Ares, Medifast And Zscaler: 3 Stocks For Income And Growth Investors

Crowded video screen, briefing, brainstorm, virtual meeting of multiracial work team

Vadym Pastukh/iStock via Getty Images

Preamble

Many believe that investors need to have a certain outlook on the market. This message is transmitted through the army of talking-heads on CNBC, financial writers on the WSJ peddling their opinions on market movements (and in recent years, finance YouTubers). With the exception of a few who advocated caution against the state of over-valuation in equities, the general 2020 to 2021 consensus from most financial experts was “Don’t fight the fed”. With rampant QE and stimulus money being doled out to individuals and businesses, everyone from retail investors and big corporations became excessively exuberant. Deals in the IPO and SPAC markets were heating up, interest rates were low at near 0%, asset prices from stocks, properties, and cryptocurrencies were breaking new all-time-highs every week, and ever more bullish analysts upping their price targets after every earnings call, exuberance kept pushing indices like NASDAQ and DOW to break new highs.

Then 2022 happened. The last seven months have been a sobering wake-up call that forces investors to think more realistically and strategically about their investments. Are we in a recession? Will we be facing stagflation? How long will inflation last? Should I buy the dip or stay in cash? Psychologically, when FOMO (fear of missing out) and/or FOLO (fear of losing out) is the prevailing sentiment, can we stay rational?

Realistically, nobody knows how the market would behave today at the opening bell, nor how it would close. Therefore, not to mention how the market would look six months, a year, or five years from now.

Strategically, if investors structure their portfolio to perform in different environments, achieving a positive overall return over the long term should not be in doubt.

Psychologically, one way to take the emotions out of investing is to design a portfolio that can perform in different market conditions, a so-called balanced portfolio.

Constructing A Balanced Portfolio

I believe that it is fundamental to construct a balanced portfolio that can weather different market conditions. If a portfolio is imbalanced in a certain way, FOMO and FOLO can get amplified during different market cycles, and these strong emotions may prompt investors to buy when asset prices are rising, or sell when the same assets are tanking.

It is no wonder retail investors underperformed most asset classes even after taking into account the post-March 2020 V-shaped recovery bull-run in 2020.

Retail Investor's Returns

Retail Investor’s Returns (JP Morgan)

I want to seek alpha as much as the next investor. I am just cognizant that not all the stocks in my portfolio will help me achieve that in the same way.

The diagram below represents my paradigm in portfolio design. Basically, I group my holdings into three broad groups: Income Providers, Income Compounders, and Alpha Champions. Different stocks have different purposes, just like different football players from a team each has a different role on the field; not everyone should be (or can be) a quarterback; nor should everyone be a linebacker. Underlying this approach is a value investing mindset; I will always prefer to spend $0.50 to buy $1 worth of assets.

Portfolio Paradigm

Portfolio Paradigm (Author)

The Income Providers are stocks that I can trust to provide me with a steady stream of income at a high yield for reinvestment. One would naturally gravitate toward the Dividend Aristocrats. However, I find most of them overvalued now. I discussed this aspect in my article on Best Buy. Besides, the yield that most Dividend Aristocrats provide is not sufficient to meet my requirements to be an Income Provider.

The Income Compounders‘ job is to grow the dividend at a high rate, providing me with investable income that could double every 7-10 years. However, just depending on these two groups of stocks will not be sufficient for me to reach my early retirement goal. Hence, income from these is reinvested into the Alpha Champions.

The Alpha Champions‘ role is to provide that boost to overall gains. When I realize the gains from selling the Alpha Champions, I can reallocate these to either the Income Providers or the Income Compounders to generate more investable income to invest in more Alpha Champions.

Enough explanation. Let’s look at 3 stocks that fit these roles.

1. The Income Provider: ARCC

ARCC Income Provider

ARCC Income Provider (Author’s)

Ares Capital (ARCC) is an attractive Income Provider candidate. If I had $10,000 invested in ARCC 10 years ago, I would have received all my capital after exactly 10 years. Yes, the annualised rate of return (excluding dividends) is laughable; holding ARCC shares for the entire duration of its 15 years of existence yield a measly return of 0.32% before including dividends. But providing alpha is not ARCC’s purpose in my portfolio. What I want from ARCC is a dependable stream of income at a high yield.

ARCC Performance

ARCC Performance (Fast Graph)

Since its inception in 2004, ARCC has been paying out dividends between $0.30 per share and $0.43 per share. It did that throughout all manner of global upheavals: the aftermath of the dot-com burst, the SARS epidemic, the sub-prime mortgage crisis, the European debt crisis, the peak oil crisis when oil was at $150 per barrel, when oil was under $0 per barrel in the first two months of covid … you name it. ARCC just kept on doling out that dividend.

ARCC Dividend History

ARCC Dividend History (Seeking Alpha)

ARCC is also known for being one of the best BDCs in the industry. Seeking Alpha ranks ARCC as the third best company out of ninety in the Asset Management and Custody Banks Stocks industry. Kiplinger describes ARCC as “the world’s largest BDC by market capitalization, with a value of roughly $10 billion” and that it has a “conservative profile“.

I like the company’s conservative risk management approach. The bulk of the loans it makes are first lien (45%) and second lien (19%) meaning in case of defaults on its loans, ARCC will be the first or second in line to get paid. And with 74% of the loans of the floating rate kind, in the current rate hike environment thanks to the Federal Reserve, management has the flexibility to increase the rates to potentially get more returns. And there lies the possibility for ARCC to yet increase the dividends again, either in Q3 or Q4 2022, giving shareholders another reason to cheer.

ARCC Asset class

ARCC Q2 Earnings Presentation (ARCC Investor Relations)

The loans are made to companies in numerous industries, diversified to reduce concentration risk (no more than 5% in any industry other than software and healthcare). I am fine with the 23% in the software industry as those businesses typically have higher profit margins, and the 11% in the healthcare industry as healthcare products and services are usually needed even when times are bad.

ARCC Investment portfolio

ARCC Q2 Earnings Presentation (ARCC Investor Relations)

Valuation Of ARCC

As of market close on 12 August, each share costs $20.56 which I think is trading at a slight premium to its net asset value per share of $18.81.

ARCC Q2 Earnings Presentation

ARCC Q2 Earnings Presentation (ARCC Investor Relations)

Final Word On ARCC: Hold

I do not advocate the purchasing of ARCC shares right now. However, anytime ARCC’s share price dip below its NAV, I will be on the lookout to add.

2. The Income Compounder

Medifast Overview

MED Overview (Author’s)

Medifast (MED) is the quintessential Income Compounder. The rate of dividend growth for the past 6 years is a staggering 88.07%. At that rate, $1 will become $23.48 in 5 years.

Medifast Performance

MED Performance (Fast Graph)

$10,000 invested in this wealth-loss company in 2015 would have generated $5747 in dividends by the end of 2021, which is $5747 that could be reinvested. The yield on cost would have increased from a paltry 0.78% to a mouth-watering 17.62% – without having to do anything except hold onto these shares.

Granted, MED has only paid dividends for 6 years and that 88.07% dividend growth rate has been on the decline but that is to be expected. Unless a company can also increase earnings at that insane rate, a slowdown in dividend growth is only prudent. However, so long as the dividend growth rate stays above 10% per year, the dividend will double in around 7 years. I will continue to hold it for its outsized dividend payout that provides income for reinvestment.

MED Dividend Performance

MED Dividend Performance (Fast Graph)

In addition, MED is not just a dividend compounder; it is a growth company too. MED’s total returns bested even mature growth companies such as Alphabet and Microsoft. $10,000 invested in each of these companies in 2005 through July 2022 with dividends reinvested would yield the following results.

Performance Comparison MED vs AAPL vs GOOGL vs MSFT

Performance Comparison (Portfoliovisualizer)

MED performed admirably, crushing Alphabet (GOOG) (GOOGL) and Microsoft (MSFT) handily, losing only to Apple (AAPL).

MED’s CAGR over its 18 years as a publicly listed company ranged from 23% (the lowest) to 56.93% (highest) so I am very confident that the company can continue to perform well even through difficult market situations.

Isn’t the 50% Decline From ATH Worrying?

Some may wonder if MED is a safe pick after a 50% decline from its all-time highs of $332.25 in May 2021 to $136.79 as of close on 12 August. After all, for a dividend compounder to serve its role, it must be able to keep growing earnings in order to keep growing the dividend payments.

Firstly, I see the price decline as making MED a safer and less risky investment.

Secondly, investors should understand the nature of the beast they own. MED is a relatively high beta stock at 1.1. meaning swings in either direction in the market will amplify MED’s stock price movement by an additional 10%.

Thirdly, investors should put the recent “bad news” in context. Just 2 weeks ago, management reported a fantastic end to Q2 (non-GAAP EPS of $3.87 beats by $0.64; revenue of $453.3M beats by $5.43M), but issued a cautious outlook for the rest of 2022,

MED’s FY non-GAAP EPS outlook is now $12.70 to $14.10 compared to a previous guidance of $14.60 to $16.05. The consensus EPS estimate is $11.15.

The causes of the lower guidance are macroeconomic factors such as inflation that impacted consumer sentiment, which impacted customer retention, and both are outside the control of any company. However, many investors lost faith and dumped the shares. The share price nose-dived 29% in 5 days from $177 on 4 August 2022 to $126 on 9 August. It has since recovered slightly to close at $136.79 as of close on 12 August.

When management projected a lower $12.70 to $14.10 adjusted earnings range, which means management is projected either a best case scenario of 1.5% year-on-year non-GAAP EPS growth ($14.10 – $13.89 = $0.21) or a worse case scenario of 8.57% year-on-year non-GAAP EPS loss ($13.89- 12.70 = $1.19).

That is certainly not the same rosy picture that was painted 2 quarters ago. However, to put matters in perspective, even if earnings come in at the lower end of $12.70, that will still be higher than earnings received in any year from 2020 and prior.

Besides, management has proven itself capable of producing EPS surprises (36%-46% of the time) versus analysts’ 1-yr and 2-yr projections. Put together with the company’s impressive track record since 2005, I have confidence that MED will do well over time.

Valuation Of MED

Analysts from different sources are projecting a range of adjusted earnings growth for the next 1-5 year period for MED that ranges from -14% to 24.7%. I am more conservative and after taking into account management’s comments about near-term headwinds from inflationary concerns affecting consumer sentiments, I project a 20% slowdown in earnings growth. Averaging these give a possible 1.54% earnings growth for the next year.

MED Value Estimate

MED Value Estimate (Author)

Then, I considered 3 scenarios where earnings grow at 3.53% of different earning ranges (from $11.95 in the bear case and $14.10 for the bull case). Next, using MED’s PE history as a reference, I factored in different possible PE for each of the bear, normal, and bull case.

Based on these conservative assumptions, I believe that MED is worth at least around $149.08 now, and buying at the closing price of $136.79 on 12 August will represent an 8.99% margin of safety.

Final Word On MED: Buy

I would rate MED as a buy at the current price and valuation. It was definitely a strong buy last week at $126. Analysts’ consensus price target is $214, representing a 57% upside; the lowest price target estimate is close to my valuation of $149.08.

MED Price Target

MED Price Target (Trading View)

Investors should understand what MED does. Weight loss management is a multi-decade trend, and MED is the leader in this industry. With a more educated global population showing greater appreciation for a healthy lifestyle, MED’s business model of getting coaches to teach clients healthy habits – not just selling products – is unique.

3. The Alpha Champion

Zscaler (ZS) would be an excellent choice to double my investment within 10 years or less. A company’s past gives investors a glimpse of what they were capable of. Investment however is about a company’s future and ZS is leading the way.

Analysts expect ZS’s growth rate to continue to grow at a blistering rate between 31% to 43% in the next three years.

ZS Sales Growth

ZS Sales Growth (Fast Graph)

That kind of growth rate certainly deserves and demands a premium. Even if ZS’s price-to-sales ratio were to be halved (which I think is unlikely) from its normal 33.18 to 16.59, ZS could potentially still cough out an 11% annual rate of return by 2024.

ZS Forecast Sales Growth

ZS Forecast Sales Growth (Fast Graph)

I believe that ZS’s products will continue to resonate with their customers due to the following three reasons:

  1. Strong revenue growth
  2. Strong tailwind
  3. A clear path to profitability.

Strong Revenue Growth

Although the topic of revenue growth was discussed above, I would like to add the following to put ZS’s impressive growth in context. In the recent Q3 earnings call, Chairman and CEO Jay Chaudhry said:

We are pleased to report another strong quarter. In Q3, we delivered 63% year-over-year revenue growth, 54% billings growth and 15% free cash flow margins, all while investing for high growth.

While most public SaaS companies are happy to get to Rule-of-40, we again exceeded the Rule-of-70 based on revenue growth and free cash flow margins. With our increased guidance today, we expect to achieve the Rule-of-80 for the full year.

That is a big deal for a software as a service (SAAS) company. Not all SaaS companies grow at this rate. Of the 100 public SaaS companies in the United States with revenues above $100 million that McKinsey analyzed in May 2021, the median revenue growth rate was just 22 percent. Only a small share of SaaS companies sustains growth rates above 30 to 40 percent. And ZS is reporting revenue growth far exceeding the top-tier SaaS companies.

Strong Tailwinds

A report by MarketsandMarkets valued the Cybersecurity Market at USD 217.87 billion in 2021. This is projected to grow from USD 240.27 billion in 2022 to USD 345.38 billion by 2026, representing a CAGR of 9.5% in this period. ZS provides cybersecurity in a subset of this huge market under “cloud security”, an even faster-growing segment projected to grow at a CAGR of 13.7% between 2021 to 2026. According to the report,

The major factors fueling the cloud security market include growing sophistication of cybercrimes, cyber espionage campaigns, and generation of new cyberattacks, upthrust in the use of cloud-based solutions and upsurge in BYOD and CYOD trends to boost the demand for cloud security. Moreover, increasing government initiatives to support smart infrastructure projects, and securing online payment applications, social media, and OS would provide lucrative opportunities for cloud security vendors.

With more companies adopting work-from-home and flexible-hours working arrangements in the post-Covid world, more employees will be communicating via tools such as Zoom (you can read my writeup on Zoom here), Cisco WebEx, Microsoft Teams, and Slack, there will be more vectors of attack to compromise sensitive data in both the public as well as private sectors.

In 2018, Forbes estimates that by 2020 more than 83% of enterprise workload would be in the cloud. I suspect the figure is higher now, fueled by the pandemic. According to another report by MarketsandMarkets,

Major cloud companies, such as Amazon and Google, heavily invest in enhancing their cloud security offerings to combat the ever-evolving cyberattack scenario. The demand for cloud-based services has soared due to the outbreak of COVID-19. The outbreak of COVID-19 forced enterprises to adopt cloud services to a large extent due to work-from-home scenarios worldwide. Microsoft reported a 775% increase in the demand for its cloud service platform during the pandemic.

Enters Zscaler.

According to the company’s website:

Zscaler, creator of the Zero Trust Exchange platform, uses the largest security cloud on the planet to make doing business and navigating change a simpler, faster, and more productive experience.

ZS is recognized by Gartner as a leader in the Security Service Edge, 11 years in a row.

ZS Leader in SSE

ZS Leader in SSE (Gartner Magic Quadrant)

As the pioneer of the Zero Trust Exchange, Zscaler works with and integrates its solutions with over 80 technology parts dealing in SaaS (MSFT, NOW, CRM), Endpoint Protection and Management (MSFT, CRWD, S, VMW), Identity Management (MSFT, OKTA, etc), Cloud Providers (AMZN and MSFT) and many more.

ZS Product Presentation

ZS Product Presentation Video (ZS website)

ZS has over 5000 customers of which 40% are from the Fortune 500 and 30% are from the Global 2000 companies, all trusting it to secure their digital transformation. These companies come from a range of industries – conglomerates; banks, aerospace, and even apparel – because data protection is only getting more important in a digitalized world.

Zscaler market leadership

ZS Earnings Presentation Slides (Seeking Alpha)

Clear Path to Profitability

A company’s operating cash flow is an important benchmark to determine the financial success of a company’s core business activities. Operating cash flow indicates whether a company can generate sufficient positive cash flow to maintain and grow its operations, and I consider this a core benchmark for hypergrowth companies because it gives the clearest sign if a clear path to profitability is present. ZS has been generating positive and growing operational cash flow for a few years that far exceeds its total annual capital expenditure.

ZS Financials

ZS Financials (Fast Graph)

In fact, the rate of growth of operating cash flow (NOCF) has increased rapidly since 2018. In 2018, the NOCF is just enough to pay off a tenth of the total current liabilities (TCL). In 2021, the NOCF has narrowed to a third of the TCL.

ZS NOCF and TCL

ZS NOCF and TCL (Author)

This is not surprising as ZS continues to attract new customers and retain current ones. According to ZS’s Net Promoter Score (NPS), which is an indicator of customer satisfaction, ZS scored an NPS of 70 which is more than twice that of an average SaaS company. ZS has 288 customers paying sums exceeding $1 million in annual recurring revenue, an increase of 77% year-over-year. ZS added 140 customers in Q2 paying it more than $100,000 annually, ending the quarter at 1,891 such customers. ZS also boasts of high net retention rates (NRR) that exceeded 125% for the last 6 quarters.

With such impressive, sustained results, I have confidence that ZS will be able to show positive diluted earnings in a few years.

Valuation of ZS

In February 2022, Morningstar analyst Dan Romanoff maintained his fair value estimate of $265 per share for Zscaler. He wrote:

We are maintaining our fair value estimate of $265 per share for narrow-moat Zscaler after it reported strong second-quarter results. Zscaler continues to achieve revenue expansion to the tune of 63% year over year behind secular tailwinds stemming from organizations making digital transformations and increased adoption of zero-trust security. That said, our model already incorporates robust growth. As expected Zscaler’s expanded product offering has enabled it to not only up- and cross-sell but to increase switching costs for its existing customers. These factors were on display as its dollar-based net retention rate was above 125% for the quarter.

Consensus analysts’ price target is $204.48.

ZS Price Target

ZS Price Target (Trading View)

ZS is a hypergrowth SaaS company and I find using the price-to-sales ratio a more appropriate valuation metric compared to price-to-earnings. My valuation of ZS comes in at $220.46, around the mid-point of these two figures.

ZS Value Estimate

ZS Value Estimate (Author)

My valuation of ZS based on discounted cash flow resulted in an intrinsic value of $187.31, providing only a small 2.6% margin of safety.

ZS DCF calculations

ZS DCF calculations (Author)

I would argue that the operating cash flow assumptions made for ZS are conservative, considering analysts’ adjusted operating earnings growth forecast for ZS for 2023 and 2024 is 56.22% and 55% respectively, and 43% thereafter till 2028.

Final Word On ZS: Buy

The average of these three valuation figures is ($187.31 + $220.46 + $265)/3 = $224.26. I believe that entering ZS at the current price of $182.64 offers a 22.8% margin of safety.

Conclusion

In a balanced portfolio, Income Providers like ARCC with its 7.99% dividend yield will provide peace of mind and reduce the chances of investors dumping them during a market downturn, Income Compounders like MED with its expected 10% dividend growth rate will provide the added stream of income that can potentially double in 7 years, fueling the capital you have for reinvestment, and Alpha Champions like ZS will provide that “5x” capital gain opportunity.

How should one allocate capital to these three categories of stocks? That will depend on your financial state and risk tolerance. I am semi-retired now with more time on my hands but I am earning less than before. With less income on hand for investment, I turn to dividend income so my allocation to Income Providers and Income Compounders is greater than my allocation to the Alpha Champions. All my dividends are currently reinvested. If you are still bringing in a healthy level of income, and you are able to set aside funds from your salary for investment, and if you have a higher tolerance for risk, your allocation will be different from mine.

Whichever is the case, whether you are an income-oriented or a growth-focused investor, having these three categories in mind will be helpful in making your capital allocation decision as you construct a balanced portfolio that provides returns in different market cycles.

Be the first to comment

Leave a Reply

Your email address will not be published.


*