Feature interview
Cestrian Capital Research, Inc. is an SEC-registered independent equity research business publishing pro-grade work in a simple, easy-to-understand format. Cestrian Capital Research operates a premium-quality real-time service on the Seeking Alpha Marketplace. You can learn more about Growth Investor Pro, here. And you can get started with Cestrian for just $99/yr – try their Growth Investor Pro Newsletter, here. We discussed mispricings created as the fundamentals have gotten stronger the lower the stock price goes, contrarian opportunities in SPACs and how/why they combine technicals and fundamentals to gain an edge.
Seeking Alpha: Walk us through your investment decision making process. What area of the market do you focus on and what strategies do you employ?
Cestrian Capital Research: We use four steps. One, what is the overall market context at present – bullish or bearish? We use purely technical analysis to answer this question. We track the major indices and their proxy ETFs at least daily and frame our decisions within those trends. Two, sector rotation analysis. We use the main SPDR sector ETFs to try to gain some insights into which sectors are down-at-heel (i.e., relatively cheap) and which are reaching for the skies (ie. relatively expensive). In a perfect world we want to be buying in the down at heel sectors and selling names in sectors that ran up already. We have yet to execute this perfectly of course but in the last couple years we’ve had success buying defense stocks when tech was on fire, and selling defense stocks when tech swooned – and the converse, buying tech stocks early in their run-up and then selling as they reached their highs. Three, fundamental company financial analysis – we dive deep into each of the specific stocks we cover with a focus on financial statements above product stories or marketing positioning. And four, technical analysis of single-stock names. Phew!! Our ideal new long investment is: in a generally rising market, in a beaten-up sector that has started to turn up, in a company with superb revenue visibility, growth and cashflow margins, which has a stock early in a Wave 3 up. Apart from that, we’re not picky. Short? Bearish market, run-up sector, weak fundamentals, stock topped in a Wave 3 or 5 already.
SA: Can you discuss the opportunity in companies or industries that lack earnings? How should investors analyze them?
Cestrian Capital Research: It has become axiomatic that investors should now take positions solely in GAAP EPS-positive companies, because that is deemed to be a more grownup way of investing. And again, there’s nothing wrong with that per se. But most people who repeat this maxim don’t fully understand the difference between earnings per share and cashflow. There are many truly wonderful high growth companies that feature negative earnings per share but positive cashflows – positive, that is, after capex and after change in net working capital. Right now, these stocks have sold off hard – very hard, like, down 70-80% from their highs in some cases – and the best of them, the stocks attached to companies with high levels of revenue growth, large order books and order growth as a function of TTM revenue and revenue growth, offer compelling buying opportunities at present in our view. Again, this isn’t a fashionable view but then the best buying opportunities are rarely popular at the time. Just as the best selling opportunities attract scorn in the moment! The easiest EPS-negative, cashflow-positive stocks to analyze are recurring-revenue cloud software companies. A simple method is – check TTM revenue and its growth rate and compare against remaining performance obligation quantum and growth rate. If RPO is large vs. TTM revenue AND RPO growth is higher than TTM revenue growth rate then there’s a good chance that revenue growth is going to accelerate, and there’s also a good chance that a lot of folks haven’t noticed that yet. Because RPO rarely features in the press release come earnings time. Then look at the cash generation – as a simple measure you can take cashflow from operations, minus capex to give you a rough pretax FCF number. If cashflow margins are positive and trending up, and revenue growth is looking up, and you can confirm sufficient cash buffer on the balance sheet, then that is a compelling set of fundamentals. Of course you still need to lean on technicals to analyze the stock, but that’s a simple way to analyze the underlying company.
SA: Can you unpack your idea of effectively doing venture capital investing through buying speculative publicly traded stocks? What are the advantages of this approach versus traditional VC investing? Can you give an example of a “VC stock”?
Cestrian Capital Research: This is deeply unfashionable right now, because everyone’s best idea is Verizon or something (and we’re not knocking that. See our recent note on AT&T for instance!). But in amongst the grownup stocks in a portfolio we believe there is room for some higher-risk stuff and right now there are some great opportunities to buy new-to-market stocks at a way more attractive valuation than has been possible for some years. The SPAC class features a lot of froth but in amongst there – it’s less froth than rubble at present – there are some real companies with sound levels of growth and viable balance sheets. Traditional VC investing is a closed world unavailable to most, and that’s correct in our view. The risks in the asset class are colossal and very few VC firms are consistently successful. That’s not a place where in our view most retail investors should want to play. But for those who wish to dip a toe in the water, the best of the SPAC cohort offers the experience. Our top pick in that group is Spire Global, Inc (SPIR), which is one of the lowest-profile of the new space companies but which also has the strongest fundamentals. It operates a recurring revenue business model with a diverse customer base, solid gross margins, and we expect it to become cashflow positive within a couple of years. We’ve written about it extensively on Seeking Alpha – and the stock is now on sale! Remember too that VC investing usually has a decade-long timeframe – you do need to look very long term with these kinds of investments and SPIR is no different.
SA: To follow up, do you see any mispricings where the fundamentals have gotten stronger the lower the stock price goes? If so, can you give an example? What do you think are potential explanations for what seems like illogical behavior on the part of Mr. Market?
Cestrian Capital Research: A great example of this would be DataDog (DDOG). TTM revenue as of September 2021, the last reported quarter before the Nasdaq hit the skids, was growing at 67% off a prior year base of $539m. In the March 2022 quarter, reported recently following a sizeable Nasdaq selloff, TTM growth stands at 78% off a prior year base of $671m. Cashflow margins, on a TTM unlevered pretax FCF basis, have moved up from 12% to 23% in the same period. Balance sheet net cash stands at $935m vs. $733m. The stock is down some 55% off the highs struck in November. So, if you think the market is likely to move up soon – or even, you think the market may rotate capital out of say energy and into say high growth – then there’s a good chance DDOG moves up too.
Repricing isn’t really illogical in our view. It’s just a consequence of sector rotation. Why is stock X worth Y times earnings today vs. Z times earnings last year? Why were energy stocks moving up off the lows in early 2021 and why did high growth stocks sell off in Q4 2021? There’s no particular logic to it, save for everyone’s favorite kind of genius, ex post facto rationale. Cohorts move up on momentum, generate gains for shareholders, then the smarter holders liquidate those gains to recycle the capital elsewhere – either into other stocks or into other asset classes altogether. In our view it’s illogical to expect otherwise. This is why we believe investors need to use both fundamental analysis – to pick the best or worst companies to go long or short – and technical analysis – to pick prime candidate stocks to go long or short. SPY and QQQ in Q4 2021 were extended on technicals and signalled a correction – we said so loud and clear in our Growth Investor Pro service. That wasn’t obvious at all on fundamentals but it was crystal clear on technicals. And right now there is a good chance that on technicals the market can find support – despite apparently a crushing recession descending upon the world!
SA: You recently said that “multiple expansion is the easiest source of free money going” – are there any companies or industries that deserve a re-rating higher? How do you determine what the multiple should be? Are specific catalysts required for a re-rating or not?
Cestrian Capital Research: Multiple compression – a stock selling for a lower multiple of earnings today vs yesterday – is the most painful and fastest source of losses – that’s what has been happening in markets not called energy all year. Corporate earnings have mostly risen; EPS multiples mostly fallen. Multiple expansion – when EPS or EV/Revenue or EV/EBITDA or EV/cashflow multiples go up – is the opposite. That’s what gave investors most of the gains in the Q2 2020 – Q4 2021 timeframe. We don’t think it is possible to determine what the multiple for any one stock “should” be, since that judgement is always relative – to the market at large, to the stock’s peers – so again we find technical analysis is helpful here. Taking a bull scenario – if the slope of your projected stock direction is faster than the rate of earnings growth then you are assuming earnings multiple expansion. If the slope is more gradual, you are assuming multiple compression. This all helps to build a picture of where you think a stock might be headed. The major catalyst for re-rating is sentiment, which as we know is fed by all manner of things including policy, liquidity, and whether it rained in Wichita this morning or not.
SA: Are there any contrarian opportunities in SPACs given the steep sell off in the broader SPAC market? Are there any lessons learned from the previous run up (and down) in SPACs that can be applied going forward to investing in general?
Cestrian Capital Research: Spire Global (SPIR) is the standout SPAC diamond amid the rubble in our view. The lessons learned are the same as always – do your work on the fundamentals and then, separately, on the stocks. If you know that the stock you own is issued by a lightweight business, then you know you ought to sell it when risk starts coming out of the market. If you know that the underlying company is solid, growing, cash generative and likely long-lived, you know it can be a strong buy candidate when the stock is on the floor and twitching.
SA: Can you discuss the opportunities and risks of trading around earnings (particularly for a core position)? Can you give an example?
Cestrian Capital Research: We don’t do this – it’s too scary!! There are other services on Seeking Alpha who do this very well, but we aren’t one of them. We prefer longer time frames to smooth out earnings surprises, which are inevitable no matter how good the analysis beforehand.
SA: What’s one of your highest conviction ideas right now?
Cestrian Capital Research: DataDog (DDOG), for the reasons we lay out above. Great and improving fundamentals, stock way off of its highs, plenty of growth ahead in our view.
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Thanks to Cestrian Capital Research for the interview.
Cestrian Capital Research is long TQQQ DDOG SPIR
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