Friday File: Buying Growth, Thinking about Retail, Tariffs and Panic

by Travis Johnson, Stock Gumshoe | June 7, 2019 10:45 am

The jobs report from ADP was frightening on Wednesday, bringing more fear that the trade war uncertainty and/or some shift in sentiment is cutting business spending, and it seems to be contributing to the rapid “narrative shift” that has happened this year — whereas we were all shocked that the Fed would even consider cutting rates in a booming economy back at the beginning of the year, given the very strong economy and low unemployment, now we’re all lathering at the mouth as we scream for an immediate rate cut to save us from disaster.

Which is all absurd, of course. No one knows when the next recession will come, but the Federal Reserve is again showing its true colors: Focusing on the protection of the investor class and the health of the stock market, which should not be their job at all, and panicking over the possibility that assets might lose value or that inflation might be too low (technically, zero inflation should be the Fed’s goal — that’s “monetary stability” — but the goal is actually 2% inflation, which fuels asset inflation and helps to continue the decades-long gradual shift of the economy’s returns to asset owners and away from wage earners).

Yes, recent economic growth has already been heavily subsidized by the government, in the form of tax cuts and subsidized borrowing costs, but regardless of the source the economy has been fine… GDP is growing at a decent clip, commensurate with the size and demographic “potential” of the country, and unemployment is so low that businesses in urban areas can’t find employees at all. Cutting interest rates here would clearly be a way to mitigate the impact of the trade war on the stock market, and it would continue to distort the economy and over-emphasize the stock market, but when Wall Street starts baying at the moon for a Fed rate cut odds are pretty good they’ll force it to happen.

Which is probably why the government employment report that came out this morning, which was almost as shockingly weak as the ADP report (75,000 jobs added, versus 175,000 expected), will probably drive the market higher still… we seem to be back in a Fed-driven market, where headlines about trade wars cause volatility (and, in fact, probably cause businesses to pull back from hiring or investing), but the warm blanket of expected rate cuts gives investors confidence.

The investing punditry business is all about reading tea leaves and making dire predictions — no one tunes in to hear folks on CNBC say “things will probably be fine, and stocks will probably return 5-6% a year over the next decade,” they tune in to hear predictions of what will happen in the next few months and expect definitive forecasts about whether the market will surge or crash this summer. No one subscribes to an investment newsletter for the promise of average returns. That means all the stock market does during uncertain and news-heavy times is amplify the headlines — China trade deal won’t get done? Panic! Sell stocks down 5%! Oh, wait, now the deal will get done? Yay! Buy stocks! Up 3%! The government is going to investigate Alphabet for antitrust?! Oh no, the run for FANG stocks is over, sell them all down by 5-10%! The Fed might raise rates? Quick, SELL EVERYTHING! Oh, wait, now they might cut rates? BUY EVERYTHING!

The market is made up of people who forgot over the past few years that stocks sometimes go down, and who are more than anything else addicted to the “easy money” of low interest rates… and have now seemingly recalibrated to expect a crash and a recession. What they’ll recalibrate to expect next week is anyone’s guess, and it probably depends as much on the next Trump Tweet as anything else.

Which means, of course, that we should ignore the chattering heads on financial television and ignore the front page of the Wall Street Journal. We should keep reading and researching, of course, but stick to things that are real — actual companies and their actual profits or projections for the year, and the societal trends that we think will support growing businesses in some sectors over the next few years… and, of course, the valuations of those businesses, since buying stocks at nosebleed valuations gives you much less margin for error than buying them at what you think is a discount to the “real” future value of the profits that company can make if you’re correct about their future.

And, of course, this only works (and imperfectly, at that) if you base your assessment of the company’s value on something real — you can’t just guess. A belief that “this stock will double because marijuana is HOT,” for example, is not an assessment, it’s a roll of the dice. An assessment is an analysis of that specific company’s business, including things like their sales and operating costs, and how you expect that business specifically to change in the next few years. If you think it out in that kind of detail you can still be wrong, of course, but you’ll be basing your decision on something real and rational and you’ll therefore be able to reconsider that stock a few months or years down the line to see if your reasoning still stands up.

I’ll repeat what I’ve often said: I wouldn’t dissuade anyone from becoming an active long-term investor, I find it fascinating and fun and it can be lucrative if you can tame your emotional reactions… but it’s not at all likely to be a quick way to get rich or “save your retirement.” Investing in individual stocks is a fairly time-consuming hobby, and most people, including most professionals, have track records that indicate their returns are worse than passive index investors… so there’s no reason to dabble in stocks if you don’t enjoy it.

If you’re not going to dig pretty deep into the financials and try to understand the long-term dynamics of a specific business, and can’t separate your decisionmaking from your emotional response to your portfolio’s minute-by-minute moves, then you’re very likely to just ride the waves of sentiment and buy and sell at the worst times — and the probability is that you’ll do worse than the market as a whole. If you don’t like thinking about businesses and studying how they work, then either try to get good at technical trading using charts if short-term trading appeals to you, and rent your stocks instead of buying them (and be prepared to lose a lot of money quickly, since machines are probably better at trading than you are), or just buy diversified ETFs and ignore them.

Oh, wait, sorry — I forgot that I also sell memberships to this site. What I meant to say was, “I’m the foremost expert on all things investing, just follow my lead and you’ll get super-rich, probably by Tuesday. And don’t forget to buy my extra-super premium membership for $5,000, I can only share the real secrets of wealth with a very small group of people.” I don’t have a sarcasm emoji for you, so I’ll just share a wink… 😉

OK, lecture done. What’s going on that caught my eye this week? Newest news first…

DocuSign (DOCU) earnings were perfectly fine yesterday, with what I’d call a “mild beat and raise” quarter — they did beat the expectations by a couple cents on earnings, with 37% year over year revenue growth that would generally be enough to keep investors happy… and they increased their revenue guidance very slightly (by about half a percent), so they still think they’ll bill over a billion dollars this year and will collect most of that in revenues before the year’s out, which is pretty impressive.

It doesn’t make DOCU cheap, of course — this is still an $8 billion company, so that’s a price/sales ratio of about 8, and they’re profitable on an adjusted basis but not dramatically so — the shares are trading now at about 63X FY2022 earnings (that’s calendar year 2021, but still). So that means investors look for chinks in the armor, or signs that growth might slow down — and it seems that they found that in the billings and the billings guidance. In the past the billings number has been a stronger “beat” than the actual revenue number, signaling that the company is signing new business faster than they’re raising revenue, which is encouraging, and now those two numbers, at least for this quarter and the second quarter guidance, are more in line with each other.

Whether that’s a real sign that billings are slowing down, or just a hiccup caused, in part, by the fact that they’re rolling out new updates to the software this quarter and selling the more complex “Agreement Cloud” offerings, or just by a little softness caused by the uncertainty that everyone seems to be feeling and that might be making customers a little slower to place orders… I don’t know. That’s all guessing, but investors crave a narrative and the narrative here seems to be “the billings aren’t blowing out with surprises any more, so maybe subscription growth is slowing.”

The company’s explanation is mostly “the products are getting more complex, and the sales cycle is longer” — this is from the conference call transcript[1]:

“First quarter billings increased 27% year-over-year to $215 million included in this growth with a strong starting customers’ purchasing multi-product solutions of e-signature together with document generation and CLM products. Multi-product sales involved more complexity in terms of integration designs and related SOW. This very positive motion in our business also elongated some of our upsell cycles this quarter, for existing customers wanting to deploy our expanded offerings. This extended sales cycle impacted our billings in dollar net retention in Q1.”

I like the company because they’ve really pioneered their e-signature space and are broadening their sales offering to document and contract management with that DocuSign Agreement Cloud, and I think they have a chance to either become a leader in that broader space or get taken over by one of the major document management players at a nice premium (Adobe, Salesforce or Microsoft would be the logical possibles that come to mind, though one never knows).

There are other concerns we can visualize with DocuSign, like the fact that realtors make up a lot of their customer base so they’re subject to some risk if the housing market takes a tumble, but e-signatures are a growing trend with obvious convenience advantages and better traceability, so the main risk that worries me is still competition… from those same players like Adobe who also offer their own e-signature solutions, though the specifics vary, and from smaller companies with competing offerings.

But when you’re worried about competition and big picture stuff, it’s also important to let the numbers guide you — DocuSign increased its customer count by 20% year over year, subscription revenue grew by 37%, and their net retention, in dollar terms, was 112% (meaning that their customers not only stuck around, but spent more). We don’t know for sure whether they’re taking market share, since the market is huge and changing quickly for these products, but we do know they’re doing very well.

Cash flow is also improving, so on an annualized basis DOCU now trades at about 65X free cash flow — which is not bad for a company that’s likely to grow revenue at 30-40% a year. It’s not “cheap,” of course, and some of that cash flow appeal comes from the fact that a substantial amount of employee compensation is share-based, but, well, it’s cheaper today than it was yesterday, and the stock is back down near my cost basis thanks to the ~20% drop, so I added a few shares.

This is still a small position, still speculative, still subject to competition — and it will probably remain quite volatile, like all of its richly-valued “cloud SaaS” friends, even though compared to many of them it looks like a near-bargain at “only” 8X sales… partly that’s because of the competition and the perception of the size of their end market, but I think odds are pretty good that they’ll remain in the lead, and they’re well-financed enough (with nearly a billion dollars in cash and investments) to beat out all of the smaller competitors.

Of course, that was mostly true back in November, too, and the stock traded under $40 for a while then… the momentum train has slowed for at least at moment here, and richly-valued growth stocks can certainly bounce around a lot. I’ll continue to keep an eye on my stop loss trigger for this one (that’s around $35), and if we hit that I’ll have to do some more thinking, but I added a little bit on the 20% drop in after-hours trading and am happy to put some more capital at risk in the low $40s.

*****

Five Below (FIVE) earnings came out earlier in the week, with numbers right about as expected, adjusted for some odd stuff like the new lease accounting rules, and they offered guidance for the year that was slightly lower in revenue and higher in earnings than the average analyst had been expecting — though both are within 1% of analyst estimates, so no big deal.

FIVE is still doing very well, they’re still getting decent 3%-ish same store sales growth even as they open new stores rapidly (now at 750 stores, after opening 39 in the quarter) and generally have those new stores do very well right off the bat. The stock price reflects that, which is why I took a little bit of profit earlier this year around $125, but it’s generally good to hold on to companies that have real and sustainable growth, even if they get expensive — if you were to sell FIVE because it “got too pricey” you would have also sold at $60 two years ago, or in the $80s a year ago. It’s now trading at about 39X this year’s expected earnings per share, or at a forward PE on 2020 numbers of about 32… which is definitely a rich valuation, but within the realm of rational for a stock growing earnings at 15-20% a year, as FIVE is expected to do over the next couple years.

We’re not likely to get another “surprise” growth year like 2018 when it comes to earnings, just because we’re not going to get another huge tax cut, but the continuing rapid store expansion and their brand building should keep the growth coming, and it seems like the tax increase on imports, while it will make FIVE take a hit to earnings, will not destroy the growth completely.

I think it’s likely that they’re being cautious with their forecasts given the trade environment and the uncertainty among businesses in general, so their forecasts for the year are likely to be lowball numbers if we end up with any kind of stability in the economy and/or some meaningful trade resolutions — but even so, they expect 3% same store sales growth and roughly 20% overall revenue growth, which is still pretty remarkable… and driven, again, by the fact that they’re increasing the store count by about 20% this year. Earnings per share growth is forecast by the company to be roughly 18% this year, with EPS of roughly $3.15 (roughly what analysts had been forecasting earlier this year).

If you have been looking for an opportunity in FIVE I still think it’s worth a small position if you can buy under a PEG ratio of 2.0 (PEG is price/earnings/growth rate, its a shorthand valuation tool and doesn’t mean anything definitive, but anywhere between 1-2 is widely perceived as “reasonable”), which is now right in that $120-125 range… but I don’t think we’re likely to see really dramatic “double in a year” growth from FIVE anytime soon.

I recommend checking out their conference call, the transcript is here[2]. This is what the CEO said about tariffs…

“Finally, I’d like to discuss tariffs and the increase from 10% to 25% announced in May. As a value-driven retailer, we are concerned about higher tariffs as they will be impactful to our business and lead to higher prices. With the current $250 billion of products imported from China subject to tariffs, about 15% of our total receipts for 2019 are impacted, including both directly and indirectly imported products. As we previously discussed, we were able to fully mitigate both the dollar and the margin rate impact of the 10% tariff.

“We expect to mitigate the jump to 25% and are working on a number of options to do so, including vendor negotiations, price increases on our $1 to $4 items, process efficiencies and over time, moving production to other countries. Our vendor partners have continued to support us in this process and I would like to thank them. They truly have been amazing partners. We will continue to pursue a combination of all of these as well as increasing prices on our $5 items.”

That “maybe some things will be above $5” change could create some uncertainty, though I don’t imagine tweens will freak out too much if their $5 mermaid blankets suddenly move to $5.55, but FIVE does have some pricing flexibility and they are getting slightly more efficient as they grow… and if only about 15% of their revenue is subject to the new Chinese tariffs at this point, as they indicate is the likely range, then I think they’re in pretty good shape. Expensive stocks react sharply to news, so it might be a wild summer, but FIVE has been merchandising and marketing so effectively, providing a real bright spot in a troubled retail sector and with the real potential to keep increasing the store count dramatically for at least several years, that I’m happy to remain a shareholder.

****

And as those who saw yesterday’s Trade Note and new teaser solution[3] will know, I also put on a small position in At Home (HOME), which is another expanding big-box retailer. It’s not nearly as good a company as Five Below (FIVE), to be sure, but the huge hit they took to the share price following their disastrous earnings forecast made it reasonable to nibble — the speculation is that it’s a decent value because of the current earnings, which they forecast to be in the 70 cent/share neighborhood, and there’s substantial upside if they can reignite growth after this year’s missteps (caused partly by weather, they say) and get same store sales growth back above 1% as they also expand aggressively into new markets.

As with all retailers, the end of the year will really tell the story — I don’t love the company, but they do seem to have a niche in very low-cost decor and furniture with their mega-warehouse stores, and they’re expanding the store base quickly, increasing their store count by 15% or so each year, which if the new stores are well-received (and so far they are, getting to break-even after two years) should allow them to grow revenue very quickly and gradually get the earnings back up as well. It’s a tough time to be a tight-margin retailer, both because of the tariffs and because the country remains “over-stored” in general and retailers have been hurting right and left, but my initial impression is that the beat-down was so severe, given the generally decent (though disappointing) financial performance and growth potential, that I’m willing to start to speculate here. That goes in as a 0.2% or so position in the Real Money Portfolio, including both some equity and a tiny options speculation that’s there just in case they get their act together quickly (which is a low-probability bet).

*****

We’re actually seeing a little progress in augmented reality again, though the big guys are being a lot more quiet about it these days, and the hype cycle hasn’t really restarted just yet. Google Glass 2.0 is finally being released, and technically it’s pretty similar but this time it’s a much more specifically enterprise-focused productivity tool, not the super-creepy geek chic specs that we saw trotted out a couple years ago. They look like safety glasses[4], and they have a job to do — you won’t see them out on the town, they’ll be used by workers to more productively call up hands free access to instructions, directions, checklists, and the other stuff that makes worker bees more productive and effective.

I also was reminded of a great turn of phrase from Gartner when describing adoption of new technologies, specifically Augmented Reality — this is a quote from Investors Business Daily last week[5]:

Augmented Reality In ‘Trough Of Disillusionment’
Late last year, market research firm Gartner said augmented reality technology was nearing the bottom of the “trough of disillusionment” stage of the hype cycle for emerging technologies. It had fallen from the “peak of inflated expectations.” Gartner said AR still has five to 10 years before it reaches the “plateau of productivity” stage.

I wonder if the hypester newsletter dudes will be hitting us with a “trough of disillusionment” ad sometime soon… they sure did talk up virtual reality a lot back when it was in the “peak of inflated expectations.”

That cycle is why the big guys are so often the only really successful companies in new technologies — because their massive cash flow and huge R&D budgets make it easy for Microsoft, Google, Apple and Facebook to pour a few billion dollars into developing something that’s ten years from the “plateau of productivity”… little guys don’t usually have that luxury (though Magic Leap has certainly gotten a buttload of funding over the years for their “very cool but not sure where it’s going” augmented reality technology), and usually the volume on these products is so small that even the teaser pitches about suppliers seem a little silly — particularly for products like these where most of the components are not really “special” and have been largely commoditized by much-larger-volume products. “Getting your chip into Google Glass” is not going to make or break any supplier, even a smaller one… though that doesn’t mean we won’t see overhyped teasers to that effect make the rounds again.

The first real applications for consumers are going to be in handsets, building on the sort of thing that Pokémon Go did in adding fictional characters to real spaces (the new Spider-Man movie is being marketed with an app that puts Spidey wherever you want him, too… here he is standing on my chair at Gumshoe HQ), so, hurray, we’ll all be spending more time walking around and watching an “augmented” version of the real world on our tiny screens. Technology is cool, progress has brought some amazing things to our lives, but there are plenty of things I miss about the 1980s — and “people who watch where they’re going on the sidewalk” is one of them.

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Finally, we got a little update on one of my worst investments this week. Clean TeQ (CLQ.AX, CTEQF) announced that they are “commencing a partnering process”[6] for their Sunrise project, the nickel-cobalt mine they’d like to build in Australia.

As some background, here’s why I own this stock: I got overly enthusiastic about electric vehicle battery demand, and the impact that would have on cobalt prices. That enthusiasm about the cobalt price potential meant that I failed to remember the cardinal rule of resource investing: High prices change the supply picture… and demand never grows as dramatically as the headlines expect.

And, of course, financing matters. Building a mine means sinking a huge amount of capital into a project that won’t show any return for at least a few years, and which, even if things go well, will be subject to prices that are completely outside of the operator’s control — there are very few mines of any kind that are big enough to drive the price for a specific metal, so they are price takers, not price makers.

So financiers need to either be strategic, companies who need the end product and are willing to prepay to get guaranteed access to it, or financial… and in either case, they will not typically be as rosy-eyed as investors are when it comes to assessing the value of a project or taking the feasibility study at face value. A 5% discount rate sounds reasonable to an individual investor, but if you’re tying up hundreds of millions of dollars for five or ten years then you want more room for error than that.

So… Clean TeQ’s project still looks pretty good, but the financing enthusiasm from their Chinese partners was not as overwhelmingly positive as I was imagining when I was building that position mostly through late 2017 and the first half of 2018. Now, with tariffs and trade disputes and possible China slowdown hitting most of the metals and the lower hype levels about the electric vehicle adoption rate, the hype cycle for Cobalt has really run its course and we’re left to wait and see what happens next.

But really, here’s a chart of the all-important cobalt price — over the past five years:

And it’s pretty much that simple — you can see the almost exact match to the Clean TeQ price chart:

[7]

So… lessons learned? I should have not overthought the value of the property and been as trusting of the results of the feasibility study, particularly for a project that is (still) not yet financed or under construction… and I should have either kept the position smaller as a longer-term speculation on the mine being built, or used a stop loss to lessen the impact of being “really wrong” on the portfolio. It’s not an egregious error, you have to accept the risk of loss if you’re going to speculate on stocks like these, but I let myself get too optimistic about a development-stage project.

We should keep those risks in mind with the current rare earth enthusiasm, too — we’ve been down this road with China restricting rare earth mineral exports, mostly as another inducement to get manufacturers to build their products in China instead of just source raw materials from them but also as a political stunt (as with their territorial disputes with Japan). The prices surge, junior miners get excited, and then life goes back to normal and someone starts supplying at decent prices again… or just paying a premium that Chinese suppliers can’t resist, since the raw material prices of rare earth elements are not terribly meaningful in relation to the value of the end products, whether those are missile guidance systems or iPhones.

So by all means, try to trade those ups and downs in “strategic” minerals, whether that’s cobalt or uranium or neodymium, but remember that in many cases you’re gambling on short-term political events… and on markets that are not as open as we’re used to seeing. There is no futures contract for uranium or neodymium, and many countries (and companies) have substantial strategic reserves of irreplaceable minerals that aren’t necessarily “seen” in the discussion of fluctuating supply and demand imbalances.

And next time you’re convinced of the strategic importance of a natural resource and have great certainty about where prices are going and how exciting it’s going to be, go back and read this post from Inka Kola News that was posted yesterday on Cobalt and Timing[8]. It’s about a different stock, the story-driven “Cobalt Bank and Streamer” Cobalt27 (KBLT.V, CBLLF) that was briefly a hot number at about the same time that Clean TeQ was, but Otto’s snarkiness might help you (and I) avoid being quite as dumb next time as I was with this one.

*****

Contributing to sentiment swings this week has been that big “antitrust is coming” threat for the FANG stocks, so in answer to some questions I’ve seen about that…

I think Facebook (FB) still has the most regulatory risk of that group (Facebook, Apple, Alphabet) in “regular” terms, given their influence over the spread of fraudulent ideas, hate speech and disinformation, particularly about politicians and political campaigns (the pols do not like that at all), but they are also the fuel for a lot of “real” democracy, helping to build movements and push forward the candidacies of lower-profile politicians. Probably there would have been no President Trump without Twitter and Facebook, but also no President Obama, and there would have been much less attention driven to non-national figures like Mayor Pete Buttigieg.

But Alphabet (GOOG) and Apple (AAPL) face real “old fashioned” antitrust challenges, mostly because of their control over the marketplace for mobile software — if there’s going to be an antitrust push against them (and we’re early yet, in the “investigation” phase), then it would probably be most successful first in the “App Store” arena… Apple and Google both control who can distribute apps to users of their operating systems, and they take a cut (usually a pretty large one) of any sales on those platforms.

But the “Alphabet down 7% because an antitrust investigation is being considered” move seems quite reactionary to me, and an indicator that investors are probably just a little too eager to sell stocks so they can get that little dopamine rush that you get from “doing something” in uncertain times. Action feels better than inaction, but based on the real and dominant business at Alphabet, which is by far my largest “FANG” position (and the one I’ve owned for the longest, 14 years now), I still think it’s an entirely reasonable buy in the sub-$1,050 neighborhood. If we’re going to see a real antitrust case built against Apple or Alphabet, I would expect it to take at least 5-10 years to come to any conclusion — the world has generally gotten faster since the big Microsoft antitrust takedown, but the legal world has not. Don’t panic.

*****

And another question from a reader to close things out for today (yes, I’ve got a pile of your other questions that I haven’t gotten to yet — sorry, I definitely won’t get to all of them but I’ll try to keep catching up, and you can feel free to keep asking more questions):

Reader A.T.:
Where is the best place (listing or directory or association) to research REITs or LMPs?
Thanks for a great reporting job on the “Freedom Checks” Mr Johnson

By far the best source for information about “income” investments like these, in my opinion, is QuantumOnline, a free resource for income investors that has been around for more than a decade (and looks it, but don’t let the old style fool you).

As I type this, QuantumOnline.com[9] is actually offline for some reason, hopefully it’s temporary, but they have great lists of all kinds of exchange-traded income investments, from mini-bonds to structured products to preferred shares, and also cover all the “more normal” things like REITs and MLPs, including usually some detailed information about the company and things like links to prospectuses for preferred shares and info about “call” prices and conversion rights that are often hard to quickly find elsewhere.

So if you’re interested in income investments of any kind, check it out — they have some good explanatory materials including a “Quick Start” guide[10], but it’s also worth just browsing around (assuming they get their website fixed)… and if you like it, do contribute, the site seems mostly to be a labor of love but is also funded by donations.

And with that, I’ll leave you to your weekend — please let me know if you have comments or questions on any of the above by using our happy little comment box below, and I’ll be back to blather at you again before you know it. Thanks for reading!

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