Small caps rose 1.7% in the face of more political uncertainty over the past week.
This following chart is a little hard to read. But if you study it for a minute, you’ll notice that year-to-date, it’s small-cap tech, healthcare, industrials, financials and materials that are pulling the index higher. We have a lot of exposure to tech, a modest amount to healthcare, a little to industrials and a very small indirect amount to financials through Q2 Holdings, which is a mix of tech and financial (it benefits as banks do well).
Earlier this week, I wrote an article in Cabot’s Wall Street’s Best Daily in which I spelled out five of the reasons small caps could outperform again in 2017. It’s not as if it’s all blue skies and smooth sailing out there in the market—not by a long shot. But I think it’s helpful to step back and look at the big picture every now and again. So today, I’m including my bull case in our Weekly Update. I’ll present a bear case too (it’s a lot less entertaining to write!) within a few weeks so you get a balanced perspective.
But today, we’re drinking from the glass that’s half full. And there’s a little cause for celebration too. Two of our positions reported this week. One was up over 8% the day after reporting. And the other is up nicely in early trade today after reporting yesterday. All the details, including the rationale for moving one of these stocks to Hold, follow after my small-cap bull case presentation.
Reason #1: One Year of Small-Cap Outperformance Isn’t a Trend.
This is just a restatement of the old market adage that bull markets don’t die from old age. Or put another way, trends often persist for longer than expected. Small-cap outperformance isn’t yet a trend. While there’s nothing magical about analyzing calendar-year returns, the method does show that in recent history, small-cap outperformance tends to run in twos—the asset class outperformed (and delivered positive returns) in 2009 and 2010, then again in 2012 and 2013. There’s no reason why it can’t go back-to-back in 2016 and 2017.
This is admittedly a rudimentary way of looking at things. But sometimes that perspective is valuable, especially when many of the reasons small caps rallied at the end of 2016 are expected to play out in 2017 and 2018. Let’s discuss those.
Reason #2: Small Caps Outperform During Economic Expansions.
This is a carry-over trend from last year when I expected small cap stocks would get a lift from GDP growth. The same goes for 2017, but the growth outlook is even better now. Many analysts are forecasting 2017 GDP growth in the 2% to 3% range. That’s the zone of growth that tends to correlate with strong equity performance. Data from Credit Suisse shows that since 1979, GDP growth in the 2% to 3% range has resulted in small caps being up 88% of the time, and outperforming large caps 75% of the time. Since 1986, small caps have been up 100% of the time when GDP growth is in the 2% to 3% range, and they’ve outperformed large caps 86% of the time. In other words, it hasn’t paid to bet against small caps when GDP growth is in the 2% to 3% range.
Reason #3: Small Caps Should Benefit from Protectionist Policies Due to High U.S. Exposure.
Investing in small caps is like a leveraged play on the U.S. economy. That’s because around 80% of small-cap sales come from within the U.S. In comparison, around 31% of large-cap (S&P 500) revenues come from the U.S. There are a lot of variables to factor into a full-blown analysis of a pro-U.S. agenda, mainly the potential negatives of taking such an agenda so far that it alienates the U.S. But assuming such an agenda isn’t pushed over the line, protectionist policies should help small caps in 2017.
Reason #4: Rising Interest Rates Are (Still) Good for Small Caps.
This is another carry-over from 2016 given that it was such a hot topic last year, and that the Fed raised rates for the first time in almost a decade in December 2016. That event was likely the beginning of a trend of rising rates, although the precise timing and pace is up for debate. The Fed could easily be holding off on any more decisions to see if Trump makes progress on infrastructure spending and corporate tax cuts, both of which could lead to a faster hiking cycle. What isn’t debatable is that four decades of data show that rising rates have been good for small caps, not only in absolute turns (generating higher returns than in falling rate environments) but also in relative terms (generating higher returns than large caps).
Data from Fidelity (going back to 1979) suggests small cap stocks enjoy an average 12-month gain of 14% when long-term rates rise by 1%. And when short-term rates rise by 1.2%, small caps average a 12-month return of 15%. Stocks, including small-cap stocks, tend to go down before they go up after the first hike. But that part of the cycle is most likely already behind us.
Reason #5: A Corporate Tax Cut Would Be Disproportionally Beneficial to Small Caps.
If Trump is able to push a lower corporate tax cut through Washington, small caps should benefit. It’s estimated that the effective tax rate of the Russell 2000 is 32%, versus 26% for the S&P 500. That’s a big difference, and those small companies would most likely pour that money into dividends, stock buybacks, M&A or rainy day funds. In just about any scenario, share prices should react favorably, at least initially. The last major tax relief was enacted with the passage of the Tax Reform Act on October 22, 1986. And while there were some stock market bumps in the road afterward, most notably Black Monday (October 19, 1987), the broad market increased by nearly 50% by the time Bush’s Omnibus Budget Reconciliation Act of 1990 was passed, effectively raising individual income tax rates on November 5, 1990.
A Word About Small Cap Valuations
Small-cap valuations are one of my biggest concerns. With the S&P 600 trading at 19.5-times forward earnings, there’s not a lot of upside to valuations before we get seriously overheated. And history shows that when small caps trade with a forward P/E of around 20, upside is capped.
There is one thing to consider, however, which might justify a historically high P/E ratio. In the words of Goldman Sachs (they refer to large caps, but the same logic applies to small caps): “Here, it’s helpful to remember that the S&P 500’s long-term average P/E ratio— which many investors use to gauge fair value—was forged over a period when risk-free rates averaged 4.5%. In contrast, the risk-free rate now is just 0.5%-0.75% and the Federal Reserve estimates its new long-run equilibrium level has fallen to 3%, a full 1.5 percentage points below the historical average. Of equal importance, the Federal Reserve is not expected to reach that 3% target for six years…”
In other words, an extended low-interest rate environment is an anomaly, and could help validate an extended period of historically high valuations. With other investment options—bonds, cash, even hedge funds—not expected to do better than equities, where’s the real motivation to move away from stocks?
High though valuations might be, the lack of a next-best alternative is a major reason to stick with stocks. And that, along with just enough logic to support high valuations coupled with real GDP growth, revenue and EPS growth, and the potential for tax reform, might mean we shouldn’t be overly concerned about valuations. I don’t think we’re going to see small caps up over 20% again in 2017. But I can foresee a scenario in which they could rise 5% to 10%.
Updates
Airgain (AIRG) Management reported Q4 results yesterday after the close that came in just about as expected. Revenue in the quarter was up 35% to $12.6 million ($400,000 ahead of consensus) and adjusted EPS of $0.12 was $0.02 ahead of consensus. In the quarter, average number of antennas per device grew to 2.96 (up 11%) and average selling price per device was up 7% to $0.83. All of these metrics came in slightly better than I expected. And the results pushed full-year 2016 revenue up 56% to $43.4 million and adjusted EPS to $0.40 from a loss of $4.30. The company has $45.2 million in cash, $5 million more than I expected, partially because it added around $2.5 million in cash from operations (that’s good).
Airgain continues to generate gross margins above its target of 40%, with gross margins of 43.4% in Q4 and 44.4% in full year 2016. When asked about this, management said anything above 40% is gravy. It said the market can speculate about where gross margins will go but it’s sticking with its internal target. I believe this is a strategic decision to under-promise and over-deliver so that the company has some wiggle room with the market if and when competition heats up and cuts its pricing power.
Airgain is continuing to see strength in set top boxes and gateways for cable operators. No surprise there. It was also designed into a next gen 4K HDR wireless set top box that is already shipping in Europe. It began shipments for its next gen 802.11 ac dual band 4x4 cable gateway. And demand is picking up for an 802.11 ac wall and ceiling-mounted access point with a networking vendor. Router orders for consumer-oriented products are also picking up. It’s too bad management can’t get into details of specific product names, but that’s just the way it goes.
It is also working on a prototype for a commercial IoT antenna. To support IoT, it is also working on GPS antennas. It sounds like these could be high-volume, low-margin products. And it is continuing to push into the automotive connectivity market. One analyst asked about CAPEX costs to build a test facility to help move this market forward, and management said it doesn’t see anything major. It seems as though it left the door open a few years out to ramp CAPEX for this, however they weren’t entirely clear. It would make sense that testing environments for moving cars are different than for in and around buildings, for obvious reasons. We’ll follow the automotive opportunity as it unfolds.
Airgain is also working on antennas for the next release of eight antenna (8x8) 802.11 standards, 802.11ax. Initial designs are done, and it expects to be ready for the standard’s release in 2018. But it noted that products will likely hit the market before the standard is officially released. Remember from my report that Huawei, who is leading the charge on 802.11ax, says the protocol increases max theoretical bandwidth by up to 10-times the current 802.11ac protocol.
Management broke its standard policy and talked about the issues with a large customer in the Smart TV market, China-based LeEco (a.k.a. Leshi Internet Information & Technology). The company does everything from internet content to smart TVs to electric cars. It had a cash crunch and shares were halted last November, until it received a cash infusion on January 15 and began trading again. Airgain management said it has begun to receive orders from its LeEco supplier again (who supplies to the company’s TV unit), and that it shipped orders in December. They did say that the cash crunch hurt LeEco’s ability to pay its vendors, but didn’t say if orders from October and November were hurt. Either way, we’ll want to continue to watch LeEco and take note if it runs into further financial problems.
The stock sold off heading into earnings but is trading higher today. I see analyst upgrades and price target increases. There is still a relatively large number of shares that insiders can sell which could pressure the stock. But they aren’t dilutive, so I think we’re looking good here. Keep accumulating on the dips. BUY.
Earnings: DONE
Aspen Aerogels (ASPN) We’re still in recovery mode here. The stock had a nice day Wednesday and has (barely) held above 4.50. With the price of oil moving sideways and no material updates, that’s about all we can ask for at the moment. Things will change next week however. Earnings are due out on Thursday and you can bet management will be asked about progress on the BASF partnership and plans for starting the second plant. Realistically, I don’t expect they’re ready to greenlight the project just yet, so don’t get your hopes up. We need to see an uptick in orders from around the globe for Aspen management to feel bullish enough to expand capacity. Otherwise, why dump capital into making more product that nobody is ready to buy? We don’t want that, for obvious reasons. Long-term, I like this stock, and I continue to believe it’s one of the few energy infrastructure stocks that hasn’t enjoyed a Trump bump. So there’s reason to believe it’s showing up on screens, especially given it’s been holding above its 50-day moving average. Keeping at Buy. BUY.
Announced earnings release date: February 23
Everbridge (EVBG) Shares were up 4% over the past week on no new news. Earnings are due out a week from Monday. As I said last week, I’m expecting revenue growth in the neighborhood of 27% in Q4. The stock continues to trade at a discount to its high-growth software peers so, if earnings are good, I expect to see a move back above 20. BUY.
Announced earnings release date: February 27
LeMaitre Vascular (LMAT) Biotech stocks broke out above their post-election rally and small-cap health care stocks hit an all-time high this week. That strength didn’t help shares of LeMaitre however, as the stock is essentially unchanged over the past week, and fell over the past two days. It was making a move to cross above its 50-day moving average, but that attack broke down yesterday. I think this is just a case of the pre-earnings doldrums. Action will pick up next Tuesday when earnings come out. Keep holding. HOLD HALF.
Announced earnings release date: February 21
LogMeIn (LOGM) The stock had a down week, mainly because Amazon announced a videoconferencing tool “Chime” that will compete with LogMeIn’s solutions. That news drove the stock down to 93.90 from 102 on Tuesday, but the stock didn’t break below the dip (to 93.35) from late December. This announcement has ignited speculation that LogMeIn could be doomed (check out two recent articles on Seeking Alpha, one of which is decent, the other is total garbage). Hogwash, I say. Yes, there will be more competition. But that’s nothing new. Look at Slack and Fuze (both private), Cisco WebEx, Google Hangouts, etc. They’re all in the business. It’s not a simple matter of launching a product and grabbing customers from one of the leading providers of collaboration tools. And, if you believe the market for such solutions is still growing (i.e., the pie is getting bigger, not just being sliced into smaller servings), there is room for new entrants. Chime is expected to be priced at free (Basic), $2.50 (Plus) and $15 (Pro) per month. The implication is that it will be geared toward larger organizations. I’m not suggesting that LogMeIn won’t face any competition from Chime. I think it will. But I don’t think it’s a game changer, at least not at the moment. Chime might be another Skype (Microsoft), which I don’t think is a particularly good product. Side note here: Why isn’t Microsoft investing in Skype? Is it because they have bigger fish to fry, and know that when the time is right they can just acquire a company like LogMeIn (hint, hint)? Remember, Microsoft bought LinkedIn. It isn’t averse to buying market-leading solutions. Bottom line: this Chime business isn’t great news, but we’ve already booked partial profits on LogMeIn and management has executed well over the years. I expect they’ll continue to do so. They’re in the midst of this major acquisition/integration (perhaps Amazon saw this timing as an opportunity to grab some market share?), and in general, I’d say there is a lot of uncertainty surrounding LogMeIn. That’s the bigger story. I continue to believe investors should hold some shares (sell a few more if you’re getting nervous) through earnings. We’ll know more after that event. HOLD HALF.
Announced earnings release date: February 28
Marrone Bio (MBII) Shares of Marrone enjoyed a little bump when they announced on Monday that the work they’re doing on seed treatments with Isreal-based Groundwork BioAg is helping to improve yields and pest-resistance versus synthetic pesticides for row crops (soybean, corn, etc.) in Midwestern trials. The seed treatment market is around $4.2 billion annually and growing at 10%. No word on when this technology could be commercialized, but I’m sure Pam Marrone will address that on the next earnings call (date not yet announced). We’re still in accumulation mode as that event draws closer. Shares are now below their 50-day moving average line and trading on very light volume. I believe this is just another case of pre-earnings doldrums. Remember that Marrone will be hosting a webinar with Western FarmPress next Thursday, February 23. You can register here. BUY.
Estimated earnings release date: April 1
MindBody (MB) After last week’s report, I noticed a number of analyst upgrades and price target increases. They see the same long-term market opportunity I do, and the stock appears to be stabilizing in the 23 to 25 range. It could easily bounce around in here for a while. I’d say a break of 23 would be somewhat concerning, but could motivate me to move back to Buy. For now, just keep holding. I continue to think that a few years from now, this stock will be significantly higher. HOLD.
Earnings: DONE
NanoString (NSTG) Just like LeMaitre, NanoString missed out on the healthcare/biotech rally this week. But shares remain above 19 (barely). I think yesterday’s action sums up the situation: the stock traded in a range of 18.37 to 19.68 but ended up closing just 10 cents below Wednesday’s close. In other words, investors don’t really know what to expect on March 1. Same as last week, I’m keeping at Hold through the next earnings release. HOLD HALF.
Estimated earnings release date: March 1
Ooma (OOMA) The stock finally broke and held above the 10 level, where it’s closed for six consecutive sessions. It’s only up 2% since last Thursday’s close, but what I find interesting is how tight the trading range has been since then. And, it’s now up 15% from 8.95 on January 23. I continue to think the stock is being accumulated by institutional money that’s looking for exposure to rapid growth dependable software stocks without having to pay a premium valuation. Who doesn’t like the sound of that? Ooma announced this week that it is now the official provider of cloud-based phone services for WeWork, a provider of shared office spaces. WeWork isn’t an insignificant sized company—funding rounds suggest a value of around $16 million. I don’t know how many phones it needs and what the revenue for Ooma will be, but it’s clearly an incremental positive—especially since it suggests Ooma is growing in the business market, where it has stated it intends to focus more resources. I still like it. BUY.
Announced earnings release date: March 7
Primo Water (PRMW) I suspected the stock could drift lower after a 25% move from 12 to 15 in early February. That’s the case now, and shares are back to 14.56 as of yesterday’s close. Nothing new to report, just keep holding. HOLD.
Estimated earnings release date: March 8
Q2 Holdings (QTWO) The company reported on Wednesday afternoon and shares jumped 8% yesterday. Fourth-quarter revenue was up 38.8% to $42.2 million (beating by $1 million) and adjusted EPS was -$0.03, an improvement from -$0.09 in Q4 last year. The company also recorded its first quarter of adjusted EBITDA profitability ($1.3 million versus a loss of $1.9 million in Q4 2015). Non-GAAP gross margin in Q4 was 53.2% versus 48.4% in Q4 2015. Management has put a 60% gross margin target out there as a long-term target. We’re getting there.
For the full year 2016, revenue was up 38% to $150.2 million and non-GAAP EPS was -$0.32, vs -$0.37 in 2015. The company added 800,000 users to end the year with 8.6 million registered users, up 10% over Q3 2016 and up 36% over Q4 2015. Management said that only around 50% or 60% of a bank’s customers use e-banking solutions, so that means there are another seven to eight million potential users that currently bank with Q2’s clients that could come on the platform as time rolls on. The company has $97.1 million in cash, up from $92.3 million at the end of last quarter.
Management provided guidance for 2017, including revenue of $191.5 million to $193.5 million (up 27% to 29%). I think that’s conservative, and they’ll increase it to 30% or more half way through the year. They also see positive adjusted EBITDA of $5.3 - $6.7 million. The company has potential to reduce its adjusted EPS loss to -$0.12 in 2017, and turn an adjusted EPS profit in 2018. That would be big. As in past years, it has over 90% of the coming year’s revenue under contract already. It just needs to execute, which it has a history of doing.
CEO Matt Flake said that in the beginning of the year, the tone from potential customers was cautious, given uncertainty on the economy, interest rates and the U.S. presidential election. He said that now the tone of discussions is more positive, and that the sales team signed the most net new customers in Q4 since Q2 Holdings went public. The company also landed two large banks, one on each side of the country. These institutions signed up for Q2 Smart (which now has over 20 customers), the company’s new behavioral analytics platform. That’s great news, and this will turn into revenue in 2018 (it takes a while to go live with these large projects). Mr. Flake also said they signed a record number of contract extensions in Q4. This is more great news.
An analyst asked about competition, specifically with respect to Jack Henry, NCR, Fiserv and FIS. Management said no change—they still compete well with the major players. When asked if there was any pricing pressure on renewals, management pointed toward a 12-month revenue retention rate of 122%. That means revenue from existing clients is growing (i.e., Q2 Holdings is selling more new products to existing customers when their contracts come up for renewal. If revenue from existing clients was flat, this metric would measure 100%). In short, they’re holding their own on pricing. When asked about acquisitions, management said it’s not looking to do anything transformational. It likes the two acquisitions it’s made since the IPO, and anything it does would likely be done for strategic reasons (are there other reasons to do an acquisition?!). The company will be holding its annual client conference in April and will talk about new products and existing product enhancements at that time, with more details coming on its second-quarter conference call. It’s spending 18% to 19% of revenue on R&D, so it’s certainly looking to keep innovating in the e-banking space.
The bottom line here: another good quarter with a road map toward adjusted EBITDA profitability in 2017, with adjusted EPS profit to follow in 2018 (I think). I had the stock at Buy heading into the report, and am moving it to Hold now that we’ve moved up 11.2% over the past week, and up 16% over the past two weeks. This is still a stock to buy on the dips and hold on the rips. HOLD.
Earnings: DONE
USA Technologies (USAT) Nothing new to report. SOLD.
Earnings: DONE
U.S. Concrete (USCR) There are no fundamental updates as the stock continues to bounce around near its 50-day moving average line. I still see this as an entirely reasonable retreat, so keeping at Buy. It’s worth noting that aggregate producer Martin Marietta reported Q4 results that came in shy of analyst expectations on EPS but slightly ahead on revenue (up 14%). This year’s guidance was also a little light. And last week, aggregate producer Vulcan Materials missed on both revenue and EPS. Both of these stocks have traded down lately, but it doesn’t look like investors are walking away en masse. It’s worth reiterating that these competitors sell ready-mixed concrete as just a portion of their core business of selling construction materials, whereas U.S. Concrete specializes in value-added ready-mix concrete in specific markets. I’m not expecting a blowout quarter when it reports. Instead, I expect that management will point toward 2018 as a year of potential growth acceleration if infrastructure spending increases as forecasted. BUY.
Estimated earnings release date: March 8
