I wrote a piece for Cabot’s Wall Street Best Daily this past week that centered on the exceptionally strong performance of small cap stocks year-to-date and the potential for further gains throughout the rest of the year. To recap, small caps are up around 7.6% YTD, versus just 2.2% for large caps.
A lot of the content from my piece was based on my 2018 Small Cap Outlook, which I sent to you in January. If you missed the article, the one sentence summary of the key drivers for small caps boils down to: deregulation, favorable tax policy, domestic exposure and relative underperformance compared to large caps in 2017, all of which, when taken together, paint a picture for outperformance based on strong revenue and EPS growth (and expanding profit margins) for the asset class.
Let me quantify just how much the growth outlook for small caps has improved just five months after I wrote my outlook.
Back in January, analysts expected 2019 S&P 600 (my preferred index for tracking small-caps) earnings of $54.95.
Today, they are forecasting 2019 S&P 600 earnings of $61.88. That’s almost a 13% increase!
Applying this updated EPS estimate to my 2018 target year-end forward PE range of 19 to 20 for the S&P 600 yields a value of 1,175 to 1,238. That implies 16% to 23% more upside this year, which is far above the 3% to 9% more upside implied by my initial year-end index range of 1,045 to 1,100.
Frankly, I think these new estimates are a little too bullish and we should be slightly more conservative. But, let’s be honest, even 9% more upside is still pretty darn bullish!
As I stated in that Wall Street’s Best Daily, “For argument’s sake, let’s say S&P 600 earnings for 2019 are closer to $60 at year end. Slap a forward PE of 19 on that figure and you get an index value of 1,140. That implies small caps will have rallied 21% in 2018, and 13% from where they are now.”
Thirteen percent upside in six months or so is a lot—well above the average annual gain for stocks. I can’t guarantee it will happen of course! But I do think the underlying drivers should keep the wind at the back of small-cap stocks.
In our portfolio, the past week was one of mixed performance as our positions continue to digest the gains from an exceptionally strong second quarter.
Our absolute gains are still very nice, with relatively new positions contributing strength despite a short holding time-frame.
While I’m keeping most stocks at Buy this week, I do think near-term upside is somewhat limited and that being more selective with new purchases is a wise decision. Look to nibble on those stocks that aren’t overly extended but still have strong momentum—AxoGen (AXGN), MiX Telematics (MIXT), Apptio (APTI), Everbridge (EVBG) and Arena Pharmaceuticals (ARNA) come to mind. I also think the dip in MGP Ingredients (MGPI) is buyable.
I am moving AppFolio (APPF) to Hold this week given that it’s quite extended and trading at a premium valuation.
Updates
AppFolio (APPF) fell 3% this week after a downgrade to underweight from Morgan Stanley halted the recent rally. The analyst note wasn’t all that different in substance from what I wrote last week, which was, “That said, shares are now up 40% since the beginning of April and without a known catalyst on the horizon we could move sideways for a while. Don’t be surprised if the stock dips back near its previous high. What’s most important is that it holds that level (around 52). Technically, I’m keeping at buy. But I suggest limiting buying to the 52 to 55 range, for now.” Morgan Stanley basically made a valuation call, and with the stock trading at a rather elevated 8.7-times Enterprise Value/2019 Sales ratio there appears to be limited near term-upside. I don’t think the firm is negative on the stock, it’s just saying it’s time to hit the pause button and give valuation time to come down. I think the market still wants more information on the growth plan moving forward (i.e. is AppFolio sticking with the Property Management and Legal verticals, or expanding into another, and if so, what’s the investment required to do so) before it’s willing to assign a super-premium to shares of AppFolio. With the stock unlikely to jump out to fresh highs I’m moving to Hold at the current level. HOLD.
Apptio (APTI) presented at the JP Morgan Chase Global Technology, Media and Communications Conference two weeks ago and I finally got around to listening to the webcast replay this week. I was reminded how much I like the company and how specialized it is. Case in point: When asked why Gartner doesn’t place Apptio in a magic quadrant for TBM software Apptio’s founder said, “Because we’d be the only one in it.” If you think powerful software that helps large organizations manage their technology spend—which is already a huge figure and exceptionally strategic in nature—is important, then you should like Apptio. The founder also touched on how big the FedRAMP opportunity could be long-term, and how Apptio has illustrated its ability to move down market to somewhat smaller companies (but still quite large by most people’s standards) by offering streamlined, easy to implement software solutions specifically designed for certain use cases. Keeping at Buy. BUY.
Arena Pharmaceuticals (ARNA) has had its management speaking at conferences lately and I’ve listened to some of the discussion. Nothing major to announce, but management is clearly setting a confident tone and isn’t shying away from saying that it believes its compounds are superior to the competition. In terms of what to look for over the coming months, I’ll just quote CEO Amit Munshi, who said at the UBS Global Conference on Tuesday, “We have significant catalysts coming up this year and throughout next year including the initiation of Phase 3 trials for both Etrasimod and Ralinepag, cardiopulmonary pipeline expansion with additional cardiopulmonary assets clinical stage which we will be disclosing later this year, and of course additional data readouts including open label extension et cetera throughout 2018 and 2019 … Importantly in the next quarter, we’ll have an early data readout from the Phase 2a trial for olorinab, our specific CB2 agonist…” His pitch sounds good, is polished and appears supported by data. After a 10% rally two weeks ago Arena dipped 2% this week. I’m keeping at Buy. BUY.
AxoGen (AXGN) is still holding up after its recent secondary offering, which was completed at $41 a share. The nerve repair specialist will send its founder, President and CEO, Karen Zaderej, (who was also just named Chairman of the Board) to the Jefferies Global Healthcare Conference in New York City on June 6. I think there’s more room for the stock to run in both the near- and long-term. Keeping at Buy. BUY.
Everbridge (EVBG) moved sideways this week and the critical communications software stock is still a buy. Revenue growth is solid and there’s potential for it to accelerate faster than management’s implied guidance of around 30%. An 11% pullback would bring us down to the 50-day line, a support area the stock has found support in the past. I’m not saying that will happen, but at the same time it wouldn’t be too surprising. I’d be a buyer of a few shares here, and more down near that level. BUY.
Instructure (INST) remains a relatively low-profile software stock and that’s one of the reasons I like it. Shares are hanging around their 50-day line now, but have shown an ability to break out in quick rallies, like the one in February. The next earnings report is going to give us a much better idea of the new corporate learning product’s growth potential (I’m talking about Bridge), as well as Instructure’s competitive positioning in higher education. It’s still a stock I suggest accumulating. Keeping at Buy. BUY.
LogMeIn (LOGM) presented at the JP Morgan Chase conference a couple weeks ago and I listened to the webcast replay this week. There was a lot of talk about the future organic growth rate, which management said it sees bringing back up above 10% once the Jive acquisition is fully integrated (consensus is 8.5% revenue growth in 2019). There was also talk about the company’s go-to-market strategy in the unified communications (UCC) market, which is the exposure LogMeIn picked up with Jive, and which is much, much bigger than the collaboration market where LogMeIn has traditionally played. In this market, the company will go up against players like as RingCentral (RNG) and 8x8 (EGHT). With Jive, LogMeIn purchased a company growing at a faster rate than LogMeIn, which was at a point when it needed to raise capital. LogMeIn has already been able to pull costs out of the asset and will be doing more work on the operations and sales side to raise the business’ margin profile. Shares of LogMeIn haven’t done great recently and just dipped below 110 yesterday, meaning its pattern of lower highs and lower lows continues. I think we’re seeing some small-cap funds moving out of the name and more mid-cap oriented funds moving in. If that’s true, the shifting shareholder base is likely driving some of this lackluster performance. Continue to Hold. HOLD HALF.
MGP Ingredients (MGPI) was my May pick and the short version is that it sells whiskey and food ingredients. If you drink Bulleit rye, or any number of over 150 different craft whiskeys (mostly rye whiskeys) distilled in Indiana, you’re probably drinking MGP spirits. Also, if you’ve worked meat substitutes into your diet—like all those “fake” chicken, beef and pork products that have been showing up in supermarkets—you’re probably eating value added wheat proteins and starches from MGP.
The big news lately is that MGP is continuing to grow its stable of self-branded spirits, including its latest addition to the lineup, Rossville Union, a proprietary rye whiskey named after its Lawrenceburg, Indiana distillery, which was founded in 1847 as Rossville Union. Price point should be $40 (94 proof Straight Rye) to $70 (112.6 proof Barrel Proof Straight Rye). MGP held its 2018 Annual Shareholders’ Meeting on Wednesday but I didn’t have time to listen to the webcast. I plan to do so this weekend. BUY.
MiX Telematix (MIXT) is our South African-based provider of fleet management, driver safety and vehicle tracking software solutions. The stock jumped right out of the gate after I added it in April and we’re now sitting on a 26% gain. In short, the company’s software helps fleet managers keep track of their assets, but it also sells consumer-oriented solutions into certain markets where auto theft and safety are serious issues. It’s biggest market for consumer solutions is South Africa. After the Q1 report management gave guidance for fiscal 2019 that was better-than-expected, including subscription revenue growth of 13.5% to 15%, revenue growth of 9.1% to 10.9%, and adjusted EPS per ADS of $0.59 to $0.63. Shares spiked as high as 21 in the days after the report came out, and a normal-looking little pullback and sideways action here gives me the confidence to keep at Buy. The stock’s trend is powerful so I’m likely to keep at Buy until we get a significant break below MiX’s 50-day line. BUY.
Q2 Holdings (QTWO) is still trading near all-time highs and is likely to pause for a while as it regroups before the next batch of fundamental data comes out in the Q3 earnings report. In the second quarter, the story was about another string of larger deals, deregulation, positive industry growth (financial institutions are spending on technology) and rising interest rates. If you believe bank stocks have upside, and like the idea of investing in the behind-the-scenes technology that helps them work, then Q2 is your ticket. For a little more insight into the positive impacts of deregulation you should read Crista Huff’s piece in Cabot’s Wall Street Daily from today, which touches briefly on the recent bank legislation that rolled back some of Dodd-Frank. Crista is the Chief Analyst of Cabot Undervalued Stocks Advisor and has been pounding the table on bank stocks lately. You can continue to pick up a few shares. BUY.
Rapid7 (RPD) was flat this week after the stock hit an all-time high two weeks ago. A non-dilutive offering from existing shareholders, who sold three million shares at 30.25, is a positive in my opinion as it will help increase the public float. I don’t worry about why early investors have decided to sell a chunk because the real reasons are difficult (at best) to figure out. In my experience these sales rarely hurt a stock, assuming the underlying fundamentals, growth, etc. are still good. Rapid7 is a cloud security stock that has recently made the switch to an all subscription model and this makes for funky number comparisons, especially when combined with accounting changes. But an expanded product portfolio, growing sales force, new incentive system, focus on larger clients and general strength in the demand for cybersecurity solutions all point to further gains in the stock. BUY.
