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Cabot Growth Investor 1405

The market’s downturn continues, with the trends of the major indexes and most growth stocks clearly down. Our longer-term Cabot Trend Lines even turned negative last Friday, reinforcing the view that the sellers are in control.

Cabot Growth Investor 1405

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Clear

Trends are Down Until Proven Otherwise

When volatility picks up in the market, often after a sharp decline, investors are bombarded with predictions, many of them dramatically bullish (this is the buying opportunity of the century!) or bearish (another global financial crisis has begun!), frequently in order to generate clicks.

Other writers focus more on the wild day-to-day action, writing paragraphs about how a talk by a Federal Reserve member, politician, CEO or Chinese negotiator was likely to move markets. And then there are those who dig into the minutiae to try to see the future, looking at overseas shipping rates, regional economic reports or tertiary market indicators in order to get an edge.

But one of the big keys to successful investing is to realize that you don’t need to predict the future; you simply need to interpret what’s going on right now. And on that front, the picture is clear: the market’s trends are now down and most growth stocks are in disarray, a fact that was reinforced last week when our long-term Cabot Trend Lines turned negative. That tells us a defensive stance remains appropriate.

As we said above, though, we’re not predicting anything. There’s always a chance that this might be one gigantic September-October shakeout, with investors piling back into the market soon and kicking off a great run to the end of the year. (Historically, stocks do well after a midterm election, for instance.) Indeed, we’re finally seeing some signs of investor panic (a good thing), including in our own Real Money Index, which flashed a green light last Thursday—something that typically leads to solid performance from the market for a month or two.

But investing is an odds game, and with the trends now pointed down, the odds are that this correction will take more time, whether it suffers another leg down or not. The goal at this point, then, is to get from today to the start of the next sustained uptrend with as much capital (and confidence!) as possible—and, just as important, to keep a close eye on the action of stocks in this earnings season, as some leaders of the next sustained advance are likely to reveal themselves.

[highlight_box]WHAT TO DO NOW: Stay defensive and remain patient. In the Model Portfolio, we sold our remaining shares of Ligand last Friday, leaving us with a large 71% cash position, which provides not only a cushion against any further market plunges but also plenty of buying power for fresh leaders when our indicators turn green. And we’re also keeping tight stops on our remaining positions.[/highlight_box]

Model Portfolio Update

With the market remaining weak, the Model Portfolio has remained in a defensive stance during the past two weeks. In fact, we’ve raised a bit more cash by dumping what was left of our position in Ligand Pharmaceuticals on a Special Bulletin last Friday. The result is a cash position of 71%.

Of course, when the market and stocks are skidding sharply, even 71% cash doesn’t feel like enough. And maybe it isn’t: As we write on page 7, in most cases a Cabot Trend Lines sell signal (which we received last Friday) leads to another round or two of selling in the Nasdaq during the following weeks. If that happens, it will almost surely cause some damage in growth stocks.

Still, there’s the real possibility of a near-term snapback based on the various oversold readings (which we’re admittedly not big fans of). And our own Real Money Index is now showing investors rapidly yanking money out of equity funds. (Some narrower money flow measures, like the assets in Rydex bull funds, are starting to show something similar.)

What should you do? First, make sure you’re in a defensive stance. If you haven’t raised much cash yet, it’s time to pare back, starting with your losers and also selling pieces of your bigger winners. If you’re already in a highly defensive stance, we advise patience and vigilance—if a stock really gives up the ghost, we’ll sell (we’re never in favor of simply holding and hoping for good results), but with less than 30% invested and with some shorter-term readings at extremes, we’re trying to give our remaining names a bit of rope.

In the meantime, we’re keeping an eye on a variety of stocks and sectors as we build our Watch List. Earnings season, which picks up in earnest this week, should help separate the contenders from the pretenders, so we’ll be watching for upside gaps, ideally from some fresh, undiscovered stocks.

Current Recommendations

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BUY—Five Below (FIVE 112)—Our investing results improved in a big way years ago once we began thinking from the perspective of institutional investors, who are the ones who drive a stock (and the overall market) with their huge buying and selling. As we’ve written before, for hundreds of funds to take good-sized positions in a stock that isn’t a mega-cap, they need to see great growth, the potential for further growth and (importantly) some surety that the growth story will play out—all of which Five Below possesses. We continue to think Five Below is rare merchandise for big investors, given its best-in-class store economics (payback in less than a year, including some recent new stores paying back the initial investment in just seven or eight months) that enables rapid (20%-ish increase in the store count each year) store expansion, with a big runway of growth (2,500 locations should be up and running eventually, up from 692 at the end of July). And, of course, the business itself isn’t economically sensitive (everything is $5 or less and tends to be high-use stuff) and isn’t likely to be chewed into by the likes of Amazon, which adds predictability (same-store sales have lifted every year for more than a decade). That doesn’t mean there are no potential potholes. Every retailer needs to stay on the right side of fashion and gadget trends (which Five Below has) and the U.S.-China trade war might raise costs, though management said the current list of products on the tariff list shouldn’t impact its results next year. As for the stock, it’s come down with the rest of the market, but the decline looks normal to this point given its overall advance. We don’t expect anything great before the market turns around, but if you have a lot of cash and want to put some of it to work while stocks are down, we’re OK starting a small position in FIVE here.

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HOLD—Grubhub (GRUB 110)—Like many growth stocks, GRUB never bounced much during the past two weeks, though it’s found a little support near its low from two weeks ago, which is a bit better than the market. There have been some news reports lately that have caught investor’s attention—delivery competitor UberEats, for instance, aims to reach 70% of the U.S. population by year-end, up from 50% today. But we’re more focused on (a) the fact that the stock is holding just above its 200-day line (around 109.5), which so far keeps the longer-term uptrend intact, and (b) the earnings report, which is due out tomorrow morning (October 25); analysts see sales of $239 million (up 47%) and earnings of 41 cents per share (up 46%), with a lot of attention paid to profit margins, customer growth and order growth as well. As we’ve written many times, we think Grubhub (the company) is set to get a lot bigger in the years ahead as the trend to online takeout ordering and delivery booms. That said, the company is not the stock, so after a big uptrend and recent weakness, the upcoming earnings reaction will be key. Hold for now.

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SOLD—Ligand Pharmaceuticals (LGND 167)—We pulled the plug on our remaining shares of LGND on a Special Bulletin last Friday afternoon, as the stock fell to lower lows, sinking beneath its 200-day line. While the overall story appears sound, we have doubts given the stock’s action. Yes, the market environment is crummy for growth stocks, but even so, LGND’s weakness is notable, with the stock having fallen all but one day this month (!), including a plunge on its heaviest weekly volume in years. Maybe one of its key currently licensed drugs isn’t selling as well as hoped; we don’t know, and frankly, it doesn’t matter. What does matter is that the stock is now completely broken, and while bounces are always possible, big investors are still selling. Bottom line, we’re out, and there will surely be better stocks to own when this market downturn ends.

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HOLD—Okta (OKTA 53)—OKTA’s decline hasn’t been pleasant, but we think it looks reasonable on the chart; shares are back into the prior base (when the stock traded between 48 and 58 for most of June, July and August) and are well above their 200-day line (near 49), which is a rarity in the current environment. We think the firm’s upbeat presentation at its Investor Day a couple of weeks ago is enticing some institutions to grab shares, as there aren’t many firms with a multi-year outlook that includes 30%-plus revenue growth and rapidly improving profit and cash flow margins. Our pain threshold isn’t limitless here, and a break below its 200-day line might have us cutting bait. But right here, we’re gritting our teeth and giving OKTA a chance to find some buyers.

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HOLD—Teladoc (TDOC 62)—TDOC is another stock like OKTA that’s had a sharp decline, which is why we took partial profits (selling one-third of our position) in the first week of October. But it’s still well above its 200-day line (which is way down near 55) and, recently, has held a smidge above its prior low (63 this week vs. 62 two weeks ago). Long story short, while painful, the correction looks normal to this point, though it’s likely the stock (like most others) needs time to build a new launching pad. The big key will come on November 1, when the company will release its quarterly report. Teladoc nudged up its guidance and revealed many fundamental nuggets at its Investor Day last month, but any new outlooks and updates will be key, especially regarding the uptake of its virtual care services with any large customers. If you still own a partial position, sit tight.

Watch List

Ciena (CIEN 30): Networking stocks are often tricky, but when they make moves, they can go a long way. Ciena broke out of a multi-year base last month on earnings, and has held up very well since then as investors expect growth to accelerate as telecom service providers, cable providers and webscale cloud firms lay fiber to keep up with capacity demand.

Dexcom (DXCM 125): We’re not opposed to buying back something we recently sold, and DXCM is a candidate. The stock has shown great relative strength during the past two weeks and, of course, the fundamentals continue to look outstanding (its G6 CGM will be available to Medicare beneficiaries early next year). Earnings are due November 6.

Ensco (ESV 7.26): Energy stocks (and oil prices) have “caught up” on the downside with everything else, but we’re still intrigued with Ensco, which looks like a powerful turnaround situation in the offshore drilling sector, with some well-timed acquisitions boosting its potential. The stock is still holding its 50-day line. Earnings are due October 30.

Exact Sciences (EXAS 60): EXAS has been skidding all month, but it’s still in the broad area of its Pfizer-induced surge back in August. We’ve also seen some encouraging, bullish option activity here (usually a good sign). Earnings are due October 30.

Glaukos (GKOS 59): GKOS remains in great shape, as it’s about two months into a flat-ish base. The firm’s entire outlook changed in August when the main competitor for its glaucoma stent threw in the towel. Earnings are due out November 7.

PetIQ (PETQ 33): PETQ has basically gone sideways since the first week in October, which is a small plus. It’s little known (and the stock is thinly traded for now), but we think this retail story has big potential. The firm just made a small acquisition of a firm with specialized pet supplements and treats.

ServiceNow (NOW 170): NOW is one of the blue chips of the cloud software space and continues to sport fantastic growth. Moreover, while the stock has taken a hit, it’s not in bad shape as earnings approach (out tonight after the close). Despite its big run, NOW has a shot at being a liquid leader coming out of this market correction if it reacts well to earnings.

Wayfair (W 110): Wayfair remains controversial in some quarters, but this is a thriving business that can grow rapidly for many years. See more on page 6.

Other Stocks of Interest

The stocks below may not be followed in Cabot Growth Investor on a regular basis. They’re intended to present you with ideas for additional investment beyond the Model Portfolio. For our current ratings on these stocks, see Updates on Other Stocks of Interest on the subscriber website or email mike@cabotwealth.com.

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Bilibili (BILI 12) — While there are lots of Chinese internet companies that offer video, games and other content, Bilibili sets itself apart from the herd by concentrating on the tastes of China’s Generation Z, those born between 1990 and 2009. Starting with a ton of anime, comics and games, the company now offers a full spectrum of licensed videos, live broadcasts, mobile games and professional content. The big news sustaining BILI during this slump in Chinese stocks is a recent $320 million investment from Tencent Holdings, China’s dominant messaging company. Tencent gets a 16% stake in Bilibili and in exchange Bilibili gets enhanced access to Tencent’s vast user base. BILI has been etching higher lows during the past few months, defying the downward pull of Chinese stocks. This is one to keep an eye on.

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GoDaddy (GDDY 70) — GoDaddy’s cloud platform is the largest in the world aimed exclusively at website hosting, security and promotion services for small, independent companies. The company boasts 18 million customers around the world and manages 77 million domain names. GoDaddy was incorporated in 2014, turned profitable in 2017 and has grown revenue by at least 15% since its foundation. Earnings growth is variable, but has increased by triple digits in five of the last eight quarters. Analysts expect this trend to continue, forecasting 225% EPS growth this year. The company will report its Q3 results after the market closes on November 6, with analysts forecasting $674 million in revenue and 17 cents per share in earnings. The stock’s correction looks reasonable so far.

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Tabula Rasa Healthcare (TRHC 70) — It’s not widely known that the cost of treatment, hospitalization and death from adverse interaction among prescription drugs may actually cost the healthcare system more than the drugs themselves, which is a huge issue, considering that the average senior in the U.S. takes five prescription drugs. Tabula Rasa is a leader in data-driven technology that can predict which combinations of drugs are likely to cause problems, and healthcare organizations, prescribers and pharmacists are signing on rapidly, giving Tabula Rasa revenue growth of 34% in 2016, 43% in 2017 and 57% and 65% in Q1 and Q2 2018, respectively. The company enjoys a 98% client retention rate, which makes recurring revenue a solid source of growth. TRHC came public in late 2016 and took nearly a year to break out above resistance at 17. But once it got going, TRHC roared to 91 in early September and is now pulling back. Q3 results are out November 6.

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Wayfair (W 110) — Wayfair is an online home furnishings and décor store with a market cap of over $12 billion and annual revenue of $5.7 billion. The company increased revenue by 40% in 2017 and by 46% in Q1 and 47% in Q2, which is outstanding. But Wayfair has neither a penny of profit (so far) nor any profit forecast at least through 2019, as the company plows revenue into expansion into new markets. This has led to a heavy short interest in the stock, with well over 20% of the float shorted as of late September. After a long sideways period, W rallied from 62 on May 1 to 151 in mid September, but has pulled back to around 120 as investors await the company’s latest quarterly results on November 1. The longer W can hold in its current trading range, the better the chance it can resume its advance. We have it on our watch list.

Cabot Trend Lines Turn Negative

For the first time since April 4, 2016, our Cabot Trend Lines flipped to a bearish signal at the end of last week, as both the S&P 500 and Nasdaq finished their second straight week below their respective 35-week moving averages. Granted, it was a very close call—the S&P 500 finished the past two weeks less than 0.1% below its 35-week line!—but rules are rules, which means our long-term trend-following measure is now pointed down.

In our case, we started raising cash at the start of October, even before the intermediate-term trend turned down; our cash position has moved from 16% to 71% in a little over two weeks. If you’re heavily defensive like we are, we wouldn’t sell wholesale just because of the Trend Lines signal—most action has already been taken.

But, looking ahead, what does the sell signal portend? Well, first, it’s important to remember that trend-following indicators are more descriptive than predictive; when negative, they’re telling you the environment (be it intermediate-term or, in the case of the Trend Lines, longer-term) is unhealthy right now. It’s less about predicting than following along with the current environment.

That said, we look to history for guidance as well. There have been 13 prior sell signals from the Cabot Trend Lines since 2000. Three of them led to whopping declines (they occurred during the two big bear markets), one led to a wipeout in early 2016 (Nasdaq down as much as 14% during the next month) and another four resulted in a good amount of pain (5.5% to 8% Nasdaq declines during the next one to two months). On the flip side, five could be considered duds, seeing only minimal declines after the sell signal before the bulls put up a fight.

Tallying up this simple study, eight of the 13 signals (about 60%) led to at least another round or two of selling in the Nasdaq, with half of those resulting in big declines for growth stocks. On the flip side, there was a 40% chance the signal was reversed in short order. Of course, a 60-40 edge isn’t gigantic, but you have to consider the size of the potential losses should the downtrend accelerate.

And that plays a big role in our thinking. To paraphrase legendary investor Paul Tudor Jones, nothing good ever happens below the 200-day line. (Similar to the 35-week lines we use.) While there’s always a chance that a trend-following measure can stage a quick reversal (we’re all for it), the Trend Lines being negative opens up the possibilities of further sharp declines. The next week or two will probably be telling; if the market can power ahead from here (something our Real Money Index suggests is possible—see page 8), it would raise the odds of a reversal. If not, another leg down would become more likely.

Either way, you know us—we always go with the evidence in front of us. Right now, with both the intermediate-term (Cabot Tides) and longer-term (Cabot Trend Lines) negative, it’s best to remain defensive.
Picking up Nickels

When the market falls, volatility picks up, which leads to some outsized day-to-day moves. And with that come a lot of questions from subscribers about ways to “play” this volatility—trying to make some money here and there even if the overall trend is down.

We’re not philosophically opposed to trying to do this, but we have three thoughts. First, given that the major indexes can move quite rapidly, you might consider ETFs (or maybe leveraged ETFs); that way you avoid event risk (like earnings). Second, you should only consider doing some trading if you’re in an overall defensive stance.

But third and most important, just realize that jumping in and out to earn a few points, isn’t where the real money is made—you’re not going to look back two years from now and say, “My returns were great thanks to the 5% and 7% swing trades I put on in October 2018.”

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Instead, always remember the big money is made in the big swing, by getting onboard some new leaders after this market slide concludes. As such, we’re keeping our focus on stocks that, even if they’ve taken lumps, have long-lasting fundamental stories with reasonable corrections thus far. HealthEquity (HQY), the largest custodian of health savings accounts (HSAs), is a good example, with an enviable record of growth and the potential for that to continue for many years (management thinks the overall HSA industry can triple in the years ahead).

Of course, HQY may fall apart, but the point is that a new leader, after building a fresh launching pad, can make a big run—and latching onto one or two of those can make a big impact on your overall portfolio.

Cabot Market Timing Indicators

Short-term, there are a few rays of light, from Tuesday’s show of support to our own Real Money Index. But both of our trend-following indicators are now negative, and most growth stocks remain in tatters, telling us to stay defensive until the evidence improves.

Cabot Trend Lines: Bearish

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For the first time in two and a half years, our Cabot Trend Lines have flipped to the bearish side of the fence, with both indexes closing two straight weeks below their respective 35-week moving averages. As we write on page 6, it’s certainly a negative and often portends another leg down (at least), though as always we’ll just take it as it comes. Right now, it’s another sign to hold plenty of cash.


Cabot Tides: Bearish

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Our Cabot Tides remain clearly negative, with all five indexes (including the S&P 400 Midcap, shown here) well below their lower (now 25-day) moving averages. After such a big decline, a bounce is certainly possible, and the stronger any bounce is, the better the odds a tradable low is in. But until proven otherwise, the path of least resistance continues to be down.

Cabot Real Money Index: Bullish

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On a positive note, our Real Money Index flashed a green light last week, as investors have yanked out just over $18 billion from equity funds and ETFs during the past five weeks. During the past 10 years, such an occurrence has led to above-average gains for the Nasdaq during the next one month (up 3.2%, up 82% of the time) to two months (up 4.9%, up 88% of the time), offering some evidence the market could be ready to get off its knees.

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Send questions or comments to mike@cabotwealth.com.
Cabot Growth Investor • 176 North Street, Post Office Box 2049, Salem, MA 01970 • www.cabotwealth.com

All Cabot Growth Investor’s buy and sell recommendations are made in issues or updates and posted on the Cabot subscribers’ website. Sell recommendations may also be sent to subscribers as special bulletins via email and the recorded telephone hotline. To calculate the performance of the portfolio, Cabot “buys” and “sells” at the midpoint of the high and low prices of the stock on the day following the recommendation. Cabot’s policy is to sell any stock that shows a loss of 20% in a bull market (15% in a bear market) from our original buy price, calculated using the current closing (not intra-day) price. Subscribers should apply loss limits based on their own personal purchase prices.
Charts show both the stock’s recent trading history and its relative performance (RP) line, which shows you how the stock is performing relative to the S&P 500, a broad-based index. In the ideal case, the stock and its RP line advance in unison. Both tools are key in determining whether to hold or sell.

THE NEXT CABOT GROWTH INVESTOR WILL BE PUBLISHED NOVEMBER 7, 2018

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