Below is an 18-month chart of the S&P 600 Small Cap Index. I showed this chart below several times in January and February, each time stating that I thought the index would hang out in the trading range bounded by the blue lines for a while. And I said I thought that would be a healthy thing and could set us up for a rally in the back half of the year.
What’s been most interesting about watching that scenario unfold is that, while small caps are trading within this 70-point range (between 920 and 990), large caps raced to an all-time high.
The sharp correction in the S&P 500 Index last week (and the Nasdaq and Dow Jones Industrial Average) led to a lot of talk about a correction (albeit in the context of a bullish market) and a change in the broad market trends. For instance, the Cabot Tides, which aggregates five indexes and compares the results to 25- and 50-day moving average lines, is negative. This broad market monitor suggests caution right now.
But you look at our little asset class and last week looks like just another normal pullback in the context of an extended consolidation phase.
What’s the takeaway?
The likely scenario is that investors watching the broad market are more spooked by the potential impact on large caps than small caps, stemming from the recent resurgence in trade war talk. That makes sense because large caps are more exposed to trade, while small caps are more insulated.
Also, large caps may be more prone to a pullback given where they are relative to historical levels, while small caps need to move 15% higher before they’re near their all-time highs.
Looking forward, assuming the U.S. doesn’t go to war with Iran and this trade fight/war continues about as it has (let’s be honest: this isn’t going away for years), I think the prospects for a small-cap rally into the back half of the year still look good.
Why?
First, small caps are trading on par with large caps on valuation, at 16.5 times forward earnings.
Second, analysts, who became overly bearish in late 2018 as the market tanked, have begun to turn more bullish. Forward estimates are now moving up. Consensus estimates suggest earnings in the S&P 500 will grow by 11.7% in 2020, while S&P 600 earnings will grow faster, by 18.7%.
That, combined with a recent uptick in forward revenue estimates, is notable because it comes directly after most companies have reported Q1 results and management teams updated forward guidance. In other words, the data/evidence of how companies are doing, and expect to do, is very fresh.
There’s not always a direct correlation between what we see at an index and/or broad market level to what we see in individual stocks. In fact, despite the uninspiring performance of the small-cap index this year, for the most part the stocks in our portfolio are on fire.
Our average gain is now 86%. Had you, instead, purchased a small-cap index instead of each of our current recommendations on the date it was added to the portfolio, your average gain would be just 6%! That’s a performance differential of 80%. Over the last two weeks the average gain in our portfolio is 8%, and over the last week it’s 3%.
This is a great time to be invested in these stocks, clearly. And I hope the trend continues. But I do think we have a missing ingredient before we can feel super confident that these gains will stick. And that ingredient is more participation from a wider group of small-cap stocks. If we get that, we’ll see the S&P 600 Small Cap Index break above 990 and move back toward its 2018 high.
Changes this week
CareDx (CDNA) moves from Hold to Buy
Updates
AppFolio (APPF) reported a good quarter last week that delivered on revenue expectations but was light on earnings given the pace of investments, acquisitions and hiring. Management doesn’t spend much time explaining (actually, no time at all) so this is one of those stocks were you’re either on board, or you’re not. It’s hard to argue with the big picture trends; revenue was up 36% in 2018, should be up 32% this year and is expected to rise 28% in 2020. Meanwhile, EPS doubled last year, to $0.56, should be up a modest 9% this year (for the reasons stated above) then accelerate 64% in 2020, to $1.00. I’m on board, but also think the big run year-to-date and lack of details on guidance will keep big investors from going in heavy right now. Keeping at hold and letting the stock digest its gains. HOLD.
Arena Pharmaceuticals (ARNA) reported last week, delivering what was mostly an update on the trial designs for etrasimod in ulcerative colitis (UC), along with a few other pipeline updates. While the company will report over $800 million in revenue this year, don’t get fooled—almost all revenue is due to the licensing deal for ralinepag with United Therapeutics (UTH). I upgraded Arena to buy after its earnings release and it has since broken out above its previous high of 51.63 and looks like it has a chance to trade up into the low 60s. With new money seemingly flowing in I’ll keep at Buy but start ratcheting down the size of new purchases as it will likely move back to hold soon. We should get another good idea of buyer interest next week as Arena’s management is presenting at three investor conferences in New York, starting with UBS on Monday, RBC Capital Markets on Tuesday and Barenberg on Wednesday. BUY.
Earnings: DONE
Avalara (AVLR) reported a great quarter last week and followed it up with a compelling presentation at the JP Morgan Conference this week. The big-picture idea here is that sales tax compliance is complex, becoming more so, and it should be a forgone conclusion that the process will become automated. Avalara is best-in-breed, and investors (and potential customers) are just starting to figure that out. One of the benefits of Avalara is that it’s autonomous—retailers that sell on various platforms can use it and maintain security and ownership of their data. This is particularly important for merchants that sell through their own stores, Amazon, Wal-Mart, etc. Management presents at the Needham Emerging Tech Conference next Tuesday. BUY.
Bottomline Technologies (EPAY) reported a couple weeks ago and for the second quarter in a row the stock fell sharply after reporting. The deal here is that there’s just not a lot to get excited about. In the second half of 2017 and into the first half of 2018 the stock was cranking because revenue growth was in the mid-teens and EPS was growing faster. It looked like that trend would continue, but revenue growth over the last two quarters has decelerated to 10% and 5%, respectively, while EPS has decelerated to 13% and 10%. Now, not all of this is Bottomline’s fault—there have been fluctuations in currencies that impact its bottom line. Revenue should be up around 8% this year then improve to 10% in 2020. EPS growth is expected to be a modest 5% this year, then 8% in 2020. Those numbers just aren’t big enough to get new investors excited, even though new revenue streams from digital banking solutions could represent upside. Given that the stock has been a dog for several months now it’s likely we’ll move on soon. But I’m still not ruling out a sale, and with the stock trading within an established trading range between 40 and 51 there isn’t a sense of urgency here. Keep Holding, for now. HOLD.
Earnings: DONE
CareDx (CDNA) reached a 2019 high of 39.38 back in February then went on a big slide that didn’t end until shares had moved 35% lower, likely helped by news of the litigation with Natera (NTRA). The stock began to recover in mid-April and with a nice quarterly report last Wednesday continues to advance. It’s now been 38 days since the glory days of April, and the stock is just 12% off its 52-week high. Importantly, CDNA has moved back above 30 and held there since earnings. That’s key because 30 became an area of formidable resistance last fall, and in January (see chart below). Then the stock finally broke above in late February. CDNA has responded more quickly than I anticipated and while bad news on the Natera front could impact shares quickly, I feel the trend (CDNA is up +20% over two weeks) here is strong enough for risk-tolerant investors to start averaging back in. BUY.
Codexis (CDXS) reported last Monday and there’s no news otherwise. The stock is unchanged over the last couple weeks, despite delivering a better-than-expected quarter. Stay patient. Management will speak at three upcoming conferences, starting with UBS next Tuesday, Craig-Hallum on May 29 and KeyBanc on May 30. BUY.
Domo (DOMO) is our newest stock, recommended on May 3. Domo is a $1 billion market cap company that has developed a business intelligence (BI) platform that allows every worker in an organization to access real-time data from their mobile device. Think of Domo as being like an operating system for business intelligence. While many people in a company work on computers that run a Microsoft or Apple operating system for everyday tasks, upper management uses Domo to see exactly what’s going on in the business at all times. It connects to virtually everything, including Microsoft, Amazon Web Services, Salesforce, Facebook, Shopify, etc., pulls all the data in and allows it to be worked with and viewed in ways that help people make better decisions.
The bullish case for Domo begins with the size of the potential market, which is estimated at over $20 billion if we just look at BI. But because Domo is a single, integrated platform that offers a scope of functionality that enterprises typically purchase seven solutions to get, the market could be far bigger. Industry analysts say Domo could address $45 billion in enterprise spending.
It’s a newly public company, having just come public last June. And one of the major criticisms is how much money it’s spending to build an incredibly complex and powerful platform. A few years ago this criticism applied to a lot of youngish cloud-based software companies. But as the space has matured many of those companies are now profitable or getting close. Many are also up several hundred percentage points! Domo could be like buying many of these strong stocks a few years ago.
We have a Q1 fiscal 2020 (ended April 30) earnings report and call scheduled for Thursday, June 6. And management will also present at the Cowen and Company Conference on May 29. Both should be interesting. BUY.
Announced Earnings Date: June 6
Everbridge (EVBG) broke out to a new high after reporting last Monday and hasn’t stopped climbing. Our total gain now sits at around 440%. Management spoke yesterday at the JP Morgan conference, then moves on to Needham next Tuesday, Baird on June 4 and Stifel on June 10. Scarcity value, expected revenue growth of 33% this year and 25% next, EPS losses getting cut in half each year before expected first profits in 2021 are just three of the reasons the stock is doing well. It’s trading at a premium valuation too. HOLD.
Goosehead Insurance (GSHD) reported a great quarter last week that appears to have generated renewed interest in the stock. Shares initially spiked to a six-month high above 34 before pulling back, then have advanced to north of 36 this week. A move above 38 would be a major milestone here as that could signal a breakout above what’s essentially a nine-month consolidation phase in the 20.5 to 38 range. We’ll see what happens. Keeping at Buy. BUY.
Q2 Holdings (QTWO) reported a somewhat messy quarter last week with revenue beating but profits coming in light due to spending and investments. Shares dipped but have come back strong and are back above their March-to-mid-April consolidation range (65 to 72) and just 3% off their 52-week high. This is a good sign. With Q2 Holdings trading slightly below last year’s peak valuation (on enterprise-value to forward revenue basis; see chart below), analysts looking for revenue growth to accelerate this year (up to 29% versus 26% in 2018) and 2019 likely to mark a short-term trough in EPS growth (down 50% to $0.13 before expected to catapult 254% to $0.46 in 2020) there’s enough wiggle room in the numbers for rational analysts to tell clients there’s still upside. We also received interesting news today that Q2 has teamed up with privately held ALTR to integrate that company’s smart driver and blockchain technologies into a new solution, Q2 TrustView. This new solution helps control how people access data and protects data assets for Q2’s customers and end-users. I like it. BUY.
Quanterix (QTRX) reported a huge quarter last week and the stock initially did great, then tanked later in the day and traded down on Monday too. What gives? I dug around in the halls of the SEC and found a couple filings that likely explain the drift. First, the company will issue some shares to cover employee stock options and incentive plans. And it plans to offer up to $50 million in stock “at the market,” meaning dribbled out, not all at once, to help fund various growth initiatives. After doing the math it looks to me like the total dilution is around 15%, which matches up roughly with the stock’s peak-to-trough decline over the last week. However, after the initial decline shares of QTRX are climbing back and can still be bought, with the caveat that the at-the-market offering could keep a lid on shares for a little while. That said, volume stepped up over the last week, so in time we may find that many of the shares have already been dispersed. BUY.
Rapid7 (RPD) is consolidating gains near its 52-week high after reporting a great quarter last week. There’s no news and I’m sticking with a Hold rating for now. HOLD.
Repligen (RGEN) is within spitting distance of the 52-week high of 70.50 that it hit last October. Between now and then, the stock went on a bit of a rollercoaster ride, dipping over 30% to 48.26 last December. The current action feels like a victory for the faithful, there’s no doubt about that. And with a good quarter and compelling guidance, and a yet-to-close acquisition not factored into the numbers, I think there’s more upside. There are no guarantees but be on the lookout for a break above 70 to send RGEN up to the next level. BUY.
Upland Software (UPLD) has a terrific-looking chart marked by breakouts, followed by consolidation phases, followed by breakouts. The latest jump was yesterday when Upland traded up 4.5% and put out a press release announcing a few industry awards and product enhancements. This action signals to me that more serious money is moving in. You can keep Buying; I don’t think we’re done. BUY.
