Cabot Small-Cap Confidential Weekly Update
Small caps made no net new progress over the past week but we definitely saw some movement under the surface. This week we’re pulling back just a little given some softening in momentum stocks. A few positions were moved to hold, but for now we’re not cutting anything from the portfolio.
In aggregate, small caps made no net new progress over the past week but we definitely saw some movement under the surface. Growth-oriented sectors like health care and tech sold off while value-oriented sectors like materials and utilities rose. It’s notable that small caps diverged from large caps in many areas of the market, as the chart below shows.
I personally don’t think it’s worth stressing out too much about the shifting sands represented by this chart. And while it’s beginning to feel like small-cap value stocks are drawing interest, the small-cap ETFs I follow don’t show a performance differential between growth and value over the last couple of weeks. A theme to consider, and one which I factored in when adding Chefs’ Warehouse (CHEF) to our portfolio, is the potential for stocks with both growth and value attributes (sometimes referred to as Growth At A Reasonable Price, or GARP stocks) to be a good way to straddle the gap between pure growth and pure value stocks. More on that stock’s outperformance over the last week in a minute.
Backing up to the 10,000-foot perspective, sector performance year-to-date shows that stock performance has been quite broad based.
And the performance of each of our stocks relative to the benchmark Russell 2000 Index over comparable holding periods shows that, while we’ve hit a few speed bumps in individual positions, we’re still besting the market in all positions, save one. Our average margin of outperformance is 73.8%.
This week we’re pulling back just a little given some softening in momentum stocks. A few positions were moved to hold, but for now we’re not cutting anything from the portfolio.
Changes this week:
Rapid7 (RPD) moved to HOLD
IntriCon (IIN) moved to HOLD in Special Bulletin
AxoGen (AXGN) moved to HOLD in Special Bulletin
AppFolio (APPF) just keeps on trucking. The company, which sells software for property managers and small law firms, has a very efficient business model that boasts low customer acquisition costs and high customer lifetime values. The market loves these types of cloud software businesses, which is why AppFolio has been able to trade at a premium for so long. That said, I’ve kept at hold due to the valuation premium in shares, but as time marches on the case grows that AppFolio is like the Amazon of small-cap software – a stock that breaks the mold and trades at a significant premium forever! Last week AppFolio acquired WegoWise, a cloud-based software provider with solutions that help building owners and managers understand, track and improve building efficiency. Utilities represent a major expense, and by integrating WegoWise into its Property Management solutions AppFolio should be able to offer customers more value, while rolling out another Value+ Service to drive revenue growth. Shares of AppFolio were up 6% this week and we’re now up around 198%. HOLD.
Apptio (APTI) sells software that helps companies manage their technology spending and benchmark IT spend against peers. Historically its customers were the biggest of the big, but it’s been launching products for just plain big companies too, and this move down-market (to companies with under $20 billion in revenue) is opening up new growth opportunities and propelling revenue growth (revenue should be up around 23% this year). The company is also about to turn its first annual profit; EPS was -$0.24 last year and should be around $0.04 this year, then $0.25 in 2019. The recent acquisition of Digital Fuel, which is partnered with VMware in a large number of accounts, is also contributing pipeline growth, even though it remains a small part of the overall business today. This company is a pioneer in its space and with +20% growth, emerging profitability, a large and growing market opportunity for its products and a market cap <$2 billion, it remains a buy. Shares were up 5% this week, bringing our total gain to around 80%. BUY.
Arena Pharmaceuticals (ARNA) continues to gain momentum after a period of dramatic underperformance in June and July. Shares have traded up 5%, 2% and 2% over the last three weeks, respectively. The move off the bottom – shares are up to 40 from 36 in mid-August – has lifted the stock back above both its 200- and 50-day moving average lines. We can likely attribute some of the strength to recent news that an extended-release (XR) tablet formulation of ralinepag was shown in two Phase 1 clinical trials to have improved pharmacokinetic (PK) performance over Actelion/Johnson & Johnson’s Uptravi for the treatment of pulmonary arterial hypertension (PAH). Also, the management team has been on the road plugging Arena’s long-term potential. It spoke at Wells Fargo and Citi last week and moves on to Morgan Stanley today. We should also have an update on Phase 2 results on Olorinab (non-opioid candidate intended for the treatment of visceral pain, specifically pain associated with Crohn’s disease) within the next two weeks. Then there is an R&D/Analyst day coming up on October 4. Clinical success with pipeline assets is key to Arena’s long-term success so updates on trial results and the R&D efforts will likely move shares. BUY.
AxoGen (AXGN) has raised a few eyebrows over the past week with another big slide that pulled shares down to the August low of 36. Shares traded in an especially wide range yesterday, but were able to close right on that 36 level. This appears to be one of those situations where the market is just plain wrong (I hope!). Most of the time, the market is right in the long term. But, especially with smaller stocks, there are market inefficiencies in the short term.
Here’s my reasoning. Shares of AxoGen sold off in June when the market was weak, then shares got hammered after management missed Q2 revenue projections by around 4%, due to changes in the sales force. Existing sales reps had been moved up to management and backfilled with new ones (who were less productive). And an outside sales company, which drives around 20% of revenue, didn’t perform up to snuff. However, on the conference call management said it’s still on track to reach its 2018 guidance of 40% revenue growth or better because it has more reps and they start to get rolling after eight to 10 months. The market decided the revenue miss was a big change in the growth story. I haven’t agreed, believing it represents a shifting/adding of resources which caused some disruption.
On Wednesday, at the Morgan Stanley Global Healthcare Conference, management was asked about the sales issues and forward guidance. The response? “We’re going to be just fine!” I’m paraphrasing here, but the management team said it still expects to reach its 2018 guidance and be a 40% to 50% grower for several years. Now, it’s mid-September, which means there are only two weeks left in the third quarter. Either AxoGen is extremely confident it can hit its number this quarter and next, or management is just plain dumb. Making comments like that at a major conference, regardless of the disclosures, would be downright reckless if Q3 was not tracking well and the salesforce wasn’t performing well.
So what do we do? I moved the stock to hold in a Special Bulletin this week due to the sell-off. But the Morgan Stanley conference comments represent new information. My hunch here is that shares of AxoGen will bounce around a little, but eventually begin to climb heading into the Q3 earnings release, which is about six weeks away. We’re also going to get an update on a big peripheral nerve repair study (RANGER) from the Annual Meeting of the American Society for Surgery of the Hand (held in Boston) in the next couple of days. This might not move the stock, but provided the results are good (as I expect) they’ll support the investment thesis that AxoGen’s nerve repair solutions are as good if not better than the gold standard allograft procedure.
What you should do now depends on what kind of investor you are and if you already own the stock, or not. Fundamentally, I think it’s a buy. Based on the stock’s technicals, it’s a hold (if not a sell). I’m not ready to sell it as I think this is the stock’s first major test in what should be a long-term success story.
Bottom line – if you don’t own any AxoGen and you have a decent risk tolerance, I think it’s a buy here. If you own some and have seen your gain cut down, but like the story and have a longer time horizon, you can buy more. If you own some and have seen your big gain cut down and are getting concerned, you might consider selling a small chunk, say 25% or so, and seeing what happens. You can always buy more, even at a higher price, and make out just fine over the coming years (provided the stock gets going again). The best way for me to ride the line between all these perspectives is to maintain my hold rating, and then upgrade if and when we see an improvement in the chart. HOLD.
Bottomline Technologies (EPAY) is our play on business-to-business digital payments, and the stock’s upward trajectory is a thing of beauty. It’s been trading in a relatively tight range, mostly above its 25-day moving average line, on steady volume and without any volatility to speak of (in fact, the stock’s beta of 1.15 is barely above that of the broad market). Dependable revenue and EPS growth is the name of the game here and with Bottomline expected to grow revenue at roughly 10% and EPS at roughly 15% for the next few years it appears to have a winning plan. Shares were up 4% this past week and are now up 24% since I recommended them a month and a half ago. BUY.
Chefs’ Warehouse (CHEF) is one of those stocks that jumps out in our portfolio because it doesn’t offer super-rapid growth (revenue should be up around 10%) this year and it’s not a high tech or medical device stock (it’s a specialty food distribution company, sort of like a smaller U.S. Foods). In other words, it’s not exactly a pure growth stock, but has a profile closer to the growth and value, or GARP, stock profile I discussed above. My gut says Chefs’ future performance will surprise investors. This past week is evidence of how that could unfold – shares of Chefs rallied 14% and broke out to a new all-time high. If you feel there’s room for any small-cap growth and value stocks in your portfolio, consider picking up a few shares. BUY.
Everbridge (EVBG) sells software solutions that keep people safe and businesses running. Think of alerts for severe weather, terrorist attacks and active shooter scenarios. The company has been growing in both North America and internationally and has the potential to be a global powerhouse in critical communications software, an increasingly necessary and powerful technology. One of the compelling parts of the story is that as Everbridge gains scale the incentive for new customers (businesses, local and state governments, and even entire countries) to sign up grows since customers and citizens will receive better alerting services from one large platform (as compared to many smaller ones). The stock has been consolidating in the 58 to 62 range where it could easily hang out for a while, especially since it was trading at 44 at the beginning of August. Be on the lookout for a press release outlining how many alerts have been sent out to help people prepare and deal with Hurricane Florence. We could see a dip or even a decent pullback, but long term Everbridge is a buy. BUY.
Goosehead Insurance (GSHD) was last week’s new addition and the stock has responded by blasting 14% higher since I added it to the portfolio. The company has developed a new business model for selling personal lines insurance that revolves around cloud-based technologies and a blended distribution channel of corporate sales offices and franchises. It’s looking to disrupt the industry and spread nationwide. The evidence to date suggests it’s on the right path. We’re looking for average annual revenue and EPS growth of around 40% and 60%, respectively, through 2021. The company hasn’t grown through acquisitions and with an innovative business model M&A isn’t likely in the future, but we could see a dividend (one-time or regular) at some point.
I have one correction to make – in my report I made a mistake in the financial table. An image of the corrected financials is below. Please note that these figures may differ from what your data provider shows because I’ve included adjusted EPS figures, which are what the analysts that work for the investment banks that brought GSHD public are using. Some data providers aren’t using these numbers yet, and due to the recent IPO there are a couple of sizeable one-time items that should be adjusted for. Thanks to Bob (a subscriber) for alerting me to my error. The stock is a buy. BUY.
Instructure (INST) sells learning management software and after a period of underperformance the stock is now poking its head back above its 200-day moving average line and plotting a break back above its 50-day line. Revenue should be up around 31% this year, but Instructure won’t deliver a profit for a few years. Keeping at buy. BUY.
IntriCon (IIN) was moved to hold in a Special Bulletin earlier in the week and I’m going to stick with that rating for now. In general, medical device stocks sold off in recent sessions so there might be a modest headwind from that, but probably the bigger driver in IntriCon’s retreat was that one analyst moved the stock from buy to hold, citing valuation. We’ve come very far, very fast here – shares were trading at 20 in mid-April and topped out at 75 two weeks ago – so it makes sense that shares should pause. The big question on investors’ minds is how long of a leash to give IntriCon. On that matter everybody is different. A 50% to 100% gain in a few months is plenty for some, others want to go for the big winner. I personally think there’s a lot more upside ahead provided IntriCon’s management continues to execute on its growth strategies, so am sticking with a hold rating for now. I’m interested to see how the new manufacturing capacity and robotic assembly works out, as well as IntriCon’s efforts to sell hearing aids direct-to-consumers. HOLD.
Q2 Holdings (QTWO) is our digital banking stock and is attracting customers because it’s been cloud-based from the beginning. Many competitors are transitioning from an on-premise delivery model, and this can lead to some risk and disruption to customers as the transition progresses. Q2’s revenue growth is mainly driven by the number and size of new customer wins, and the number of users that those financial institutions are able to get onto the digital banking platform. Even though Q2 might get a number of new wins each year, some of which are quite large, it takes time to get a new client on to the platform (i.e. to “go live”), so time from client win to actual revenue can be up to a year or more. That all said, revenue growth is steady here and should be up around 23% this year and next. Leverage in the model should drive very attractive EPS growth of 267% this year and 155% in 2019. The actual EPS estimates are $0.11 (2018) and $0.28 (2019). The stock is chopping higher after what looks like a breakout above 64. BUY.
Rapid7 (RPD) is our cybersecurity stock and is one of those companies transitioning from an on-premise to cloud-based delivery model. It’s relatively far along in the transition and, combined with new product rollouts, I believe all solutions are now offered on a subscription basis. Financial analysis is still a bit of a pain as the historical numbers still reflect the old business model. In any event, demand is out there and Rapid7 is drawing its fair share of business – revenue should be up around 19% to 20% this year and next while EPS should be around -$0.49 this year and then break even in 2019. In the coming quarters we want to see new customer count grow. Shares look like they could be topping out for a spell so we’ll be a little conservative and move to hold. HOLD.
Please email me at firstname.lastname@example.org with any questions or comments about any of our stocks, or anything else on your mind.