Steer Clear of These Cash-Strapped Tech Stocks

Welcome to this week’s mailbag edition of The Bleeding Edge.

Your fellow Brownstone Research subscribers have been sending in their most burning questions about the ideas we discuss in these pages.

And this is where we feature some of my favorite questions with my responses.

If you have a question about profiting in the tech sector that you’d like me to answer, you can email me at feedback@brownstoneresearch.com.

I read every question you send in. I can’t give personal investment advice, but I’ll do my best to write you a response.

Now, let’s dive into this week’s batch of questions and answers…

You say this is the time to buy small and mid-caps. Outside of the companies that have the cash flows to finance their purchases, credit conditions are tightening. Many regional banks are not out of the woods as yet.

And with the Fed’s “higher for longer” thesis, where are these companies going to get the funding to go forward with credit conditions tightening?

– Gordian B.

Great question. Thanks for writing in.

You’re referring to the September 26 Bleeding Edge issue.

I showed you a chart of how small-cap iShares Russell 2000 ETF (IWM) was at the bottom of a long-term trading range. And I argued that this was a good time to buy based on previous times the ETF has touched the bottom of its range.

But you’re right, small- and mid-cap companies are at earlier stages of growth than their large- and mega-cap cousins. They tend to have less cash coming in to fund operations and expansion. This makes them more reliant on borrowed money.

For good reason, investors have fled cash-burning companies with little opportunity to offset that with revenues. The biotech sector is ground zero for this phenomenon.

Take the SPDR S&P Biotech ETF (XBI). It tracks an index of leading biotech stocks. It’s down nearly 48% since the start of 2021.

These companies are often years away from even sniffing a profit. So, they need to borrow money to keep going.

As you point out, the Fed warned investors last week that it would be keeping interest rates “higher for longer” to combat inflation. That pushes up borrowing costs across the economy… including for companies.

So, I’m steering clear of sectors that will need to borrow at these higher rates or issue new shares to bring in cash. This dilutes the value of existing shares.

The tech sector is different. Take software makers. Their gross margins – the portion of revenues left over after the cost of goods sold – are often 70% or higher. More money falls to the bottom line. So, these companies don’t have to rely so much on borrowed cash.

Also, many tech companies pay their employees with stock options instead of just cash. This can make a company look unprofitable on paper according to standard accounting rules, known as GAAP (Generally Accepted Accounting Principles). These rules count stock options and other items as expenses, which reduces reported profits.

But when you check these companies’ cash flow statements, the story can change. These statements focus only on the money coming in and going out of the company from day-to-day business operations, such as sales and payments. And it doesn’t minus out stock options.

That’s why some companies might show a loss in GAAP profits but are not actually using up a lot of cash. This is especially important for new companies, which is why we often focus more on cash flow than on reported profits.

Keep in mind also that we have just exited an era in which many companies drew on credit lines at record low rates, or they did equity raises when their share prices were sky-high. So, many of these smaller companies are flush with cash and trade at reasonable valuations.

That’s not to say we should be complacent about the effect of higher rates on these smaller companies. But we’re not taking the Fed’s “higher for longer” warning as gospel.

You’ll recall that this is the same organization that claimed inflation was “transitory” and that rates didn’t need to go higher in the first place.

Plus, when you look at a chart of the Consumer Price Index (“CPI”), it’s clear that inflation peaked in the summer of 2022 and has been trending lower since.

So, the Fed doesn’t have to work as hard to bring inflation down. This tells me rates have likely peaked and will come down next year.

Meantime, my team and I are focused on emerging tech stocks with fat gross margins, little reason to fundraise, and are operating in sectors such as AI that have strong tailwinds right now.

That’s where the biggest opportunities are … even if rates stay higher for longer.

Thank you for your work. Wondering if any private AI companies are worth investing in currently? Thank You.

– Randy O.

Thank you, Randy!

Public or private, the key to finding the best AI plays is the data these companies use. If the company is “scraping” publicly available data, such as websites, they have an uphill battle.

Scraping is copying publicly available data – think Wikipedia – to train ChatGPT and other large language models (“LLMs”).

Google, Meta, and OpenAI already have a huge number of users and all the data they need. It would be highly unlikely for an upstart company to come along and take market share from the large tech giants simply using the same scraped data.

I’m also avoiding companies that are layering an AI solution onto another company’s data. For example, a software company that makes an AI app to manage Google Ads.

This tool is likely useful and will gain users. But Google will launch its own suite of tools serving the same market and crush the upstart.

The real opportunity is in companies that build highly specialized and targeted AI software. These will be companies that have data that users can only access by using the company’s AI app.

As you may know, at Brownstone Research, we have an advisory called Day One Investor that focuses on finding best-in-breed private companies to recommend to our readers.

And as part of my research for subscribers, I’m meeting with founders of AI startups. Most companies fall into the areas I’m avoiding. But I’ve also come across some promising AI startups. And I’ll be recommending them to Day One Investor subscribers in the coming months.

So, if you’re already a subscriber, keep an eye out for those in your inbox. And if you’re not already a subscriber, you can find out how to get access to all my pre-IPO recommendations here.

All the hype about so many companies using AI to improve productivity makes me even more irritated by the nonsense answers I continually get from AI chatbots.

They never answer the questions I ask. And since live customer service reps are few and far between, maybe improving that part of their business would give the impression companies actually care about their customers.

I just canceled and closed a long-time bank credit card for this very reason. I wasted 20 minutes repeating the same question to a chatbot which just kept referring me to the Q&A articles that didn’t address my question.

I will continue to close the accounts that don’t care about customer service. I don’t care about their improved productivity when I can’t get an answer to a simple question. A lower price is nice, but way below the importance of good customer service.

– Kathy D

Kathy, thanks for your question. I understand your frustration.

First, most companies are not using generative AI for their chatbots. Most are still using chatbot tech that’s been around for many years.

As you’ve experienced, these systems are designed to pluck a few keywords from your request and kick you to a FAQ section. This isn’t AI.

Most companies aren’t rolling out the next generation of AI for customer service yet because they need to do more testing first.

Generative AI systems need guardrails in a customer service scenario because these systems could reveal too much, such as customer or company data. Another risk is the AI system could express bias or say something controversial, which would not positively represent the company.

But rest assured, it’s coming. And it’s going to be spectacular.

OpenAI, for example, recently showed off a feature that not only instructed a user how to adjust the seat on a bike but also told the user which tool in their toolbox they’d need from the job. All the user had to do was upload a photo of the bike seat.

It didn’t kick the user to a FAQ about how to adjust the seat. It gave a solution to the problem on the spot.

To take your example of banking, with these new systems. you’ll be able to tell it, “Transfer $100 from my checking to savings.” And it will do it. Or you could say, “Send $100 to my son via Zelle.” And it will.

But the banking sector, as you experienced, will be late to adopt the latest and greatest AI chatbots because of regulations and compliance. The systems aren’t yet able to safely handle your personal information. Once they are, you’ll have a much better experience.

But banks and credit card issuers have already adopted AI to detect fraud. In the past, if your credit card info was stolen, you wouldn’t find out until your statement arrived and you saw that someone had racked up a bunch of fraudulent payments.

Now, AIs can scan a ton of information about how you normally use your card… flag fraudulent transactions… and stop them from going through. You’ll often get a text message or phone call to make sure you’re the one using the card. This has helped cut down on cases of fraud.

You’re right, there’s a ton of hype around AI. But it’s still early in the development cycle. One of the issues is that AI systems are so advanced, companies have to figure out ways to reign in the responses they give to customers.

That’s a challenge, particularly in highly regulated sectors such as banking, education, and health care. But within the next two years, your days of dealing with frustrating chatbots will be over.

Regards,

Colin Tedards
Editor, The Bleeding Edge