Fountainheadinvesting

Fountainhead Investing

  • Objective Analysis: Research On High Quality Companies With Sustainable Moats
  • Tech Focused: 60% Allocated To AI, Semiconductors, Technology

5 Star Tech Analyst Focused On Excellent Companies With Sustainable Moats

Categories
Market Outlook

The Macro Approach And Historic Valuations;. Are We Overpriced?

Top down-market strategy is relevant and sometimes essential when you want to compare the S&P 500 against historical benchmarks. I did this in a series of articles for Seeking Alpha from Dec 2022 to June 2023 and spoke about the same things that market outlook strategists do – historical valuations, poor market breadth, interest rate correlations, smaller categories dominating, and future earnings being misleading especially when they start to falter. I still pretty much look at the macro backdrop every week even now, but it’s a great backdrop, an important framework and benchmark but not a primary factor or thesis for making individual stock decisions. I stopped doing the market outlook top-down series a while ago, when I realized I should get back to my roots and focus on fundamentals getting into the weeds, rather than trying to get better returns by forecasting market direction. As an example, in April-June 2023, I was trying to predict a 3-5 % correction in the S&P 500 when the AI revolution was happening in companies like Microsoft and Nvidia right before my eyes, again ironic because my first article recommending Nvidia was in October 2022.

And that’s been the story for the better part of 3 decades – more success in fundamentals than macro/market direction and technical analysis.

There are several bearish top down-market prognosticators talking about the overpricing of the current market with equally good rebuttals from the bull camp – the correlation with the Nifty Fifty gets the most pushback as does with the 1999 internet bust. There is the concern about poor market breadth with tech stocks hogging too much of market cap and profits, with the rebuttal being the GFC peak. In the 2007-2008 Great Financial Crisis bust, the financial sector had the highest concentration of the S&P 500; financials are typically cyclical with P/E’s rarely exceeding 12-14, and then they were at 20, with expectations of 25% growth, their debt-to-equity ratios were like 33:1 That was an example of ABSURD overpricing! 

The point is – it is extremely difficult to compare and predict the bull market euphoria peaks, and to a great extent that time is better spent getting into the weeds of individual stocks and also using the macro backdrop as a variable but not the prime one. Also, how are we going to make better returns trying to time the S&P 500, through downturns or predicting bubbles?

A great company bought at a good price will also go through a drop when the market turns bad – sometimes only because the sentiment has turned and more often on its own demerits and reduction in earnings power, often we’ve overpaid or not taken profits when the going was good. There is no escaping the inevitable downturn, and we try our best to mitigate it. Profit taking is important, not chasing momentum is important; Not overpaying is equally important. Buying quality companies is very, very important. Diversification is important, I do want to have less tech or AI stocks and am always looking out for good ones in other sectors, without getting into value traps just because they’re cheap. There are a bunch of strategists who’re advising buying the Russell 2000 as a de-risking strategy because the gap between the valuations of the Russell 2000 and the Nasdaq 100 is the widest in decades. There is some merit in that, but de-risking is a strange way to put it, because by definition the Russell 2000 has the biggest loss making stocks with the highest earnings risk, and the highest weighting in it is the overpriced SuperMicro (SMCI)!

In terms of macro strategy, I like using the FactSet S&P 500 monthly earnings report, which I follow for the broader Price/ Earnings multiple, earnings and earnings growth. In my opinion, the market is overpriced by about 10% for sure, the last decade’s P/E ratio was about 18-19, we’re at 21 now, with the Index at 5,100 / $245 earning per share. 

If you look at the earnings yield of the S&P 500 it is $245 per share / index of 5,100 = 4.8%. The first question you would ask is why am I investing in the market when the 10-year risk free treasury gives me 4.4%, what, am I getting only 0.4% extra for the extra risk?? The historical risk premium in the last two decades has been closer to 1.5%. Even though I ran the numbers from 1962 the other decades have their own idiosyncratic reasons and are not comparable.

In late December 2023, early Jan 2024, I did expect the 10-year treasury interest rates to stay range bound between 3.75% to 4%, with a downward trend moving to 3.25 to 3.5% by the end of 2024, equating to a risk premium of about 1% – given the AI euphoria I wasn’t expecting anything better, and markets do tend to lead, always expecting better times. That hasn’t happened and we’re instead at 4.4% today, which has put a cap on the index and rightly so.

Bottom line – We are slightly overbought and likely to see sluggishness in the index and that reinforces my focus on still finding great companies at bargains, bargains are even more important now.

Categories
Market Outlook

The 2% Fed Neutral Rate target Is a myth

The 2% Fed target is a myth and highly unlikely to be achieved. Historical CPI has been closer to 3%, and given the move away from globalization, and China decoupling in the past 3-4 years, that era of persistent disinflation is likely to be over. You saw Japan’s move.

That said – At least, I believe that beyond a certain point Fed induced higher interest rates will not name inflation, a lot of US inflation is fiscal, not monetary, the Feds know that and will cut for sure as insurance – nobody wants to derail the economy. I still think the three cuts of 25% each in 2024 are achievable. But to your point, yes, I don’t think we’ll go below a 3.5% treasury for a long, long time. I agree with energy stocks doing better in 2024, they will take up more space in the index. 

Categories
Market Outlook

Payrolls Report For March 2024

The much-awaited payrolls report is out

Strong numbers, up 303,000 much higher than consensus estimates of 212,000

Wage growth, 0.03 MoM, +4.1% annual, as estimated.

The unemployment rate inched down to 3.8% from 3.9%. Economists, on average, had expected the jobless rate to hold steady at 3.9%. Labor force participation rate of 62.7% vs. 62.6% consensus and 62.5% prior. This is a good sign.

Treasuries yields are at 4.37% up 7 basis points – expectations of rate cuts fade.

S&P Futures up 0.4%

Nasdaq Composite up 0.49%

The past few days there was a lot of consternation in the market, with reports about Fed cuts delayed or as one Fed Gov, Neal Kashkari suggested yesterday

The markets had fallen the last three days and looks stable at least for now. 

Categories
Healthcare

Humana: A Healthcare Giant Facing Challenges but Offering Long-Term Value

Humana (HUM) $302

Humana has fallen 40% in the past year to $302, after lower guidance and missing estimates, and 14% today, after a lower than expected reimbursement rate from Medicare Advantage, where it is the second largest player. Losses have extended to major players like United Health as well.

Revenue projections for the next three years on lower MA payments are already down to low single digits 2-4%.

However, Humana has better operations than most, better cost control and profit margins while low, are still better than other providers. It should have better growth in 2025, and consensus estimates are calling for $24 earnings per share and mid twenties earnings growth from such a low base. Most of this is already in the price.

That said, it is a $112Bn giant, and given how regulated this industry is and how difficult it is to make money, entrenched players like it will survive and recover, but expect 2024 to be volatile, there could be further misses.

It’s worth buying in the $270-$280 range, or starting and accumulating on dips. There is value at the current multiple of only 12x 2025 earnings of $24. It’s below their historical multiple of 15-16.

Returns should be muted though, it’s a healthcare company after all, but the discount should help get over 10% per year, including dividends over the next few years.

Categories
Stocks

 Solventum Has No Revenue Growth Prospects

Solventum (SOLV) $67

The valuation is reasonable, the price to sales ratio is just 1.5x with a $12Bn Market Cap and $8.2Bn in sales.

Solid profit-making company with 25% operating margins and an EPS of $6.25, which gives it a decent multiple of 67/6.25 or just 11 – this is a discount to comparable health companies for sure.

The big problem is the lack of revenue growth, Solventum has been struggling at $8.2MBn in sales for the last three years, and even post spin-off is guiding to zero growth. That is also a bit difficult to swallow with all their segments – MedSurg, dental, health information and drinking water filtration, having 4-6% annual growth opportunities. There seems to be an execution problem.

Pre-spin off this was a well-entrenched 70 year business within 100,000 global customers, with presence in 75% of US hospitals and 50% international sales

3M has saddled it with $7.7Bn of debt so there is an interest burden of $400Mn which will dent profitability, till they reduce it in the next two three years.

The low valuation is definitely interesting, but we don’t want to walk into a value trap, where the stock just stagnates because of zero growth. Right now, there needs to be better execution or at least a strategic plan to start growing again. 

It might make sense to buy a small quantity to take advantage of the low valuation and then add more with better growth visibility.

Categories
Enterprise Software

Long-Term Investment Opportunity: Solid Cash Flow, Strong Margins, and Growth Potential in Cloud Storage

Solid company with big improvements in cash flow and gross margins in the past few years. Revenue growth has slowed to 15-16%, and shouldn’t grow much faster in the next three years. Renewals have been good and they have a decent pipeline with two possible upsides from customers either moving from VMware after Broadcom acquired it, and a strategic tie up with Cisco, that should help business growth.

There are ample opportunities in cloud storage though it is competitive, it’s a growing market with all the datacenter spend right now.

The stock has already moved up 149% in the past year, so that could restrict upside gains. Valuation is OK with 7x sales and 16% growth, a bit on the higher side, Buy on declines or Dollar Cost Average, this is a good long term investment.

Categories
Enterprise Software

Adobe: A Strong Franchise Facing Valuation Challenges Amid Slowing Growth

Adobe (ADBE) – $506

It has strong defensible franchises, great branding and leadership. Very profitable in all its segments with operating margins in excess of 30%.

The threat of AI replacing some of the video editing and other products is still in its infancy and Adobe is also working on its own AI initiatives; they’ve just been slow to roll it out.

Revenue growth has slowed to 10-12% for the next three years, and management did disappoint for the next quarter’s guidance. However, Adobe is also a good earnings story with 13-14% earnings growth.

The only problem is the valuation, and the market perception that this is a mature company with $20Bn in revenue. At 28x earnings and 10.5x sales there’s not much left for appreciation with that slowing growth.

I would prefer to buy on declines at around $470. At $506 I would expect a return of about 12% or so a year.

Categories
Semiconductors

Marvell Technology: Positioned for AI Growth but Priced for Perfection

Marvell Technology (MRVL) $74

Networking infrastructure – It had a down year, with cyclicality in China and slower data center growth. China is about 50% of revenues.

That said, the forecast for the next three years is good, with 24% revenue growth and 35 to 40% adjusted earnings growth. 

A lot of this is riding on growth from Nvidia and other AI investments in data centers. 

Like most companies in the sector Marvell has also appreciated 73% in the past year so valuations are a bit expensive, 11x sales, with cyclicality and China exposure, it’s definitely on the higher side. It has also financed its acquisitions with debt, carrying a lot of interest burden.

I would prefer to buy 10% lower in the mid sixties for a better return – there is an AI event on April 11th, which may have more specifics/catalysts. Will keep a look out for that.

Categories
Market Outlook

Fed’s Preferred Inflation Gauge Eases in February, Matching Expectations

Fed’s preferred inflation gauge subsides, in line with consensus, in February

Core PCE Price Index, which excludes food and energy, rose 0.3% M/M in February vs. +0.3% consensus and 0.5% prior (revised from +0.4%).

On a year-over-year basis, core PCE increased 2.8% Y/Y, compared with the +2.8% consensus and +2.9% prior (revised from 2.8%).

Including food and energy prices, the PCE Price Index grew 0.3% M/M, less than the +0.4% expected and slowing from +0.4% in January (revised from +0.3%).

Prices for goods rose by 0.5%, bolstered by energy prices, and prices for services rose 0.3%. Food prices edged up 0.1%, while energy prices jumped 2.3% during the month.

2.5% Y/Y vs. +2.5% expected and +2.4% prior.

Personal income increased less than expected, up 0.3% M/M vs. +0.4% expected and +1.0% prior, the U.S. Commerce Department said on Friday.

Personal outlays climbed 0.8% M/M, exceeding the +0.5% expected and accelerating from +0.2% in January.

Real disposable income, which is adjusted for inflation, declined 0.1% M/M in February, while real personal consumption expenditures increased 0.4%.

Categories
Leisure

Disney’s Rebound: A Hold for Steady Returns, but Limited Upside

Disney (DIS) $122 Hold

Disney bounced back strongly in the last 12 months gaining 28% and 50% from its October now, a commendable rise reflecting the efforts of management to turn it around.

Going forward total revenues should be muted around 4 to 5% after the last three years gain of 8%. Entertainment and sports are slow growers, theme parks grew a lot after the pandemic ended, but won’t have that tailwind on a higher base.

Streaming while plateauing in the US will grow abroad, but the sluggish growth will not allow for major price increases. Besides Netflix and Prime, they should be the 3rd survivor, WSJ research indicated that there was resistance beyond 3 subscriptions per home.

Disney used to have over 20% operating margins, now they are like 10-11%, ESPN weakness, theme park shutdowns during the pandemic and all the expense of streaming really killed margins, but they are turning it around and the Dec quarter showed improvement.

Earnings will grow around 13% –  that’s the biggest positive, the brand value is tremendous and Disney will carry a premium multiple.

Valuation – Disney is already priced at 26x earnings, twice its growth rate, mainly because of the 28% gain in the past year. I would expect at least a 22-24 multiple of FY 2027 earnings of $7- that’s about $160-$170 per share, three years out, that’s a 10% return per year from the current price.

A good hold if 10% a year is good enough, I wouldn’t add more unless there is a major drop in price or a big improvement in strategy.