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The Morning Filter Podcast – February 9th, 2024: Market Review & Investment Opportunities

Key Concepts:

• AI Buildout Boom: The current period of significant investment in artificial intelligence infrastructure and technology.
• Economic Moat: A company’s ability to maintain competitive advantages over its rivals, protecting its long-term profits. (Cost Advantage, Intangible Assets, Network Effect, Switching Costs)
• Fair Value: Morningstar’s estimate of a stock’s intrinsic worth, based on fundamental analysis.
• Capex: Capital Expenditure – funds used by a company to acquire, upgrade, and maintain physical assets.
• Discount to Fair Value: The percentage difference between a stock’s current market price and Morningstar’s fair value estimate, indicating potential undervaluation.
• Five-Star Rating: Morningstar’s highest rating, indicating a stock is significantly undervalued.

I. Market Overview & Software Sector Analysis

The podcast began with a review of the previous week’s market performance, specifically a multi-day selloff in tech stocks like Microsoft, Salesforce, and ServiceNow (down 7-14%). The central question posed was whether the rise of AI poses an existential threat to software companies. Dave Sakara responded by acknowledging the uncertainty surrounding the interaction between AI and software, but highlighted a recent Morningstar note titled “The Only Thing to Fear is Fear Itself” by Dan Romangh.

The core thesis of the note is that AI is more likely to enhance existing software platforms through third-party providers, rather than completely replace them. This is based on the belief that it will remain more cost-efficient to utilize third-party software in the long run. Sakara noted that internal “do-it-yourself” AI projects within companies have largely failed to replicate the functionality of established software solutions. Currently, AI-driven revenue within software companies represents only about 2% of total revenue, indicating the technology is still in its early stages.

Actionable Insight: Investors should consider software companies with complex platforms, high client touchpoints, and significant switching costs.

II. Specific Software Picks & Valuation

Sakara highlighted two specific software picks from Dan Romangh’s research:

• Microsoft: A recurring recommendation, benefiting from its broad ecosystem and ongoing AI integration.
• ServiceNow: Favored due to its business model centered around automating processes – a core function of AI. ServiceNow currently exhibits the highest AI uptake rate in the software space, double the average.

He emphasized that many software stocks are currently rated four or five stars, presenting potential buying opportunities.

III. The AI Trade: Is it Over?

Addressing the recent decline in AI-related stocks like Nvidia and AMD, Sakara asserted that the “AI trade” is not dead. He characterized the AI buildout as still being in an accelerating phase of the technological cycle, with no evidence of slowing investment. In fact, new capital continues to flow into the sector. A significant bottleneck is the shortage of hardware needed for the AI buildout, with demand exceeding supply. Sakara anticipates at least another year of this trend.

Data Point: Hardware shortages are prevalent across the entire AI supply chain.

Actionable Insight: Focus on companies leading in AI technology design (Nvidia, AMD, Broadcom, Taiwan Semi) which are currently trading at discounts (23-31% to fair value). Avoid commodity-oriented hardware companies, as increased capacity will likely pressure prices and margins by mid-next year.

IV. Investment Strategy for AI as a Theme

Sakara recommended focusing on companies at the forefront of AI technology and design, specifically mentioning:

• Nvidia: Four-star rated, 23% discount to fair value.
• AMD: Four-star rated, 23% discount to fair value.
• Broadcom: Four-star rated, 31% discount to fair value.
• Taiwan Semi: Four-star rated, 18% discount to fair value.

He cautioned against investing in commodity hardware companies, anticipating price and margin compression as supply increases.

V. Macroeconomic Outlook & CPI Impact

Regarding the upcoming January CPI data release, Sakara believes it will likely have minimal market impact unless it significantly deviates from expectations. The market’s current focus is on earnings and the AI buildout boom. He expects the Federal Reserve to hold rates steady until at least June.

VI. Earnings Previews & Stock Specific Analysis

Several earnings reports were discussed:

• Applied Materials: Strong results and guidance expected, but currently a two-star rated stock trading at a 43% premium. Fair value is likely to increase, but the stock remains pricey.
• Zimmer Biomet: A prior pick that has disappointed, with a reduced fair value estimate (down 25% since the end of 2023). Currently a five-star rated stock at a 30% discount. A recovery requires significant cost reduction measures.
• Alphabet: Strong Q4 revenue (up 18%), but operating margins contracted slightly. Google Cloud revenue accelerated (48% growth). Successful integration of AI into Google Search is protecting its core business and improving ad pricing. However, the $180 billion capex guidance for AI caused investor concern. Currently a three-star stock at a 5% discount.
• Amazon: Good results across all segments, but the $200 billion capex forecast for 2026 overshadowed the positive news. Currently a four-star rated stock at a 19% discount, making it a buy.
• AMD: Q4 revenue exceeded guidance, and Q1 guidance is positive. The stock selloff remains unexplained, presenting a buying opportunity. Currently a four-star rated stock at a 23% discount.
• Palantir: Fair value increased to $150, but the stock remains expensive (120x forward EPS). Requires high growth rates to justify the valuation.
• Pterodine: Significant fair value increase to $250 due to strong performance and positive outlook. Currently a two-star stock at a 20% premium.
• Constellation Brands: Stabilizing beer volumes and share buybacks are positive signs. Currently a four-star stock at a 25% discount.
• Peloton Networks: Benefiting from the AI buildout, but the stock is still expensive.

VII. New Morningstar Research & Market Valuation

Sakara discussed Morningstar’s updated stock market outlook:

• Overall Market Valuation: Currently at a 5% discount, considered fairly valued.
• Capitalization: Overweight small-cap stocks, underweight mid-caps, market weight large-caps.
• Style: Overweight growth stocks, underweight core, market weight value.
• Interest Rates: Expecting at least two Fed rate cuts in the second half of the year and declining long-term interest rates.
• M&A Activity: Anticipating increased mergers and acquisitions.

VIII. Stock Picks of the Week

Sakara presented four stock picks:

• Clorox (Four-Star, 27% Discount): Stabilizing volumes and cost advantages.
• Manderly International (Five-Star, 18% Discount): Strong brands and exposure to emerging markets.
• Constellation Brands (Four-Star, 25% Discount): Stabilizing beer volumes and share buybacks.
• Palto Alto Networks (Four-Star, 29% Discount): Benefiting from the increasing importance of cybersecurity in the age of AI.

Conclusion:

The podcast emphasized a cautious but optimistic outlook, highlighting opportunities in AI-related companies, particularly those with strong competitive advantages and trading at discounts to their fair value. The importance of diversification and a long-term investment horizon was also stressed. The key takeaway is to focus on quality companies with sustainable competitive advantages, rather than chasing short-term hype.