TMT Model Portfolio Update: The Skeptics Guide

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We assessed the valuations of 188 large cap TMT stocks, using our proprietary framework, which separates EV into near term and long term components. Graphed on these axes, the names fall into quadrants with interesting implications for trading. Historically, “Dream” stocks, with strong expectations both short and long term have tended to outperform, while performance by the other quadrants has been mixed. This quarter, we are taking a closer look at the “skepticism” quadrant – i.e. stocks with above average expected 5-yr cash flow growth, but with implicit 5th yr terminal values representing <80% of the total EV. Skepticism stocks are fighting narratives of long term risk that does not preclude strong near term result. While performance in recent quarters has been strong, these companies still must deliver evidence sufficient to change investor biases beyond meeting immediate expectations. This quarter, there are 42 skepticism stocks – semiconductor names are the most prevalent, followed by enterprise software, Internet and hardware. Of these stocks, we believe that GOOG and GRUB have particular potential to change their investor narrative and break out, and have included them in our large cap model portfolio. Both large cap and small cap model portfolios performed well over the past quarter, beating the tech elements of their respective benchmarks by 90 and 120bp respectively. We are removing AAPL and FIS from our large cap portfolio, adding DIS and ADBE. In our small cap portfolio, we are replacing QLYS and OPWR with TNET and VEEV.

“Dream” stocks have outperformed. Applying our framework, which separates EV into short term and long term components, shows that over the past three years, Dream stocks, with strong near term consensus expectations and implied terminal values, tended to outperform. The other three categories have been volatile, with the Skepticism sector (ST strong/LT weak) largely outperforming and Comeback (LT strong/ST weak) sector underperforming over the past 18 months. The Death Watch cohort has been particularly volatile, with spectacular appreciation in 2013 offsetting otherwise poor performance. This is due to the influence of a handful of stocks – AAPL, AVGO, BRCM, CSCO and EA – which delivered unexpected gains after residing in the quadrant during that time.

Skepticism gaining momentum. Based on 12 month returns, the Skepticism quadrant has gone from being a poor bet, prior to mid-2013, to being a relatively good one. These stocks typically must counter negative investor narratives before they can rerate. Today, 16 of 42 Skepticism names are semiconductor vendors, with 3 more from semi cap equipment and fab services, arguably, suggesting that investors are looking past a near term cyclical peak. 12 companies are in enterprise SW and services, most selling on-premises solutions at risk to the cloud. ADBE and ADSK stand out as on their way to a SaaS future. Consumer internet names are also well represented – GRUB, YELP, PCLN, P, and GRPN joining GOOG, the company that is often cited as the primary threat to the others in the category.

GOOG stands out as the opportunity in the quadrant. Despite expectations for 20% annual cash flow growth over the next 5 yrs., less than 2/3rds of GOOG’s EV is in its terminal value, putting in the bottom 20% of the large cap TNT universe. A narrative suggesting that the company’s search franchise is seriously threatened by mobile apps has gained hold with investors, miring it in the Skepticism quadrant for every period of our analyses. We believe GOOG’s coming initiatives to orchestrate value in mobile commerce and its emerging strength in IaaS hosting can counter the bearish story and catalyze a rerating, while the likelihood of continued growth in the near term protects to the downside.

ADBE and ADSK are intriguing. In our recent work on SaaS application software, we noted that ADBE and ADSK had proactively moved to cloud-focused strategies that exploit falling prices for IaaS hosting from AMZN, MSFT and GOOG. The appearance of both stocks in the Skepticism quadrant suggests that investors have not yet embraced the new narrative, pricing them with obviously cloud threatened SW players such as VMW and RHT. Similarly, we believe food delivery leader GRUB has a far more defensible position vs. feared future competition from Uber, AMZN and GOOG, than do other consumer Internet names in Skepticism, such as YELP, PCLN, P, and GRPN.

The Large Cap Model Portfolio beat its benchmarks and its time to remove AAPL. Our Large Cap Portfolio was up 210bp since our last update on Feb 23, 61bp above the tech components of the S&P500. NFLX, DATA, TMUS, AMZN and MSFT were particularly strong performers, offsetting disappointing performance from TWTR, WDAY, WDC and CCI. We are removing AAPL, which has appreciated nearly 24% since we added it last October. While we expect another blow out for June, the blasé reaction to the big upside surprise in March earnings suggests that investors are already fixated on the extraordinarily difficult compare that the company faces in December. We are also removing FIS to avoid confusion with our Financials franchise. This should not be construed as a change of heart on the stock.

Adding DIS and ADBE. DIS has delivered exceptional execution in developing content and managing its parks division. With a well-planned slate of movies, TV programming, and consumer products tied to tent-pole franchises like Marvel, StarWars, Pixar, and Frozen, we believe its current position in the Dream quadrant is well justified. ADBE, as mentioned above, has reinvented itself as a leader in SaaS subscription software and is well-positioned to defend and extend its leadership in the cloud era.

The Small Cap Model Portfolio returned to strong performance. Our Small Cap Portfolio was up 380bp from February, vs. a 130bp rise in the S&P 600 and a 240bp increase in its tech components. OLED, RENT, and HUBS contributed to the outperformance. The latter two names were also recent additions in February. On the flipside, we saw sharp declines in OPWR, QLYS, and SMCI. We are removing OPWR and QLYS, both of which screened poorly in our recent research on SaaS application software, which assessed 43 SaaS names based on the potential of their applications, the efficiency of their operations, and the flexibility of their infrastructure approach. In their place, we are adding two stocks that screened well on all three of the criteria in our research framework – TNET and VEEV. We note that portfolio constituent HUBS also excelled on all three criteria.

Please see our published research page for the full note.

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