January’s Market Rally Consistent with Northlake’s Favored Strategies

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The stock market is off to a great start in 2023 in line with Northlake’s Market Outlook anticipating more volatility, avoidance of a severe recession, and positive returns in 2023.  We are encouraged that our models, favored themes, and individual stocks are off to a good start.

Our Market Cap model favors mid cap again this month after shifting from large cap to mid cap (MDY) to start the year.  The Style model remains neutral between growth (IWF) and value (IWD).  The shift to mid cap looks good so far as small and mid cap outperformed large cap in January.  The expansion in market breadth to companies of all sizes is also evident in strong returns for both growth and value so far this year.  In our thematic strategies that do not use our models, we have maintained a modest bias toward value and small/mid cap and we continue to believe that is the best approach.  Our outlook for a mild recession at worst accompanied by an end to Fed tightening in the spring supports continued good performance from these themes.  We also maintain exposure to international equities across many client strategies.  Intentional performed relatively well last year with performance accelerating in the fourth quarter and continuing in January.  A weaker dollar is now joined by China’s COVID reopening as bullish underpinnings for international equity performance.

Northlake’s individual stock portfolio is off to a good start this year, with earnings reports still due from most of our holdings.  Disney (DIS) and Meta Platforms (META) are each up 24% this year as they rebound from awful performance in 2022.  Neither has reported 4Q22 earnings.  Nexstar (NXST), Sony (SONY), and Comcast (CMCSA) are up between 15% and 18%.  Only CMCSA reported earnings and we sold the shares shortly thereafter.  Part One of our 4Q22 earnings review blog post discussed the sale of Comcast.  Alphabet (GOOG/GOOGL), Apple (AAPL), and T Mobile USA (TMUS) are up 8-10% in 2023.  TMUS reported good 4Q22 results and initiated solid 2023 guidance.  AAPL and GOOGL report this week.  IBM (IBM), Home Depot (HD), and Walmart (WMT) have lagged with IBM selling off after a mixed 4Q22 report.  More comments on IBM can also be found in our Part One 4Q22 blog post.  Home Depot and Walmart report later in February.

MDY, IWF, IWD, DIS, META, NXST, SONY, GOOG/GOOGL, AAPL, TMUS, IBM, HD and WMT are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov.

4Q22 Earnings Updates: Part One – IBM, TMUS, and CMCSA Sale

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IBM (IBM): IBM reported mixed 4Q22 results that were not good enough to support the stock in the near-term or bad enough to derail Northlake’s bullish long-term thesis.  Revenue came in above expectations, which for us is the key component in the bull case.  IBM has not shown consistent growth for a long time.  The company is growing under the new CEO thanks to the timely acquisition of Red Hat opening up a growth opportunity in cloud services.  Management also completed the divestiture of its lowest-growth businesses last year.  New guidance calls for mid-single-digit revenue growth and the last several quarters have been right on target, including the just announced 4Q22.  If IBM consistently grows at a mid-single-digit rate, the P-E multiple for the stock can expand from its current discounted level of 14X 2023 estimates.  The stock performed well in 2022, rising 5% against declines of 18% to 33% for major stock market averages as investors began to believe in the company’s return to growth.  IBM shares also pay a dividend yielding roughly 5%, so the total return in 2022 was nearly 10%.  One thing about success on Wall Street is that it raises the expectations bar.  In 4Q22, IBM fell short of expectations for free cash flow, lacked profit margin upside despite the incremental revenue growth, and guided 2023 revenue and cash flow to the low end of previously announced ranges.  These factors led to the stock declining about 8% since the report.  Pressure is on IBM to achieve the new guidance amid a softer macroeconomic environment that could limit enterprise spending on technology.  Northlake takes solace in strong revenue growth in recent quarters and expects 2023 results to support our bullish outlook. Our price target is now $155 based on 2024 estimates that assume two years of mid-single-digit earnings growth.  Including the dividend, this would provide a double-digit annual return in the shares.

T-Mobile USA (TMUS): TMUS preannounced subscriber metrics that were better than expected leaving quarterly financial results and an update to 2023 guidance for the 4Q22 earnings report.  As usual, the company reported good quarterly results.  Guidance was positive but could have been a little better.  TMUS has a long history of initiating conservative but positive annual guidance and then beating and raising guidance as the year goes on.  2023 guidance was introduced in 2021 when the company’s acquisition of Sprint closed.  Amazingly, despite stiff competition, slowing mobile phone subscriber growth, and a slowing economy, TMUS updated guidance for 2023 is unchanged.  When the 4Q22 report was released, the all-important free cash flow guidance looked a little light, but management explained some one-time items and guidance assumptions that reassured investors.  One issue that came up on the call was the fact that Softbank, a major backer of Sprint and TMUS over the years, receives additional TMUS shares if the stock crosses $150.  This fact is well known and it seems as though it has kept the stock from breaking through $150 despite all the good news over the past year.  TMUS indicated they talk regularly with Softbank and that while no transaction is currently close, it is possible that something will be done.  Softbank appears unwilling to sell at $150 which is supportive of our bullish view on the shares.  We are making no changes to our valuation model on TMUS after the latest earnings report.  We see upside to at least $170 based on EBITDA, free cash flow, and the company’s massive stock buyback.  The primary risk is an industry slowdown in new mobile phone subscribers that creates even more intense competition.  TMUS is best positioned to weather this potential headwind with the biggest and most advanced 5G network and lowest cost mobile phone plans.

Comcast (CMCSA): Nine years after Northlake’s initial purchase of CMCSA, we sold all the shares held for clients after the company reported 4Q22 results.  The earnings report was in line with expectations and not the direct cause of the decision to sell.  We have noted in previous blogs that we were growing impatient with Comcast as growth slowed in its broadband internet and TV networks business. The company faces stiff competition in broadband from fiber overbuilds and new fixed wireless services.  The cable industry has fought off competition before but the difference now is that broadband is fully penetrated in the United States with all homes that can afford it having a connection.  The TV networks business is much smaller but faces severe secular challenges from competing streaming services.  Comcast’s streaming service, Peacock, is struggling to compete against Netflix, Disney, and others.  We don’t hate Comcast stock.  Rather we just see better opportunities developing elsewhere and view the 40% pop in the shares in since the October lows as bringing the stock to almost fully valued and creating a selling opportunity.  Furthermore, we continue to focus on diversification efforts in Northlake’s individual stock holdings.  IBM, VICI Properties, Walmart, Home Depot, and T Mobile have all been added to the portfolio over the last couple of years.  Each has produced nice gains and, importantly, provided diversification from the media stock focus in place when Northlake was established in 2004.  We have a lot of knowledge in media stocks that can help produce winners such as Comcast, but we also realize secular changes in the media landscape have severely hurt long-term growth prospects, even for the best media companies.

IBM and TMUS are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov. 

3Q22 Earnings Updates: Part One – IBM, GOOG, META, CMCSA, TMUS, AAPL, VICI

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IBM (IBM): IBM reported good results in a tough macro environment, further increasing our confidence in the transformation underway at the company.  Revenue and EPS exceeded expectations with strength across all segments of the company.  Management raised 2022 revenue guidance and maintained free cash flow guidance.  The only real negative in the quarter and outlook is currency translation due to U.S. dollar strength.  While this leads to lower EPS estimates, investors largely overlook the impact since it equally affects all companies.  On the quarterly call, analysts asked about the long-term outlook previously provided calling for mid-single-digit revenue growth and $34 billion in free cash flow in the 2022 thru 2024 period.  Management reiterated confidence while noting increasing foreign exchange impact and a few signs that weaker demand may emerge in Europe.  Demand in the rest of the world is firm.  IBM serves very large corporations where IT upgrades to cloud computing so far remain intact given they have a quick and meaningful financial payoff.  Northlake’s thesis on IBM is that the company is going to grow again thanks to the acquisition of Red Hat driving a corporate transformation focused on hybrid cloud computing.  The new CEO engineered the acquisition before he was promoted.  The company spun off most of its slowest growth potential businesses a year ago to continue the strategic shift.  IBM shares have done well this year, down just 5% and a flat total return after the healthy dividend.  The shares trade at about 13X forward earnings estimates and we think multiple expansion will occur if the company continues to meet expectations.  Investors still are not buying the IBM turnaround despite multiple quarters of good results.  Our morning notes from a dozen brokerage firms only contained one note recapping IBM’s results.  A year from now we expect the story to be better appreciated, resulting in multiple expansion.  A P-E of 15X on 2024 estimates would put the shares at $160, up 25% on top of the 4% gain post the earnings report.  The stock carries a safe 5% dividend yield enhancing the total return potential and providing near-term support.

Alphabet (GOOG/GOOGL): GOOG reported a disappointing third quarter.  We expected a continued slowdown in revenue growth, but the weakness accelerated even excluding the material impact of the strong U.S. dollar.  Search held up better with a bigger deceleration at YouTube.  Most disappointing to us was the sharp contraction in operating margins.  With the benefit of hindsight, it is clear that GOOG over-earned in 2021 due to the pandemic accelerating the top line and depressing certain operating expenses like travel and marketing.  One of our core reasons for holding GOOG shares has been the added discipline that CFO Ruth Porat brought to the firm when she was hired years ago.  While it may be beyond her control given the circumstances of the pandemic and unusual macro environment, 3Q22 was a step backwards.  GOOG now employs 186,000, up from 150,000 a year ago, and up 12,000 since June 30th.  GOOG is smart to continue invest in the many opportunities it has across search, media, mobile, and entertainment; sustaining industry leading AI and machine learning is critical to the company’s long-term growth and competitive position.  Nonetheless, Wall Street is going to penalize the shares until better cost discipline is revealed and revenue growth trends improve.  Management remains quite confident in in its growth opportunities and feels that Search and Cloud are doing well against a tough macro environment.  Management also indicated that headcount growth would slow in the next quarter but remain elevated against revenue trends.  Northlake still sees GOOG as a good long-term growth investment with a great balance sheet.  Capital and expense discipline have improved markedly over the years but presently are out of balance with macro-pressured revenue growth.  It may take a few quarters for trends to turn and investor confidence to improve.  We are willing to wait given current valuation of the shares is just 10X EBITDA, below the historical average.  Moving back to an average multiple of 12X on depressed 2023 estimates gets the stock back to $125.  If revenue growth and operating margins are showing improvement later in 2023, estimates for 2024 should show double-digit growth which can drive the shares substantially above $125.  It will take patience and a better economy, but patience will be rewarded from current prices.

Meta Platforms (META): META shares are plunging following the company’s 3Q22 earnings report that included initial guidance for operating expenses and capital spending for 2023.  The stock is down 22% as we write to $100, a level last seen at the start of 2016.  In our recent write-ups on META, we have noted that the top line was under pressure but had the possibility to stabilize in late 2022 and 2023.  We also noted that the company was reigning in expenses to help protect earnings against below budget revenue trends.  3Q22 showed hope for stabilization in the top line with reported revenue and engagement, while qualitative 4Q22 guidance was mostly in line with recently lowered expectations.  Heading into the quarter, investors expected another signal that expenses were being budgeted cautiously given macro, competitive, and privacy headwinds.  This turned out to be far from the case.  Stunningly, management plans for operating expense and capital spending in 2023 to each be $10 billion higher.  This budgeting is crushing for earnings and free cash flow.  Ahead of the report, 2023 consensus EPS and free cash flow were $10.75 and $20 billion.  New EPS estimates range from $6.50 to $8.00 and free cash flow is $10 billion.  In 2021, the company was at nearly twice these levels.  Just maintaining expense and capex guidance would have led to a forecast just below prior consensus. Not surprisingly, the conference call went very poorly.  We listen to a few dozen calls each quarter, and this META call was about as bad as we can ever remember.  Management seemed unfocused and did not provide detailed answers to many questions, instead often just repeating that it had confidence in the core business and ability to grow again as metaverse investments stop growing and the core business benefits from continuing investment of operating expenses and capital spending.  We concluded last quarter’s META blog by noting, “Simply put, the shares are valued as though META is going the way of MySpace and AOL, a much too drastic scenario.”  Today’s plunge in META shares reflects concern that the company may be facing an existential crisis.  Investors clearly do not believe that current strategy is going to reinvigorate the company.  Management’s willingness to accelerate spending against uncertain revenue growth could be read as reflecting internal concern of that existential crisis. Northlake generally will not invest where we do not believe management is industry-leading.  Right now, for META, that is hard to believe.  However, the company still maintains a massive and highly effective advertising reach.  Arguably, the best in the world besides Google search. We may admit defeat and sell the shares, but we want to let the dust settle first and evaluate in a less emotional, lower volatility environment.

Comcast (CMCSA): CMCSA reported a better quarter with no new negative surprises for the first time this year.  This is an encouraging sign that could lead to a material recovery in the shares over the next several months. The company is not out of the woods given the competitive dynamic in broadband and secular decline in the linear cable and broadcast businesses.  However, management continues to do a good job, remains transparent, and has improved focus on shareholder friendly capital allocation in lieu of the company’s history as an acquirer of assets.  The share buyback in 3Q22 was aggressive, and on the conference call management noted that acquisitions are not necessary and less attractive given a higher cost of capital.  In 3Q22, revenue, EBITDA, free cash flow, and broadband subscribers all exceeded consensus.  The company added 14,000 new broadband subs and saw broadband ARPU rise about 4%.  This is encouraging after a string of subscriber misses.  The ability of the company to sustain price increases on broadband amid a heated competitive environment while subscriber growth is expected to stay minimal is critical to maintaining financial strength that supports shareholder friendly capital allocation.  Management also reiterated its capital spending plan against concerns that it would have to spend more to sustain subscriber levels against increasing fiber and fixed wireless competition.  Comcast shares trade at just 6X 2022 and 2023 EBITDA, a discount to Verizon and AT&T despite a still faster growth profile, a better balance sheet, and more free cash flow.  The better quarter and accelerated share buyback give Comcast and the cable industry a window to rebuild investor confidence, leading to slight multiple expansion due to stability in financial and operational performance.  A target in the low $40s is plausible but we may exit in the mid to upper $30s.

T Mobile USA (TMUS): The TMUS story is developing exactly as we hoped when he purchased the shares in February.  The stock is up almost 25% in a lousy market as each milestone we had hoped for has been achieved.  3Q22 earnings were the third consecutive beat and raise quarter in subscriber and financial growth.  Synergies from the Sprint acquisition are exceeding initial estimates.  Integration of the Sprint network came in ahead of schedule and is now complete.  The benefit of gaining Sprint’s mid band spectrum has made TMUS the leader in 5G just as consumers are upgrading phones.  Expansion into rural and business markets is proceeding and TMUS market share has a lot of room to rise.  Free cash flow is on target and set to explode in 2023 as costs to obtain synergies disappear and cost savings fully kick in.  One thing we did not anticipate was that the timing of closing the Sprint deal allowed TMUS to lock in long-term contracts on many costs, thus allowing inflation of operating expenses to be minimal.  Management delivered the promised share buyback two quarters ahead of schedule and is already aggressively buying back stock.  The strength in TMUS shares shows that investors have recognized all the good news, but we still think there is room for more upside as growth looks secure as the wireless industry benefits from 5G, and the share buyback kicks in to dramatically shrink shares outstanding and perhaps the float if Deutsch Telecom continues to hold its large stake.  TMUS is emerging as the wireless industry leader and deserves its premium valuation with a couple more years of highly visible elevated growth.  We think there is another 20% plus upside.

Apple (AAPL): AAPL reported a solid quarter against mixed signals coming into the report.  Guidance for the December quarter was cautious but still showed growth near estimates despite even harsher U.S. dollar strength impacts.  Surprisingly, to Northlake, the shares jumped about 8% in response.  We saw nothing in the report that was concerning but neither did we see anything that was materially better than expected.  However, after Alphabet, Meta, and Amazon reported earlier in the week with clear disappointments and weak guidance, Apple stood out for the resilience of its reported results and forward guidance.  It seems like AAPL’s core business is only being impacted by macro whereas the other tech leaders face issues beyond macro (Amazon: overbuilt cost structure, Meta: excessive operating expense and capital spending and weakening competitive position, Alphabet: weakness at YouTube from Apple privacy changes).  Since AAPL shares are not that expensive at a low 20s P-E multiple, resilience is good enough for investors and treated as a positive surprise.  Key for the next move in the shares will be the outlook for growth in 2023.  Macro is definitely a headwind impacting services growth the most.  iPhone still has upside from the transition to 5G phones.  Mac needs to digest an unusually strong quarter led by filling the channel that lacked inventory.  Overall, the stability of AAPL’s business, its well defended competitive position, and the strength of free cash flow and the balance sheet makes the shares a good investment for the current tricky macro environment.  We do not see a lot of upside, but we are happy to continue holding an overweighted position.

VICI Properties (VICI): VICI had another boring quarter in terms of financial results.  That is exactly what Northlake loves about VICI! The business mode is simple:  the company collects rent from high-quality tenants on the casino properties it owns in Las Vegas and regional gaming markets.  The pandemic shutdown of casinos battle tested the model as not a single VICI lessee missed a rent payment.  This is very comforting ahead of a possible recession.  VICI is essentially an alternative source of financing to casinos and experiential real estate and it is becoming a more attractive alternative as high yield credit markets have tightened making VICI a low-cost alternative.  This is keeping the pipeline of projects full which builds on inflation-protected growth in current rents.  While another quarter of mid-single-digit growth in revenue and earnings provides little fodder for analysis, VICI’s proven management team is executing on its growth strategy and taking advantage of the current environment.  In casino financing, the company announced it would buy another regional gaming property in Maryland.  VICI was also active as it diversifies into experiential real estate with new agreements with Great Wolf (family resorts), Canyon Ranch (spa and wellness), and Cabot (golf).  Shareholders are benefiting directly from the consistent performance as management announced an 8% dividend increase.  Mid-single-digit core growth plus acquisitions should provide 8-10% earnings and cash flow growth which when coupled with the current 5% dividend yield provides a low-risk, mid-teens total return for VICI shareholders.

IBM, GOOG, META, CMCSA, TMUS, AAPL, and VICI are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov. 

2Q22 Earnings Updates: Part One – IBM, WMT, GOOG, TMUS, META, CMCSA, VICI, AAPL, SONY

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IBM (IBM): IBM reported mostly solid 2Q22 results, but the stock fell victim to its strong performance from earlier this year.  Ahead of the report, the shares were nearly unchanged against a 20-30% decline for major stock market averages.  This strong performance raised expectations for IBM, and a good report with a few small flaws led to a sell-off of nearly 10% in the following days.  We still find the story attractive, underlined by another quarter of mid-single-digit constant-currency revenue growth and a forecast for more of the same in the second half of the year.  This sales strength is occurring against a weakening economic backdrop, including concerns about enterprise spending on technology – a key sector for IBM.  The flaws in the quarter were related to disappointing guidance from the impact of the strong U.S. dollar on revenue, free cash flow, and margins.  We expect similar guidance from other leading technology and internet stocks reporting earnings over the next two weeks.  The fact that IBM traded down on macro issues out of management’s control that are also impacting the company’s peers is why we think the shares are a victim of their year-to-date success.  Northlake’s bull thesis on IBM is built upon a return to growth that eventually flows through consistently to profit margins and free cash flow.  2Q22 might not have been good enough for short-term traders, but we are sticking with our long-term thesis and enjoying a 5% dividend yield and significantly discounted P-E ratio while we wait for the return to growth story to play out.

Walmart (WMT): WMT updated its guidance for 2022 ahead of its formal earnings report on August 16th.  As is usually the case when companies preannounce, the news was not good.  Management lowered the earnings outlook for 2022 by more than 10% due to the impact of shifting consumer spending habits.  The shares fell about 10% in response, giving up the gains since Northlake purchased the shares for clients with individual stocks.  The stock has rebounded somewhat and now sits about 7% lower.  Interestingly, WMT raised its sales forecast even as it slashed the earnings outlook.  Customers continue to spend but the basket is now filled with inflation-elevated groceries with little contribution from general merchandise.  General merchandise has higher margins, so the shift is dilutive to earnings.  Furthermore, to help clear unsold merchandise, particularly in apparel, management is aggressively marking down prices.  The combination of these factors is why the earnings hit is so steep despite rising sales.  Assuming WMT gets back on track in the next 6 to 12 months, the new guidance essentially costs the company one year of earnings growth against our investment thesis.  We do not believe our investment thesis has been delayed by a full year, however.  Management took strong action with markdowns and indicated that other than apparel, inventories were in good shape.  We think the shares can start working well again once there is a signal that demand trends are stabilizing.  Given our outlook that any recession will not be severe, this could occur later this year.  While we wait, the initial rebound off the post guidance lows supports our idea that WMT shares offer both defensive and offensive characteristics, a good combination in an uncertain economic and stock market climate.  We stand by our target of $150 for WMT shares.

Alphabet (GOOG/GOOGL): GOOG reported mixed results for 2Q22, but the shares rallied significantly.  Revenues were in line with expectations, while operating income and EPS fell slightly short.  Investor reaction was notably positive after major earnings misses from Snap and Walmart raised the prospect that GOOG might suffer similarly.  Instead, results indicated stability beyond the macroeconomic concerns that are impacting almost all companies.  Management cautioned investors about a continued deceleration in growth over the balance of 2022.  However, these comments were not notably different from the 1Q22 report three months ago when the shares were about 20% higher.  In other words, the stock reflected a worse report and outlook.  Search and Cloud continue to hold up well, while YouTube and the Play Store have seen a greater slowdown.  Analysts believe that Search is less impacted by Apple’s privacy initiatives.  Search is also further down the buying funnel and has more exposure to still-rebounding services like travel.  YouTube advertising is an early-cycle business and more sensitive to initial advertiser cutbacks in response to changing consumer buying habits.  The Play Store has exposure to discretionary consumer purchases that might be losing share to higher inflation-driven spending on staples like gas and food.  The Play Store also reduced fees, which management noted had a material impact.  GOOG still faces challenges from the uncertain macro environment that could hurt revenue and profit margins.  However, we believe the shares already reflect a conservative outlook trading at less than 20X forward earnings and less than 11X EBITDA.  Both metrics are below historical averages for GOOG shares.  At the long run average of 12X 2023 EBITDA, we see the shares worth nearly $140.  Using a conservative 10X multiple still provides 6% upside to $120.  Notably, management spent the most ever in a quarter on share buybacks in 2Q22 suggesting confidence in the outlook and supporting Northlake’s view that the stock is undervalued.

T-Mobile USA (TMUS): TMUS continues to reward our decision to swap from AT&T earlier this year.  The company reported another strong quarter and increased guidance for all important metrics including subscriber additions, revenue, EBITDA, and free cash flow.  The stock has performed very well, up from $121 when we purchased at the end of February to the current $140.  This is great performance in a very difficult market environment, even more so when considering poor performance at wireless and cable peers.  TMUS is not only executing on its merger with Sprint, but it continues to gain market share in wireless and now has a multiyear growth driver with fixed wireless broadband which at a minimum can reduce churn with current customers.  TMUS has been a share gainer for years.  The Sprint acquisition is key to sustaining the growth profile for the next several years.  TMUS gained a massive amount of mid-band spectrum from Sprint.  In fact, the value of that spectrum is probably as important as the former Sprint subscribers.  TMUS is able today to offer 5G speeds at capacity across most of the US at very competitive prices versus AT&T and Verizon.  With Sprint synergies kicking in and cost to capture falling off, TMUS is poised to see already high free cash flow nearly double in 2023.  Growth in EBTIDA plus debt reduction has the balance sheet at investment grade status.  This sets up one more big catalyst: commencement of a massive share buyback.  Depending on how TMUS majority owner Deutsche Telecom participates in the buyback, TMUS will either repurchase a material portion or virtually all its public float in the next several years.  We expect the buyback to be announced by year end.  Near-term, TMUS shares have additional upside to about $150, but we expect the benefit of the buyback can dramatically accelerate upside as the share count shrinks looking out to 2024 and beyond.  We try to keep our price targets based on the year ahead and show patience based on our long-term investment thesis.

Meta Platforms (META): META, formerly known as Facebook, reported roughly in line 2Q results against the dramatically lower guidance the company issued three months ago.  Unfortunately, despite many indications from anecdotal evidence that revenue trends improved over the last couple of months, the company again lowered top line guidance.  The new guidance is about 10% below consensus expectations.  The hit to earnings is not nearly so severe as the company also announced another $3 billion cut to its operating expense guidance.  This is the second pullback in in the 2022 expense budget this year, so management is at least being responsive to unexpectedly weak revenue trends.  Key to the near and long-term outlook for META shares is how much of the revenue disappointments are secular versus transient.  Encouragingly, management noted that engagement with the company’s apps, including Facebook and Instagram, continues to grow, albeit at very modest levels.  Nonetheless, with all the controversy the company has faced, sustaining engagement is a good sign and increases the potential that revenue growth will again emerge late this year and in 2023.  Beyond macroeconomic challenges from a weaker economy and advertising market and the stronger dollar, the company faces two primary issues: ongoing impacts from Apple’s (and soon Google’s) decision to offer opt-out tracking on mobile devices, and the rise of Tik Tok as competitor in social media.  The privacy initiatives have been hurting growth for several quarters, and despite lapping the initial impacts, the headwind remains significant.  META lost much of its ability to individually target users, which in turn lowered the effectiveness of its advertising.  In response, advertisers are either spending less overall or paying lower prices to reach META’s users.  Tik Tok appears to have broken the barrier with advertisers and is taking an increasing share of a smaller pool of economic and privacy-impacted advertising dollars.  META shares are very inexpensive, but the company needs to reassert topline growth to get the stock moving upward.  In order to be as conservative as possible, we looked at META valuation on a GAAP basis which ignores material non-cash charges based on stock-based compensation.  We also lowered our target EBITDA multiple to 10X, a level at which traditional media companies traded at in the years before the pandemic.  This conservative approach leads to a target of $190, up 21% from current levels.  Should revenue growth resume in the next six to nine months, less conservative valuation approaches could easily justify a stock well above $200.  We believe META still is one of the most effective and cost-efficient places for advertisers to spend money.  This should eventually lead to resumed growth, so we are sticking with the stock despite the hurricane force headwinds.  Simply put, the shares are valued as though META is going the way of MySpace and AOL, a much too drastic scenario.

Comcast (CMCSA): CMCSA posted another quarter of good financial performance and deteriorating cable fundamentals.  Entertainment properties at NBCU performed well with the exception of continuing losses for the company’s Peacock streaming service.  Overall, Comcast reported 5% revenue growth, 10% EBITDA growth, and 20% EPS growth.  On their own, these would be considered great results.  However, the slowdown in cable broadband subscribers stole the show even though the segment showed 4% growth in revenue and 5% growth in EBITDA.  This pattern of strong financial results amid slowing broadband subscriber growth has been in place for the past year.  The difference this quarter is that for the first time ever Comcast had no growth in broadband subscribers.  Historically low household moving activity continues to have a big impact as the pool of potential subscribers remains small.  Churn among broadband subscribers for cable or fiber connections is typically quite low.  For several quarters, investors have been concerned about increasing competition as AT&T, Verizon, and other telcos are aggressively expanding their fiber networks.  In addition, T-Mobile and Verizon are aggressively promoting fixed wireless broadband that runs on their LTE and 5G networks.  There remains debate about the speed and capacity of these networks but for the time being T-Mobile is adding over 500,000 subscribers a quarter with Verizon adding another 200,000.  It does not seem these subscribers are leaving cable broadband but there is little doubt they are further reducing the pool of potential subscribers.  Comcast shares are down about 10% in response to the earnings report, giving up recent gains.  We have been extremely patient with Comcast shares based on their low valuation and strong financial results.  With risk rising that financial growth will slow as Comcast has to compete harder to add and maintain subscribers, a recovery in valuation seems less likely.  The stock trades at a premium to AT&T and a small discount to T-Mobile.  We believe the 10% sell off is overdone against the positive financial results and strong balance sheet.  We are leaning toward selling Comcast but think a modest recovery could occur and offer a better exit point.

VICI Properties (VICI): VICI reported a typically boring quarter in line with analyst estimates other than some timing differences.  Boring is exactly why we like VICI!  The company is a REIT offering triple net leases to casino owners.  VICI owns most of the properties operated by MGM and Caesars, and is paid rent under long-term leases with inflation escalators.  Results for MGM, Caesars, and other casino owners can be sensitive to economic activity but are rarely if ever weak enough to warrant concern that VICI will not be paid.  2020 was a great test for VICI’s business model as most casinos were closed for extended periods due to pandemic restrictions.  VICI never missed receiving a rent check.  This proof of concept has contributed to the strong performance for VICI shares.  Investors are now willing to pay a higher multiple of earnings given credit concerns have been laid to rest.  This is important currently given the impact a recession could have on casino visitation.  VICI completed several large acquisitions in the last few years and is now one of the largest REITs of any type.  Looking ahead, management expects to complete more smaller deals and expand to “experiential” properties such as golf course developments, professional sport training facilities, or other real estate intensive leisure businesses.  Between rent escalators, expansions of current properties by their operators, and modest-sized acquisition activity, VICI can grow by 7-9% per year.  The current dividend provides a yield of 4.3% and should grow in line with earnings.  In a world full of uncertainty on economics, politics, and war, VICI’s consistent, predictable results and double-digit annual total return potential are especially attractive.

Apple (AAPL): AAPL reported mixed 3Q22 results that showed resilience against the macroeconomic factors that have tripped up many other companies.  Guidance for the September quarter was a little soft with management calling out the potential for reduced consumer spending.  The primary area of concern on the conference call related to slowing growth in the company’s services business.  Growth in the June quarter was 12%, the lowest since before the pandemic.  Management noted that further deceleration should be expected in the September quarter.  Services represent about 20% of company revenues and carry a gross margin over 70% compared to mid-30s for products.  iPhone is still the most important product at around 50% of revenues, and trends remain solid even with low to mid-single-digit growth.  Offsetting macroeconomic concerns, Apple seems to be past the headwind from supply chain constraints.  The impact in the June quarter was below the low end of management guidance and there was not a specific call out for the current quarter.  Apple shares remain near fully valued but as we have explained, we are willing to hold on given the overall quality of company.  The June quarter and guidance commentary were excellent examples of Apple’s quality.  Apple continues to gain share in iPhones and Services and build a larger installed base that can drive future earnings growth and share price upside.  As long-term investors, that is worth showing patience.

Sony Corporation (SONY): SONY reported better than expected 1Q22 earnings but guided down full-year operating income and operating cash flow forecasts.  Two factors are at work on the guidance.  On an operating basis, the company lowered its forecast for the Gaming segment due to weak first-party software, slowing engagement with live services, and continued investment in software development.  A smaller operating impact was noted for Image Sensors where the company noted weakness in Chinese smartphone sales.  Interestingly, Apple reported better than expected sales of iPhones in China.  Operating cash flow is more severely impacted based on working capital and non-operating foreign exchange accounting.  More generally, SONY adopted a more cautious forecast due to management’s weak outlook for the economy.  Games and Image Sensors were again the focus, while Pictures, Music, and Financial Services are expected to be less impacted.  Along with these cautious economic comments, management noted that they are prepared to move into a recessionary mindset if necessary.  All these comments should take into account that the company has a very conservative mindset consistent with Japanese culture.  We like SONY’s conservative nature, especially in such uncertain times.  We also like their willingness to continue to invest in their growth businesses where we see substantial long-term upside.  It may take a better quarter to get the stock moving upward again.  We are willing to wait given a history of strong management operating and strategic execution and a well thought out strategy for the company’s global leadership in video games, music, filmed entertainment, and image sensors.  Long-term upside to $120 or more remains our forecast.

IBM, WMT, GOOG/GOOGL, TMUS, META, CMCSA, VICI, AAPL, and SONY are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov. 

1Q22 Earnings Update: Part Two – FB, CMCSA, AAPL

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Facebook (FB):  FB shares soared off recent lows after the company reported 1Q22 results and issued updated guidance.  The stock had fallen about 50% since last summer and was trading at pre-pandemic levels heading into the report.  This is a good example of how expectations play a huge role in short-term stock price action.  FB’s multiple had collapsed to where it was trading in line with legacy media companies indicating investors felt the company’s recent issues were the trigger for a secular decline in the business.  This is somewhat understandable given competition from TikTok, Apple’s ongoing crackdown on privacy, and increasing regulatory action by governments all around the world.  The highlight of 1Q22 results was a pickup in daily active users of Facebook and Instagram and signs of significant engagement at Reels (FB’s TikTok copycat services).  These two items cut against the bear argument that the company is at the start of a secular decline.  Further helping the stock was management’s much more focused and realistic tone on the conference call.  A clear statement noting that expense growth would be aligned with more uncertain future revenue growth rates was reinforced by a cut in the company’s operating expense growth guidance.  The entire call was more confident and less defensive than the last quarter which triggered most of the drop in the stock price from all-time highs.  As long-time followers of media companies, we strongly disagree with the idea that FB should be valued similarly to legacy media companies like Paramount and Warner Brothers Discovery.  We expect FB growth to pick up later this year as comparisons ease, efforts to offset Apple’s privacy moves gain traction, and monetization of Reels begins. A target of 10X 2023 estimated EBITDA gets the stock back to $250.  Should growth rates improve to the mid-teens on a long-term basis, our target multiple can easily go higher with the stock recovering to $300 over the next 12 months.

Comcast (CMCSA):  CMCSA has been a poor performer since peaking last September at over $60.  The shares are down by 1/3rd since then.  What might surprise Northlake clients is that analyst estimates for the company’s revenues, EBITDA, free cash flow, and EPS are virtually unchanged.  Revenue, EBITDA, and free cash flow growth forecasts remain at mid-single digits annually with EPS growing 10-15% as free cash flow is used to buy back shares. In September, CMCSA shares traded at 17X 2022 estimated EPS.  Today, the P-E multiple is just over 11X.  As we pointed out in Part One of our 1Q22 earnings recap, the market multiple has fallen about 2 points.  The incremental decline in CMCSA shares is due to dramatically slower broadband subscriber growth.  Broadband growth is the key driver of financial results in the company’s cable segment that accounts for 2/3rds of EBITDA and the bulk of free cash flow.  The causes of the slower growth include (1) historically low household formations and moves, and (2) competition from wired and wireless broadband from the major wireless companies.  At current prices, CMCSA shares are assuming little to no growth, trading at multiples in line with the much slower growing wireless telcos and the traditional media and entertainment companies that face secular decline.  Northlake missed the opportunity to sell CMCSA shares at a higher price since we felt the valuation was too low.  At this point, we think the shares are too cheap to sell given the strong balance sheet and dedication of huge free cash flow to dividends and share repurchases equivalent to upper single digits of the company’s market cap each year.  To get moving upward again to our revised target in the low $50s (down from $56), CMCSA must disprove the negative that broadband revenue and earnings growth will slow from price competition.  We have confidence the industry will grow but it is going to take time and a sharp rebound in the next several months seems unlikely.

Apple (AAPL):  AAPL reported good results for the March quarter but the shares reacted negatively to guidance for the June quarter.  For several quarters, AAPL has called out supply chain issues that lead to an inability to meet demand for the company’s products.  iPhones have largely been spared thus far with iPads taking the biggest hit in the March quarter.  Management warned of an additional $4-8 billion in lost sales in the June quarter across most product lines.  The COVID surge and crackdown in China is at fault although management also noted that there has been some improvement in April.  Northlake is less concerned about this issue as there are no signs that demand for iPhones, Macs, iPods, Apple Watches, and Air Pods are slowing.  The Services businesses that are built off the large and still growing base of hardware products had another good quarter even though growth is beginning to normalize.  We expect further slowing consistent with management guidance but growth should remain comfortably above 10% and enhance the company’s overall growth.  Services carry very high gross margins and with services now 20% of total revenue, AAPL’s profitability has moved structurally higher.  AAPL shares have held up better than most growth stocks, most likely due to the signs of strong underlying demand for the company’s products and services.  The shares are vulnerable to same macroeconomic worries that have buffeted the market and the P-E multiple remains elevated.  In turbulent markets, AAPL’s financial strength is a major positive and the company raised its dividend and issued a new $90 billion share buyback.  We still find AAPL shares fully valued but also remain willing to hold and let earnings growth catch up.

FB, CMCSA, and AAPL are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov. 

Comcast Expectation Reset Appears Complete

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Comcast (CMCSA) reported a mostly in-line quarter that is somewhat reassuring after a tough stretch for the stock and its cable peers.  Potentially improving sentiment for the shares, the company reported new broadband subscribers in-line with estimates that management had lowered multiple times over the prior four months.  Furthermore, there were no further cautionary comments to lower broadband subscriber guidance in early 2022.

Stock Reaction:  Initially the shares traded sharply lower in what has been a common reaction at each recent earnings report.  However, the shares rebounded to just a small loss that was no worse than the market by the end of the day.  The shares flipped nicely positive in Friday’s big market gain to finish above the pre-earnings report level.  We take this action as a good sign that expectations have been effectively reset (lowered), something that could clear the way for improved stock performance.

Earnings Analysis:  Comcast’s financial performance is dominated by its cable business which is now driven by broadband.  Traditional cable TV is shrinking and has operated at a low profit margin for several years.  Losing cable TV subscribers has little impact on the company.  In fact, growth in mobile phone subscribers is now more important and profitable with the new bundle being broadband plus wireless phone.  This backdrop keeps churn low on broadband and allows the company to grow cash flow from the cable business at least at a mid-single-digit rate. 

Comcast’s other businesses are in entertainment.  The Universal theme parks are performing very well and expanding internationally along with new investments domestically.  The company’s traditional linear TV businesses in the US and Europe continue to face challenges.  The businesses produce cash flow but are in secular decline.  In response, like its other media peers, Comcast is investing heavily in streaming.  With its earnings announcement, management announcement a doubling of the investment (losses) at Peacock over the next two years.  Peacock has gotten off to a slow start although management’s defense of the strategy on the earnings call seemed to be grudgingly accepted.  We believe part of the initial plunge in the shares following the report was due to the increased Peacock losses. As noted, the rebound in the shares is an encouraging sign that the expectation reset is complete.

Target Price: Last quarter, our update noted that challenges facing Comcast shares had arrived ahead of schedule.  This quarter showed no real letup in the challenges but investors appear to have adjusted to the new reality.  Importantly, it is clear that Comcast can continue to generate solid growth in cash flow that can drive dividends and share repurchases.  Buybacks are doubling this year, and the capacity to maintain the strong balance sheet and buyback even more stock is quite evident.  As long as broadband subscriber growth has reached a nadir, this should put a floor under the shares and allow for a modest rebound.  We plan to hold Comcast shares but have reset our target price to $56 from the low $60s.  Improved broadband growth later in 2022 would bring the $60s back in play as this would indicate that despite growing competition from telcos offering fiber and fixed wireless broadband, Comcast’s long-term cash flow profile is secure.

CMCSA is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov. 

Comcast Questions Starting Sooner

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Comcast (CMCSA) reported another good set of quarterly financial results.  Revenues, EBITDA, and free cash flow all at least met Wall Street estimates in 3Q even as the company had preannounced a slowdown in growth of new broadband subscribers.  From a financial perspective, the huge increase in broadband subs during the peak of the pandemic provides much greater financial reward than the small shortfall in broadband subscriber growth.  3Q21 marked the point at which Comcast had reduced debt to the level before the acquisition of Sky.  This is an important milestone as management has been promising to accelerate stock buybacks once financial leverage targets were achieved.

Stock Reaction:  Immediately following the report but before the conference call, CMCSA shares were trading up about 3%.  During the call, when management discussed broadband trends in 4Q21 and beyond, the shares dropped sharply to a loss of as much as 4%.  Now, two days later, the stock is off about 2% from the close before earnings were released.  In our last update, we mentioned that there were likely two issues related to broadband subs but not until 2022.  Management guided 4Q21 subs below the level that had already been reduced in September.  The company also refused to comment on 2022 expectations noting lack of visibility.  The latest commentary has moved the concerns we expected to emerge next year forward.

Earnings Analysis:  Short of the broadband subscriber outlook, Comcast had good results across the board.  Cable is still growing over 10% thanks to the much larger broadband base, a shift to profits in Xfinity Mobile, and continued steady growth in connectivity services to businesses.  The company’s media and entertainment businesses at NBC Universal continue to recover strongly after being crushed during the pandemic.  Advertising, theme park attendance, and Sky’s UK and European TV operations all grew very strongly.  Comcast is continuing to invest heavily in its Peacock streaming services which reduces headline growth at NBC Universal and obscures the underlying organic recovery.

Target Price:  We are sticking with our target price in the low-$60s for Comcast but expect it to take a few quarters before investor sentiment improves and the shares resume an upward trend.  Financial results will remain quite strong and the stock buyback should accelerate sharply to about 10% of the shares outstanding per year.  Unfortunately, the unclear outlook for broadband subscriber growth is dominating the investment narrative.  The big fear is that now much higher penetration of broadband households and increasing fiber-to-the-home investments by telcos means that Comcast’s growth will slow dramatically.  Management notes (we believe correctly) that thus far the slowdown is merely due to COVID impacts on increased penetration and lower churn from less housing moves.  Currently slower growth is coming ahead of a pickup in fiber passings by telcos over the next few years.  Investor fear is driving the terminal value placed on Comcast lower even as financial results continue to grow with almost no impact.  Northlake believes that over the next few quarters, Comcast will prove to investors that broadband remains a growth business.  Greenfield builds and a pickup in housing formation should provide enough room for cable and telcos to co-exist with modest growth.  Comcast will also enjoy continued growth at NBC Universal and Xfinity Mobile.  Today, Comcast shares assume close to no growth.  This is a dire view given the dominant competitive position cable broadband will maintain in most of the country even as telco fiber penetration grows. 

CMCSA is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov. 

Improved Sentiment Emerging for Comcast

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Comcast reported another good quarter with growth in the dominant cable business sustaining in the high single digits with margins continuing to expand.  Encouragingly, the much smaller but still material media businesses at NBC Universal and Sky are showing clear signs of emerging from the severe impacts of the pandemic.  It seems like most every quarter we are happy with Comcast’s results, especially at the cable business.  This is a testament to the superior competitive position the company has in broadband services and an excellent job by management to support and exploit the company’s edge.  It also seems that most every quarter the company reports good results and the stock trades lower.  This changed last quarter after an earnings beat and it happened again this quarter.  We think this means the perception of the company is changing and the value we have felt could be created may be finally emerging. 

Comcast has been in the penalty box since its acquisition of Sky and aggressive battle with Disney for control of much of the Fox Corporation media empire.  Northlake agrees with many investors that Comcast should not be diluting the outstanding financial growth profile offered by the broadband business.  What is done is done, and over the next several quarters Sky and the legacy media businesses are poised for big cyclical upside.  In addition, the company is one quarter closer to reaching its deleveraging goals and turning toward share repurchases.  On the 1Q21 conference call, CEO Brian Roberts mentioned his excitement at getting close to the resumption of the buyback.  There is lingering concern that Roberts is an empire builder, so reiterating the promise made last quarter to return to buybacks in 2021 is a positive sign.  It is also another step toward rebuilding investor confidence in Comcast, which was harmed by management’s capital allocation decisions rather than the excellent operating execution the company consistently exhibits.

We are raising our target on Comcast to $64, up 14%, by rolling our calculation to using 2022 estimates and giving the company credit for 2021’s free cash flow.  Last quarter, our target was $58 based on an average of 2020 and 2021 EBITDA with no credit for free cash flow.  We are making these adjustments because we have more confidence in the company’s outlook.  A feared slowdown in broadband adds after the huge rush from new subscribers during the pandemic does not appear to be in the cards.  As noted above, we also see green shoots in the COVID-impacted NBCU and Sky businesses.

We continue to monitor several risks.  AT&T, Verizon and T Mobile are making big efforts to supply broadband through fiber buildouts and 5G fixed wireless.  More competition is never good, although it might keep the government from taking too tough action against the “cable monopoly” under a Democratic-led FCC.  The FCC and Congress could still hurt the cable business through regulations or legislation with the primary threat being price controls under the auspices of net neutrality. 

CMCSA is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov.  CMCSA is a net long position in the Entermedia Funds. 

Comcast Set to Emerge Strongly from COVID

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Comcast remains a tale of COVID winners and COVID losers.  The cable/Xfinity business is performing great, driven by broadband.  Cord cutting has minimal impact given margin dynamics and the fact that you cannot really cut the TV cord without maintaining the broadband cord.  The NBCUniversal and traditional media side is still feeling pressure from COVID.  Cord cutting acceleration hurts NBC and the company’s cable networks.  These businesses also are hurt by weak advertising related to the recession and directly impacted advertisers in travel, hospitality, and services.  NBCU also is a major theme park operator.  This business is very slowly recovering and remains way down vs. 2019. Finally, NBCU is major film studio so the closure of theaters and limited attendance where they are open has been a big loss.  Comcast Sky business in Europe faces similar impacts from COVID on advertising and cord cutting without the benefit of a broadband business.

In 4Q20, cable saw customer relationships, revenue, adjusted EBITDA, and free cash flow rise 5.1%, 6.3%, 12.3%, and 26.1%, respectively.  NBC, on the other hand, saw revenue fall 18.1% and adjusted EBITDA decline 20.7%.

Northlake feels better about the outlook for Comcast shares coming off 4Q20 results.  First, we think the cable business will hold onto decent growth in 2021 despite tough comparisons to the work from home broadband boom.  Management guided 2021 to look similar to 2019, which was a very good year for Xfinity with adjusted EBITDA rising over 7% and a then best in a decade gain in broadband subs.  Second, NBCU should see much improved results as hopefully COVID impacts steadily fall through 2021 and into 2022.  Theme parks and movie theaters should fill up and advertisers will fully reengage as consumers emerge from their homes anxious to spend money.  Sky should benefit also benefit from improved advertising demand and also as pubs reopen and turn their TV subscriptions back on.  This scenario sets up Comcast as a long-term COVID winner thanks to broadband gaining permanent importance and COVID loser businesses enjoying a cyclical rebound.

As important as the fundamental business outlook, Comcast’s financial profile is improved.  The company has been paying down debt in lieu of buybacks since what we still view as the ill-advised acquisition of Sky.  Leverage is now below 3X EBITDA and should hit the long-term target of 2.5X in 2022.  CEO Brian Roberts indicated that Comcast would resume share buybacks in 2021.  Buybacks are a very shareholder friendly way for management to spend the company’s massive and growing free cash flow.  A return to buybacks also suggests Comcast is strategically complete and no major acquisitions are on the horizon.  Neither should there be a big investment to build out a wireless network or buy or spend heavily on steaming services.  Peacock is off to a good start as the company’s streaming effort and a restructuring that combines Peacock, NBC, and the cable networks should efficiently produce sufficient content to support all three businesses.

Using an average of 2021 and 2022 EBITDA to account for the recovery of the COVID loser businesses, we now see a price target of $58 for Comcast.  This could prove conservative as we are only giving Comcast credit for about 15% of the free cash flow it will generate over the next two years.  Risks include headlines around net neutrality, tough comparisons for broadband in 2021, increased broadband competition from telco 5G and fiber builds, and any decision to materially increase investment in streaming.CMCSA is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov.  CMCSA is a net long position in the Entermedia Funds. 

Ready for the Rotation Trade

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There are no changes to Northlake’s favored themes for December.  We remain neutral on growth versus value and continue to favor mid caps.  As a result, current client positions following the models in the Russell 1000 Growth (IWF), the Russell 1000 Value (IWD), and the S&P 400 Mid Cap (MDY) will be held for at least one more month.

Our recent monthly updates have discussed our view on what Wall Street is referring to as the “rotation trade.”  At Northlake, we believe the rotation trade has legs well into 2021 and our models have positioned clients to benefit by owning value and mid cap.  There are several aspects to the rotation.  First, large cap growth stocks have massively outperformed, while all value stocks have been left behind.  Relative performance between growth versus value and large versus small/mid cap is well above even past historical extremes.  Think about stocks like Apple, Facebook, and Alphabet as leading examples of large cap growth.  Second, the pandemic exacerbated the performance gap between large versus small and growth versus value by creating COVID winners and COVID losers.  Large cap growth companies are largely winners in a work from home environment.  COVID losers include many companies in cyclical industries such as hospitality and entertainment.  Losers also include naturally cyclical economic sectors such as finance, energy, and industrials.  A recession is bad news for companies in these sectors under almost any circumstance.

The rotation trade is a shift in leadership from large cap growth stocks to small and mid cap value and COVID losers.  The rotation started in late summer and accelerated when initial Phase 3 trial results for leading vaccines were encouraging.  Northlake expects pent up demand in cyclical industries and COVID loser businesses.  As long as vaccines can be widely distributed in 2021 and prove as effective as they have been in trials, we think the recent outperformance of value, small and mid cap, and COVID losers has a long way to go.  Just getting back to near historical relationships provides a long runway.

Northlake’s models picked up on the rotation trade.  In Market Cap, we have favored small or mid cap since late 2019.  Thanks to the large cap growth winners, this proved costly on a relative basis until August, but since then clients have regained a lot ground on a relative basis.  The extreme outperformance of large caps for the last five years driven by growth stocks tricked our models.  Now that a sustained shift has taken place, we believe it will have legs.  In Style, we captured most of the growth stock outperformance as we mostly favored large cap growth over the past five years.  At the start of October, we moved to neutral and sold half our large cap growth exposure and reinvested in large cap value.  So far, the timing has been excellent.

It is important to note that we are not bearish on growth stocks, large or small.  We just expect small and mid cap value stocks and COVID losers to lead the market higher in the months ahead. This is expressed in client portfolios though our ownership of individual stocks including Alphabet, Apple, Activison Blizzard, Facebook, and Home Depot.  We also have value and COVID loser exposure with Comcast, Disney, Nexstar Media Group, IBM, and ViacomCBS. Viacom and Nexstar have been huge winners over the last few months.

Overall, we like Northlake’s positioning in our equity portfolios.  Between our models and individual stocks we have a barbell of large cap growth/COVID winners and small and mid cap value/COVID losers.  The balance should work if the market can continue to move higher as we expect.

Many clients are still carrying above average cash balances despite reinvestment this summer into stocks including Home Depot, VICI Properties, and preferred stocks of CGI Liberty and Qurate Retail.  We are actively looking for new ideas at both ends of the barbell to further reduce cash reserves.

MDY, IWD, IWF, AAPL, ATVI, GOOG, GOOGL, DIS, NXST, HD, VIAC, CMCSA, FB, IBM, VICI, GLIBP, and QRTEP are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov.