Our Best Ideas On Stocks To Buy If Tech Sells Off

Oct. 13, 2021 3:44 PM ETSalesforce, Inc. (CRM), DT, FSLY57 Comments48 Likes

Summary

  • Buying the dip has been a veritable religion for a decade or more, and a serially lucrative act of faith at that.
  • We believe this bull market has a little way to run yet, and with it, we believe there are likely still some dips to be bought.
  • Here we walk you through how to spot suitable dips, and we give you three ideas of stocks to buy should they sell off.
  • One of those stocks - Fastly - is already on the floor and can, we believe, be bought now in anticipation of medium-term gains.
  • Looking for a helping hand in the market? Members of Growth Investor Pro get exclusive ideas and guidance to navigate any climate. Learn More »

Calm vs Panic

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DISCLAIMER: This note is intended for US recipients only and, in particular, is not directed at, nor intended to be relied upon by any UK recipients. Any information or analysis in this note is not an offer to sell or the solicitation of an offer to buy any securities. Nothing in this note is intended to be investment advice and nor should it be relied upon to make investment decisions. Cestrian Capital Research, Inc., its employees, agents or affiliates, including the author of this note, or related persons, may have a position in any stocks, security, or financial instrument referenced in this note. Any opinions, analyses, or probabilities expressed in this note are those of the author as of the note's date of publication and are subject to change without notice. Companies referenced in this note or their employees or affiliates may be customers of Cestrian Capital Research, Inc. Cestrian Capital Research, Inc. values both its independence and transparency and does not believe that this presents a material potential conflict of interest or impacts the content of its research or publications.

Never Did Virtue Pay So Well

Since 2009 this market has been moving in one direction only, and that has been, up. Couple yikes moments here or there. Q4 2018 when Jerome Powell flirted with orthodox monetary policy. Q1 2020 when there was, you know, the first act of a global millions-of-deaths pandemic thingummy. March 2021 and then May 2021 when it was declared that Tech Was So Over Right Now. Until June 2021 when it was then decided that Value Was So Over Right Now. But, zooming out, looking at the larger degree? Always up.

And lo has a whole cohort of public stock investors - some new to the bloodsport and some not - become conditioned to Buy The Dip wherever they see it. Because for twelve years it has worked, as long as you had the stomach to keep holding. Dismiss, if you like, the Reddit chorus of "HODL", but, for the most part, this has been absolutely the correct investment strategy for more than a decade now, and if you overthought it, you likely made less money than the HODLers.

We can argue as to why always-up since 2009. Limitless supply of Fedamphetamines? Deflationary super-cycle in tech leading to giant tech companies invading the S&P500 leading to an always-up S&P? Mass delusion? Who knows. Who can ever know? But the fact is, always up.

If one is a dip-buyer one has to resist the temptation to buy too soon. A quick one-day sell-off of say 5-6% in a stock you like can easily cause that FOMO feeling to run from your lizard brain all the way down to your gut lining and back up to your itchy Buy finger. Most often that works, but as the market reaches the top of its long cycle - as surely it will at some point, we know not when - we think it pays to get a little more scientific about the whole BTD thing. Well, if not scientific then at least quasi-rational. Or at a minimum, not totally reliant on your gut.

We think the key to buying dips successfully in the coming months is to be patient. Go slow when others are going fast. Sit back when others lean in. Do your work on the companies ahead of time, on the stocks of those companies ahead of time (remembering always that stocks and companies are completely different things), have your numbers and charts at hand, and be ready. And most of all? Learn to control that lizard brain. Your lizard brain is stupid and thinks it is still One Million Years BC when you could be eaten by a predator at any time. Unless you live in the further reaches of the tundra, in which case, congratulations on reading this courtesy of Iridium (IRDM), we have news. You can't. So tell the lizard to calm it all down and get your conscious brain fully in command of your gut lining and that trigger finger. Patience is a virtue, and this particular virtue, if exercised correctly, can pay well in the coming months we think.

Why Does Technology Sell Off?

Our professional technology investing experience here at Cestrian spans three decades and includes a whole bunch of only-up and only-down markets. Or at least they felt that way at the time. One thing you know about markets is that whichever direction they are pointing in right now, they turn. A matter of when, not if. Our house view on market direction is that we likely have at least 12-18 months more up for the S&P500 and Nasdaq level before we reach a potential top of the current bull run; and we think that within that 12-18 month period, there will most certainly be dips in tech stocks and further that some of those dips will be very buyable. We may, of course, be utterly wrong, but it's important you understand the context in which we think so that if you choose to factor our work into your own, you know our prejudices (in other words you can work out in which direction we are likely to err).

So let's assume that there are a few tough tech sell-offs to come in the next 12-18 months - that seems a safe assumption to us. And let's assume that a bad day at the office type selloff doesn't count. Let's assume we are talking March 2021, May 2021 type selloffs in tech. Material selloffs which cause you to have to brace yourself when you look at your broker screen. Not 1999-2001 type selloffs, not 2007-8 selloffs, but material.

Tech sells off periodically because the key stocks are "always too expensive". They get bid up in times of overexcitement, regret sets in first in tech because the valuation multiples are so much higher than in other sectors, so when fear hits, people dump these supposedly higher-risk names first. But if you know what you are doing in tech, this represents a wonderful opportunity on a regular basis. Because the prevailing "too expensive and too risky" wisdom is nonsense if you ask us. Market participants who believe this are just lazy. They conflate the risk of owning say a commodity DRAM business, which has little pricing power, low gross margins, hefty capex commitments, poor working capital characteristics and extreme earnings and cash flow cyclicality, with a consistent-growth, high gross margin, highly cash generative subscription software business that has two years' worth of forward revenue already contracted and one years' worth already prepaid. To call them both tech is fine whilst talking about them over a beer. But for the serious analyst to consider them both the same thing is just to ignore reality in favor of a common refrain. Which doesn't stop most market participants from doing just that. In short, tech sells off because people think it is going to sell off, and so when a few scary things hit the market, people dump tech so that they aren't left holding a bag when other people dump tech.

It will not surprise you to learn that there is a better way of playing this game.

How To Buy The Dip In Tech

The first thing to figure out about buying the dip is, well, is it a dip? And the answer to that can only come from your view of market direction. If you think the whole market is going to move down in the coming months, the logical extension of that view is that a dip is likely a precursor of a bigger drop. In which case you probably won't want to commit dollars now in case you feel rather queasy later. We cannot say you would be wrong here. Nobody knows where markets will go, at best one can only work out probabilities, and anyone who says otherwise is either an idiot, or selling something, or both. You have to reach your own view on market direction first, before all else. Again - our house view is, SPY and QQQ likely move up for the next 12-18 months. And so if we see a material dip in the tech names we like, we think making a buy decision is solely about that stock, not a wider call on the market, because we already formed our view on market direction and closed that logic gate behind us.

How do you know when a dip is ready to be bought? Well, again, there can be no certainty, but you can use tools to improve your odds of getting it right. The best tool we have found - and remember we do this for a living so getting it right does matter to us, a lot - is to use something called Fibonacci retracement levels. You're probably familiar with these but in case you aren't - Fibonacci numbers are those in a sequence which seems to have some basis in nature itself. You can read all about them here. What's important for our purposes is that market participants, or at any rate enough market participants with enough money, do often trade using Fibonacci levels as guides for price support and resistance. Whether that is because their lizard brains and lizard-trained algorithms actually work according to the Golden Ratio, or whether their conscious brains do so because other market participants seem to do the same, creating a self-fulfilling strategy, we know not. What we do know is that plenty of stock movements are bounded by those Fibonacci levels and can be predicted - to a degree - by using them.

You can work out Fibonacci levels by hand if you like, but for the rest of us mere mortals, various charting tools will do it for you. In our business we use both TradingView and Barchart and either will do just fine if you want to try them. (They are both free in their basic incarnations).

"Retracement" is a big word but it just means retreat. If a stock moves up a lot, then falls back, it has "retraced" its steps. If a stock moves down a lot, then moves back up, similarly, it has retraced its steps. See? Simple.

The levels to which a stock retraces aren't completely random, because trading systems are set to trigger limit orders at or around the key Fibonacci levels. For instance, in Fib-world, a big selloff is a 0.786 retracement of the most recent move up. So you will often see a lot of buying step in at or around that level. Not exactly at the level all the time of course, because people and their bot twins set limit orders a little above or below the key levels in order to not make the obvious move; but close enough to tell you that these things are things, not just voodoo.

For instance, a sociopath investor would see Q1 2020 not as a panic induced by the burgeoning market and real-economy threat of an airborne respiratory virus, but merely as a 0.786 retracement of the most recent advance of a bunch of high growth stocks.

Here's Tesla (TSLA). Starts a big run up in June 2019 from around $35/share (split-adjusted). Peaks on the 3rd Feb 2020 at around $193/share, a $158 move up. Then comes the Covid selloff, the stock troughs at around $69/share, this being the 0.786 Fibonacci retracement level. It then sets off on a monster move back up again.

Source: Barchart, Cestrian Analysis

Or try Zscaler (ZS). Puts in a post-IPO low of $24-ish in mid 2018. Runs up to $89-ish in the second half of 2019. The stock swan-dived following sales execution snafus that year, started to recover, Covid hits, and there it is again, the 0.786 retracement of the runup. Indeed the sales execution collapse almost hit that level in 2019.

Source: Barchart, Cestrian Analysis

That 0.786 retracement is a big one and you don't see it all that often. More common is the 0.618 retracement which still gives you a materially better entry point than at the top of the prior move, or indeed the 0.5 retracement, better still.

Here's Salesforce (NYSE:CRM).

Source: TradingView, Cestrian Analysis

The stock was hit hard when the Fed flirted briefly with normality on Fed rates in Q4 2018. If you recall, CNBC at the time was full of tales of the End Of Days, the Big One, etc. But all you see here is a common-or-garden 0.5 retracement of the last two years' worth of stock price growth, in a knee-jerk reaction to the CNBC episode, "The One With The Four Horsemen of the Apocalypse". How would you know it was a dip to buy? Because it bounced, hard, off that 0.5 retracement level and headed back up. Telling you that nobody really wanted to dump CRM - the following few days also saw high volume buying, telling you that the dip was likely done with.

So - these Fibonacci levels can help you measure on a consistent basis, how bad is the drop in this stock? And it can help you calibrate, do I want to buy in now? How much has the stock fallen from that prior high? What does the price and volume activity on the chart tell me about whether market participants are leading the stock out of the darkness or whether they are tossing it overboard?

A method you may like to think about is to buy piecemeal when a stock is on the way down. Hits the 0.236 retracement? Write a very small check. Next stop, 0.382 retracement, bigger check. And if it goes all the way to the 0.786 retracement, big fat check. All of this is predicated on the notion that the stock does then rebound of course! But the information you pick up on the way down - are the Fib levels respected, do they act as some kind of temporary support, what is the volume of buying at those levels - will help you continue to judge this. Alternatively, don't write any checks until you see the stock bottom, test that bottom a couple times, then move up again. There's no perfect method, you just have to find an approach that works for your own wallet and psychology. But there are methods. You don't have to just spray and pray.

So now you have some tools that your conscious brain can use to parry and counter the lizard. Which stocks might present themselves as dips to buy next time the market dumps tech?

Three Buy The Dip Tech Stocks To Consider

Let's consider three stocks in increasing order of risk, meaning, if you buy and get it wrong, which are you likely to most regret?

First up is Salesforce, a company that has a rock-solid, predictable, growing, cash generative business model but an unfathomably volatile stock. If you spend a little time on the financial fundamentals of the company you may reach the same conclusion as us, being, it's a great stock to buy and hold for a very long time, and if you buy a dip that turns out to keep on dipping, and you don't want to average down or crystallize the loss, the company will probably save your embarrassment if you just brazen it out for long enough.

Salesforce Stock Price And Valuation

CRM's fundamentals are superb.

Source: Company SEC filings, YCharts.com, Cestrian Analysis

The fundamental valuation is unchallenging too. You're being asked to pay 12x TTM revenue for a 23% grower with 22% TTM unlevered pre-tax free cash flow margins.

Source: Company SEC filings, YCharts.com, Cestrian Analysis

The stock has a habit of swooning on news of big M&A; it has done so for some years and thus far the company has always executed its acquisitions well, both pre and post deal. CRM has set itself ambitious revenue growth targets which imply more major M&A is on the way and if the pattern continues we believe multiple buy-the-dip opportunities may come along. Should you wish to avail yourself of these opportunities, you might keep an eye on the retracement levels indicated below - all measured from the March 2020 rebound at the Covid lows.

Source: TradingView, Cestrian Analysis

Now, whilst Salesforce might have gotten a blank stare from neurotypical folks if you talked about it 10-15 years back, today it's as close to a household name as enterprise software gets. Our next pick, which is higher risk than CRM in our view (as in, getting your dip buy wrong could hurt more for longer), is largely unknown still, despite running one of the very best quality companies we have seen in several decades of tech investing.

That pick is Dynatrace (NYSE:DT), which is an 'application performance monitoring' and 'observability' software vendor. It sits deep in the enterprise datacenter, watching the other apps in a rather Stasi-like fashion, reporting back to the IT function should anything be awry among the troops of virtual machines under its purview.

Dynatrace Stock Price And Valuation

If you want to know what good looks like in software company fundamentals - actually in any company fundamentals - this is what good looks like.

Source: Company SEC filings, YCharts.com, Cestrian Analysis

A particularly attractive feature for dip-buyers is that remaining performance obligation table. Most folks don't look at RPO, because it's to be found in the SEC reports a couple days after earnings; rarely will you see it referred to in earnings releases, though if you listen carefully a number of companies now update you on the number during earnings calls. RPO is the total forward contract book, including some prepaid contracts (which fall into deferred revenue, a subset of RPO) and yet to be paid. The bigger a number RPO is vs. TTM recognized revenue, the more visibility you have into the future revenue line; and the faster RPO is growing the more likely it is to drag up TTM recognized revenue growth. Naturally what you want to see is RPO > TTM recognized revenue and RPO growth rate > TTM recognized revenue growth rate. Well, as of the June quarter end at DT (that's their Q1 of FY3/22), RPO was fully 1.65x TTM recognized revenue and it was growing at +46% vs prior year, compared to 31% growth in TTM recognized revenue vs. prior year. This is good. Very good.

As befits a company born in the fires of hell, aka. a crucible forged by private equity, the cash flow margins are exceptionally strong for the rate of revenue growth. TTM unlevered pre-tax free cash flow margins were 36% in that same June quarter - fully eight points higher than the corresponding EBITDA margin. In other words the company produces more cash than profit, and if you look, it does so consistently. Doubleplusgood.

The fundamental valuation is, again, not so bad in the current environment. Note the cash flow multiple is lower than the EBITDA multiple.

Source: Company SEC filings, YCharts.com, Cestrian Analysis

Here's the stock chart with potential pullback levels at which to consider adding on a dip. The range is the March-2020 Covid lows to the most recent high.

Source: TradingView, Cestrian Analysis

Finally, Fastly (NYSE:FSLY) a yikes-it-could-go-horribly-wrong name, which could, in our view, go very very right.

Fastly Stock Price And Valuation

This one is not for the faint of heart because the fundamentals are frankly dreadful compared to those two paragons of virtue above. Low or no revenue visibility (by choice!), very negative cash flow margins, oh and also plenty of competition and limited pricing power.

Source: Company SEC filings, YCharts.com, Cestrian Analysis

Valuation is likely OK as long as growth starts to pick up again in Q3. If it stays flat quarter-vs-prior-quarter (as you can see it was in the June quarter) there may be trouble ahead.

Source: Company SEC filings, YCharts.com, Cestrian Analysis

The thing is, the stock has been beaten down so hard already that frankly this is already a dip to buy in our opinion (we have been doing so in staff personal accounts). It could drop further if the market at large weakens, but right now the stock sits at that big 0.786 retracement from the run up from the March 2020 lows. The stock has tested this retracement level on 2-3 occasions and thus far it has proven robust. So whilst we wouldn't declare this any kind of slam dunk dip buy, it has fallen a long way, and it could run up a lot just on "technical factors" (translated: because it has sold off a lot already!). In addition the company could be acquired - there are persistent rumors of the company being sold to Amazon (AMZN) for instance - and there is also a rather public campaign afoot to replace the CEO (a move we would applaud by the way).

Here's the stock chart. We've overlaid an Elliott Wave pattern on the retracements. It's possible that the next move for the stock is up, and bigly, if it follows a standard wave pattern. The stock is hovering around the 0.786 retracement of the move up from the 2020 lows.

Source: TradingView, Cestrian Analysis

We cannot look you in the eye and say, buy in the low $40s and sell in the $160s. That's just one possible path that the stock could take. But we can say, well, if you want a big dip to buy in this only-up market, here's one, and if you choose to join us in having bought it, good luck to us all!

Cestrian Capital Research, Inc - 12 October 2021.

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Disclosure: I/we have a beneficial long position in the shares of CRM, FSLY, ZS, AMZN, TSLA, IRDM either through stock ownership, options, or other derivatives. Business relationship disclosure: See disclaimer text at the top of this article.

Additional disclosure: Cestrian Capital Research, Inc staff personal accounts hold long positions in CRM, FSLY, ZS, AMZN, TSLA, IRDM.

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