Weekly Update - The Declining Relevancy of The Small Cap Index
This week’s market recap is a familiar story—the major big-cap market indices are doing great! But the small cap index is still wallowing in the mud.
Over the last 12 months the Russell 2000 index is down by 8%. Meanwhile, the S&P 500 is up 7% and the Nasdaq is up almost 6%. That’s a roughly 15 percentage point differential.
There are a lot of ways we can unpack why this is happening. But given time and space constraints I’m mostly going to rail against the Russell 2000 Index, which just went through its annual reconstitution in June, in broad generalities.
For those that don’t know, the Russell 2000 is essentially just a group of 2000 stocks that fit within the small cap market cap bookends that FTSE Russell decides is most relevant each year.
Their pitch is that this market cap constrained methodology removes subjectivity and increases transparency, so index investors get an index that’s “representative, reliable and relevant.”
The issue, if you invest in assets that track such an index, is this: we’re in a bull market! Ten years ago, the breakpoint between the Russell 2000 Small Cap Index and the Russell 1000 (which holds larger companies) was $1.9 billion. In 2018 it was $3.7 billion. In 2019 it’s $3.6 billion.
Growth investors know that good stocks go up! If all the good companies are getting bigger where’s the incentive to blindly purchase a basket of 2000 smaller companies? It would be one thing if the IPO market refreshed the index at the low end. But from what I’ve seen IPOs are getting bigger, not smaller.
Removing subjectivity from index stock selection is great, if the subjective opinions of decision makers are dreadful. But if subjective opinions are good, that’s what you want! As currently constituted, the Russell 2000 Index holds zero allure for growth investors in my opinion.
That, in a way, is frustrating for me. Because I think it means your everyday investor, who should be interested in small cap opportunities, looks at the poor performance of the small cap indices and says “why invest there?” And that means they’re missing out on all the great microcap and small cap growth stocks of today, which will likely become the mid-cap stocks of tomorrow.
If you compare the average gain of each of our stocks to the Russell 2000, over the exact same holding period, our stocks are outperforming by an average of 97%.
Yes, we’re doing exceedingly well. But let’s be honest, the competition is sucking wind.
At the end of the day the reality is that an index of 2000 stocks (the Russell 2000), or even 600 stocks (the S&P 600 Small Cap Index), doesn’t come remotely close to representing the range of opportunities in our 15 position Cabot Small-Cap Confidential portfolio.
Which begs the question: is the small cap index even relevant anymore?
Just something to think about. In the meantime, we continue to focus on the best opportunities we can find in a (relatively) concentrated format.
Changes this week
CareDx (CDNA) moved from Hold to Buy
Updates
AppFolio (APPF) provides cloud-based software solutions for small businesses in the property management and legal verticals. Property management represents the bulk of revenue, and in recent years growth has come from adding new Value+ services, which include payments, renters insurance, tenant screening and the like. AppFolio is moving upmarket, attracting larger property managers with more units. Management has a no-nonsense style, which is great when things are going well, but mentally challenging when the stock is under-performing and investors yearn for more press releases, however trivial the news may seem. All is good now with APPF up 6% over the last two weeks and just 3% from all-time highs near 110. HOLD.
Estimated Earnings Date: 7/29/19
Arena Pharmaceuticals (ARNA) is up 4% over the past two weeks and just 4% from its all-time high. The stock broke out in May and has been making a series of higher highs and higher lows since. Arena is a biopharmaceutical company that develops novel, small-molecule drugs with optimized receptor pharmacology designed to work across a wide range of therapeutic areas. The pipeline includes potential treatments for pulmonary arterial hypertension (PAH), ulcerative colitis (UC), pyoderma gangrenosum (PG), primary biliary cholangitis (PBC) and pain associated with Crohn’s disease. The pathway to commercialization is long (potentially 2021), but Arena is well funded so patient investors should just sit tight. A couple weeks back management announced it had dosed the first patient in the first of two Phase 3 trials (ELEVATE UC 52) evaluating etrasimod in patients with severely active UC. BUY.
Estimated Earnings Date: 8/5/19
Avalara (AVLR) has been a rocket ship lately, having risen 5% over the past week and 17% over the past two weeks. The big picture story here is that Avalara is a cloud-based provider of sales and indirect tax compliance software. Traditionally, a lot of this work has been done manually, which is labor intensive, inefficient and prone to error. Avalara is automating the process, and it seems a foregone conclusion that this is the wave of the future. That said, it’s not an easy thing to do because of lots of different little tax regulations in geographic markets and for different items. Avalara has a big lead in developing a tax library, so it can handle most transactions for customers, some of which file once a year, and some of which file tens of thousands of returns a year. The average customer files 200 to 300 times annually, at $40 to $50 a pop. It’s a big trend and the stock is working insanely well. We’re up 108% since February 1st of this year! BUY.
Estimated Earnings Date: 8/9/19
CareDx (CDNA) has good friends in Washington. Alex Azar is the Secretary of Health and Human Services (HHS), and along with President Trump the two are working to increase the supply of kidneys available for transplant and extending Medicare coverage to transplant patients for the lifetime of the transplanted kidney, which is currently set to just three years. Trump recently signed an executive order that, among other things, aims to reform the U.S. organ transplant and kidney dialysis system, which could help increase supplies. Secretary Azar’s father received a kidney transplant. This news has helped push CDNA back near all-time highs and I see a good chance the stock can keep moving higher from here. Aggressive investors can buy again. BUY.
Estimated Earnings Date: 8/9/19
Codexis (CDXS) was moved back to buy a few weeks ago but hasn’t done much since. There’s no new news. The company is an industrial biotechnology company with a proprietary technology platform, CodeEvolver, that uses AI and machine learning to create new proteins for use in customer products, manufacturing processes, and other commercial dimensions. In their natural form, proteins come up against inherent barriers that limit their commercial potential. Codexis engineers novel proteins that overcome those limitations. BUY.
Estimated Earnings Date: 8/8/19
Domo (DOMO) is one of few remaining pure-play business intelligence stocks out there (the other is Alteryx). Given that so much enterprise data flows through its infrastructure, and this is hugely valuable data, it would seem the company has a bright future. At the same time, it’s not a slam-dunk, and there are other, bigger players in the market, notably Salesforce, Microsoft and Google. It wouldn’t surprise me in the least if Domo is acquired at some point. But I could see a scenario in which the business needs to gain enough traction first (and the stock needs to perform) for shareholders to want to let it go. The stock hasn’t done great since I added it to our portfolio in May, and I moved it to hold a number of weeks ago. That said, DOMO just popped off its 200-day line and looks to be stabilizing around here. I’m watching it closely for an opportunity to go back to buy and help those that bought early lower their cost basis before a run higher. HOLD.
Estimated Earnings Date: 9/6/19
Everbridge (EVBG) sells cloud-based software that provides fast, automated communications services during life threatening situations and mission-critical business events. Think hurricanes, active shooter and terrorist attacks. It’s growing in the U.S., but a lot of the recent excitement surrounds international growth. Everbridge is one of the few players out there that can send messages directly to mobile devices in over 200 countries. That’s not an easy thing to compete with. It’s a hot stock (up 13% over the past two weeks) that just broke out to new highs. We’re sitting on a 540% gain. HOLD.
Estimated Earnings Date: 8/6/19
EverQuote (EVER) operates the largest online marketplace for insurance shopping in the U.S., with over 11 million visits per month from consumers that compare and buy plans. While we’re still early in the shift to online insurance shopping, the trend is unmistakable, which is why insurance carriers continue to integrate their marketing efforts with EverQuote and pay the company for referrals. The stock’s been in a consistent uptrend all year, is up 16% over the past two weeks, and with a market cap of just $355 million, is one of the smaller companies in our portfolio. It just announced the launch if its health and renters’ insurance offerings. BUY.
Estimated Earnings Date: 8/5/19
Goosehead Insurance (GSHD) is shaking up the insurance brokerage market by building an independent insurance sales and support platform and deploying it at a national scale, through a hybrid corporate and franchise distribution model. It’s the only publicly traded insurance broker of its kind out there. Its focus on auto, homeowners and other personal lines (boat, umbrella, etc.) gives it access to a sticky market with high renewal rates. Between Goosehead and EverQuote, we’re well covered to profit from emerging trends in the insurance industry. The stock was a little extended a week ago but has come in a bit since. BUY.
Estimated Earnings Date: 8/7/19
Q2 Holdings (QTWO) is up 5% over the past two weeks and continues to trade above the 67 to 76 range that occupied during May. The company is a pure-play provider of digital banking solutions to the highly personalized community banking and credit union market. It offers a purpose-built platform that brings small banks and credit unions up to speed with solutions for deposits, money movement, lending, security and fraud, giving them the power to compete with the mega banks for depositor accounts. There’s been no new news since management announced a new partnership with PrecisionLender, which specializes in pricing and profitability software for commercial banks, a few weeks ago. BUY.
Estimated Earnings Date: 8/5/19
Quanterix (QTRX) took off in June but has come down in July and is now 16% off its high. This isn’t all that surprising and I had moved the stock to hold a few weeks ago anticipating that the rally was losing steam. Quanterix still has a market cap well under $1 billion and I expect it will be volatile at times. Two weeks ago the company announced it would acquire UmanDiagnostics, which produces the best currently-available antibodies for measuring neurofilament light (Nf-L) in blood, providing them to many researchers and biopharmaceutical and diagnostic companies. Quanterix has developed assays based on Uman’s Nf-L antibodies that have applications in diagnosing and monitoring Alzheimer’s Disease, Multiple Sclerosis, Parkinson’s Disease, traumatic brain injury (TBI), ALS and Huntington’s Disease. Quanterix locks up supply of NF-L and lowers its cost (25% of Quanterix revenue relies on Nf-L) by buying UmanDiagnostics. HOLD.
Estimated Earnings Date: 8/8/19
Rapid7 (RPD) continues to extend upward after a consolidation phase that lasted for most of April, May and June. There is no specific new news driving shares of the security software specialist. Rather, we’re just in a good environment for these types of companies given the secular growth trends in cloud and all the network security threats that creates. I moved Rapid7 back to buy two weeks ago and am sticking with that rating now. BUY.
Announced Earnings Date: 8/1/19
Repligen (RGEN) sells bioprocessing supplies to life sciences and biopharmaceutical companies around the world. The trends point toward more personalized medicine and small batch drug production, and Repligen, as one of the few small cap pure plays offering exposure, has scarcity value. There’s no new news recently, but shares are trading just 3% off their highs. The stock looks like it’s going to consolidate the spring gains in the mid-80s. You can keep picking up shares around this level, but don’t be surprised if we get a little pullback into the low-80s before Repligen goes higher. BUY.
Estimated Earnings Date: 7/31/19
Upland Software (UPLD) sells cloud-based Enterprise Work Management (EWM) software to companies where collaboration and teamwork are critical to their operations. This software is designed primarily for people in mid to large organizations (Upland has small customers too) that work in dynamic, knowledge-based work environments all over the world. Think of it like a smaller version of ServiceNow (NOW). The stock dipped below its 50-day line in late June but is back up near that technical level now. Keeping at buy. BUY.
Estimated Earnings Date: 8/8/19
Veracyte (VCYT) was the July recommendation and was sent out early (last Monday) since our offices were closed on Friday due to Independence Day. The company specializes in genomic diagnostics solutions that can help detect disease early and inform treatment decisions. Veracyte has four commercialized first-to-market genomic tests that address significant unmet needs in disease diagnosis; Afirma for thyroid cancer, the companion Afirma Xpression Atlas (XA) test for genomic alteration content, Percepta for lung cancer, and Envisia for idiopathic pulmonary fibrosis (IPF). They’re all minimally invasive, requiring just a single fine needle aspiration (FNA biopsy), nasal swab, airway brushing or a sample taken during bronchoscopy. All tests are covered by Medicare. The company has an addressable market of around $2 billion now, but that could surge to $30 billion if some of its current projects come to fruition, including a nasal swab test that could detect more types of lung cancer. Veracyte is working on this project with Johnson & Johnson Innovation. We’re looking for revenue to grow around 29% this year and EPS to improve by 50%, to a loss of -$0.31. Management also says Veracyte is on track to achieve cash flow breakeven by the end of this year. BUY.
Estimated Earnings Date: 7/30/19
