The New Tech Economy

volume xx - issue 2

By Definition: Part 1

A friend of mine called me out recently about the stocks I’ve bought in recent months, and that I advertise New Edge Analytics as a niche proxy hunter. More like a buy-side equity analyst, looking for pure plays in certain tech industries. Software and semiconductors mainly. He aptly pointed out that I went with mega-caps, multiple industries, multiple markets, multiple technology solutions. And he had me there. I had to think about it and remind myself what fits my definition of a proxy.

New Edge exercises a disciplined approach to performance recognition among IT companies. A company has a proxy when NEA attributes outstanding growth to a tangible product that, standing alone, makes a positive contribution to earnings and moves the price of the stock. Staying true to the core, stocks with good fundamentals, New Edge adds emphasis to technical indicators; the patterns that show up in the stock charts of publicly traded companies. I have always used technical indicators to pick entry and exit points but have added weight to those methods to pick growth stocks that would otherwise be ruled out based on their fundamentals alone.

Every seven years on average the stock market gives you the opportunity to shuffle the deck and pick new economy leaders. That is how you must look at bear markets and corrections in the long run – opportunities. It was twelve years ago, using 2018 as the middle of a bear market lasting 17 months, that the S&P 500 dropped over 56%. At the time some of the technologies among the companies named in this essay had been in development for at least several decades. But they were not yet mainstream and hence an investment in these stocks came along with high risk. Some fell hard in the Great Recession. Some mentioned here were under $5 per share – penny stocks.

The companies that suffered with bleeding edge innovation in that bear market have in a few sectors become companies that produce strong growth in earnings now. They enjoy double digit earnings growth year-over-year, and (prior year) quarter-over-quarter. Software and semiconductor technologies that once fit the description of a niche are now developed or acquired by companies that participate in multiple markets. These technologies include subscription software, 4G/5G mobile networks, cloud computing, RISC architecture in data centers, machine learning, artificial intelligence, and high-performance computing. Fringe networks accommodate the Internet of Things and are patrolled by cybersecurity systems.

The IT industry, like most industries, consolidates during bear markets and recessions. Some large companies emerge as winners and address more than one automated solution. The tell is if they can continue to integrate smaller companies, the stand-alone proxies, as well. This means there is still a pipeline of leading-edge solutions. These new economy leaders form the new baseline.

In the context of the recent COVID pullback and recovery, the stocks with the fastest improving prices telegraph who qualifies as new leadership positioned for the next leg up. For now, we need to think about sustainable trends and manage the risk over twelve to eighteen months. A longer bear market affecting all industries is not out of the question, with looming COVID fears and the election in November weighing on forecasts for economic growth.

Twenty-First Century Tech Portfolio

Tech companies with double digit sales and earnings growth have figured out how to move into new markets without assuming much debt. If debt is needed, borrowing continues to be financed with historically low interest rates. There are no significant monetary policy changes indicated by the Federal Reserve. Here are the categories of IT companies that now fit New Edge strategies from the perspective of a buy-side equity analyst:

SaaS

Software as a Service (SaaS) simply means the customer leases or subscribes to a software application running in the cloud, pays usually by the month, and can cancel at any time. There is no upfront purchase by the customer nor annual maintenance fees for a truly SaaS company. Client retention depends on how sticky the solution is. If it is a key necessity inside the company, the company is likely to remain subscribed. Teenagers and their mobile phones, social media, and gaming apps – not so much. The rub for the SaaS companies is a high gross margin percentage, and predictable cash flow. The stock market loves predictable cash flow.

There are just a couple of varieties of SaaS. The application may run entirely in the cloud (in data centers). The application may partially run in the cloud and partially on a user device (the fringe network). The application may run in an enterprise setting, meaning a large organization where the application, database, and network run both in the cloud and in the company’s own facilities. We call this “hybrid cloud computing”.

Chips

Semiconductor companies are coming out of a mild bear market. The rub in this sector is the amount of debt a fabless semiconductor company avoids versus a chip manufacturer. The industry over the last decade has moved to integrated circuit designers who outsource the mass production of the chips they create to a handful of manufacturers. We call these “fabless” or “non-fabricating” chip companies. Sometimes they are endeavoring to create a market. In the end, the emergence of fabless semiconductor companies is now mainstream, has shortened the design-to-build cycle, and helps manage inventories without the need for CapEx and a lot of debt.

Mass production facilities are called foundries, aka “fabricating plants”, and can operate from the early stages of making polysilicon ingots to mass production of wafers and chips. There is a lot of industrial equipment required to mass produce integrated circuits. There are three main foundries who are capable of building nearly all semiconductors – from computer memory, to CPUs, to graphics and solid state drives, to chips in a cell phone. They are Taiwan Semiconductor, Samsung Foundry and Global Foundries (privately held). Intel, Texas Instruments and Micron are examples of North American companies who design and in part have their own foundries. These are called “semi-fab” manufacturers. If we continue to be at odds with China, watch what these companies do to bring mass chip manufacturing back onshore to the US and South America.

Networks

Here is where 4G/5G mobile networks, data centers, telecom carriers, entertainment, and social media live. I would also include fringe networks, here in the context of devices that access the network for computing resources. The Internet of Things. The main 5G carrier companies in North America are AT&T, Verizon, and T-Mobile/Sprint. You could add Comcast and Cox to the mix with satellite feeds, and dozens of independent fiber and cable companies serving secondary markets. 5G is the radio enabler for more applications than cell phones.

5G in an industrial/municipal setting creates revenue for carriers to build infrastructure. This subsidizes the commercial end of the user market such as mobile devices. 5G devices will have applications with intelligent endpoints, sensors, and actuators in all kinds of environments. These include urban smart city solutions, durable gear for demanding indoor and outdoor manufacturing settings, automated logistics and shipping, and automated cars. The list grows daily.

Network Security

Cybersecurity and National Defense are included together at the author’s discretion since beyond traditional thinking about the ability to protect a computer network and data in the private sector, it’s unsaid that cybersecurity is a big area of spending for the military and intelligence communities. Unfortunately, the government doesn’t publish what it spends for network technology and cybersecurity.

You must work hard to understand the spending by the government and revenue opportunities for the cyber companies. Find companies whose primary customers are the military and research the contract awards that they win. Useful information can be found in earnings conference calls, a close look at financial statements, trade journals for defense contractors, and their websites.

Choose companies that make or implement firewalls, who have highly predictable sales and earnings growth. If they make a few strategic acquisitions a year among privately financed cybersecurity companies – the better. The industry is consolidating and the younger, privately held companies are clustering around the firewall manufacturers pre-IPO, or an M&A transaction.

Leading Stocks

Here are the New Edge picks for the second half of 2020. Stay tuned for follow up articles with justification for the companies mentioned here. Hover and click over any stock symbol.

• SaaS: Adobe (NASDAQ:ADBE) and Microsoft (NASDAQ:MSFT). Based on broadening product lines, auto-updates, their embedded base of installations, and relevance with both consumer and business markets. They nearly own your user experience with desktop and Web applications. And you pay by the year/month.

• Chips: Advanced Micro Devices (NYSE:AMD) and Nvidia (NASDAQ:NVDA). Given a confirmed uptrend in the use of RISC microprocessors in data centers, this new industrial opportunity complements their popularity with graphics and gaming. Add machine learning and artificial intelligence to the mix.

• Networks: American Tower (NYSE:AMT). Cell towers figure prominently delivering both 4G LTE radio bandwidth, and in the hosting of new 5G antennas that reach both mobile and stationary devices. AMT is a real estate investment trust that passes lease revenue through to investors.

• Network Security: Mercury Systems (NASDAQ:MRCY) and Palo Alto Networks (NASDAQ:PANW). Both participate with government civilian agencies, the military, and the intelligence community. Both make a few strategic acquisitions a year, some in government space. PANW is my favorite firewall pick.

Copyright © 2020 New Edge Analytics. All rights reserved.

Market 3000! Let’s Slow Down Here, But Just a Little

volume xix - issue 3

How Long the Bull?

All index prices are day-end with decimals omitted unless otherwise noted.

The S&P 500 Index passed a milestone at 3000 in July, truly an achievement of the longest bull market in history. And it bears plenty of notice. But this article is about perspective. Over a twenty-year span, 3000 is not such a big number.

I would like to ask the reader to humor me and consider it significant when the Index has crossed an upward bound, non-arbitrary threshold of 1500. This has happened three times. Twice the market retreated to roughly half that number. The Index first crossed 1500, then reached 1527, a rarefied milestone, on March 24, 2000. Y2K – The Dot Com Boom. By October 2002, the Boom had gone Bust. Soon following Nine-Eleven, the index cratered to 776. Almost half the peak value.

The most brutal stock market routs stem from broadly mispriced assets in large markets experiencing hoards of new cash invested. In the Dot Com era, frothy stock IPOs for new tech companies poorly reflected the truth that most had never earned a dime before going public and had no tangible prospects of ever breaking even. Promoting the bonds and collateralized debt of independent telecom companies as safe havens was another sham. WorldCom was not Ma Bell (AT&T), a regulated utility with a guaranteed income stream.

Finding the Bottom

This is what happens with every big stock market crash. Some structural element of the financial system becomes impossible to price and the assets must be marked down once realizing that those holding the assets – pros and moms and pops alike – won’t be getting their money back. Sounds like musical chairs doesn’t it?

The bust following Y2K was the first of two striking retreats from 1500 for the S&P 500. The years 2000 – 2010 were labeled “The Lost Decade” for shares of Information Technology companies, particularly telecommunications. It took eight years for the Market to return to the 1500’s, breaking the barrier again in 2007 and peaking October 9th that year at 1565.

This time, mortgage backed securities were the unpriceable assets. I recall at the time listening to a morning report on CNBC, that the size of the secondary market for mortgage backed securities had grown to three times the value of the US Treasury market. I gasped a little, and within the following weeks went to cash in portfolios except for the large, stodgy mega-cap and old money stocks that historically survive economic crises. Fortunately I side-stepped the slaughter coming up. The Big Short.

And so, the Mortgage Crisis ensued in 2008. Lehman Brothers went bankrupt, the largest in history. AIG and Bear Stearns nearly did; the latter bought by JP Morgan for $2 per share. Bank of America acquired Countrywide Mortgage and Merrill Lynch. The government quickly passed the Troubled Assets Relief Program (TARP), allowing the distribution of over $700B in liquidity to the largest US banks.

At the bottom, March 6, 2009, the Index had collapsed intraday to 666.79 but rallied. The lowest daily close came through a few days later, March 9, at 676 – lower than the bottom following the Dot Com Bust and the Nine-Eleven attacks. All the major brokerage firms were now owned by large banks under the jurisdiction of the Federal Reserve.

These banks, were given greater access to short term credit through the Fed Funds Discount Window, under the guise “Too Big To Fail”. Morgan Stanley and Goldman Sachs were the only two large investment banks still standing. They formed bank holding companies and grudgingly acquiesced to direction from Congress and control by the Fed.

It’s Just a Double

The Great Recession followed. But the S&P 500 Index climbed again and that value on March 6, 2009 of 666 stands as the most recent low point marking the start of a bull market that is now over ten years old. The media is celebrating the performance of the market as measured from the bottom, clearly through 1500 in 2013, and continuing uninhibited to 3000 last month. The statistics are accurate. The path from 666 to 3000 is four-and-a-half times your money from-trough-to-recent-peak. Astounding. Even accounting for a possible correction underway.

But here’s the thing: If you bought the S&P 500 Index, meaning “The Market” near the top of the Dot Com Boom, peaking near 1500, it would have taken nine years to reach that level again before the mortgage crisis. Then again dropping to half its value. Ten years later, here we are toying with 3000. This is only – not to discredit – a 100% gain, or double your money, over a few months more than nineteen years.

If you invested $5 in The Market in 1999, you would have about $10 now. I’ll do the math here. That’s about 5% annually without compounding, without inflation adjustment. The compounded annual rate of return for the S&P 500 over those twenty years is closer to 3.5%. When accounting for inflation, the ROR is actually worse. The long-term statistical mean of the S&P 500 is 8% annually with an 18% swing in one standard deviation.  The actual twenty-year average return from 1999 to 2019 is nowhere near the mean.

Healthy Sector Rotation and Market Cycles

I recently completed a fifteen-year look back into the prices of the stocks of deliberately non-tech companies and have decided they are fairly priced. This opinion based on dividend yields, relative price to earnings ratios and a few other fundamentals. It’s boring but stocks of energy, natural resource and utility companies, and consumer brands that pay dividends are safe bets now.

This economy is quietly going through about as normal a sector rotation as I can remember since joining the investment finance business in 1985. Prolonged periods of low interest rates impact the banks, but that industry has been steadily on the mend. Growth in fee-based services is replacing money earned on the spread; the difference between the bank’s borrowing cost and the rates they charge as interest on loans to consumers and businesses.

The energy sector rolled over in 2015 when the fracking boom peaked. It became apparent that we have enough of our own energy resources to last without foreign imports. Most analysts believe that oil and gas prices have already reached the bottom of their cycle. I do, too.

Industrials and the manufacturing sectors are further along in the economic cycle, so I wouldn’t be surprised with a pullback here, but not like the breakdown in 1999 – 2002. Semiconductors peaked in 2017 and some have dropped by half their value. They had also in part fueled the ride up to 3000. But sector woes haven’t taken the broader industrial economy along with it.

Late Stagers Still Need to Peak and There is Cautious Upside

The S&P 500 and the Dow Jones Industrial Average are now heavily Information Technology weighted and that won’t change. This isn’t your grandfather’s portfolio. Of the 30 Dow Industrials, Apple, Cisco, IBM, Intel, and Microsoft are included. In the S&P 500, these stocks and the FANG Gang – Facebook, Amazon, Netflix and Google – are prominently represented due to their size. Their extraordinary new highs make the news. These stocks and companies like them are the most exposed to a correction and most heavily weigh on the price of the S&P 500 Index.

Consumer spending, jobs, the service economy, software, and military spending are usually the last to peak and we haven’t seen it.  We have yet to show any real evidence that the economy is slowing down in a dramatic way.  So, take a breath here.  Consider raising some cash and increasing positions in safe-haven assets but don’t go overboard.

Sector rotation describes a healthy economy. Daily ups and downs that follow the news – China Trade, Brexit, the behavior of Iran and North Korea, an upcoming election and ongoing Congressional angst – are offset by cuts in corporate tax rates, share buybacks, more than a decade of low interest rates and a sensible Fed. Taking the long view, the Market knows what it’s doing and a double-the-money in twenty years means statistically there is more room for the bull to run.

Copyright © 2019 New Edge Analytics, All rights reserved