2 Stocks Hedge Funds Are Buying Right Now

Some reports suggest the U.S. is winning the fight against inflation and that the Federal Reserve realizes leaving interest rates elevated for too long might have a domino effect that cascades through the economy, but for now rates remain intact.

So, where to invest now? One answer is to follow the smart money and invest in stocks that hedge funds are buying. Two of the top contenders in this category are Adobe and Costco.

Adobe’s Foray Into AI Pays Off

Adobe Inc. (NASDAQ:ADBE) stock is barely positive over the past twelve months but its recent quarterly results garnered significant attention. Hedge funds appear to be quite excited about the Adobe stock, as seen from the Q1 holding disclosures.

The company is seeing significant tailwinds, posting a record top line figure of $5.31 billion in the last reported quarter as demand keeps operations buoyed. A primary reason for this is the company’s integration of artificial intelligence into applications alongside increased revenue diversification.

The Digital Media segment is the flagbearer and accounted for 74% of Adobe’s total revenue in the second quarter of fiscal 2024, ended May 31, 2024.

The company’s leading offering, Creative Cloud, also falls under this segment and accounts for 80% of the company’s digital media revenue. Adobe exited the last quarter with recurring revenues of $16.25 billion in the Digital Media division .

Although the company is not a leader in the field of AI, Adobe has seamlessly integrated AI well. So far, the progress has been notable and customers are increasingly interested in Adobe’s generative AI-powered conversational interface, called Adobe Experience Platform AI Assistant. Notable customer names include General Motors and Hanesbrands.

Adobe’s AI integration has also helped the company grow its subscription revenue base. These recurring revenues are typically more steady than product-based sales, especially for the technology industry.

All in all, the start of Adobe’s AI Assistant monetization has been promising and analysts seem to be positive about the effect of AI integration on Adobe’s portfolio as well as its user acquisition.

Such encouraging results have led the company to raise its forecasts for the current year. It raised its revenue projections from between $21.30 billion and $21.50 billion to a range of $21.40 billion to $21.50 billion. Management also raised its digital media net-new ARR from approximately $1.90 billion to $1.95 billion.

ADBE share price sits at 30.70x its forward non-GAAP earnings. While this stretched compared to the industry standard, it is trading lower than its own five-year average. 

Analysts see reasonable upside of around 15% to fair value of $604 per share while a discounted cash flow forecast paints a more upbeat picture with a price target of $666 over a 5 year time horizon.

Costco 

In the wholesale retail market, Costco’s membership-based model has been faring quite well. At its peak Costco (NASDAQ:COST) stock was up by around 28% for the year, outpacing the broader market.

The company is renowned for its cheap offerings and commitment to customers, even in the face of inflation. For example, over 50% of operating profits stems from membership fees. Or in other words, the vast majority of revenues produced by the firm do not translate into profits because Costco largely passes on the savings to customers.

Customers aren’t the only ones to fall for Costco, hedge funds love it, too, given the Q1 increases in positions.

The company obviously relies heavily on membership fees to keep product prices low and stay competitive. As of the third quarter of fiscal 2024, membership fees represented almost 2% of Costco’s total top line, while sales make up the rest. Net sales for the quarter rose by 9.1% from the prior year’s period to $57.39 billion.

The company’s growth has persisted and largely been a function of new warehouse openings. Costco currently operates 882 warehouses, with a majority of them inside the U.S. The company expects this count to reach 890 by the end of this fiscal year.

The Costco brand is extremely valuable and translates to loyal members. It enjoys a 90.5% membership renewal rate globally. This rate is even higher, 93%, in the U.S. and Canada. For the third fiscal quarter, the company’s total number of cardholders increased by 7.4%.

In July, Costco announced some new developments relevant to its stock performance. First, the company reported a 7.4% year-over-year increase in net sales for June. Next, carrying its long-standing dividend history forward, the company declared a quarterly cash dividend of $1.16 per share. The annual dividend of $4.64 yields 0.55% on current prices. It has a low payout ratio of 26.49%.

Lastly and most significantly, Costco announced an annual membership fee hike. Starting from September 1, U.S. and Canada Gold Star (individual), Business, and Business add-on members will have to pay $65 (a $5 increase).

Annual fees for Executive Memberships in the U.S. and Canada will increase from $120 to $130. This is the first time since 2017 that the company has raised its fees. This fee increase will affect around 52 million memberships, a little over half of which are Executive members.

Costco’s price sits at 52.59x its forward non-GAAP earnings, which is stretched, but not far from historic norms. 

Analysts still see upside to $881 per share while a discounted cash flow forecast is more pessimistic and forecasts fair value at closer to $609 per share, suggesting material downside risk. Will the analysts or the cash flows prove to be more accurate when the price action resolves in the coming years? 

Whatever the outcome, it seems that for now the reward to risk ratio is not overly compelling for new investors at this time.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.