Cabot Small-Cap Confidential Weekly Update

Despite all the tariff talk, small caps continue to hold up well and even rose by 0.3% this past week.

Year to date, small caps are now up 11.7%, versus 3.2% for large caps.

The underlying reasons for this relative strength are more or less in line with those I put forth in my 2018 Small-Cap Outlook, including high exposure to the U.S. economy, outsized benefits from tax cuts, etc. More recently, some analysts (and The Wall Street Journal, in an article published yesterday—see headline below) have begun to attribute part of small-cap strength more to their domestic exposure given potential challenges beyond our borders arising from Trump’s protectionist stance, a strengthening dollar and the Fed’s tightening.

The intensity of the strength in small caps is, understandably, causing some market observers to question how long this rally can go. Especially in light of the really big question, which is when the next recession is most likely to arrive. Consensus (for what it’s worth) is that the economy is still going strong enough to ward off a downturn for some time. That said, analysts are talking more about the likelihood of a rolling bear market scenario, in which certain sectors will correct one or two at a time, and as that process rolls through the market the S&P 500 (i.e. the broad market) is likely to trend sideways for some time.

The silver lining is that, in this scenario, stock selection becomes even more important. And, of course, that’s what me and the other talented analysts at Cabot are here for—to help you maintain as much exposure as possible to the “winners”!

From my perspective the most relevant war being waged out there isn’t over the dollar value of specific tariffs and who and what they might be applied to. It’s between the trade-war bears and the earnings-growth bulls.

Until this week, the earnings-growth bulls have been firmly in control and the market has mostly shrugged off trade-war concerns. That changed with Trump upping his game with additional, and very public, tariff threats to America’s major trading partners. It accelerated with retaliatory threats from China, Canada, the EU and India. What happens next is impossible to predict. But it does appear the threat of a real trade war has the market on edge.

But push that out of your mind for now and look at the earnings-driven bull case for stocks. The case is especially strong for small caps, as analysts continue to bump up revenue and earnings estimates.

Back in January, the 2019 consensus EPS estimate for the S&P 600 was around $55. About a month ago it was $61.90. Now it’s up to $62.06 (image below courtesy of Yardeni Research).

If you place a forward-year price-to-earnings ratio (P/E) of 19 and 20 on those respective earnings figures, six months from now you have an implied S&P 600 index value of 1180 and 1241, respectively.

Those targets imply 12% to 18% more upside over the next six months!

The counterargument to those rather lofty projections is that either analysts have been smoking too much weed now that it’s being legalized and/or decriminalized in more states, or we’ve already reached peak valuation, and a forward P/E of 19 to 20 is too high.

There’s probably some truth to the latter (the peak valuation scenario) given that a lot of the projected earnings boom is due to the tax cut. But even if we reduce the forward P/E to 18, and lower projected 2019 EPS to $60, we get a year-end target S&P 600 value of 1080, which implies about 3.5% upside from here. While that’s not a ton, in the context of a 12% move already YTD, it’s pretty damn good. And it helps explain why small caps are doing so well, despite all the trade war talk.

I’m going to cut myself off after saying just one more thing: small-cap software stocks have been on fire. One of the reasons, aside from the broad strength in small-cap stocks, is that cloud software stocks make great acquisition targets these days. And YTD M&A activity in software is trending ahead of 2016 and 2017.

According to Morgan Stanley, there have been 52 publicly announced software M&A deals so far this year, well ahead of 36 in the first half of 2016, and 37 in the first half of 2017. Moreover, these deals are being completed at higher multiples, with several completed at more than a 10 times Enterprise-Value-to-Trailing-12-Month-Revenue multiple (EV/TTM revenue), and some at over 15 times (including MuleSoft and AppDynamics).

One of the benefits of looking at valuations, like EV/TTM revenue, is it gives you something other than feelings (which are very subject to personal bias) and a chart to go on when evaluating stocks. This is especially important when momentum starts to fade.

Today, to help put our software stocks in better context, I’ll discuss where each is trading based on this valuation measure (see images below, and stock-specific summaries to follow).

Finally, given that we have seen the action in several leading growth stocks out there turn choppy this week, we’re moving incrementally more conservative and switching a number of stocks from buy to hold. We even take one of ours from hold to sell a half. Details below.

Changes this week:

Updates

AppFolio (APPF) is a provider of cloud-based software solutions for small- and medium-sized businesses in the property management and legal industries. I moved the stock to hold a number of weeks ago given a premium valuation that is somewhat warranted given its growth (revenue should be up 27% this year). But with the stock trading with an EV/TTM revenue multiple of 14.5, and EV/2019 revenue multiple of 10, even more good news is priced in than was a month ago. We’re up around 115%. Given everything in front of us, I’m downgrading AppFolio today and recommend selling half your position to lock in partial profits. Keep the other half in case this high flyer finds another updraft. SELL HALF, HOLD HALF.

Apptio (APTI) was an early mover in the Technology Business Management (TBM) software category and sells a cloud-based suite of solutions that help IT leaders analyze, optimize and plan technology investments and benchmark financial and operational performance against peers. On an Enterprise Value basis, the stock is currently trading at 7.5-times TTM revenue, and at 5.6-times 2019 revenue. This isn’t expensive, though with expected revenue growth of 21% this year Apptio isn’t in the top tier of software growers out there. I still like the stock and suggest buying on any sizeable pullback down to around the 50-day line (which is at $32.25) BUY.

Arena Pharmaceuticals (ARNA) is developing treatments for a broad range of immune and inflammatory conditions. The two most advanced assets are ralinepag and etrasimod, which are entering Phase 3 programs. Ralinepag (APD811) is intended to treat pulmonary arterial hypertension (PAH) and etrasimod (APD334) is a candidate to treat both ulcerative colitis (UC) and, in the future, will enter a program in Crohn’s Disease (CD). The company is also moving olorinab (APD371) into Phase 2 for the treatment of visceral pain associated with Crohn’s disease. There hasn’t been much news lately and the stock was doing well up until yesterday when it was whacked for a 7% loss on no stock-specific news. That dip brings it down to its 50-day line at 44.40, which is also where it found support in late-May. Keeping at Buy. BUY.

AxoGen (AXGN) makes implantable products for peripheral nerve injuries. Revenue has been growing by more than 40% and analysts project the trend continuing through 2019, if not longer. With that kind of growth in a specialty market the stock has been steadily ascending, and while there’s certainly the potential for a correction I would expect most dips will be filled in with new buyers. Keeping at Buy. BUY.

Everbridge (EVBG) sells cloud-based critical communications software that help keep people safe and businesses running. The stock has been a standout performer. With revenue expected to be up 34% this year and 26% in 2019, and a leading position in a compelling growth market, it’s easy to see why the stock keeps going up. That said, Everbridge has traded down in each of the last five sessions, and shares trade with an EV/TTM revenue multiple of 12.3, which makes them quite expensive on that measure. Given the rapid growth, the stock’s EV/2019 revenue multiple of 7.8 is much more palatable. But given the stock’s recent action I’ll move to Hold for now and see if we can’t get a better entry point for new money. HOLD.

Instructure (INST) sells a variety of cloud-based learning management and collaboration software solutions to schools (K through higher ed) and corporations. The stock had been consolidating in the 40 to 44 range for a few months but jumped off its 50-day line (at 42) last week, rallied above 44 this week, then briefly traded at an all-time high on Wednesday before a retreat back to 45 yesterday. Overall, I find the stock’s action encouraging, despite this pullback. Plus, Instructure is expected to grow revenue by 31% this year and 26% in 2019, and trades with an EV/TTM revenue multiple of 8.5 and EV/2019 revenue multiple of just 5.6, which compared to other rapid-growth software names isn’t expensive. Given relative valuation attraction, rapid growth and potential to break out, I’m keeping Instructure at Buy. BUY.

IntriCon (IIN) is my June recommendation and went ballistic in the first two and a half weeks of June, then began falling apart over the last two sessions. That said, yesterday shares fell dramatically at the open, which was probably a reflection of follow-on selling from Wednesday, then firmed up throughout the day to close down less than 5%. It’s too early to tell if this is topping action. With these hot stocks it’s not uncommon to see wild swings as the market tries to sort out where the stock should trade. To recap, IntriCon has a mix of stable business from large medtech companies, including Medtronic, to whom it mostly sells continuous blood glucose monitoring device parts. And it has potential to disrupt the hearing aid market through sales to other manufacturers, and through its own eCommerce platform, Hearing Health Express (HHE), as growth in the Over-the-Counter hearing aid market evolves. The stock is trading at around 40 right now. Part of the recent rally is likely attributable to recent price target increases from both B. Riley (to 45) and Stifel Nicolaus (to 50). I stated last week that stocks like this can be as streaky to the downside as to the upside, and that you should average in and be methodical about your buying. I also said I’m likely to keep at Buy until we get a couple of really big down days on high volume, and we’ve just had two of them. Accordingly, I’m moving to Hold. You can fill another order for a small number of shares around this level, then sit back and see what happens. HOLD.

LogMeIn (LOGM) has been out of the limelight lately given that it’s one of the few stocks in our portfolio trading below its 50-day line. That trend changed this week as shares rallied up to that technical level and held more or less firm during the Thursday market selloff. I actually think the stock looks pretty good here and wouldn’t hesitate to place a short-term trade on. Growth projections aren’t huge (revenue should be up 19% this year and 8% in 2019), but the stock is inexpensive, trading with an EV/TTM revenue multiple of 5.1 and a EV/2019 revenue multiple of 4.3. LogMeIn paid less than 2.5-times TTM revenue for Jive recently, and with other stocks in that unified communications market, such as RingCentral (RNG) and 8X8 (EGHT), doing fairly well, I think LogMeIn has the potential to surprise to the upside on upcoming quarterly reports. That all said, LogMeIn is no longer a small cap so I’m unlikely to move back to buy unless the chart really starts to look good. Keeping at Hold. HOLD A HALF.

MGP Ingredients (MGPI) is our whiskey and food ingredients stock and continues to climb at a slow and steady pace, despite a modest dip yesterday. The stock is flirting with an all-time high, and I’m keeping at Buy. The EU has threatened tariffs on whiskey, and while I haven’t had time to fully analyze the situation my first instinct is that if overseas whiskey gets more expensive that makes it better for domestic producers like MGP that already sell premium spirits. Bottoms up!! If you want a refresher on the company and its history, check out the recent analyst day presentation on MGP’s Investor Relations website. BUY.

MiX Telematix (MIXT) is our South African-based provider of fleet management, driver safety and vehicle tracking software solutions. The stock had been on a nice and steady uptrend for several months then went a little crazy in May, jumping from 17 to 21. It has since pulled back in June, and after a down week is now trading right on its 50-day line at 18. The historical pattern here is that during each pullback MIXT will find support around the level of the high that preceded its previous consolidation period (see chart below). The pattern didn’t quite hold given that there was no pullback to the April high of 16.28, so we could see a little more volatility this time around. But if the pattern holds, shares should find support around 17, which is 5.5% below where we are now. The wildcard element is that the company is based in South Africa and emerging market stocks aren’t doing so hot. Also, dollar strength isn’t great for MiX given that it reports in South African rand. Moving to Hold. HOLD.

Q2 Holdings (QTWO) sells cloud-based virtual banking software solutions and is well-positioned to keep growing as deregulation, rising interest rates and positive industry growth spur financial institutions to increase spending on technology. The stock just broke out to a fresh high, even though it trades at a premium valuation. Shares trade with an EV/TTM revenue multiple of 12.3, and an EV/2019 revenue multiple of 8.6. I’m keeping at Buy for now, but recommend only adding small positions at this level. BUY.

Rapid7 (RPD) sells cybersecurity software. With a broader set of solutions to sell as part of its entry into the emerging SecOps movement, which brings together security and IT operations, and a transition to an easy-to-deploy Software-as-a-Service (SaaS) pricing model, Rapid7 is landing larger deals, more multi-product deals and more customers. The stock traded down 3% this week but is still close to its all-time high. It’s another stock trading at a reasonable valuation; the EV/TTM revenue multiple is 6.6 and the EV/2019 revenue multiple is a mere 4.9. Keeping at Buy. BUY.

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