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Why The Recession Will Catalyze Aggressive Growth Winners

Romans Chapter 5 verse 10 states, "For if, while we were God's enemies, we were reconciled to him through the death of his Son, how much more, having been reconciled, shall we be saved through his life!"


I like how Pastor Greg Laurie tells his story of how he became a Christian. During high school at a bible study, he recognized God's word "if you are not for me, you are against me". This was a big part of his understanding that his Christian peers were for God and he realized that he must be against God. The beauty of the Bible and Jesus is that He came to earth to save anyone and everyone who is looking to find peace and hope, which is the Gospel.


Investing is a trying and testing endeavor. For many, this is the reason why mutual funds and ETFs are a requirement. This is great as if everyone had to dig into the weeds of financials, economics and politics to piece things together, it would probably be a pretty dry world. The good news is that like the Gospel, there is always hope and opportunity, even in the midst of undue short-term market gyrations and a pending recession.


It is very interesting that aggressive growth equities find themselves in the current situation - down substantially and discounted extremely. This statement is specific for mid-term and long-term winners, as many pretenders have been hammered justly. Markets always move in tandem and very rarely break parity, which over the short-term masks winners versus losers.


Today, however, this is not the case, as aggressive growth has been selectively targeted, with leading innovators primed to yield investment returns well beyond most managed funds and ETFs.

Unfortunately for the majority of investors, today's perceived safer bets (cyclicals, Big Tech, etc.) will underperform, and in many cases, result in dead money, and in worst cases, losses.


The pandemic has served as a critical point in this discussion. Through global governments shutting down economies, innovation was able to illustrate how remarkably resilient it could be as aggressive growth winners thrived during difficulty.


Nefarious government policies continue to attempt to control global economies and this has led to policies substantially constraining the supply side - the primary cause for inflation. A recession is imminent and just as during the pandemic, aggressive growth innovators will continue to thrive. The combined pressures of the pandemic and inflation will have a detrimental effect on weaker and less innovative companies pushing them further away from the leading competition.


Recession


There are two key ways to review a recession. First, the straightforward way is to consider overall economic activity through Gross Domestic Product, or GDP. Second, is to take a closer look at areas that can weaken and indeed go into a recession as a component of GDP. The latter technically isn't an overall economic recession, but still has substantially negative impacts across the economy, as well as for investments.


There have been three recessions over the past 22 years - the Tech Bubble, the Great Recession, and the Pandemic. Key elements of each generally were as follows - excessive consumption and speculative investing during the Tech Bubble, the housing crisis driving the Great Recession, and the government-generated Pandemic recession most recently.


My opinion is that we will be entering a recession over the next 12 months or so. Whether this will indeed be a full-blown economic recession or isolated recessions, things will still be negatively impacted for a variety of investments. The most recent economic pain prior to the pandemic was felt during 2014-2016, and in 2019, when commodities, transports, and industrials were all in recession to varying degrees.

At the low-point in 2016, global commodity prices had fallen to levels below the Great Recession, with 2019 seeing near-similar results. Remember those $140 barrel oil prices during the summer of 2014. Those investing in corn, soybeans, etc., surely were going through some serious pain until the pandemic, while many consumer staples were on easy street.

At the same time industrial production also displayed a correlation with 2016 being more severe than 2019, but all-the-same, dropping into recessionary and contraction levels. Many key freight companies were intently focused on industrials during this time as heavier loads and contracts were struggling.

Speaking of the freight industry, clearly both the trend from 2014 through 2016 and 2019 witnessed extreme recessions, with 2019 seeing unprecedented bankruptcies across all modal carriers and operators - remember Hanjin Shipping, this was less than three years ago.

Unlike commodities where consumers still keep volumes steady, the freight transport industries witnessed the doubling impacts from both falling volumes and negative pricing power over the course of these years, again, largely correlated with industrials and commodities. Many companies were hard-pressed to absorb both ends and sustain their operations as mentioned above.

And now, the infamous Real GDP that has proven resilient with only three recessions, despite the challenges across broader sectors and industries from 2014 through 2016 and in 2019 - no grey recession line. How has this been possible - the consumer.

Remember the V, the K, the W, the L, and any other letter economy recovery dialogues as the pandemic ensued. I guess we'll be figuring out what letter it will be for a while over the years. The point here is that the consumer has been responsible for for why there hasn't been a recession, other than the Pandemic, the past 12 years.

As we've gone through 2021, an anomaly has occurred with respect to physical versus e-commerce sales. This has been driven by the extreme divergence that occurred during 2020 where e-commerce sales peaked up over 40% and physical retail sales bottomed at a low of negative 4%. The comparable during 2021 for these opposing trends has been the core driver for the inverse cross that has never before occurred. This is a great example of why the demand side is so murky at the moment and why it is important to still see in 2022 how this normalizes. It could take until 2023 for this to occur.

Regardless, e-commerce as a percentage of retail sales continues to increase penetration. During earlier years, it was common to exclude certain retail sales categories like automobile sales, housing, etc. With iBuying now challenging some of the largest physical goods markets, total retail sales are now a fair comparison. As e-commerce further penetrates food deliveries, overall food services will likely be included as well. Despite the drop from the 2020 penetration peak near 14%, 2021 penetration is still 20% higher than in 2019.

So the next question is how has the consumer sustained this. Household debt has seemingly improved with respect to the percentage of disposable income. However, there has been a lot of stimulus and deferral of payments for rents and student loans, among other areas. The combinations of stimulus and deferrals of typical responsibilities has strongly contributed to the sub-10% levels post-Great Recession. These factors, similar to the murky retail sales information, has created a less clear perspective that will need to play out further over the coming years. The Administration's recent inability to normalize student debt payments last week is a clear example of their fear of how quickly things may go south.

What is clear is that overall household debt has continued to rise via mortgages notably, and also student loans and auto loans. This picture specifically from the 2013/2014 time frame onward clearly illustrates how the consumer has been able to sustain GDP. The fact that the constrained supply-side is already weighing on the economy, getting consumers back to business as usual is a definitive recipe for a much broader recession.


So the final question again is will it be an overall recession or multiple sector/industry recessions. There is no way to be sure, but I'm betting on commodities, industrials, and transports to be seeing some serious pain at some point over the next 12 months or so. Key catalysts include the Fed's tightening policy, continued global centralist policies impacting supply chains and constraining the supply-side of the supply-demand equilibrium, and further government actions attempting to defer the inevitable.


Winners v. Losers

Now let's talk about what we all want to know - who are the winners to consider as these events play out. For me, I've been focusing on this since 2019 and refining my portfolio to reflect it through my holdings. Initially, I had north of 50 holdings, but with the recent pressures of the anti-aggressive growth trade intensifying during 2021, the current number has tightened to 20.


For the purposes of keeping it at a level for most investors, I'll focus on holdings that most would consider versus others that some may view as still more speculative for the mid- and long-term. The key focus is to consider valuation - valuation historically, as well as across peer groups, and based on future potential.


Valuation has been very difficult as the pandemic pushed levels beyond reason to the upside, and today, the opposite has occurred with some of the best aggressive growth opportunities now being at severely depressed levels. I'll use two examples of winners for investors to get a sense from in Roku, Inc. (ROKU) and Teladoc Health, Inc. (TDOC).

The scatter chart above provides the 40 companies built out to date on the Competitors List. The performance goal for the portfolio is 25-30% annualized over the long-term. Each company on this scatter chart has a detailed financial model considering the mid-term forecast, and valuation determined by historical, relative/peer, and Cash Flow analysis. Based on this assessment, I'm not expecting many companies to be higher than the15% annualized investment return level, with only about 20% greater than this level, and only 10% greater than a possible 20% annualized return.

Comparing EV/Revenue across Revenue mid-term growth projections shows that most companies are expected to grow below the 20% annualized level. Specifically only 12 of 40 or 30% are anticipated to see annualized Revenue growth above 20%. There is a clear correlation with higher valuation multiples and Revenue growth expectations as well, however there are some exceptions. These include Roblox Corporation (RBLX) and Snap, Inc. (SNAP).

With respect to Cash Flow performance over the mid-term, the correlation is fairly tight for the most part for most companies. However, there are some anomalies for lower and higher valued peers. Regardless, there are clear explanations for all, especially as some companies may have had a poor year serving as a lower base versus the forecast. Only 12 out of 40 or 30% are expected to generate annualized OCF/Share growth north of 20% with both RBLX and SNAP standing out again.


The key takeaways from the Competitors List are:

  • Average EV/Revenue is 11.5 times

  • Average Revenue growth is 17% over the mid-term

  • Average OCF/Share growth is 20% over the mid-term (excluding major negative performers)

ROKU

The thesis for ROKU is simple. The company has generated annualized Revenue growth at 44% since 2015, and I am projecting them to achieve north of 30% over the next five years. At the same time, OCF/Share has increased by nearly 50% the past four years since going positive, and I am projecting ROKU to see this accelerate further over the mid-term modestly towards 55%. These are of course projections, but the past four years have served as a strong precedent of the companies potential. ROKU's potential remains strong as ARPU is expected to lead this growth.

When considering ROKU's valuation, the company is severely discounted at less than 5 times EV/Revenue, while OCF/Share is consistent with higher growth peers and Cash Flow inflection potential still affords strong investment returns over time.


TDOC

TDOC's story is similar to ROKU. The company has generated annualized Revenue growth just below 75% since 2015, and I am projecting them to achieve growth towards 22% over the next five years. This is a strong deceleration, but there will be potential for re-acceleration over the longer term. OCF/Share increased by over 70% from 2019, including the completed merger of Livongo Health, and I am projecting TDOC to see mid-term growth north of 35%. Telemedicine is here to stay and will continue to increase its utility over time.

Similar to ROKU, TDOC's valuation is at the lowest level over the course of its annual levels. EV/Revenue is near 5 times EV/Revenue and OCF/Share stands at 55 times. The story here is consistent as EV/Revenue is expected to expand over the mid-term, and Cash Flow inflection is poised for further expansion.


Both ROKU and TDOC have substantially higher Revenue and Cash Flow projected performance over the mid-term than the Competitors List peers, and yet both companies trade with EV/Revenue multiples at a 50% discount versus the average. Many of the most robust Revenue growth Competitors List peers are not Cash Flow positive and for those that are, their OCF/Share multiples are substantially higher. While the Competitors List is growing weekly, it is very hard to justify how leading innovators and aggressive growth peers like ROKU and TDOC can be discounted as they are.


Both companies clearly benefited during the pandemic through their innovation. Prior to the pandemic, both were already leading markets towards transformative shifts. With a recession on the horizon, both companies are poised to continue to see performance track regardless. Streaming is still in the early stages and further inflection will be hitting. There's a lot of information regarding expectations with respect to remote/virtual behavior. The initial data is showing that while there are economic reasons why many legacy entities and their leaders want the pre-pandemic status-quo to return, consumers, employers, patients and users are not looking for the same.


Conclusion


The reality is that there are more examples beyond ROKU and TDOC that will continue to display a stronger growth trajectory, despite macroeconomic cycles, and shocks. This is because these companies are innovative leaders for their markets, while the substantial majority of their competitors are incapable of pivoting to where the next trends are headed.


The recession will catalyze aggressive growth winners like ROKU and TDOC in two ways. First, the sinking tide will bring companies bucking the trend today lower in-line with underperforming aggressive growth plays. Thereafter during the recovery cycle, companies like ROKU and TDOC will likely see further acceleration, while not at the same rate of the pandemic, well-beyond their peers on the Competitors List. This will lead to a normalization of valuation multiples from today's extreme discount, longer-term as they continue to win, the market will re-value them accordingly.













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