TMT: Portfolio Update – Sooner, or Later?

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TMT: Portfolio Update – Sooner, or Later?

We sorted a universe of 67 large cap TMT stocks based on the 5-year cash flow growth projected by consensus, and the percentage of EV represented by the implied 5th year terminal value. Arrayed on these axes, the companies fall into 4 distinct quartiles: 1) Fast growing, high terminal value “Dream Stocks”, where investors are betting on long-term leadership; 2) Fast growing, low terminal value “Skepticism Stocks”, where investors expect current luster to fade; 3) Slow growing, high terminal value “Comeback Stocks”, where investors believe set-backs are temporary; and 4) Slow growing, low terminal value “Death Watch Stocks”, where investors have little faith in long-term viability. With our firm belief in thematic TMT investing, the majority of our large cap model portfolio is squarely in category 1, where stocks like NFLX, AMZN, and TWTR are expected to grow into their valuations. MSFT and STX are our “Death Watch” representatives – we believe both will deliver substantial future growth not reflected in their valuations. Names like AAPL, INTC and portfolio pick QCOM inhabit quadrant 2 – this quartile can be intriguing IF results and news flow can break the deep investor skepticism over their long-term sustainability. We are most negative about the “Comeback Stocks”, generally erstwhile leaders like IBM and HPQ, where the modest enthusiasm seems misplaced and the risk skewed to the downside. However, we are adding FIS from group 2 to the portfolio, replacing IACI, as we believe mobile payments could drive significant near term upside. In small cap, we are adding RKUS, and FUEL, replacing the recently acquired OPEN and the volatile 3D printing name XONE.

TMT valuations reflect expectations driven by themes. Valuation metrics have been poor predictors of TMT performance – expensive stocks often grow into their valuations, while cheap ones often get cheaper or fail. Still, in the context of a thematic investing approach, valuation can shed insight into the sentiment behind individual names. We built a model to sort a universe of 70 large cap TMT stocks based on consensus 5-year cash flow projections and the percentage of enterprise value represented by the 5th year terminal value implied by the current share price, metrics intended to represent the short term and long term growth expectations of the market.

“Dream Stocks” must keep investors believing. We have labeled the quadrant characterized by high growth expectations for both the short and long term as “Dream Stocks”. These are the companies that are believed to be the long term leaders in the emerging cloud/mobile era – names like GOOG, NFLX, AMZN, FB, CRM, and WDAY reside here. Typically, investments in this category work, as long as that belief of long-term dominance remains intact. Unexpected signs of competitive rivalry or other business model deterioration are treated far more harshly than short term sales or EPS fluctuations. While these stocks are maddening to value investors, they are analogous to DELL, CSCO, MSFT, and INTC during the heyday of the PC era. Half of our large cap model portfolio comes from this category.

“Death Watch” stocks must overcome deep investor biases. The “Death Watch” quadrant is the group of stocks with low expectations in both the short and long term. These companies are often value traps with little prospect for reversing decelerating earnings. Today, the “Death Watch” includes PC era leaders like ORCL, EMC, and CSCO, where we largely concur with the negative implications of their valuations. However, the “Death Watch” also includes stocks, like MSFT, STX, and WDC, where neither short term nor long term expectations reflect the real growth potential. If we are correct, these names could show significant appreciation as results belie the market bias.

Investors do not believe that “Skepticism Stocks” can sustain near term momentum. Stocks that sport strong consensus short term FCF growth, but modest terminal values reflect low investor confidence that current success can be sustained. This quadrant contains stalwarts like AAPL, INTC, VMW, GLW, and EBAY. In each case, the size of the company, the emergence of disruptive competitors, and the lack of compelling new paradigm growth narratives tempers investor enthusiasm. These stocks may continue to underperform their near term performance unless they can reestablish their growth bona fides with new product initiatives and/or substantial upside revenue surprises. Otherwise, strong results by these companies may go unrewarded, much as MSFT remained “cheap” during its post-Gates decade of slow growth and high cash flows. Our pick from this group is QCOM, which we believe can extend outside of its high end smartphone chipset stronghold.

“Comeback Stocks” often reflect unwarranted investor optimism. The 4th category holds stocks with dismal short term expectations but high implied long-term value. Here we find a smattering of cyclical, like LLTC, TXN and AMAT, where a substantial future turnabout is sensible, but also old-line IT names, like IBM, HPQ, XRX, ADP and PAYX, where recovery is a substantial stretch. These stocks are amongst the most vulnerable in the TMT universe, as unless near term cash flows can surprise significantly to the upside, it is almost certain that the implicit long term expectations will have to contract.  Eventually, we expect most to be excellent candidates for short side investments. We currently have no stocks from this quadrant in our model portfolio.

Adjusting our model portfolios. Performance in the large cap portfolio was poor for the past 3 months, driven by the significant downturn in internet stocks, such as TWTR and DATA, which didn’t really reverse until later in the quarter. We are removing IACI, which is losing relevance as an acquisition target, in favor of FIS, which we believe is ideally placed to profit from the early rise of mobile payments programs. In contrast, our small cap portfolio performed well in the quarter, driven by OPEN, SYNA and XONE. We are replacing OPEN, which recently agreed to acquisition by PCLN, and XONE, which has been extremely volatile. We are adding RKUS, which stands to benefit from accelerating demand for public WiFi, and FUEL, an intriguing ad tech company that uses big data to facilitate programmatic ad buying.

For our full research notes, please visit our published research site.

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