SNOW - Spear Advisors Q3 2023 Fund Letter
2023-12-01 02:45:00 ET
Summary
- SPEAR is a fundamental asset manager and ETF issuer specializing in investments in industrial technology value chains.
- Spear Alpha ETF underperformed the S&P 500 and Nasdaq Composite in 3Q23 but had strong performance in CY23.
- B2B technology companies have shown strong earnings, creating a favorable setup for technology in 2024.
- Hardware and cloud/data infrastructure were underperformers, while cybersecurity companies held up relatively better during the quarter.
Dear Reader,
Spear Alpha ETF ( SPRX ) was down 4.5% in 3Q23 compared to the S&P 500 ( SP500 , SPX ) down 3.3% and the Nasdaq Composite ( COMP.IND ) down 3.9%. SPRX was up 46.6% in CY23 compared to the S&P 500 up 13.1% and the Nasdaq Composite up 27.1%, as of the end of the third quarter.
Macro headlines overtook fundamentals in 3Q23, with interest rates spiking to 5% and US credit downgrades sparking macro fears. The pullback throughout the quarter started relatively rational, with some adjustments to valuations, hype, etc., and worsened as we got into October. But as interest rates stabilized, we are just starting to see focus shifting back to fundamentals.
Earnings from B2B technology companies have been strong over the past two quarters, especially in areas that we consider to be early indicators. This is creating a favorable set-up for technology as we look out to 2024, with the potential for upward estimate revisions and attractive valuations, as stock prices have not kept up with earnings revisions.
From a fundamental perspective, the upside in hardware that we noted in 2Q/3Q23 started to broaden out to areas outside of GPUs, such as CPUs and networking. Cloud spending, which we expect will drive the next leg of the recovery, also showed signs of bottoming. On its most recent earnings call, Amazon ( AMZN ) noted that the company "signed several large deals effective in October, the collection of which is larger than the total reported volume for the entire 3Q23", something that went un-noticed as investors were panicking out of investments and nit-picking on results that would generally not be considered to be leading or representative indicators.
We believe we are just scratching the surface of the ultimate AI opportunity. The tourists left the AI space over the summer, creating a very attractive entry point. On that note, we will host an educational webinar on December 6th to dig into the different layers of the AI opportunity.
Our framework remains unchanged; we expect slow macroeconomic growth, recovery capped by high interest rates, and persistent inflation. While interest rates and inflation concerns create short-term volatility for technology, these pullbacks are often attractive entry points as the secular trends remain intact.
Performance contributors
During the quarter, both hardware and cloud/data infrastructure were significant underperformers, while our investments in cybersecurity companies held relatively better.
Outperformers:
- Cybersecurity held-up relatively better post-strong CY2Q23 earnings from Zscaler ( ZS ) , Crowdstrike ( CRWD ) , and SentinelOne ( S ). After a year of tight enterprise budgets with increased deal scrutiny and staggered deals, the comparables for cybersecurity software are relatively easier going into 2024. Two key trends are providing a tailwind for the cybersecurity space: cloud security and shifting left (i.e., embedding security earlier in the application development process). This trend is different for cybersecurity hardware (and enterprise hardware more broadly), where companies experienced double-ordering post covid and are now facing tougher comps. As a result, we exited our position in Palo Alto Networks ( PANW ) during 2Q23. While the company has an outstanding software business that will likely offset the downturn in hardware, there is less room for error.
Underperformers:
- AI hardware/Semiconductors. Among hardware, Nvidia ( NVDA ) held up relatively better, although the performance did not reflect the company's strong results. Estimates for FY 2025 over the past two quarters increased from ~$20bn to $50bn while the stock remained/flat to down, implying a significant contraction of the multiple and an attractive valuation. Other hardware stocks, such as AMD and Marvell ( MRVL ) , significantly underperformed as investors started questioning if AI is just hype. We used this opportunity to size up our investment in AMD ahead of the company's 3Q results. Our channel checks indicate strong interest in AMD's new GPU, the Milano 300, but also strong demand for the company's next -gen CPUs (Genoa and Bergamo).
- Cloud Infrastructure companies also underperformed despite strong results from the hyper-scalers. Our investments in Snowflake ( SNOW ) and Datadog ( DDOG ) contributed to our underperformance during the quarter. While the hyper-scalers (both Azure and AWS) noted bottoming fundamentals in 2Q and some signs of a pick-up in 3Q, investors are in an "I'll believe it when I see it" mode. During the quarter, we increased our position in Datadog, a leader in observability, benefiting from a platform approach. The company guided conservatively in for 3Q23, which created an attractive entry point.
Portfolio composition
As of the end of the quarter, the largest exposures in our portfolio are in the following areas:
- Cybersecurity (25%) is benefiting from a major technology shift from changes in enterprise infrastructure and the continuous evolution of threats (with AI adding an incremental layer of risk). Our largest holdings are Zscaler, a leader in "zero trust" network security, Crowdstrike and Sentinel One , both leaders in endpoint security.
- Cloud/Data Infrastructure (25%) benefiting from massive growth in data and compute/storage requirements. Our largest holdings are Snowflake, a cloud-computing-based data warehousing company; Cloudflare , an integrated global cloud network; and Datadog.
- Data Center Hardware (20%) benefiting from new developments in generative AI. Our largest holdings are Nvidia , Marvell, and AMD, which we believe are best positioned to benefit from the positive trends in AI adoption and demand broadening to CPUs and networking.
There are two main points that came out of the 3Q23 earnings report that are giving us confidence for 2024.
- Data Center strength broadened from just GPUs to CPUs, networking, memory, casings, liquid cooling etc. AMD highlighted that while the company is now expecting $400mm/$2bn of incremental GPU revenue in 4Q23 and 2024 respectively, CPU demand remained very strong which was a surprise as some expected that incremental demand for GPUs will come at the expense of CPUs.
- New cloud workloads are picking up. Microsoft noted an inflection in growth with 28% growth in Azure in the quarter. Amazon pointed to cloud optimizations "attenuating" and several large deals closing after the quarter ended.
Risk management and the recent pullback
During market pullbacks, we increase our idea velocity with the objective of taking advantage of dislocations. Generally, when the market pulls back rationally, our companies perform in line with their beta, as was the case during 2Q23. But as we got into October, we noted broad deleveraging, which resulted in panic selling and increased correlations.
These are usually the times that offer the best idiosyncratic opportunities, as investors are throwing the baby with the bathwater and shortening their investment horizons (to less than a quarter). The goal for this quarter is to pick out 2-3 emerging tech leaders that underperformed in 2023 ytd, but could see fundamentals stabilize as we go into 2024 (several are still down 10%+ ytd vs. the tech sector up 30%). While these types of ideas usually take several quarters to work themselves out of issues, they can add outsized returns once the market stabilizes.
Frequently Asked QuestionsA few points on liquidity and market pricing related to ETFs that may be helpful based on frequently asked questions: Liquidity. The liquidity of an ETF is determined by the underlying holdings, not by the size ('AUM') or volume traded of the ETF itself. The ETF is backed by the assets it holds, and market makers constantly create/redeem shares. Market Makers. When investors buy/and sell shares, they often (but not always) buy/sell directly from the market maker who has created the shares and holds them in inventory. This ensures that there is always a market to buy/sell ETFs, rather than having to match a buyer with a seller (as it is for equities). Market pricing. The price of the ETF changes constantly and moves with the underlying securities. To get the most accurate pricing when buying/selling an ETF, investors should look at the actual bid/ask quote and spread. The ETF shares are backed by the fund's holdings, which in our case are custodied at US Bank. Tax Efficiency: Due to their ability to exchange shares in-kind, ETFs can be more tax-efficient than hedge funds or mutual funds. For Fund prospectus and more info, visit our website spear-funds.com. DISCLOSURES:The performance data quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than their original cost, and current performance may be lower or higher than the performance quoted. For performance current to the most recent month-end, please call 1-833-340-7222. The total expense ratio is 0.075%. For a prospectus or summary prospectus with this and other information about the Fund, please call (888) 123-4589 or visit our website at www.spear-funds.com. Read the prospectus or summary prospectus carefully before investing. “Alpha” strategy seeks to identify investment opportunities in which the performance of a company’s stock will exceed that of the market over time. B2B stands for business-to-business. Free Cash Flow ('FCF') is the cash a company generates after taking into consideration the cash outflows that support its operations and its capital expenditures. S&P 500 is a stock index that tracks the share prices of the 500 largest companies in the United States by market capitalization. The Nasdaq Composite Index tracks the share prices of all NASDAQ-listed companies and includes over 2,500 companies. Investing involves risk, including possible loss of principal. The fund is subject to both growth and value equity risk. Investing in growth companies that are based on an issuer’s future earnings may be more volatile if revenues fall short of expectations. Investing in value companies that remain unfavored or are undervalued for long periods of time could have a negative on the fund’s performance. Companies in the industrial sector may be adversely affected by changes in government regulation, world events, economic conditions, environmental damages, product liability claims, and exchange rates. Technology, Space, Robotics, and Automation companies are particularly vulnerable to rapid changes in product cycles, obsolescence, government regulation, and competition, both domestically and internationally, which may have an adverse effect on growth and profit margins. Market or economic factors impacting these companies that rely heavily on technological advances could have a major effect on the value of the Fund’s investments. SPRX is non-diversified and may invest a greater percentage of its assets in securities of an issuer in the industrial or technology sectors. An adverse event to an issuer in the industry may negatively impact the fund’s performance. Applying ESG (Environmental, Social, Governance) sustainability criteria to the investment process may exclude securities of certain issuers for non-investment reasons and therefore the Fund may forgo available market opportunities. Foreside Fund Services, LLC, distributor. |
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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Spear Advisors Q3 2023 Fund Letter