Brian Dress, CFA — Director of Research, Investment Advisor
When we were outlining today’s newsletter this week on Thursday, the mood was considerably different than it is now, just 24 hours later. After hawkish commentary from Federal Reserve Chairman Jay Powell, markets pulled back significantly. Looking at the Federal Funds market at the Chicago Mercantile Exchange, traders price the chance of a 0.75% hike in the Federal Funds rate in June at 92%. Sentiment has changed quickly: after a rally early in the week, markets appear poised to test the March 14 lows.
On the positive side of things, we are now immersed in the 1st quarter earnings season, where presumably markets can respond to fundamental developments in individual stocks rather than macroeconomic challenges. We have seen some wonderful earnings reports come across this week: Tesla (TSLA), IBM, Cleveland-Cliffs (CLF), while we have also had our share of earnings disasters, of which Netflix (NFLX) was the poster child this week. In this week’s newsletter, we will give you our first impressions of earnings so far and how that fits into our view of things.
Of course, at Left Brain we are long-term investors above all else. This means that we view short-term market weakness as an important opportunity to position ourselves for the next 2-3 years, as we take stock of the trends that appear to be taking shape. Market leadership certainly seems to have changed from “growth” sectors to “value” sectors, but we still look for areas where we see accelerating business results. We have mentioned in this space a number of times the so-called “barbell portfolio” as a potential strategy in a market in flux. This week we reexamine the concept and update you on how we are looking to position to respond to the developments that seem to be happening on a daily basis in this market. Look for additional color on this theme in this week’s section entitled “The Best Offense is a Good Defense.”
In this week’s “What’s Working?” and “What’s Not Working?” we note a significant skew: the size of the up moves in the good list is much smaller than the magnitude of the down moves on the “Worst Performing” list. The themes we have observed throughout 2022 certainly continued this week, as the most representative “risk-on” sectors again led to the downside. At the same time, real assets and cash flow dominated the “Best Performing” list. These are the characteristics we are favoring as we position portfolios.
As always, we provide you with our list of “What’s Working?” and “What’s Not Working?” for the most part, the trends have continued throughout all of 2022 into last week, but we also noticed a few securities that outperformed and underperformed that are bucking those tendencies.
With that all being said, let’s get into it!
Below is the performance data of key indices, ETFs for the five trading days between 4/15/22 and 4/21/22:
We note this week the clear skew between “What’s Working?” and “What’s Not Working?” In the Working list, the best performing ETFs are up 2-3% for the week, whereas in the Not Working list, we see moves of a much larger magnitude, on the order of 6-8% or worse.
In terms of what is working in the current market, we note that real assets and cash flow are the dominant themes, not much different than the rest of 2022. Among the best performing ETFs this week in our list are the oil pipeline tracking Kayne Anderson Energy Infrastructure Fund, Inc. (KYN), Tortoise Energy Infrastructure (TYG), and ClearBridge MLP and Midstream Fund Inc (CEM). Despite the fact that oil prices were down slightly, oil-related stocks continued to perform well. This strong performance of oil service type equities was buoyed in Friday’s session by the strength in Schlumberger (SLB), an worldwide oil service leader, which announced impressive earnings and a dividend increase Thursday after the bell.
Investors appear to be looking for something they can count on, so are looking to “safer” sectors with cash flow and exposure to real assets. We saw that in sharp relief this week, considering the relative strength of The Real Estate Select Sector SPDR Fund (XLRE) and ALPS Sector Dividend Dogs ETF (SDOG). These are themes that we have covered extensively throughout 2022.
Finally, we saw some bargain shopping in a very limited form this week. Two of the sectors that have struggled the most over the past few weeks showed up on “What’s Working” this week: iShares Transportation Average ETF (IYT) and SPDR S&P Homebuilders ETF (XHB). Though we are mindful of the challenges the homebuilders face (higher mortgage rates, rising prices of inputs), we continue to be intrigued by the sector’s potential in the context of a clear tight supply in housing in the US. We are not yet taking a position, but will continue to monitor.
What is not Working?
The message in this section is simple: “risk on” sectors continue to lag the overall market. For those of you who have been following us in 2022, you will know that this is no departure from the trends we have been mentioning since the year began. Clearly, companies that are in the pre-profit stage are very out of favor.
The worst performing ETF in our list this week was the KraneShares CSI China Internet ETF (KWEB), which lost more than 11% in value. KWEB was followed closely by Invesco Solar ETF (TAN), ARK Innovation ETF (ARKK), Renaissance IPO ETF (IPO), and SPDR S&P Biotech ETF (XBI).
Since the local bottom in the NASDAQ Composite on March 14, it appeared that growth shares were beginning to find their footing. The optimism that developed in the weeks since mid-March appears to have evaporated and tech shares appear poised to test those lows yet again. We would continue to urge caution in “risk on” stocks.
Earnings Season: a Few Good, One Really Bad
We began earnings last week with a number of financial companies. Things were mixed there, with JP Morgan (JPM) and Wells Fargo (WFC) shares slipping after warning investors of potential credit losses later in 2022.
We had quite a few earnings results come in this week, but we will concentrate on a handful that we think investors should review. The first important earnings report that we reviewed this week came from Netflix (NFLX). Analysts had expected subscriber growth to continue for the streaming giant, but were disappointed when the company announced that it had actually lost some 200,000 subscribers over the 1st quarter and expects to lose yet another 2 million subscribers in the 2nd quarter.
It is clear that the competitive pressures of the streaming business are starting to wear on Netflix, causing both a loss in subscribers and also forcing the company to spend additional money to reduce customer churn. Netflix is the poster child for what happens to shares of a growth company when growth slows/reverses: the punishment can be swift and painful. Take a look at the six-month chart of NFLX below. The last two earnings reports are denoted by the ovals we’ve placed on the chart. Growth stocks like NFLX are getting smashed when earnings disappoint:
We saw three other earnings reports of note this week. The first was Tesla (TSLA). In a world where growth stocks appear to be serial disappointers, Tesla was something of a light in the darkness. Tesla delivered $3.7 billion in adjusted profit, far in excess of the $2.6 billion that was expected by analysts. Supply chain issues appear to be dogging companies in any number of industries, but Tesla has been able to use its engineering acumen to devise ways to cope with issues sourcing inputs.
Tesla’s revenue came in at $18.8 billion, implying a yearly growth rate of 81%. With the size of Tesla, the ability to sustain such incredible growth rates is eminently impressive. CEO Elon Musk reiterated his expectation that Tesla can maintain a growth rate of 50% “for the foreseeable future.” Given the continued outperformance from a business point of view here, Tesla is one of the few growth companies in which we still have conviction.
Beyond the well-known reports of NFLX and TSLA, we received a positive earnings report from an “old school tech” name: International Business Machines Corporation (IBM). IBM announced better than expected earnings on Tuesday after the close, buoyed by growth in the consulting and cloud computing businesses. IBM shares are actually down 9% on a 5-year basis, as investors have basically left this stock for dead, considering it no longer on the cutting edge in the world of technology. As a result, the stock seems to be benefiting from relatively low expectations when compared to other technology businesses. In the current market environment, this may be the type of business investors should consider: a modest grower with consistent cash flow generating capabilities.
The Best Offense is a Good Defense: Barbell Portfolio
We have been proponents of the barbell portfolio this year. As a reminder of what we mean by “barbell,” we mean an approach where an investor concentrates much of the portfolio in “value” sectors with strong cash flow characteristics, along with a handful of growth stocks to give investors upside exposure, should the markets bottom and begin performing again.
Investors face a clear dilemma here. The financial markets, both stocks and bonds, have been weak in 2022, but significant inflation means that holding cash is also unattractive, with its purchasing power continuing to diminish every day. Defensive sectors have been the best performers so far this year and we think it makes sense for investors to consider allocating funds in these areas. Often when investments outperform in the first quarter of any given year, they tend to follow through from the remainder of the year. We are leaning into this phenomenon and continuing to concentrate our research efforts in the sectors which are working.
Among the market sectors that have outperformed this year where we remain overweight are areas where cash flow is consistent and macroeconomic trends are tailwinds to the businesses. Among these are oil pipelines, oil exploration and production, metals/mining, materials, consumer staples, insurance of all types, but particularly health insurance and property and casualty, and overall healthcare. The thread that runs through all of these businesses is that their customers are not particularly price-sensitive and their products are non-discretionary.
As regards the growth side of the barbell, it is difficult to pinpoint areas where we want to concentrate. One particular area we think it makes sense to allocate from the growth perspective is cybersecurity. Again, cybersecurity is a non-discretionary expense for both corporate and individual customers. Beyond this, the threat continues to grow, so the markets here do provide investors some potential revenue growth. Outside of cybersecurity, we remain cautious in anything related to technology or communication services. We still like serial compounders like Tesla, but admittedly, it’s slim pickings in growth right now. In short, we are skewing the barbell to the defensive side of things until growth finds a bottom.
Takeaways from this Week
This week earnings came into full swing. We saw another disappointing earnings report from Netflix that spooked investors, along with the continued hawkish tone out of the Fed. Earnings weren’t all bad, as Tesla and IBM beat expectations comfortably. We continue to see a separation between earlier-stage companies with no profits and more mature companies that consistently deliver cash flow. That difference informs the way we want to position.
Using a basketball analogy during the NBA Playoff season, we think the best way for investors to play offense is to have a strong defense. We remain bullish on “old economy” sectors that generate cash, while remaining cautious on “growth” sectors and companies that are users of cash and not yet profitable. We continue to look for ways to maintain some weight on the “growth” side of the barbell portfolio, but we remain generally cautious in terms of technology, communications services, and consumer retail.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.