Rate Hikes and Lagging Squares

In this week's episode of Industry Focus: Financials, host Jason Moser and Fool.com contributor Matt Frankel look at some recent news and listener questions. The Fed cut rates again, but the updated dot plot is turning some heads on Wall Street. Square's (SQ 2.32%) lagged the market for about a year since CFO Sarah Friar's departure, but long-term investors should stay confident. Meanwhile, amid all this talk of big banks losing hundreds of billions to transaction innovations, why don't those big banks just buy up some fintech disruptors? Plus, the guys give listeners some stocks to watch this week. Tune in to hear more.

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This video was recorded on Sept. 22, 2019.

Jason Moser: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market each day. It's Monday, September 23rd. I'm your host, Jason Moser. Sitting next to me here at the lovely Ritz Carlton in Washington, D.C., my main man, Certified Financial Planner Matt Frankel. Matt, how was your flight up?

Matt Frankel: Not too bad. I am winning in all three of my fantasy football leagues today so it's a good Sunday.

Moser: Hopefully that continues. It's still early. For our listeners, we are pre-taping Monday's show today here. It's Sunday. The reason why we're pre-taping is because we have our big event here. It is our Motley Fool Discovery event. We have 400 or so members of our various Discovery services, as well as some Motley Fool ONE members.

Matt, we'll get into what we're both doing here on Monday and Tuesday. But first, let's go ahead and jump into the topic that was on everybody's mind last week. On Wednesday, the Fed announced what was a widely expected quarter-point rate cut. The committee cited the implications of global developments for the economic outlook as well as muted inflation pressures. In other words, it seems like everything is ultimately going OK. They didn't see any reason to not give that cut to try to stoke activity a little bit and maybe keep the market on its upward trajectory. What were your takeaways from this rate cut news, other than the fact that your prediction for 2019 was somewhere in the neighborhood of raising rates once or twice, right?

Frankel: I know. I know I've been calling for the Fed to not cut rates. It's not because I predicted it, it's because I think would be the right thing to do.

Moser: You were not being selfish.

Frankel: Right. And to be fair, it doesn't look like I'm alone in that. It's worth noting that three out of the 10 people who vote on these interest rate moves voted against the rate cut. Two of them wanted to stay put. I'm in pretty decent company.

In addition to that, the biggest takeaway that surprised the market was what's known as the dot plot. That's where the Fed issues their expectations of where they think rates are going to be at the end of 2019, 2020, 2021, and from a long-term basis. Before the meeting, the market was expecting a median of about two more rate cuts in addition to this one this year. The dot plot is showing no more this year, none in 2020, and a rate hike in 2021.

Moser: I saw something, it sounded like at least there's the potential for one more rate cut this year, dot plot notwithstanding. Do you feel like that's a possibility?

Frankel: Yeah. Take it with a grain of salt because the last dot plot that we got in June, didn't show this rate cut. This is definitely an evolving situation. There's actually been a lot of movement at the Fed to get rid of the dot plot for that reason. No one can predict the future, the Fed included. They're taking a data-driven approach, as they've said many times in their statement. Who knows what the data is going to be by the time the next meeting rolls around?

Moser: Yeah, that's a good point. To your point about data, they talk about the consumer being in a good position. Unemployment is low. Wage growth could be better. But, I was looking at the personal saving rate, and that's closing in on 8%, which is considerably better here. It's on the upward trend, which is obviously good. Consumers have more savings, that gives them, as far as choices, a little bit more security and whatnot. It's nice to see that decisions are at least being made on that type of data. It does feel like we're in this unique situation where unemployment's great, wage growth isn't that great. I think people feel like things could be better. Maybe that's where this rate cut comes from.

Frankel: I think a lot of it is political pressure, as much as I hate to say it. To be clear, the Fed's job is not to prop up the stock market. It's not to do what the president wants. But the Fed has ears. The President said he wants zero or negative interest rates now, which would be a total of seven rate cuts from our current position to get to zero.

Moser: I don't think we're headed there.

Frankel: He wants that, today. I think that had something to do with it. I think if you look at the numbers, it's a lot easier to make a case for we don't need a rate cut than we're seeing in some of the Fed's language.

Moser: I tend to agree. Well, real quickly, you mentioned the dot plot. It seems like with this finance stuff, we've always got our nerdy labels that we give things. We have the dot plot. Something else that listeners may have seen in the headlines last week was in regard to the repo market. No, we're not talking about someone coming up there and repossessing your car. We're talking about something that actually does have to do with the way money moves through the system. The concerns were, at least, a big bump up in the rates of the repo market. Really quickly, Matt, this was a good headline. I don't know that there were any long-term implications here.

Frankel: It shows you how little control the Fed actually has over interest rates. They have a lot of control, obviously. The repo market means, when one party lends money to another, in exchange for a little bit more back at a future date --

Moser: So it's helping some of these firms out of a cash crunch, helping them with their cash flow.

Frankel: Right. Overnight loans. I give you $100 today, and you're going to give me $101 tomorrow. It's usually a very slight difference. And it usually goes pretty in line with the Federal funds rate, which right now is right around 2%. Shortly before the Fed meeting, we saw the repo market rate shoot up to about 5% overnight. It still hasn't normalized. It shows that the Fed might not have as much control over interest rates as the market things.

Moser: Well, that makes sense. We'll keep an eye on him. It does seem like it was a bit of an outlier. Again, if you were wondering what the repo market is, hopefully we shed a little bit of light on that for you today.

Let's jump over into another topic that we love, banks and payments. There was a tweet that you and I both saw last week from Neeraj Kapoor, @cricket99238. He says, "I'm wondering what you guys think is ailing Square. I still believe in the story for the long term, but fail to understand the indifference this is getting compared to some of the other names like PayPal. Nothing seems obviously bad. I request your input."

You look at Square, it's obviously a volatile stock. Year to date, it's worth mentioning, the stock is up 3%. It's not like it's having a horrible year thus far. But it is down from highs, and we have some great expectations for the company longer-term. Is there something there near-term that makes you wonder what's going on here, Matt?

Frankel: Up 3% is really underperforming the S&P this year.

Moser: That's a very good point.

Frankel: The obvious generic answer is that the competitive market is increasing in the payments space. What I think it really boils down to is execution risk. For years and years, Square was increasing its revenue at a 30%, 40% rate, just on its core businesses. Now it's needing to add more components to that. We recently talked that they're about to roll out a stock trading app. Every time they add another form of monetization, especially on their Cash app customer base, it's likely to be a money loser at first. So, to actually turn these into profit streams, there's a ton of execution risk involved. You're seeing risk being priced into the stock more so than before, when the growth was just reliant on their core payment processing and lending business.

Moser: I think that's a really good point. I think that you're starting to see a little bit more of a psychology out there in the market, where they're pulling back a little bit on that risk. You're seeing it everywhere from Uber and Lyft to companies like Square and a number of these different SaaS companies. At some point or another, revenue growth is great, but there needs to be the profitability and the cash flow behind that. That appetite for risk ebbs and flow, doesn't it?

Frankel: Right. You don't see this much in a stock like PayPal, which is one of your favorites, because they haven't differentiated their business model as much as Square has, I would say. They're still using more expected ways of monetizing Venmo, for example. You're not seeing a PayPal stock trading app or a Bitcoin app. They're not getting into and out of the food delivery business.

Moser: A much bigger company financially. Far more stable. Profitable, cash flow positive. All of these things. PayPal has come a long way in a fairly short amount of time. A lot of that has to do with the development of this space. We are moving more toward electronic payments, and these companies need to bring the software to support their systems. I tend to agree with you. I feel like it's more of a risk thing. There's not a business fundamental that has me concerned here. When you look through the earnings reports over the last three or four quarters, the numbers tell a very good story. It's just, at some point, you need the fundamentals to support the stock valuation. That's not there yet for Square.

Frankel: Right. Remember, Square peaked a little over $100 a share last year. The initial thing that set off the big decline was when they lost Sarah Friar. Another big perceived risk. She was the one who was the captain of the ship in a lot of ways for Square.

Moser: They brought in Amrita Ahuja as the new CFO of the company. I feel like she's still getting her feet under her. But if you listen to her on the earnings calls, and in the presentations, she certainly has a very good grip on the business and the mentality that Jack is using to run the businesses and set the company up for longer-term success. I do feel like they found a great replacement for Sarah Friar. We were both a little concerned when she took off.

Frankel: They did, but I mean, no matter how good Berkshire Hathaway does at replacing Warren Buffett, you're still replacing Warren Buffett. I'm not saying it's a giant risk. I'm saying it's a big perceived risk to the market. She was the one who was laying out, "We're going to be your one-stop, everything you need financial, you're going to be able to do in the Cash app." She was the one leading the charge on that, step by step by step. "We're going to be your interest yielding deposit account, your stock trading platform, etc, etc." So, the loss of her was the first big catalyst that sent Square over a cliff.

Moser: Yeah, I think you're right. It sounds like you and I both intend to hold onto our shares. Still very excited for the future of this company.

Frankel: I haven't sold one.

Moser: Neither have I. Speaking of the future of this company and other payments companies, let's use this subject to segue into another good tweet we got from @the_chantillyfr. He asks on Twitter, "With the banks set to lose about $280 billion in payment revenue, what stops them from purchasing a Square or a Global Payments network? I'm sure investors would love the acquisition and they'll be able to avoid some of those losses. I don't think any company will be acquiring PayPal." I think that's a really good question. You see a lot of these fintech companies that are up and coming. PayPal at this point is a little bit too big. I think it'd be tough to make that acquisition. Square, Global Payments, something like a Stripe that hasn't even gone public yet. We haven't seen very many headlines of banks interested in making these acquisitions. Why do you think that's the case?

Frankel: For one thing, all these companies are not banks. Square is in the process of applying for some sort of banking license. But PayPal, Stripe, they're not banks. There's a lot of regulatory issues as to what banks can and can't do within their business. That's one reason that's probably preventing them from looking at an acquisition.

Another thing. Banks are doing a good job of keeping up with technology in-house. We were talking before the show about how banks banded together to create Zelle, which has been wildly successful. I think Zelle actually has a bigger payment volume than either Venmo or Cash app.

Moser: It's up there. I remember that interview we had with them on the show. It's amazing, the success they've had.

Frankel: Right. They're not doing a bad job of adapting to this technology. But then, the big takeaway that brings me to, is when you hear that the banks are going to be losing $280 billion in revenue, this isn't necessarily revenue that's going to be taken by someone else. This is a pricing pressure issue. For example, let's say right now, a bank can get a 3% payment processing fee. If competitive pressures drive that down to, say, 2%, or even 1%, even if the banks are processing more and more volume, it's still a net loss of revenue. They're not necessarily losing market share or losing customers or anything like that. It's not that Square and PayPal are taking that $280 billion out of their pocket -- although, as a Square shareholder, I wouldn't mind if they did.

Moser: It's efficiency. They're bringing that money out of the system.

Frankel: Right. It's not that one's gaining and one's losing in equal amounts. I see them handling it in-house. I think they build Zelle a lot cheaper than they could have acquired a similar platform.

Moser: More than likely.

Frankel: They spent somewhere in the single-digit billions on creating Zelle.

Moser: Yeah, and to acquire any of these businesses ... to acquire PayPal would be $150 billion --

Frankel: I think Square's market cap is around $30 billion; to acquire it would be around $50 billion.

Moser: That's a good point. It's a big acquisition. It would definitely go under the antitrust microscope. Furthermore, I feel like if an acquisition like that happens -- not even coming from the investor's perspective -- consumers probably lose. I feel like big banks would take nimble tech companies like these and just screw them up. Am I wrong?

Frankel: I don't think Square would be going in some of its same directions if a bank took it. It would probably stay a payment processing company.

Moser: Probably, the innovation would come to a grinding halt.

Frankel: They'd still produce their hardware. They'd still have their little tablets, because that's what's working, and that's what's in the banks' wheelhouse. They're not going to get creative with things like food delivery, building out a Bitcoin app. They don't want that regulatory burden.

Moser: No, I imagine not. It does feel like they are very interested in partnerships. You see more of these banks focusing on these partnerships, whether it's with a Visa or MasterCard or a PayPal or a Square, Stripe. To your point, it's not like that money is going from one bucket to another. But I would rather see partnerships than acquisitions. Oftentimes acquisitions really look great because it's money in your pocket, if you've got a company that's bought out at a premium; but you have to consider what could have happened to that business over the course of the next five or 10 years. In the case of good businesses, most of the time, those five or 10 years can create a lot more value than you would have realized in just that one lump sum acquisition.

Frankel: It's true. You make a great point with partnerships. What's to stop, say, Bank of America from partnering with Square to create their deposit account? Or, something to that effect?

Moser: We'll be looking for that stuff on the horizon.

OK, Matt, let's take a quick break here from deliberating all of these questions and just read something from Twitter that someone wrote in last week. We got a lot of good responses to "what's the last stock you bought and why." I have a feeling that every once in a while, we'll be able to kick in what we're buying, but it sounds like a lot of listeners are having fun telling us what the last stock they bought was and why.

Frankel: I think we should do it once a month, or maybe every other month, something like that.

Moser: Our stocks, you mean?

Frankel: Yeah.

Moser: OK, yeah. So, we got Andy Courtright on Twitter @acortwr8. Very clever there, Andy. Andy chimed in to let us know that his latest purchases, Intuitive Surgical and Teladoc, were because he needed more healthcare in his portfolio. Andy, listen, you're an investor after my own heart. You know that healthcare is a market that I really like a lot next to the payments space. Teladoc is one we've talked a lot about in our Foolish shows here through the years. Intuitive Surgical as well. A phenomenal company that's doing a lot of great things to make surgery, to make our healthcare system better. I've spoken with a friend down in Georgia, he's a cardiologist, Chad Huggins has said a lot of good things about Intuitive Surgical and the stuff that they're doing. I suspect you'll be hearing a lot of great things from that company in the years to come. Not to mention Teladoc. What do you think, Matt?

Frankel: I actually need some healthcare exposure in my portfolio. I only have one small position in a healthcare stock.

Moser: It sounds like Andy's got your answer right there.

Frankel: If anyone else has any ideas, feel free to tweet me @TMFMathGuy. Share your healthcare ideas, I need some.

Moser: We want to hear them. We want to hear the last stock you bought and why. So, hey, tell us what it is. Hit us on the email at [email protected], or hit us up on Twitter @MFIndustryFocus. What was the last stock you bought, and why? We want to know.

OK, Matt, we wrap the week up normally with one to watch. Let's get to that now. What is the stock you'll be watching here this coming week?

Frankel: My favorite thing to do is watch stocks that have been unfairly beaten up. So I'm going to go with Roku (ROKU -10.29%) this week, ROKU. It's down 27% over the past week.

Moser: It's been a tough month for Roku.

Frankel: Even after that, it's tripled for the past year. Let's put that in perspective. It's not really down. People who have been in it for a while are still doing pretty well. The first thing that sent it down, Comcast announced it was offering its own streaming device. Used to cost $5 a month to its subscribers, now it's going to be free. The fear is that hardware costs are eventually going to zero for streaming.

Moser: That's a reasonable expectation.

Frankel: Right. Roku makes a lot of money off ad revenue. Now there's concern, analysts note that's going to come under pressure. It's still the sector leader. It's not the first time this has happened to Roku. Look about this time last year. It plunged in a similar manner, then tripled since then. The streaming market is big enough that you could have a dozen big winners.

Moser: It's a big market. I'll be talking about it a lot, certainly, in the coming months here with the entertainment industry and all of the ideas that we're pursuing in that realm. What kind of streaming device do you use?

Frankel: I have a Roku.

Moser: You do, OK!

Frankel: I have a Roku in three rooms in my house.

Moser: We have an Amazon Fire TV device. We only have one TV in the house. We have phones and all sorts of stuff but only one big TV in the house. So we only have one streaming device. But, to your point about hardware being a race to the bottom there, ultimately going to zero, that's what Roku is doing. They're incorporating that software into TVs now so you just buy the TV sans device. It's all rolled into one. Right?

Frankel: Right. And I have to believe they've been selling their hardware at a loss.

Moser: I would imagine.

Frankel: Whether they're selling $100 piece of hardware for $30 or giving it away for free really isn't going to make or break them. It's really the ad revenue and what they can generate through their platform and having a presence in millions of American homes.

Moser: I like it. I'm going to go with Microsoft (MSFT 1.82%), ticker MSFT. This is the biggest company in the world, essentially. It's still bigger than Apple, I believe. Microsoft just raised its dividend by 11%. Now they're yielding $0.51 per share per quarter. Along with that, they authorized another $40 billion in share buybacks. To put that in context, they just pulled in $40 billion in free cash flow over the last year. Take that with a grain of salt. But the fact of the matter is, this is a company that is going to be on the forefront of everyone's lives for many, many years to come. If I asked you, Matt, when do you think -- this is a good quiz here, but you can't cheat because this is all right here, right now -- what year did Microsoft start paying its dividend? Any ideas?

Frankel: I would have to say somewhere in the mid-90s. '96, '97?

Moser: That's a good guess. It was 2003. I would have guessed a little early, too. But my point ultimately is that these guys still have a long way to go to be able to qualify for a dividend aristocrat status, which I imagine we'll one day see with them. I feel like this is a company that, globally speaking, its on operating systems everywhere. We use it in personal life and business life and everywhere in between. Hard to imagine a world without them. As far as dividend stocks, it's one of the better ones out there.

We're going to wrap things up here, Matt, but before we do, tell the listeners what you have on tap for the event this week. Why did you come all the way up here from South Carolina?

Frankel: I am here for the new real estate site, Millionacres, that we've been talking about. We have a premium service through that called Mogul. These are some of our premium members, so we're trying to let them know about our real estate side and what value we have to offer. I'm giving a presentation with Matty A on Tuesday.

Moser: Tuesday. Good. I think I'll have to attend that presentation. I'm here doing my augmented reality presentation on Monday, which means I should have a little free time on Tuesday. Maybe I'll come in there and hear what you guys have to say.

Frankel: Please do. It'll be my first lecture since I stopped teaching college. I'm looking forward to being in front of a room with a PowerPoint again. It's been a while.

Moser: I'm sure you'll nail it. Looking forward to it.

As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. A big thanks this week to our production guru Dan Boyd for having a setup here in the hotel and making sure that this show happened this week for you and for us. For Matt Frankel, I'm Jason Moser, thanks for listening and we'll see you next week.