Sunday, September 20, 2015

A Clear Plan of Attack

The current market correction we're experiencing has carpet bombed some high flying stocks into submission. Alibaba (BABA), Tableau Software (DATA), and Twitter (TWTR) were all shown the door by short-term investors exiting their positions. Selling pressure has reduced equity valuations to levels that haven't been seen in months, and in some cases years. Although I've done a complete reboot with my investing thesis during the last two years by primarily buying index ETFs, I still dabble in individual equities on a limited basis. Enclosed is my current take on these three securities.

Tableau Software

Tableau Software still remains a category killer. It traded at $131 at the end of July, only to come tumbling down to $82 as of Friday. I got off the sidelines and picked up some shares, although I didn't back up the truck because my belief is that it's much more prudent to be in index funds at this juncture. Nevertheless, I wanted to own a limited number of shares to become an investor in a exciting young company. I thought $82 was a good price for a solid growth company.

My last posting gives you the lowdown on where the company stands, but here's the synopsis - It was a momentum stock for most of 2015, only to be sold off after a very solid quarter because Wall Street deemed the valuation too high. Tableau dropped roughly $50 in 45 days. Some of the depreciation is due to the quarter, some to the overall market correction, and some because on Thursday rival Oracle (ORCL) reported a slowdown in revenues. This, coupled with The Street reconfirming their SELL rating on Tableau citing better valuations among its peers, caused it to drop $6 in one day last week.

This SELL rating by The Street is short sighted in my opinion. Tableau is the proven technology leader in data visualization organizations, whether it's a pure-play, or part of a conglomerate like Oracle. It deserves a premium multiple. Granted, Tableau's technology can be leapfrogged in a heartbeat, but they've maintained pole position for years, and invest heavily in R&D. My bet is that the market sell-off we're experiencing is just a run-of-the-mill correction, and that Tableau accelerates to the upside after the next conference call. It may not become a go-go stock again, but it has the potential to beat the S&P 500 for the next few years.

Twitter

Last week Twitter CFO Anthony Noto made a presentation at the Deutsche Bank 2015 Technology Brokers Conference. Mr. Noto is a candidate for the vacant CEO position, which is now in a state of flux. Company co-founder Jack Dorsey is Twitter's interim CEO and is also in contention for the top spot. The board has yet to make its decision on who will be calling the shots, and Noto declined to make any comments on the CEO process during the presentation. A lack of a permanent leader has been cited as one of the reasons the stock is under considerable pressure.

Another reason for the equity sell-off is that the product is difficult to use, which in turn decreases the number of monthly active users [MAU]. Mr. Noto addressed this concern and went into detail about Project Lightning, an initiative by the company that is set to launch this Fall. In a nutshell, Project Lightning will curate Twitter content to make Twitter simpler and easier to use. The organization is going to make a big media blitz through television advertising and digital video, to make the mass market aware of the product change.

My belief is that once the market correction is over, the results of the Project Lightning are in, and the CEO is in place, Twitter will make considerable gains. I've written about the stock numerous times, and thought it was expensive. However, I had a limit order in for $25, and during the recent "flash crash" picked up some shares at $23. I really enjoy using the product, and believe the stock will do well after it gets through the near-term growing pains. This is an investment for me, not a trade, albeit a very small investment.

Alibaba

Most people that follow business news are well aware of the pissing match between Barron's and Alibaba last week. It started with Barron's doing a cover story about the Chinese e-commerce company with a preposterous claim that the stock could fall 50%. This is after a fall from $120 to $65. Alibaba shot back with a rebuttal, stating the article was filled with fallacies. It is difficult to know if any company is a house of cards, but if Alibaba is, it would mean the biggest stock collapse since Enron. I give Alibaba the benefit of the doubt, but must play Devil's Advocate because it is a Chinese company which tend to lack transparency.

Like Twitter, Alibaba also presented at the Deutsche Bank 2015 Technology Brokers Conference last week. Executive Vice Chairman Joseph Tsai made the presentation, but didn't shed much more light on the company then what was already given on the last conference call. He did state that there has been a slowdown in the overall Chinese economy since mid Summer, a psychological effect from the stock market crash in China. White-goods such as washing machines and refrigerators remain steady, but the lower end consumer goods have slowed down. He also discussed logistics, and how "the last mile" isn't as developed in his country as opposed to Europe or the United States. This means there's plenty of room for improvement by Alibaba partners engaged in he transport of goods sold.

Alibaba's stock was priced at $68 for its IPO a year ago. It now trades at $65. A lot of smart people in the investment banking business priced it at $65 for a reason - the underlying business fundamentals. That said, although business is improving for Alibaba, the economy is slowing in the People's Republic of China. That, coupled with a large share lock-up expiration that come to fruition on Monday, make me want to take a wait and see on this equity. I don't believe the stock will be cut in half as Barron's suggests, but if it drops $10, to $55, I would consider taking a flier on it for Asian exposure to my portfolio.

Friday, September 11, 2015

Resistance is Futile: Artificial Intelligence Invades the Markets

Black Monday was Monday, October 19, 1987, when the DOW fell 22.61% in one trading session. Illiquidity and investor psychology have been cited as possible factors for the sell-off, but the brunt of the implosion can be traced to Quant Funds that do all of the program trading. We now have circuit breakers and other mechanisms in place on the major exchanges to prevent another catastrophe, or so this is what we're told. Fast-forward to late August 2015, and the DOW drops almost 1,100 points at the open for no apparent reason other than rogue algorithms. Things could have gotten out of hand.

Omega Advisors Chairman Leon Cooperman, a vocal self-made billionaire, is often on CNBC, and he cites the proliferation of risk-parity funds as the culprit of our recent "flash crash". To use a simplistic definition, risk-parity is an investing strategy some quant funds use to limit risk by over-allocating lower volatility assets. This investing technique usually has a heavy dose of bonds over equities, and is supposed to protect investors such as pension funds in all investing environments. In theory, if stocks sell off, you make money with the bonds, and visa versa.

The problem is that both stocks and bonds are not supposed to depreciate at the same time. Enter the new "flash crash" where both stocks and bonds took a beating. A recent Reuters article gives you more depth about risk-parity funds and the possibility that they did do damage to the overall markets three weeks ago. Mr. Cooperman took exception to funds like this in a CNBC interview because they cause instability in the indexes, plus alter conventional investing tactics:

"In the world I grew up in, and the world Warren Buffett grew up in, when something went down you wanted to own more, and in the world that we're in now, it goes up you want to own more, and it goes down you want to own less, and that's just counter-intuitive. It lacks common sense."

He's absolutely right that it doesn't make sense. You've probably heard stock pickers use the expression, "It's a market of stocks, not a stock market.". That's a dead chestnut in today's era of programmatic portfolio allocations. An old stock picker like Cooperman said it almost correctly:

"I think the machines seem to be taking over."

The machines don't seem to be taking over, they have taken over. That's why it's much more advantageous for individual investors to be in S&P 500 index funds such as SPDR S&P 500 ETF Trust (SPY), iShares S&P 500 Index (IVV), or, Vanguard 500 Index Fund (VOO). Any one will do. This is especially true if you are a domestic investor. It's like John Henry versus the steam drill. John Henry and his hammer won, but only to die at the end of the competition from exhaustion. It's much better to be on the mechanized side of the fight at this juncture. Yes, you can still pick winning individual securities, but what's the probability you'll do it consistently when competing against computers.

The Reuters article cites that the world's largest hedge fund Bridgewater Associates, allegedly lost 4.2% in August. Bridgewater's 'All Weather Fund' is an algorithmic trading vehicle, a risk-parity fund. It's supposed to make money during market sell-offs. Because you need to be a high roller to invest in hedge funds, it's the one percenters that lost money during August investing in Bridgewater's fund. Nevertheless, it's Main Street investors, either through pensions, 401K plans or individual broker accounts, that probably saw shades of the 'Great Recession' of 2008-2009 flash before their eyes due to market instability. It was the lead story on the evening news for a week.

Bridgewater Associates has $165 billion in assets under management, and this is miniscule compared to the net worth of the trillions of dollars invested in the overall markets. I doubt they were the lone wolf that caused such a big market meltdown in the most recent 'flash crash', but they could have contributed to it. However, they were asleep at the wheel during August with their proprietary trading algorithms, which presumably were being monitored and adjusted by a team of human beings. What's going to happen when the machines take over, and all trading is guided by artificial intelligence? The future is closer than you think.

"I'd rather be a hammer than a nail"

High finance is quickly morphing into a machine learning world along with the rest of corporate America. Bridgewater Associates recently formed a new artificial intelligence division spearheaded by David Ferrucci, the mastermind behind the IBM and academic engineers that created the Watson computer system. According to an article by Phoebe Venable:

"The AI unit will devise trading algorithms that make market predictions based upon historical data and statistical probabilities — and like all AI systems, it will adapt to new information and get smarter as it goes."

Warren Buffett also likes to say, "If past history was all there was to the game, the richest people would be librarians.". However, Bridgewater isn't alone in its pursuit of unlimited profits by utilizing machine learning. A blog posting by Robust Tech House lists most of the major players venturing into the new era of AI, plus a brief synopsis of their business models. The firms included are:

  • Two Sigma Investments
  • Bridgewater Associates
  • Clonealgo
  • Renaissance Technologies
  • Aidyia
  • Cerebellum Capital
  • Rebellion Research
  • Commeq
  • Castilium
  • Binatix
  • Sinai
  • KLF Capital

If you have plenty of cash to burn, a closer examination of these organizations will give you a nonstop flood of ideas where to invest if you are inclined to go with machine learning algos. The prevailing orthodoxies on Wall Street would tell you to put your money in firms like these. However, I don't know which ones are flush with cash, or which ones are skating on thin ice. With the exception of companies such as Bridgewater Associates, most hedge funds have short self lives, automated or not.

Aidyia, one of the AI Funds listed above, is thoroughly covered in Quartz by Georgia McCafferty. As she states in her posting about the future of finance:

"Most quantitative trading, as it is currently practiced, relies on a human being to develop a mathematical model to identify trading opportunities. The model is then updated by hand to adapt to new markets or changing conditions. For an AI, conversely, humans develops the initial software, but the AI itself develops the model and changes it over time."

Just like the Bridgewater algo. What I find disturbing is that if the people monitoring Bridgewater's 'All Weather Fund' can't keep from losing money in a "heads I win, tails you lose" environment, what's an algorithm going to do if they aren't programmed correctly? This could put a lot of pressure on the markets and cause a collapse. It almost happened three weeks ago with human interaction. What about on autopilot?

I'm not a Luddite, but am wary of the new era. With the proliferation of personal computers and smartphones, the age of privacy is over. This becomes more evident when you mix machine learning with cloud computing. Artificial Intelligence in all forms is here to stay, especially in finance. It's a leading edge business where technology is concerned. There has to be some government intervention to monitor automated hedge funds or else they're doomed to crash the markets.

Sunday, September 6, 2015

Splunk: In No Man's Land

"Big Data is a broad term for data sets so large or complex that traditional data processing applications are inadequate." - From Wikipedia.

If you're in the corporate world, the concept of Big Data is nothing new. Even Main Street is aware of phenomenon, if not by name, then by practice. One example is Sabermetrics, the advanced baseball analytics made popular by the book Moneyball by Michael Lewis, and made even more popular by the movie of the same name starring Brad Pitt. Another is Amazon (AMZN) recommendations. The more you shop, the more they know about you. That's Big Data at work.

Although this mining and massaging of data is here to stay, Big Data as we know it is morphing from static sources to continuous data streams of spontaneous creation. This actionable data is created by HVAC controllers, smart electrical meters, GPS devices, RFID tags, smartphones and electronic wearables like a FitBit. We are now entering into the era of telemetry, the automated communications process by which measurements are made, and other data collected at remote points, then transmitted to receiving equipment for monitoring. This is where Splunk (SPLK) comes into play.

I did a posting about Splunk in early 2014 when it was the flavor of the month along with its entire sector of data mining and analytics securities. For a more detailed look into Splunk's business model, you can find my previous article here. At the time, I thought the equity was overvalued, and still do by a price/sales metric, but valuations have come down significantly in a year and a half.

Source: Stock Charts

If you examine the above chart, you can see where the stock was extremely overvalued. Stair step pattern on the way up. Elevator on the way down - penthouse to lobby in a matter of a month. However, if you are a long-term investor and bought at the IPO price of about $25 three yeas ago, you doubled your money. That beats the market. I don't want to go over old material from my last posting about Splunk, so I will concentrate on two areas of interest the company has been expanding the past 18 months, Security and Cloud.

Security

Every digital action produces actionable data, and Splunk's predictive analytics puts them at the forefront of Internet security for both corporations and The United States Government. According to CFO David Conte in the most recent conference call:

Security two plus years ago was 20% to 25% of business, and the end of last year, it ended up being not quite 50%, but over 40%.

With so much of the company's revenues devoted to security, I was surprised it didn't get caught in the updraft during the past year of many cyber security equities like partner Palo Alto Networks (PANW), which has had an incredible run, and to a lesser degree the PureFunds ISE Cyber Security ETF (HACK). That hasn't been the case. Perhaps investor sentiment will change once the market gets back in gear because of two recent acquisitions.

The first acquisition is Metafor Software, an anomaly detection and machine learning company. Splunk plans to fold in Metafor's technology into their already existing platform. The second purchase is Caspida, which adds Behavioral Analytics and machine learning to better detect advanced threats and malicious insider penetration. The software uncovers hidden breaches and new attacks out-of-the-box without extensive customization. Splunk will offer this product as a standalone application and bundle it in with their existing product line.

In the last conference call, company chief Godfrey Sullivan commented that security has become the main conduit to gain access into the inner workings of IT departments. For the first time security is serving as a steward for a lot of machine data across an organization. Splunk's sales department now targets security departments of potential clients, then expands across to application development or IT operations. Four years ago, it was the other way around, you'd go through IT operations to get to security. Splunk is the nerve center of security as one executive stated.

Cloud

Another initiative Splunk has recently launched to increase its Total Addressable Market [TAM] is its cloud service. Splunk cloud is now available through nine Amazon Web Services global regions. The results from the international launch look promising, and in the past nine months, clients have tripled their orders. According to a Splunk executive:

Our customers are excited with the speed and ease of Splunk cloud. They are happy to focus their time and attention on analyzing data to achieve their business results rather than procuring and deploying equipment.

Company management also believes they have the only solution in the marketplace that gives clients a true hybrid experience. They can search seamlessly across data stored on premises and in the cloud to get a unified experience with a single Splunk interface. One example is The City of Los Angeles who purchased Splunk cloud and the application for enterprise security to correlate cyber threat information with several other governments. This solution allows Los Angeles to monitor and analyze network traffic to identify discrepancies that indicate malicious attacks.

Offering a cloud or software-as-a-service solution is the way that many enterprise software companies are transitioning. It enables you to reach smaller customers with an out-of-the-box solution, plus takes away implementation headaches for IT departments in larger organizations. However, corporations like Adobe (ADBE) and Nuance (NUAN) made the switch, and found that it put pressure on equity valuations for a number of years. Although Splunk is in the early stages with its cloud offering, it's something potential investors should be aware of.

Some Statistics

Some pertinent points addressed in the conference call:

  • Revenues were up 46% over the past year.
  • The company can claim 10,000 customers worldwide. Including 79 of the Fortune 100 companies.
  • Since they denominate revenue globally in U.S. dollars, they do not have foreign exchange exposure.
  • Splunk expects to be profitable on a non-GAAP basis for the balance of the year.

Valuation

When I wrote my initial post about Splunk, trailing twelve month price/sales was 32 with a market cap of 9.8 billion dollars. Now it's much more reasonable with a price/sales of 14 and a market cap of 7.56 billion dollars. Still expensive. This can be reflected by the short float of roughly 11% as of two weeks ago. In addition, after a well executed quarter as reported on August 27th, the stock price went down. I realize there is no cookie cutter answer as to when the current overall stock market correction will be over, but it's taking all the growth with no earnings equities down, Splunk included.

Splunk excels at telemetric data collection with machine-to-machine data mining and analytics. This sounds like science fiction and that's why I like the company. They're using 21st Century technology in a 21st Century world. If you are considering investing in Splunk in anticipation of it regaining its go-go days of two years ago, I believe you will be disappointed. However, if you want a high growth company that appears to be turning profitable, this may be the right stock for you if you temper your expectations on price performance.

Liking a company and liking a stock price are two separate situations. I am not alone in my conclusion. A Barron's assessment of the conference call echoes my beliefs, or perhaps I'm parroting Wall Street consensus. As far as equities go, Splunk reminds me a lot of Acme Packet, a security that was engulfed by Oracle (ORCL) many years ago. Both pure-play companies had big runs, then crashed, although their respective technologies were deemed superior. I don't know what's in store for Splunk, but they'll probably be around for a long time unless a company like IBM has a better idea.