Spear Alpha ETF (NASDAQ:SPRX) was up 88.02% in 2023 compared to the S&P 500, up 26.26%, and the Nasdaq Composite, up 44.70%. For 4Q23, SPRX was up 28.28% compared to the S&P 500 up 11.68%, and the Nasdaq Composite up 13.84%.
Artificial Intelligence (AI) is a core theme for Spear and the biggest driver behind our strong 2023 performance. The strong demand for AI hardware that commenced in 1H23 continued for the rest of the year, but the fundamental upside broadened to the rest of the value chain in 4Q23. There are now several companies in addition to Nvidia (NASDAQ:NVDA) that are expecting revenue run-rates in the billions directly from AI, including Microsoft (NASDAQ:MSFT) and AMD (NASDAQ:AMD).
The most significant change that we noted in 4Q23 was the bottoming of enterprise spending. Enterprises had been tightening their budgets since 4Q22 in anticipation of a recession. This resulted in companies optimizing their cloud bills, committing only to what is necessary etc. That trend stabilized in 4Q, with the major cloud service providers noting bottoming in fundamentals and incremental AI workloads more than offsetting optimizations.
From a macro perspective, although we did not get a recession, the market significantly slowed down in October when interest rates hit 5%. As the Fed signaled a shift in policy, the markets skyrocketed, especially the riskier part of our coverage universe, which is where we noted the most outperformance.
But 2024 started on a defensive note, with interest rates tricking up and investors shortening their investment horizons. Outside of Data Center hardware, which is experiencing an earnings boost from AI, most other companies in our coverage universe have significantly pulled back, creating attractive entry points for areas such as cybersecurity and data infrastructure.
What gives us confidence for 2024:
- Ramping Capex. Despite 2023 being a strong year for investment in AI, overall server shipments declined year over year, and capex growth was muted. Even for the hyperscalers that invested significantly in AI servers, overall capex growth was relatively muted compared to prior years.
- AI is being used at scale. The most important recent development in AI is that it is becoming evident that workloads are shifting from model training to inference (which is AI used for real applications). Even though use cases are still in their infancy, inference is now a significant contributor, representing 40% of Nvidia Data Center revenues (~$30bn run rate), and most of Microsoft's AI revenues ($3bn+ run rate). The two major use cases of inference today are search (e.g., ChatGPT, Google (NASDAQ:GOOGL)) and recommenders (e.g., Meta (NASDAQ:META)), leveraging on prior customer bases, but new markets such as software development, productivity improvement, drug development, etc, are just emerging, pointing to a strong cycle ahead.
- Attractive valuations. Despite the run-up in technology, valuation multiples are very reasonable. On an EV/EBITDA basis, hardware companies, such as Nvidia are trading near middle of the 5-7 year trading range.
This is creating very attractive entry points in 1H24 as comparisons get significantly easier in the second half.
Performance contributors and commentary
Reflecting on 2023, we were able to deliver strong returns as a result of:
- Our niche approach, enabling us to identify AI as a breakthrough trend before it became mainstream, with Nvidia being our largest position going into '23
- Adding on dips to our high-quality next-gen tech leaders (e.g., Zscaler (NASDAQ:ZS)),
- Taking a contrarian view on companies where investors panicked (e.g., SentinelOne (NYSE:S)).
For 4Q23, our outperformers were Cybersecurity and Data Infrastructure companies, and our underperformers were hardware companies that did not get a meaningful boost from the expectations of lower interest rates.
- Cybersecurity companies noted that the enterprise spending caution that commenced in the second half of 2022 is now coming to an end. In addition, many of the next-gen cybersecurity companies made a push over the past year+ into tangential products such as Cloud and Data security, which are now scaling up and contributing to overall growth. Our top picks in this space are Zscaler (ZS), SentinelOne (S), and Crowdstrike (CRWD), which delivered over 50% returns in 4Q23.
- Data Infrastructure benefited from hyperscalers commentary that cloud spending optimizations are now behind us. Datadog (NASDAQ:DDOG), Snowflake (NYSE:SNOW), and Cloudflare (NYSE:NET) were our core positions and delivered over 30% upside in the quarter. We took some profit in Datadog and Cloudflare. We redeployed it into Confluent (CFLT), a leader in data streaming that fell out of favor during the quarter following a disappointing and not well-understood earnings report.
- Data Center Hardware broadly lagged the rest of our portfolio after a strong 1H23, with Nvidia up only 14% vs. our total return of 28% for the quarter.
The dynamic that we noted on software vs. hardware reversed at the beginning of the year, with software coming under significant pressure as interest started trickling up. Hardware, on the other hand, is less sensitive to interest rates as earnings are at a cyclical bottom. While this dynamic could continue in the near term, we think both of these areas are well-positioned to deliver outsized returns throughout the cycle, and we maintain our exposures in both.
Portfolio composition and risk management
As of the end of the quarter, the largest exposures in our portfolio are in the following areas:
- Cybersecurity benefiting from a major technology shift from changes in enterprise infrastructure and continuous evolution of threats (with AI adding an incremental layer of risk). Our largest holdings are Zscaler, a leader in "zero trust" network security, Crowdstrike, and Sentinel One, both leaders in endpoint security.
- Artificial Intelligence Hardware benefiting from new developments in generative AI. Our largest holdings are Nvidia, AMD, and Marvell (NASDAQ:MRVL), which we believe are best positioned to benefit from the positive trends in AI adoption.
- Cloud/Data Infrastructure benefiting from massive growth in data and compute/storage requirements. Our largest holdings are Snowflake, a cloud-computing-based data warehousing company; Cloudflare, an integrated global cloud network; and Confluent, a data streaming leader.
Despite the strong performance, many of our holdings, specifically ones levered to enterprise spending, are still down 50+% from their peak levels, highlighting the severity of the tech pull-back and the runway ahead. While investors have started pricing in the AI hardware opportunity, we believe we are in the early innings of a meaningful Data Center upgrade cycle. Moreover, we believe that the potential opportunity for data/compute management and cybersecurity created by AI remains significantly underappreciated.
We continue to manage risk actively and asses the potential risk/reward of each individual holding, incorporating the trajectory of earnings and valuation. During market pull-backs, we generally do not decrease risk, but manage it by increasing our idea velocity and asset turnover.
We aspire to perform in line with diversified indices on the downside, and generate differentiated performance on the upside, given our concentrated portfolio of investments.
Frequently Asked Questions
Few points on liquidity and market pricing related to ETFs that may be helpful based on frequently asked questions:
Liquidity. The liquidity of an ETF is determined by the underlying holdings, not by the size (AUM) or volume traded of the ETF itself. The ETF is backed by the assets it holds and market makers constantly create/redeem shares.
Market Makers. When investors buy/and sell shares they often (but not always) buy/sell directly from the market maker who has created the shares and holds them in inventory. This ensures that there is always a market to buy/sell ETFs, rather than having to match a buyer with a seller (as it is for equities).
Market pricing. The price of the ETF changes constantly and moves with the underlying securities. To get the most accurate pricing when buying/selling an ETF investors should look at the actual bid/ask quote and spread. The ETF shares are backed by the fund's holdings which in our case are custodied at US Bank.
DISCLOSURE:
The performance data quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than their original cost and current performance may be lower or higher than the performance quoted. For performance current to the most recent month-end please call 1-833-340-7222. The total expense ratio is 0.75%.
For a prospectus or summary prospectus with this and other information about the Fund, please call (888) 123-4589 or visit our website at www.spear-funds.com. Read the prospectus or summary prospectus carefully before investing.
- “Alpha” strategy seeks to identify investment opportunities in which the performance of a company’s stock will exceed that of the market over time.
- B2B stands for business-to-business.
- Free Cash Flow (FCF) is the cash a company generates after taking into considerations the cash outflows that support its operations and its capital expenditures.
- CAPEX stands for capital expenditures or funds used by a company to acquire, upgrade, and maintain physical assets.
- EV/EBITDA is a commonly used valuation metric and is the ratio between the value of the enterprise to earnings that the company generates. EBITDA stands for earnings before interest, tax, depreciation and amortization.
- S&P 500 is a stock index that tracks the share prices of the 500 largest companies in the United States by market capitalization.
- Nasdaq Composite is a market capitalization-weighted index of more than 2,500 stocks that are listed on the Nasdaq stock exchange.
Investing involves risk, including possible loss of principal. The fund is subject to both growth and value equity risk. Investing in growth companies that are based on an issuer’s future earnings may be more volatile if revenues fall short of expectations. Investing in value companies that remain unfavored or are undervalued for long periods of time could have a negative on the fund’s performance. Companies in the industrials sector may be adversely affected by changes in government regulation, world events, economic conditions, environmental damages, product liability claims and exchange rates.
Technology, Space, Robotics and Automation companies are particularly vulnerable to rapid changes in product cycles, obsolescence, government regulation and competition, both domestically and internationally, which may have an adverse effect on growth and profit margins. Market or economic factors impacting these companies that rely heavily on technological advances could have a major effect on the value of the Fund’s investments. SPRX is non-diversified and may invest in a greater percentage of its assets in securities of an issuer in the industrial or technology sectors. An adverse event to an issuer in the industry may negatively impact the fund’s performance.
Applying ESG (Environmental, Social, Governance) sustainability criteria to the investment process may exclude securities of certain issuers for non-investment reasons, and therefore, the Fund may forgo available market opportunities.
Foreside Fund Services, LLC, distributor.
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