t liquid enough for our tastes a couple of months ago, but the quarterly report caused a huge-volume breakout in June, and the stock has grown up some since. The next pullback or shakeout (which may be starting now) could provide an entry point.

Axon Enterprises (AXON 291)—AXON is yet another growth name that had a nice run late last year and into early 2024 but has now been grinding sideways to down for the past few months—ideally resting up for its next big run. The story here hasn’t changed since we wrote about it last: Axon is the leading provider of technology to law enforcement agencies, including electrical weapons (Tasers, which cut down on accidental deaths), body and dashboard cameras, drones, a cloud-based response and dispatch software and, most important, its Evidence cloud software suite that allows all the video and data to be stored, shared and analyzed digitally, which also helps with prosecutions. (Axon’s CEO said earlier this year its clients upload more content every month than YouTube!) And, with its Workforce offering, the firm is moving into the retail space, allowing front-line workers to record everything, helping to cut back on theft, which has become a growing issue in many locations. Probably most important of all is the business model, with more and more of the revenue these days coming from subscriptions (to store and manage all the video data)—in Q1, the firm’s annualized recurring revenue came in at $825 million, up a big 50% from a year ago, while total contracted revenue was just over $7 billion (up 47%). Now, one reason (we think) the stock slid after that report in February was that last item (total contracted revenue) actually fell sequentially for the first time ever; management made it sound like no big deal, but it sets up a good “test” when Q2 results come out (likely in early August). As for the stock, it’s been stuck in a 17%-deep, 13-week-long consolidation—it needs work, but any major upside should kick off a sustained advance.

Will the AI Buying Pressures Spread?

While no two periods in the market are exactly alike, we are looking back at the internet bubble as a very, very rough parallel to the AI boom that’s clearly underway. Just like today, network infrastructure names were the leaders back then, with the most dominant ones leading right into the secular top of March 2000: Cisco, of course, was the all-around liquid leader, but names like JDS Uniphase (optical switches), EMC (storage) and many others that we owned did great.

However, as the rally spread out, more internet-related names became leaders. Yahoo! and AOL were monster winners as they garnered not just eyeballs (yes, back then stocks were valued on viewership alone) but real advertising revenue; Amazon, of course, was the bet on e-commerce; and eBay had a ridiculous post-IPO run as it was the go-to place for individuals to sell anything and everything they wanted.

However, so far in the AI cycle, we really haven’t seen money spread beyond the infrastructure names—but we’re on the lookout for it. And that leads us to Palantir (PLTR), which, in our view, is fundamentally positioned to be the leading provider of AI platforms and systems to businesses and government agencies. Really, Palantir has been using AI and machine learning in some shape or form for years: It’s been providing advanced analytical software to governments (including U.S. and western-friendly militaries), with an ability to have public or private large language models use select data in a secure way—and so when AI interest revved last year, the company quickly started building and testing out its platform with select commercial customers. Sales were slow at the beginning, but the firm’s move to have “boot camps,” where it uses a potential client’s own data, integrates it on the platform and lets them see what’s possible (it can get all this together and provide firms tests within just a few days!), has U.S. businesses stepping up.

Indeed, in Q1, U.S. commercial revenue (driven by AI adoption) surged 40% from a year ago and 14% from the prior quarter, while the customer count was up 69% and remaining deal value boomed 74%, with all signs (and some press releases) pointing toward more fresh signups in Q2. And, given that the ramp started just a couple of quarters ago, there’s little doubt the upside is big going forward—think of the potential here as Palantir becomes some sort of “AI Microsoft” for a big chunk of the business world, where most big players standardize on its AI software platform.

So why has the stock had trouble making progress (no net movement from last June through May of this year)? Partially due to market factors, of course—the narrow environment has held back a lot of firms with outstanding fundamentals—but also because that booming U.S. commercial business is still just 25% or so of the overall business … and international and government AI uptake has been much slower. Hence, revenue growth, while accelerating a smidge, was up “only” 21% in Q2, while earnings per share are just pennies (eight cents per share)—and analysts forecast that sort of good-not-great growth going forward, too.

Even so, we’ve been keeping an eye PLTR for literally a year at this point because it seems a very good bet that, at some point, things will take off on the upside—or, at least, investor perception might take off, discouting a gigantic future. That could be happening now, as the stock has rallied since early June to push out to new highs. Could this be yet another false start? Of course, especially as the market remains tricky, but the combination of the great story, superb underlying numbers in the commercial business and recent strength has our antennae up. WATCH

The Upside of No Progress: More Setups

We’ve written endlessly in recent weeks about how the vast majority of the market is basically in no man’s land—our Cabot Tides remain firmly neutral, and if you simply flip through a bunch of stocks and sectors, you’ll see the same thing. Most names out there have been meandering sideways since March, and of the names that looked to be getting going in May (after the market correction), most have stalled out since Memorial Day.

That’s created a divergence, yes, but as we head into earnings season, it’s also created a lot of setups—stocks that have built multi-week or multi-month launching pads that could lift off if all goes well. Interestingly, we might be seeing that among some indexes already: The equal-weight Nasdaq 100 Fund (QQQE) tightened up nicely and has nosed out to new highs.

Among individual stocks, there are many setups, a bunch of which are on our watch list. Some, like Neurocrine Biosciences (NBIX), have been tight for months and are now perking up ahead of earnings (due July 30). And some others like Robinhood (HOOD) haven’t made any net progress since leaping to new highs in May but have tightened up nicely while the underlying story is as good as ever. Pinterest (PINS) is another name that is tight and ready to go ... if the buyers show up.

Obviously, it’s also possible these setups fail, with breakouts being rejected and/or outfit cracks of support. But given our good-sized cash hoard, it provides a straightforward plan—some powerful upmoves from here (possibly on earnings) would have us buying names that have a good chance of starting fresh intermediate-term (or longer) upmoves.

Cabot Market Timing Indicators

As we wrote on page 1, these have certainly been unusual times, with most stocks moving sideways, a few mega-cap names advancing and more growth stocks hitting potholes than staging fresh breakouts. That said, it’s more tedious than bad, our market timing indicators are split and (because of the sideways action) we’re seeing more setups. We continue to stay relatively close to shore, but are staying flexible should growth stocks kick into gear.

Cabot Trend Lines – Bullish
The big-cap indexes continue to levitate, which keeps our Cabot Trend Lines in a firmly bullish stance—coming into today, the S&P 500 (by 11%) and Nasdaq (by 16%!) are both hugely above their respective 35-week lines, so the long-term trend is up. Of course, with so much daylight between the indexes and their trend lines, a pullback/correction is going to happen at some point, and how that plays out (a rotation like we saw today? a general downturn? a sideways rest period?) remains to be seen. But the main point here is that the overall bull market is alive and well, with higher prices likely when looking months down the road.

Cabot Tides – On the Fence
The sideways grind continues, with our Cabot Tides remaining on the fence, as most everything outside the two big-cap indexes (including the NYSE Composite, shown here) is still in a trading range. Now, we are seeing some things perk up, like the equal-weight Nasdaq 100 (mentioned earlier in this issue), but the weight of the intermediate-term evidence remains sideways for most indexes and growth stocks.

Two-Second Indicator – Negative
Meanwhile, the broad market remains unhealthy, and the longer it continues, the greater the odds of some sort of sharp rotation or selloff in the market. Our Two-Second Indicator has recorded north of 40 new lows on all but five days since the start of June—maybe this clears up in the days ahead if Fed rate cut expectations remain elevated and we see buying power emerge in the broad market (today was a good start; looking like single-digit new lows), but we need to see more to conclude the crosscurrents have dissipated.

The next Cabot Growth Investor issue will be published on July 25, 2024.

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