Action Alerts PLUS Members Call - October 2023

SARA SILVERSTEIN: Hello and welcome to our October call. Chris, we've left another quarter behind. It's time to take a full review of the entire portfolio and, of course, get your broader thoughts into the end of the year.

Let's start with every holding in the portfolio, starting with the number ones. And let's kick it off with Applied Materials. Outside of earnings and a dividend announcement, there hasn't been much to say about Applied Materials. What should we be watching in the quarter ahead?

CHRIS VERSACE: Well, the things that we're going to start watching will actually begin to unfold in the next couple of weeks with the September quarter earnings season. Typically, this is the time when e-semiconductor equipment spenders, whether they're Taiwan Semiconductor, Intel, or the like, start to report their quarterly earnings. So the first thing we'll want to watch is their capital spending plans to see if there's any revisions for the balance of this year, as well as any indications for 2024.

We'll also want to hear them talk about their chip capacity levels. The higher or tighter the chip capacity levels, the more likely we're going to see some incremental spending in the coming quarters. And then finally, just outside of what we'll learn during the earnings season, we're going to want to continue to keep our ear to the ground about the release of funding for the CHIPS Act.

That's been a big driver of expectations. We want to see that start to hit the road as it were, but not only just here in the US, also in the eurozone. On a combined basis there's about $100 billion between the US and eurozone that are going to be spent to reshore their chip capacity. So we'll want to pay attention to that as well.

SARA SILVERSTEIN: And Axon had a price target reiteration from JMP Securities and Barron's, and including it as a favorite name for 2024. Why hasn't it performed?

CHRIS VERSACE: It's a great question. We know that public safety spending continues. We're seeing municipalities, state governments, and other entities continue to not only pick up new taser equipment, but embrace Axon's cloud service business. That's the higher margin business, but it also has a nice recurring revenue stream, which we, of course, like.

So it is a little frustrating. If I had to point to one thing, I think its concern over the recent government shutdown, potential budget spending issues. But I think the earnings leverage that we're going to see out of Axon will eventually trump all of that.

And the other thing, candidly, is Axon is simply one of those companies where there's just not a lot of news that we tend to hear from it. So we tend to rely on some of the competitors when they report. Motorola Solutions in particular, that was the one company that gave us really, really solid guidance and an outlook for not only federal, but local and state spending on public safety equipment.

That's when we actually upgraded Axon very early this year. And it was a great, great time to do so. I suspect we'll see something similar in the coming weeks.

SARA SILVERSTEIN: And as usual, banks kick off earnings seasons with Bank of America one of the first on October 17. How are you feeling about B of A and the recently struggling financial sector.

CHRIS VERSACE: So we feel pretty good about Bank of America. Remember, we were really angling Bank of America into the portfolio because of some share gains we thought that they would have, given events of the second quarter, early third quarter. And lo and behold, that has proven true.

We are a little cautious on the investment banking market. That could be a nice positive force for Bank of America, but we really haven't seen it emerge on a sustained basis as yet. I will say that when competitors start to report late next week, we will be watching their comments, of course, about the economy, but also about loan activity and other key drivers. And based on what we learn, we might fine-tune some of our thinking with Bank of America.

SARA SILVERSTEIN: And Coty has been a bit of a standout, raising its 2024 fiscal sales outlook, while competitors like ELF and Estée Lauder have struggled. What is Coty getting right? And what led you to upgrade its price target?

CHRIS VERSACE: So I would say that Coty is simply doing all the right things. And it really comes down to the right management team. Sue Nabi came in a few years ago and really set the path for the company, leveraging the strength in its prestige business, driving pricing, driving margins, and trying to really repair some of the margins in the consumer beauty business, all the while driving down balance sheet leverage, freeing up incremental EPS.

But they're also leaning on that prestige brand to expand their product portfolio, particularly into skincare and other fragrances, which is the bread-and-butter business. So again, they're doing all the right things. What they do not have, unlike Estée Lauder, is significant exposure to the China market, which has been very, very uncertain in the last few quarters, as we know.

That is an area of potential focus and growth for them going forward. But right now, I would just say, Coty is focused on what matters most with consumers in the beauty business.

SARA SILVERSTEIN: And one of our members wants to know how significant their planned dual listing in Paris.

CHRIS VERSACE: Oh, that's an interesting question. So from our perspective, we own the US listed shares. Listing the shares outside of the US doesn't really do much. If anything, it gives an opportunity for people-- with this being listed in Paris, people in France and other eurozone economies to buy the shares on a local currency basis. So from our perspective, nice to have, but not all that relevant to our thinking.

SARA SILVERSTEIN: And you recently noted PepsiCo is approaching oversold territory. Where would you consider adding to the position?

CHRIS VERSACE: So that's a good question, Sara, because as you can see on the screen, we've got about 3 and 1/2% of the portfolio already in PepsiCo. So odds are we wouldn't really do any meaningful ads, maybe a little nibble, as we say, to round out the position. But with it being oversold and as we think about where we're headed into the holiday season, the entertaining season, snacks, beverages, it's a seasonally strong time for PepsiCo's core snack business, which is also the higher-margin business compared to beverages.

So we really like PepsiCo going into the fall. We also do think that as consumers continue to face some inflation pressures, not only at the gas pump, but they're also strapped a little bit as student debt repayment comes back into fold starting a few days ago, we do think that they're going to incrementally eat at home. That plays right into PepsiCo's core business. So we would suggest members here that if we start to get signs that the market is indeed stabilizing-- remember, it's been very choppy of late with some concerns about where the 10-year is going.

If we get some sense after Friday's employment report that things are starting to stabilize, that could be the opportunity for members that are underweight PepsiCo shares to really snap them up.

SARA SILVERSTEIN: And let's talk about Deere. It's been stuck in a trading range, $380 to $390. It's gone a little bit lower due to broader market weakness. What's it going to take to get that stock to the price target of $500?

CHRIS VERSACE: So I think it's a couple of things. The first is we have to continue to see top-line revenue strength for the two core businesses, first, the biggest one, its ag equipment business. And we are seeing monthly data that says large tractor demand continues to strengthen. So that's a positive.

At the same time, Deere does have around 20-- excuse me. 25% of its business in construction equipment. And we know from the monthly construction spending data that we are seeing pronounced year-over-year increases in that type of spending. That's great for Deere's construction equipment business.

But the third thing we really need to see, Sara, is Deere deliver on margin leverage, driving you know pronounced EPS growth to the bottom line. And I think we're going to see that. We had better pricing earlier this year. We continue to see improvement not only on some of their input costs, but also on supply chains.

So I think we're going to really see that. The only thing that I think we have to watch out for is the association with commodity prices, particularly ag commodity prices. Even though we've seen them bounce around, the expectation for farmer income is still very robust, maybe not as strong as last year, but still among the higher levels in the last several years. That is what bodes extremely well for the replacement cycle for an aging ag equipment fleet, which, again, is great for Deere.

SARA SILVERSTEIN: Amazon has a lot going on. It seems that it always does. But right now, with its $4 billion investment in the AI startup Anthropic and its follow-up shopping holiday, Amazon Prime, expected next week. Oh, and it's also back in the FTC's headlights. How are the emerging legal concerns playing into your thinking?

CHRIS VERSACE: So on the FTC side, look, we've seen this in the past when they've gone after Microsoft and other companies. And it drives a lot of noise in the near term. But the reality is any decision is going to take not days, weeks, months, most likely quarters to come around.

So I think we can't be really distracted by that. I think we need to focus in on really what's going to drive the stock in the closer-in months. Again, you mentioned next week and its holiday shopping season, if you will, event. I think Amazon's going to do extremely well on that.

We have seen consumers really start to come back in and embracing digital shopping as they try to stretch their disposable spending dollars. Of course, that's great for Amazon. We're also seeing and hearing reports that Amazon Web Services is once again starting to pick up and pick up some incremental market share. That's great for its biggest business.

But the other thing we really want to watch with Amazon is going to be its advertising business because it will be ramping out advertising across Prime Video. That's an extremely high-margin business for the company. That could allow the Street to get a little more bullish on Amazon's earnings prospects in the coming quarters. So those are some of the things that I would watch.

SARA SILVERSTEIN: And Elevance, you still have it as a 1. We're still really bullish on it, but it's currently about 7% below our average cost basis. What keeps it at a 1 for you?

CHRIS VERSACE: So here, too, I think the reason-- excuse me. The recent pressure really stems from what we've seen in Washington, questions over budgets, potential budget cuts. But when we think about Elevance, there's really two simple things that we want to focus on.

One is the continued expansion of its footprint and two, the continued increase in its service offering across that footprint. That will be driving revenue. But we also have to remember, too, that Elevance is one of these storied companies, very conservative in its guidance.

It tends to hit exactly what it guides to. And the metrics are favorable year over year. So again, I think that in a couple coming weeks, if we get some clarity on the extension for the federal government, if we know who the House speaker is, we have some sense that there won't be a November government shutdown, I think the market will start to re-embrace companies like Elevance.

SARA SILVERSTEIN: And if you had to pick a favorite bet in the 1s category, what would it be?

CHRIS VERSACE: Oh, a favorite in the 1s. I'll say this. Between now and the end of the year, it's probably going to be Amazon. If it's between now and the next 12 months, it's likely to be Applied Materials.

SARA SILVERSTEIN: Great. OK, let's move on to the 2s. We'll kick off with Apple. We got a rare downgrade from KeyBank and expectations iPhone sales will be pressured in the final months of the year. What's your take on demand? And how important is the iPhone overall for the stock?

CHRIS VERSACE: So let me take them in reverse. So iPhone is Apple's largest revenue-generating business, so of course, it's going to be important. All indications that we have seen from the supply side have been rather favorable.

As members know, we track a number of different indicators for that, including the monthly revenue reported by Taiwan Semiconductor. Its second largest business is smartphone. So we've confirmed the smartphone ramp.

But the other side of it is we need to confirm that these units are actually being sold. And so far, indications, whether it's in Europe, in China, even in the US, that there have been long lead times to get these devices, this suggests at least initial selling is favorable. So I think Apple's going to come out and report a good quarter, probably not a great quarter.

But the guidance and what it says for the holiday shopping season is going to be important. All things being equal, Sara, we've said that if Apple's shares broke through that $170 level, we would look to revisit our 2 rating. That thinking still stands, but I'm going to want to see what Taiwan Semiconductor says first about its September quarter revenue. And we should be getting that in the next couple of days.

SARA SILVERSTEIN: And moving to Qualcomm, who actually managed to strike a fresh deal with Apple. How important is this relationship when it comes to the stock's position in the portfolio?

CHRIS VERSACE: It's huge. It is absolutely huge because you have to remember that that relationship was expected to end, fall off a cliff if you want to call it that, at the end of this year. Instead, it's been re-upped for not one, not two, but several more years.

So all of a sudden now, when Qualcomm reports, folks are going to start to retriangulate earnings expectations factoring that business back in for 2024-2025. That, I think, really gives the company a lot more lead time to build its automotive business and help diversify its business. I think some folks out there, when the stock was $135, $145, somewhere in there earlier this year, they were concerned about that cliff falling off. Understandable, but that has been removed. So it's, in my opinion, extremely important for Qualcomm.

SARA SILVERSTEIN: And an increased need for cybersecurity was a big part of your thinking behind the club's position in First Trust NASDAQ cybersecurity ETF. How does generative AI and its use in the industry play into your thesis?

CHRIS VERSACE: So I'm so glad you asked this question, Sara, because when I was making my trip through Europe, I, of course, was doing a lot of plain reading. And in it, I came across something that simply astounded me, which is this. Only 52% of all internet traffic is generated by humans.

The other 48% is generated by bots. Now, think about that and what that means for that 48% when we start thinking about generative AI. It's going to be a rather large explosion.

And as that happens and as we have more attack points, it, of course, means that the risk of being cyber compromised, let's call it, grows significantly. So I do think there are some big risks there. There are also privacy risks and other data risks associated with the data scraping that we get from generative AI.

So I continue to remain bullish on cybersecurity. And remember, from time to time, we get some high-profile attacks, but it's really the base hit attacks that really nudge companies to dial up their spending. And I think we're going to continue to see that happen.

SARA SILVERSTEIN: And you've noted it's a quieter period for Chipotle, with little action expected until earnings at the end of the month. What are you hoping to hear from management then?

CHRIS VERSACE: Well, what I want to hear is that traffic remains strong. This management team is very smart in timing and using limited time menu offerings, including you know carne asada, which I understand is now back. But we also want to hear that they're seeing some improvement on their input costs and driving margins higher as they continue to benefit from pricing initiatives taken earlier this year and even this time last year.

So that's really what we want to hear. If I had to throw one more thing into the mix, it would be that despite what some people might see as a potential risk to the economy, they're going to continue to expand their footprint, opening up new locations, driving incremental revenue. So that's what I would like to hear.

SARA SILVERSTEIN: And you boosted your price target on Costco to $600 after earnings last week. What has you bullish into the end of the year?

CHRIS VERSACE: Well, I mean, look. First off, all the data that we continue to see shows that Costco continues to win consumer share, all right? That's the first thing. Two, we know that gas prices have trended higher.

We know consumers are going to be at the margin, with the student debt repayments coming back into the fold hitting their wallets even further and, of course, just ongoing inflation pressures. So we really see them leaning into businesses like Costco to stretch those dollars, as I said before, similar to Amazon. But with Costco, you're really able to do it, not just on the merchandising side, but really on the fresh food side.

And if you think about the entertaining that people do in the holiday shopping season, Costco is right in the wheelhouse for that. One little factoid-- I don't know if you know this, Sara-- Costco is the largest seller of beef in the world.

SARA SILVERSTEIN: I did not know that. I thought you were going to say gasoline. I don't know how much gas they sell, how much air they have. But beef, that is really surprising.

CHRIS VERSACE: Yeah, well, they're also big--

SARA SILVERSTEIN: Yeah, sorry.

CHRIS VERSACE: For what it's worth-- and this might surprise some folks too-- they're also big in diamonds.

SARA SILVERSTEIN: Yeah. No, I believe that. I believe that. Our proxy for gold, the SPDR Gold Shares ETF, intended to be a hedge against inflation and uncertainty. How important is it to you to have that in our back pocket, especially given the state of politics?

CHRIS VERSACE: So you're right, with renewed questions over what's going to happen in Washington over the coming weeks, having a little bit of gold in the form of GLD is a good thing for the portfolio. But at the same time, we have to be mindful because, again, as much as we want to have positions that go higher, driving returns for the portfolio, and of course, for members, we also have to be prudent risk managers. And I'm sure we'll talk more about that in a bit.

So we have to continue to watch not only the dollar, but interest rates as well. If that pushes GLD below some critical support levels around $167, $168, $169, we might have to rethink that position. But if we do make the cut-- and I'm not saying we will. Should we do it, though, odds are GLD would wind up back in the bullpen.

SARA SILVERSTEIN: Great. And given the role providing additional funding to Ukraine has played in the recent back-and-forth in Washington, how are geopolitics playing into your thinking when it comes to Lockheed Martin?

CHRIS VERSACE: I wrote a note on this very thing yesterday to members when it looked like Kevin McCarthy would not be House Speaker. And again, there's another array of uncertainty in Washington over the next several weeks. So we'll have to sit here grin and bear it.

But at the same time, when we take a look at the press releases that Lockheed is putting out or the announcements from other entities about continuing spending on the types of things that Lockheed makes, particularly the F-35, not just long lead times here in the US, not one year or two years, but a decade's worth, and then we take a look at the orders that they're winning outside of the US, and then incremental program wins from the Army, the Navy, and elsewhere, their backlog continues to rise.

So to me, the real thing is going to be, let the noise of Washington move by the wayside, and let's focus on the multi-year backlog, converting that into revenue and seeing the company deliver some incremental margins. 2024, I think, is going to be a better year for Lockheed than 2023 was.

SARA SILVERSTEIN: And Google, Alphabet, has been fending off antitrust concerns on multiple fronts, most notably in a US case spotlighting its search dominance. With regulatory uncertainty, how should members think about the stock both in the short and long term?

CHRIS VERSACE: Great question. Again, it hearkens back a little bit to what we said about Amazon. These shenanigans, if you will, or these points of interest in Washington, they take time to play out, and they can drive disruptive headline news, again, more noise than anything else, at least in the short term. Now, we are going to want to pay attention to this just like we're going to want to pay attention to the longer-term developments in the Amazon case.

But in the near term, Amazon continues to-- sorry, Google continues to dominate search. We can see that in the monthly trade statistics. And we should be seeing the new ones for September out relatively soon.

They are continuing to lean into and gain advertising market share, not only in search, but also in video as well. And then the final thing that I think we need to watch is the progress on their cloud business becoming increasingly profitable. We started to see that. If we see that accelerate, that's going to be another positive for Google.

SARA SILVERSTEIN: And Marvell, there were reports that Alphabet could look to replace Broadcom as its chip supplier. Those have been all but refuted. So what's the next catalyst for Marvell?

CHRIS VERSACE: So if we didn't have the rise in the 10-year, I think we would have seen that catalyst when Micron reported recently and they said that the outlook for the data center business is not only positive. They see it strengthening into 2024. So check that. Great.

In terms of next potential catalysts, I can give you a couple. The first is going to be, again, when Taiwan Semiconductor reports their September quarter revenue because the largest business for them is high-performance computing, which includes, of course, data center. So that's one catalyst.

And then in the next few weeks, when we start to hear earnings from Microsoft, from Meta, from Google, from Amazon about the outlook for their cloud business and their related infrastructure, that should be another catalyst for our shares of Marvell.

SARA SILVERSTEIN: And let's use Mastercard as an opportunity to talk about the consumer. With the company projecting a strong holiday spending season, how closely will you be following monthly retail sales when it comes to Mastercard and in general?

CHRIS VERSACE: Well, we always follow the retail sales, right? And it's going to be especially crucial going into the holiday shopping season. And remember, the expectation for the holiday shopping season is it will be positive, but it will be low single digits compared to what we saw last year.

So year over year, consumers aren't expected to spend as much. But my thinking is that given the economy, given the fact that more consumers are living paycheck to paycheck, struggling, they're more likely to not pay cash. They're more likely to either use their credit cards or perhaps some other form of payment.

That should benefit Mastercard. But again, if we see signs that the consumers are dialing back their spending even more than we previously expected, that could be a reason to rethink owning Mastercard, at least in the near term.

SARA SILVERSTEIN: And McDonald's, we've seen the headlines. McDonald's is raising its royalty fees for new franchisees for the first time in nearly 30 years. What does it mean for the long term as McDonald's relationships with franchisees becomes more increasingly difficult?

CHRIS VERSACE: Well, look, it's a key relationship for them. And McDonald's has known, as you pointed out, these folks for some time. And I think they would take a cautious and prudent approach. I suspect they would probably vet any increases that they were doing.

These folks are not whimsical. They're not going to simply throw something out there. So I think this might be a little bit overblown.

To me, I think what's more important about the McDonald's story is that as consumer budgets get a little tight, we have started to see signs that, yes, they indeed are trading down from casual dining to either quick service or to fast-food dining. That plays right into McDonald's wheelhouse. As I say that, the one thing we will want to watch for is the recent strength in the dollar.

Remember, McDonald's has a nice international exposure. When the dollar was weakening earlier in the year, that was one of the things that attracted us to it. The one other thing I would say is tomorrow, believe it or not, we have earnings from McDonald's French fry partner Lamb Weston.

So their guidance will be something that we pay close attention to. I know we have a note out today saying that from a technical perspective, the shares are more than interesting, arguably compelling, at the current level. If we see Lamb Weston give favorable guidance, that could be the catalyst that allows us to add a little bit more to our McDonald's position.

SARA SILVERSTEIN: And you wrote that Universal Display is on your shopping list after earnings from Micron. What are you looking for before you pick up some shares there?

CHRIS VERSACE: Well, I think two things. One, I have to trot out the Taiwan Semiconductor comment again. Again, second largest business is smartphone. So if we see that continuing to ramp, that's one positive.

But two, we also want to see some stabilization in the market. And we're going to talk more about this with members I'm sure more so in this call, but also in our notes after today's call and then the next couple of days. We really want to get past some of the near-term data so we can understand better if the next path for the 10-year Treasury yield is indeed 5% or if we get data that says, you know what, the 10-year Treasury yield, it's a little overextended. It's going to come down.

If we see that, stocks are likely to rally. If we see that, Universal Display's shares will be one of the ones that we want to pick up.

SARA SILVERSTEIN: And we've talked about this a few times. We always talk about it, but the path that will lead us to exit, the inverse ETF positions. They've certainly come in handy during the weakness of the past few weeks.

Would you consider trimming? Same question as always, what really matters in deciding to leave these positions? Does it matter how they perform against where you bought them? Or does it matter your general outlook?

CHRIS VERSACE: So we first added them a while back really to help hedge the market. And at times, they've been great performers, really, since August 1. And other times when the market is performing well, they've worked against us.

And we recognize the reason why we have them in the portfolio, and we've been very candid in saying that as signs emerge that the risks to the economy, risks to the market fall by the wayside, we would start to revisit owning both SH and PSQ in the portfolio. So that still stands. But I think given some of the things that we've talked about ahead-- we've got questions over the consumer.

We've got questions over whether the Fed's going to raise rates one more time. We've got questions over the direction of the 10-year. We've got even more uncertainty in Washington right now.

So I would say that, at least for the next few weeks, we're likely to hang on to these positions. They may move against us, but they might also turn around and continue to insulate the portfolio, especially if it appears that the 10-year Treasury yield is indeed going to hit that 5%. And by the way, Sara, I will share this, just speaking about 5% in the 10-year Treasury. So far, the weekly AAP poll of the week seems to suggest that, members, you think we're going to 5%.

SARA SILVERSTEIN: Interesting. Let's talk about Trinity Capital. It has a rising dividend yield, a really low beta. How do you see this working in the portfolio? Do you want to add to it? I mean, how do you look at it in the portfolio?

CHRIS VERSACE: Yeah, so this is a name that we have a relatively small position in. And candidly, we have said that we would look to pick this up below $14. I think that still stands, again, subject to what we see in the next couple of days.

Do we like the rising dividend policy? Of course, we do. And when we do the math, based on what the company is expected to earn from a net income perspective and remembering that they are a BDC, which means they have to pay out at least 90% of that net income to shareholders in the form of dividends, odds are we will see a nice, special dividend before the end of the year. So we, of course, would want to capture more of that, not only for the portfolio, but for members as well.

SARA SILVERSTEIN: And one of your favorite stocks from the end of last year, if I remember right, is United Rentals, which is up nearly 20% year to date. Are you sticking with the $500 price target? And if so, what will it take to get us there?

CHRIS VERSACE: So a couple of things. One, continue to like United Rentals. And I say that because we're only really in the first year of a multi-year infrastructure buildout. Pricing comments are favorable. Utilization levels are favorable.

And more importantly, the construction spending data that we get, particularly when we focus in on non-residential construction, which is, of course, the bread-and-butter business right now, it's up double digits year over year. So I think we're just going to need to see more of these data points emerge, and we'll see United Rentals over time float back up to that $500 level.

And look, if we see even more of a turn at some point over the multi-year program for infrastructure spending, let's say, late 2024 or 2025, if we see the Fed start to cut rates, and we see mortgage rates come back, we might actually start to see a positive turn in the housing market. It could come sooner than that, but any of that activity would just be a positive for United Rentals.

SARA SILVERSTEIN: And moving on to Vulcan Materials. One of our members wants to know why it is rated a 2 and what it would take to bring it back to a 1.

CHRIS VERSACE: Excellent question. And I say that because, again, we have enough upside based on where the shares are today to upgrade it to a 1. And odds are if we get some confirmation that I'm looking for in the September Railcard data because they actually provide really nice detailed breakouts, including ones for Railcard loadings for aggregates, which is exactly in the wheelhouse for Vulcan Materials-- so if we see that pick up, odds are we would look to get off the bench with the 2 rating, bring it up to a 1, especially at the current price level. Great.

SARA SILVERSTEIN: The Energy Select Sector SPDR Fund was a point of strength last quarter. Some analysts have recently wondered if the strong dollar will impact demand for oil. How important is volatility in oil prices when it comes to XLE?

CHRIS VERSACE: Well, I think really have to delineate between demand and, of course, supply. I've written about this extensively with members. And right now, while there are some concerns about the slowing global economy impacting the demand side, it's really the supply side that we have to watch.

Just earlier today, ahead of OPEC's meeting, both Russia and Saudi Arabia said that, yes, we are going to keep our extended production cuts through the end of the year. We also know that US shale production is coming down. So look, we're going to continue to monitor this.

We could see oil prices pull back a little bit. But I do think that if we see signs that the US economy is indeed soft landing, like many expect, and China's stimulative efforts start to bear more fruit in their monthly PMI data, then I think the demand concern will fall by the wayside and could potentially turn to one where, oh, demand is rising, supply is constrained, oil prices move higher.

SARA SILVERSTEIN: And Microsoft is the only 3 rated stock in the portfolio. Break down your reasoning for the rating and why the same is different from other positions, particularly in big tech?

CHRIS VERSACE: So it is a-- excuse me. It is a very different business model compared to, say, Google or Amazon or even Apple. Are we starting to see signs of a potential turn in the PC market, which will be good for Windows? Yes. Are we seeing continued cloud adoption? Yes.

But remember that when Microsoft reported, it surprised people about the degree to which it was ramping its spending as it continues to invest in AI. So spending today to build out capabilities to bring improved tool sets and monetize that in 2024. So when we start to see that switch from investment to monetization, that's one catalyst that would lead us to revisit the current rating on Microsoft.

But there could be another one too. Remember that we have this long looming Microsoft-Activision merger, and it looks like it's going to get approval. When it does, we expect Microsoft will have an event.

It'll talk about how it's going to integrate Activision. That means revenue synergies. That means cost reductions. That'll give us another opportunity to not only rethink our 3 rating for Microsoft potentially, but also our price target as well.

SARA SILVERSTEIN: And I lied. Of course, I'm looking at the portfolio now. I forgot we've downgraded Clear to a 3. And we will get to ChargePoint in a second. But looking at that, does it feel a little bit like ChargePoint, that we're losing faith in the position and that we're going to unwind it? Or what caused us to downgrade it to a 3?

CHRIS VERSACE: Sure. So I think if we step back with some actions we did this week with American Waterworks and Clear Secure and even ChargePoint, we said, look, over the last couple of weeks, really, the last two weeks in particular, we've seen an almost explosion in the 10-year Treasury yield. And regarding American Waterworks, that has really pressured utility stocks, and it pushed American Waterworks below key support levels.

And with that one in particular, it's not like other utilities where energy demand is strong in the summer and also strong in the winter because we have to cool ourselves, we have to heat ourselves. Now, American Waterworks is a little different because it's water. So all the drivers for the second quarter, third quarter, and the seasonal strength in water demand start to go away.

So that was a big factor in our decision of exiting American Waterworks, as well as the technical threshold that we would have to punch through, not likely. With Clear Secure, the same thing because as much as utilities were punished, small-cap stocks were punished as well. And we downgraded the shares of Clear Secure because we really want to re-embrace risk management.

And what I mean by that is it's all great to pick stocks that go higher, and we do have a number of them in the portfolio that have done just that. And we're able to clip and trim them back and book some realized gains for the portfolio and for members too. But we have to remember that preserving capital is key.

And coming off of what happened with ChargePoint, we are redoubling our efforts on that front. And that's why you saw what we did with American Waterworks. That's why we downgraded Clear Secure to a 3. And as I wrote to members this morning, if the September employment report comes in hotter than expected on Friday, if wage gains are hotter than expected, if the labor market continues to be tight and we get a sense that the 10 year Treasury yield is going to go to 5%, this is a position that will move lower, and we can't have that.

So it's a 3 for now, subject to what we learn. But we've already said to members that if things are going to look like they're going to continue to go the wrong way, we will exit the position. So it's instilling a greater sense of discipline into the portfolio.

And what members will see in the coming days and weeks as we institute new positions, you'll see us talking about not only price points where we would potentially add to a new position, but price points where we would contemplate exiting the position so as not to extend any losses. Again, it's going to be all about risk management, given what looks to be continued uncertainty in the market, at least in the near term.

SARA SILVERSTEIN: And to continue with that point, let's talk about ChargePoint directly. We sold it at a steep loss. Why was it finally time to sell? And what did we learn from that?

CHRIS VERSACE: So I think, again, to me, the ChargePoint lesson is that as much as we want to have stocks that go higher, we have to when to cut ourselves off from a losing position. Clearly, we didn't do that with this one. That's why it is such a sharp reminder.

As for why we did it, look, it's going to be a battle to get that stock back to a level even close to being break even. So against the backdrop of the higher 10-year, small caps are out of favor, the Russell is now negative year to date, it was just going to be a very tough slog. At the same time, we understand that utilities are not exactly charging-- no pun intended-- to build out electrical lines for EV charging stations.

So that's going to continue to be a slow slog, if you will. So we put all that together, as well as some comments that led us to downgrade the shares of ChargePoint with some renewed questions over the management team and insider selling as well. We just said, Sara, it is time.

Lick the wound. Move on. And let's take the capital. Let's redeploy it either in cash in the near term given a nervous market, but have that at the ready to put into positions that we can see with more pronounced positive gains supported by more clear data and transparency. That's where we want to be.

SARA SILVERSTEIN: And did you expect the weakness in small-cap stocks generally? And how did that play into your thinking?

CHRIS VERSACE: So if you look back to the start of September, the 10-year Treasury yield was hovering around 4.3%. It wasn't really until the middle of the month that it really started to move demonstrably higher. So did we expect the rise in the 10-year, generally speaking, to be a headwind to the market?

Yeah, we did because it creates a natural resistance level because as we've started to see more headlines discuss, folks that are concerned about the market, what they can do is they can actually now put money in a savings account and get 4%, 4 and 1/2%, in some cases even 5% relatively risk free. So that's going to pull some folks out of the market.

But it also raises some concern about funding and refunding not just for tech companies, but really for small-cap stocks. So we were expecting it, but candidly, I did not nor do I think many people expected how quickly the 10-year Treasury yield was going to rise in as short a period of time that it did.

SARA SILVERSTEIN: And we've pretty much touched on American Water and how all of this relates, but is there anything else that you wanted to add there? Because this is the time that I'd intended to ask you about that.

CHRIS VERSACE: No, I'm sorry, I jumped the gun. Sometimes, I get a little excited.

SARA SILVERSTEIN: No, that's fine. That's fine.

CHRIS VERSACE: There isn't really anything else I would add about American Waterworks. I mean, look, is it a good company? Yes. Is it the largest in its sector? Yes. Does it have a rising dividend policy? Yes. Maybe at some point, we will revisit this name, but for now, we're going to just stay off to the side with it.

SARA SILVERSTEIN: And this is a question that actually comes from a member, but is also a question I think we have generally. Any other changes to how you manage the club and particularly in reference to unwinding ChargePoint?

CHRIS VERSACE: No. And I think I covered it. But just to reiterate and try and be as concise as I can-- I know sometimes that's a bit of a challenge for me-- I would say that, look, you're going to see us with a renewed sense of discipline in the portfolio. And we'll be talking a lot more about that in the coming days.

But we do understand the concern that members have. Clearly, we should have stepped in sooner. Lesson learned. And I think members will start to see actions to that effect.

SARA SILVERSTEIN: And another member is asking, would you consider hard and fast rules for buying and selling stocks?

CHRIS VERSACE: Yes, I'm not really sure what that means.

SARA SILVERSTEIN: Oh, if something isn't-- yeah, sorry.

CHRIS VERSACE: I was going to say, so hard rules for buying stocks, I mean, we want to buy stocks that have great growth prospects at favorable prices and compelling valuations. So that's the rule there. I think what they're getting at as I think about this is, are we contemplating instilling the use of stop losses or sharing levels at which we would start to rethink owning a position, just given the risk-reward dynamics and the risk management that I alluded to earlier?

And the first is always under consideration and may be something that we do. But the second, sharing those price points, panic points, some might call them, yes, that's something we'll be doing going forward.

SARA SILVERSTEIN: And let's move over to the bullpen. We are seeing high-profile IPOs from Arm Holdings and Instacart. Any update on Morgan Stanley?

CHRIS VERSACE: So that's an interesting question because we had a couple of different high-profile IPOs, some of which are trading below their IPO price. And it appears as if that window was open for a brief period of time. And we have since seen Morgan Stanley's shares fall back.

I believe the last I looked, they were trading below $80. So the risk-reward could be interesting there. We just don't have a catalyst that allows us to spring into that.

So we'll look to review what some of its competitors have to say when they start to report next week, again, late next week. And by that, I mean some of the big banks and what they're saying about activity, not only for investment banking, but also on the asset management side, which, by the way, remains a great business at Morgan Stanley. But no plans yet to call it up from the bullpen.

SARA SILVERSTEIN: And same question, but about M&A activity.

CHRIS VERSACE: Yeah. I mean, look, there is M&A activity unfolding, and there's some bigger deals, i.e. like I said, Microsoft and Activision. But with interest rates going higher, the hurdle rate could be a little slow for that activity. So again, it's going to be something we want to watch and want to monitor. Maybe we see a flurry of smaller deals.

But we'll have to see what might-- excuse me. What Morgan Stanley's involvement is in these deals. Remember, the Arm IPO, very big. Morgan Stanley wasn't a part of it. So we need to understand where the activity is and to what degree they're involved.

SARA SILVERSTEIN: And after recent weakness in new home sales, you noted you're keeping Builders FirstSource on the back burner. Are there any bullpen positions that are likely to get an upgrade in the portfolio?

CHRIS VERSACE: I think we're more likely to see, given what's unfolded in the market over the last six weeks, probably some newer names that come into the bullpen. We did that during the summer months. And an example, Qualcomm was entered, and it came up. So I think that's more likely to happen.

I wouldn't be surprised if perhaps we rethink about some of the positions that are in the bullpen as well. Again, this is the warm-up area companies were growing more interested in. Could be time for a little bit of a refresh here.

SARA SILVERSTEIN: And let's end with some broader thoughts on the market as we head into the last quarter of the year. Did September live up to its reputation as the worst month of the year? And is it going to stay that way? Or how does it set us up for October and the rest of the year?

CHRIS VERSACE: So I can't say that September was the worst month of the year, but it was certainly not an enjoyable one for the market, again, largely due to the 10-year and some concerns about what the Fed may or may not do, concerns about the economy, and, as we saw towards the very end, would there have been a government shutdown. So one of those-- well, not even one of those. Those all remain on the table right now.

And while October has historically been a better month leading into what typically has been a very nice fourth quarter move in the market, we're still not sure when that's going to happen. Could it happen? It could.

But again, we've got a bunch of economic data that's going to really tell us the next direction of the 10-year. I said, we got Friday's September employment report. We've got back-to-back September inflation data next week. So more on that front.

We've got earnings season. We're going to want to understand what companies are seeing. What's the impact higher energy prices? We've seen airlines already start to cut some of their outlook.

So there could be some downside pressure on earnings expectations and, of course, what's going on in Washington. So make no mistake, the next couple of weeks, there will be a lot going on.

SARA SILVERSTEIN: And what is the thing that keeps you up at night that you're most worried about? What's the headline that if you woke up and read, that would break our portfolio?

CHRIS VERSACE: I don't know about break the portfolio, but it would-- so the big concern, I think, that we have to deal with is the fact that inflation has been far more persistent than people were thinking. Even today, in the services PMI reports, something we recapped for members, the commentary on prices is that there remains price pressure in the service economy. The Fed is going to see this.

So I think the market is slowly wrapping its head around the fact that there could be one more rate hike later this year. If, for some reason-- and I'm not saying it's going to happen, but should the signs, the whiff, start to be there that perhaps the Fed needs to do even more because of the data, that, I think, would send another shock wave through the market. People would start questioning PEs.

They would see renewed conversation about a potential recession. That's really what keeps me up at night, to answer your question. What's the risk that the Fed has to do even more than what they've already telegraphed?

SARA SILVERSTEIN: And a government shutdown was averted, but politics remain volatile, to say the least, which was displayed very clearly this week. What are you watching going forward?

CHRIS VERSACE: Well, I mean, I rattled off a whole bunch of things. As it relates into Washington in particular, let's find out, who is the next speaker? When is that person elected? What's the timing to actually get something in place so that the government does not shut down after November 17? To me, that's important, and it will have repercussions, obviously, for shares of Lockheed Martin, shares of Elevance, and then perhaps take a little bit of the headline concern of Axon shares as well.

SARA SILVERSTEIN: Thank you so much, Chris. That'll do it for another call. Thank you so much for watching. And please send any and all feedback to at AAPClub@theStreet.com.