July 20, 2023

Aside from AI, a few other big-picture themes came into sharper focus for me this week.

All are positive for small caps.

First, economists and analysts are reducing their recession risk outlooks as the economy continues to hold up reasonably well. That’s good for small caps as they are more economically sensitive than mid and large caps.

Second, if the Fed is able to work a small miracle and thread the needle to get us through this historic rate hike cycle without a recession it will go down in history as one of their greatest achievements. The book is not closed, of course. But as we’ve all seen the market is in bull mode and big money is moving back in.

Small caps, which had been avoided earlier in the year like a coughing boy on a bus (I have two, I get it) are now starting to attract attention. I have said several times over the past months that for small caps to really get in gear we need small-cap financials to get off their butts. That’s begun to happen. Look at the small-cap financial sector ETF (PSCF is the ticker). It moved above its June high this week.

I know. An illiquid small-cap sector ETF is hardly a great indicator to trade off. But listen, financials carry a roughly 17% weight in the small-cap index. It’s basic math. For the index to get going, financials had to step up. Now they are, because the economy is looking better and risks to the financial system are easing.

Lastly, small caps are relatively cheap. That means they’re going to continue to draw attention given the valuation premium of large caps.

The S&P 500 trades with a forward P/E of 19.2. Not cheap.

By contrast, the S&P 600 Small Cap Index trades with a forward P/E of 14. That’s very cheap compared to large caps.

As a final note, I want to touch on AI briefly.

We all want to know where this can go and if the market is overenthusiastic about AI’s potential. The reality is nobody knows right now. During waves of tech enthusiasm stocks with exposure can go bonkers for a long time before unknowns become somewhat understood.

Right now, the “Mega-Cap Eight” tech stocks make up about 27% of the S&P 500 Index and they trade with a forward P/E of 31.2. That’s expensive. Take them out of the index and the S&P 500 trades with a forward P/E of just 16.7.

But what’s different with this tech rally is that the big boys have the tech, and are leading the charge and monetizing it right now (i.e. charging for it).

Read up on Microsoft’s (MSFT) proposed pricing for Copilot, which brings AI-powered tools to its 365 productivity suite. The $30 per user per month price is roughly triple what analysts had expected. We don’t yet know if that’s just to cover insane costs to provide the tech, or if it’s just because demand is so high.

Either way, the point is the monetization and/or margin benefits are relatively tangible for how new this feels. And that’s very, very different from many tech bubbles where investors were frothing about what could, maybe, happen someday.

Food for thought.

Recent Changes
Terex (TEX) was sold for a modest gain on Wednesday, July 19 (yesterday afternoon).

Updates

Alphatec (ATEC) announced it will report Q2 earnings on Thursday, August 3. No other significant news, though I did see that it’s no longer a “top pick” at Morgan Stanley since it’s been on the list for six months. Obviously that doesn’t impact the actual business at all. We’re currently looking for revenue to be up about 30% to $109.9 million and for EPS of around -$0.19. The hurdle for full-year guidance will be revenue of $451 million (+28.6%) and EPS of -$0.75. BUY

Earnings: Wednesday, July 26

Enovix (ENVX) announced this week that it has released a standard-sized battery cell for IoT and wearable technology use cases. I wasn’t expecting this, but it’s another incremental positive and should boost inbound inquiries. The company says that, like standard cylinder and disc batteries that we all use around the house, this standard-sized pouch cell is an off-the-shelf option for a rapidly growing market. On the downside, a short seller (logphase) put out a short report on ENVX making a number of bearish assertions. I saw it on Twitter. ENVX sold off yesterday on the news. It’s not surprising that the name is attracting attention given the big run. We’ll stick by ENVX. Earnings are out on July 26 (next Wednesday), the same day the Fed is set to hike by 25bps. Should be a relaxing day. HOLD

Earnings: Wednesday, July 26

Flywire (FLYW) got a price target boost from Truist Securities yesterday (from 35 to 40, stock closed at 32.5 yesterday). This follows last Friday’s positive news that the company has teamed up with Tencent’s financial arm to allow Chinese students and families to make education payments abroad using WeChat Pay. This payment app is very popular in China. While Flywire already allowed payments through Tencent’s digital payment methods, this deal means a simple and clear “pay” button will appear and take almost all friction out of the user payment experience. BUY

Earnings: Tuesday, August 8

Duolingo (DUOL) reports on August 8. We’re looking for Q2 revenue of $124 (+40%) million and EPS of -$0.18. Duo MAX and Math are not factored into forward revenue guidance but, as I’ve been saying, that doesn’t mean analysts and investors aren’t expecting good news. For the full year revenue is expected to be up about 38%, then grow by 27% in 2024. Naturally, we’d like to see signs that actual growth could be better. The stock is up modestly from last week and we’re looking for a breakout above 170 to really get things going. BUY HALF

Earnings: Tuesday, August 8

Inspire Medical Systems (INSP) has been very solid trading near all-time highs above 300. Not much to say except that I’m expecting another good quarter and hopefully the near-flawless execution continues. Second-quarter revenue should be around $136.7 million (+49.6%) and EPS should come in near -$0.57. Full-year consensus is for revenue of $589 million (+44.4%) and EPS of -$1.28 (an almost 20% improvement from last year). HOLD TWO THIRDS

Earnings: Tuesday, August 1

Intapp (INTA) was moved back to buy last week after shares dipped on news that CFO Steve Robertson will step down in August. His shoes will be filled by David Morton, who has held the CFO position at DigiCert. I think this is a manageable transition, but I’m sure analysts will be asking questions about it on the upcoming earnings call (no date announced yet). BUY

Repligen (RGEN) will deliver Q2 results on August 2 before the market opens at 8:30 a.m. ET with a conference call to immediately follow. Revenue is seen declining 19% in the quarter and -10% in Q3 before bouncing back to grow 7% in Q4. That suggests sales will shrink 8.7% this year, but then grow around 16% in 2024. We’re looking for management to confirm these are reasonable expectations and that the destocking issues that have plagued the bioprocessing space are about over. This morning Wells Fargo’s Timothy Daley picked up coverage with an “overweight” rating and 185 price target (RGEN closed at 159 yesterday). HOLD A QUARTER

Earnings: Wednesday, August 2

R1 RCM (RCM) was just added a couple weeks ago and hasn’t done much yet, but I’m expecting it will. Earnings are due out on August 2. As I said last week, R1 is arguably the best player in its specialized market of helping healthcare providers better manage their revenue cycle. It should benefit from the one-two punch of higher healthcare utilization (i.e. more procedures) and a major automation/AI push (helped by the Cloudmed acquisition) that can both reduce expenses and pull in new customers; the future looks pretty darn interesting here. Full-year 2023 guidance calls for revenue of $2.28 billion to $2.33 billion (+28%) and adjusted EBITDA of $595- 630M. The consensus 2023 EPS estimate is $0.29 (versus a -$0.16 loss last year). BUY

Earnings: Wednesday, August 2

Si-Bone (SIBN) received a price target increase this week from Truist (from 28 to 33, stock closed at 25.6 yesterday). We also learned that the earnings report will come out on August 7. Analysts see revenue of $31 million (+21.3%) and EPS of -0.40. For the full year we need revenue of at least $130 million (+22%) and EPS of -$1.45. SIBN has pulled back about 11% from the June high and is currently trading around its 50-day moving average line. Management will present at the Canaccord Genuity conference on August 9, just a few days after earnings are released. BUY HALF

Earnings: Monday, August 7

Terex (TEX) was sold yesterday in an effort to take a modest gain on a stock we’ve held through a serious pullback (-30% at the trough). TEX got a price target increase from Citigroup on Tuesday (from 52 to 65). I don’t make too much out of analyst price targets, but Citi’s target, almost the same as the stock’s current price, is just another data point that has me leaning toward cutting the stock and looking for more upside potential elsewhere. SOLD

TransMedics Group (TMDX) is now being covered by William Blair who initiated with an “outperform” rating and 96 price target yesterday. The analyst said, “ …even if other competitive technologies eventually come on the market, they would need to offer the ubiquitous hub network, procurement surgeons and transportation logistics, monitoring and reporting capabilities, and overall service offerings of TransMedics to even be competitive in the market, which are considerable hurdles to overcome.” The stock dipped on the day (as did a lot of stocks) but of course the real focus is now on Q2 earnings, which will be out around August 9. Revenue should be around $42.6 million (+108%) and EPS should be about -$0.14. Management is sure to talk about their plans to get into the aviation business to address supply chain challenges in the organ transplant market (and hopefully not create any for the company). HOLD THREE QUARTERS

Please email me at tyler@cabotwealth.com with any questions or comments about any of our stocks, or anything else on your mind.