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Small-Cap Confidential
Undiscovered stocks that can make you rich

Cabot Small-Cap Confidential Weekly Update

Big picture, things still look reasonably good out there. That said, we’ve seen persistent, but not severe, weakness in small-cap stocks since the beginning of September.


Big picture, things still look reasonably good out there. That said, we’ve seen persistent, but not severe, weakness in small-cap stocks since the beginning of September. That alone isn’t cause for concern. After all, small caps have been out in front of the market in 2018. But it does bear monitoring. As of yesterday’s close small caps are up 13% year-to-date versus a 9% gain for large caps. We’re still ahead, but the gap is closing.

My thesis is that the recent softness in small caps is more about performance realignment than any major issue. The S&P 500 has been climbing as small caps pull back. In my view that’s a good thing. If the performance gap were to get too wide the potential for a more dramatic correction in small caps would grow. With the performance gap narrowing, the risk of a severe correction in small caps is shrinking, in my opinion.

My thinking is also influenced by the fact that the economy is doing well. Second quarter GDP was just locked in at 4.2%, and while there is some softening in capital investment and an unexpected widening in the trade deficit (exports have declined slightly while imports have gone up), it looks like Q3 GDP growth should come in in the 2.7% to 3% range.

Back to small caps, consensus estimates are currently calling for 15.4% EPS growth in 2019. That compares favorably to 10% EPS growth for large caps and 12.4% EPS growth for mid-caps.

If we translate the forward 12-month estimates into PE ratios (chart below courtesy of Yardeni Research), we find that valuations have come down significantly since the end of 2017 (thank you tax cuts!). Small caps now trade with a forward PE of 17.7, while large caps trade at a 16.8 multiple. Those multiples aren’t out of step with where they’ve traded over the last five years.

forward pe ratios

This isn’t exactly actionable information, but it does help frame the environment. I know that a lot of investors are on the lookout for the next recession, but the evidence right in front of us now isn’t saying to slam on the breaks. Yes, we need to be cautious (as always). And we need to be mindful of the action in each of our stocks. But I’m still more focused on opportunities than cutting positions.

On the topic of being cautious, we have one more stock that’s being moved to hold today. That’s Instructure (INST), which is another case where I think the business is doing just fine but last quarter didn’t live up to expectations, so the stock took a hit. Investors haven’t come back to it yet, and another dip this week means we need to pull back on the reins.

Other than that, there are no changes in today’s issue. Earnings season will begin in about a month, and my expectation is these reports will determine if we hold or sell those stocks that haven’t outperformed lately. Near-term, the next issue of Cabot Small-Cap Confidential comes out next Friday. I’ve been working on that selection for several weeks. It looks great!

Changes this week:

Instructure (INST) moved to HOLD


AppFolio (APPF) gave back 4% this week and is now trading slightly above its 50-day line. The pullback isn’t surprising—shares were unstoppable this summer and we took advantage of that strength by taking partial profits in late-June for a better-than 105% gain. The stock continued to rise through early-September, and in my view even this modest pullback isn’t enough to put it back on the buy list. We have just over a month until the next earnings release, when we should get an update on the new AppFolio Property Manager Plus product and the WegoWise acquisition. Until then, I plan to keep at Hold. HOLD HALF.

Apptio (APTI) is behaving just like AppFolio—shares topped out a few weeks ago and have since pulled back to their 50-day line. The long-term trend is still up and we could endure a deeper dip (down closer to 35) before I’d really start to stare at the chart. The fundamental trends behind Apptio, which sells software to help large organizations manage their IT spending, are long and strong. I expect them to help power accelerating growth. Expect the stock to bounce around some more before we get to the next earnings report, which should be about five weeks away. Consider buying on the dips. BUY.

Arena Pharmaceuticals (ARNA) is unchanged this week but is up roughly 20% from its August low of 36 and looking strong heading into next week’s analyst/R&D day. This past week we received positive topline data from the Phase 2a Olorinab trial (abdominal pain associated with Crohn’s Disease). This was a relatively small trial (randomized, open-label, 8-week, 14 patients, two doses) testing a non-opioid pain medication. Management will get into more details, including the path forward, at next week’s event. While the Olorinab update is supportive of a growing pipeline of interesting compounds, there’s no doubt the juicy stories are Ralinepag and Etrasimod. Keeping ARNA at buy, but note we are just below a key resistance level, so I expect we’ll need a lot of positive commentary on the path forward for the entire company next week to get shares to punch above the 44 to 45 area. BUY.

AxoGen (AXGN) is still working through a recovery process that likely won’t be resolved until the next earnings update. That’s anticipated for the first week of November. As I’ve said in recent weeks, commentary from management regarding the company’s growth trajectory suggest it’s on track to hit full-year guidance and that new sales reps are starting to deliver as expected. I’ve kept at hold since the lower-risk play is to wait for confirmation that all is good before jumping in deeper. If you have a higher risk tolerance, picking up a few shares here could work out well, assuming AxoGen hits its numbers. HOLD.

Bottomline Technologies (EPAY) has been our most steadfast position lately. The daily gains aren’t big, but the stock just keeps ticking higher. This week the company announced it’s expanding solutions around Open Banking, which is a growing area of the fintech industry. In simplest terms Open Banking allows 3rd party applications to access and/or add data and route transactions through Bottomline’s solutions. In the latest version Bottomline’s solution aggregates data (balance and transaction) from banks in the UK and Europe in one interface and allows payments to be made from many banks. Financial institutions must give permission for the data to be accessed. We’ve seen our other fintech stock, Q2 Holdings (QTWO), roll out Open Banking solutions, and I suspect we’ll be hearing more about this trend from both companies in the future. Bottomline is a Buy. BUY.

Chefs’ Warehouse (CHEF) is a specialty food distribution company and I moved the stock to hold last week after an intense, three-week, 25% rally. The stock was a little volatile this week after a Jefferies analyst downgraded it citing valuation. That’s a reasonable call, and I think the market is going to need confirmation of the margins and EPS growth that I’ve been talking about before shares can move meaningfully higher. That said, you never know what will happen and Chefs’ growth and value profile has attracted buyers lately. Barring new information, we’ll just sit on our current gain until we get the next earnings report, which should be in the first half of November. HOLD.

Everbridge (EVBG) sells software solutions that keep people safe and businesses running. The stock was down two weeks ago but flat this past week, and shares are holding above their 50-day moving average. The only significant news this week was that the company pulled back the curtain on its new Critical Events Management (CEM) platform, which pulls its Visual Command Center software into the CEM suite so organizations have one powerful application that gives total situation awareness, locates employees at risk and gives actionable risk mitigation insights. Or, in Everbridge’s words, the solution lets clients take an “Assess, Locate, Act and Analyze closed loop approach to managing critical events”. If you want a refresher on what Everbridge does, check out the quick video on the company’s homepage (click the red “Watch Video” button). I think it will help give you a better idea of why I think this software is so powerful and why it will continue to be adopted at scale around the world. You can still buy shares, preferably on the dips. BUY.

Goosehead Insurance (GSHD) has been up and down since I added the stock three weeks ago. I received a few emails wondering about the recent pullback. My thoughts are that Goosehead remains a young company and is new to the public market, so bouts of volatility should be expected. Trading volume is also not huge, so if somebody is moving big blocks of shares that can affect the stock. Last week we had Hurricane Florence, and while Goosehead doesn’t underwrite any insurance policies it is in the financial sector (insurance sub-sector), so if there are traders dumping those stocks without discretion it’s possible Goosehead was impacted. All that said, the stock still looks good to me. Last week’s dip has, so far, been halted above the 50-day line and, more importantly, above the 26 to 29 price zone where GSHD traded in most of July and August. In short, the stock is still on my buy list. And I expect the zigs and zags will continue for a while until the market gets to know the company better. BUY.

Instructure (INST) continues to look weak and is now back to where it was in early-February. My hunch is this is one of those periods where the stock of a good company just looks poor. But that the underlying business is doing just fine and once there’s more evidence of that I think shares will respond favorably. The main reason for the weakness since the end of July was a little softness in bookings last quarter. But management has stated that the 2019 deal pipeline in the academic market looks strong, and that with the addition of some new talent it’s moving into execution phase with the new corporate learning management solution (LMS), Bridge. That product suite is a big part of the company’s future growth profile, but since it’s so new the market isn’t going to front Instructure credit for it being a success—Instructure needs to earn that credit the hard way, through client wins that bring Bridge up to around 20% of total revenue (if not more). This is all a long-winded way of saying I want to stick with Instructure, despite the stock’s weakness. We never had a huge gain here, and we’re moving back toward break-even. That means I need to move to Hold, for now. HOLD.

IntriCon (IIN) has been searching for direction lately, but the stock’s price action looks like the beginning of a normal consolidation phase with 65 (so far) acting as support. As with many of our stocks we’re getting close enough to the next earnings call that I don’t expect any dramatic change in the stock’s price (absent new information). In IntriCon’s case, we’re expecting a significant update this quarter since the company has a major capacity expansion underway that will add robotic assembly and new molding capacity for continuous glucose monitors (Medtronic is a big customer), and it should be moving closer to a big marketing push with its direct-to-consumer Hearing Health Express business. The precise timing of that marketing push is uncertain since management wants a little more insight into where the legislation on the OTC hearing aid market is headed. Bottom line, there’s a lot going on with this little company. I moved to Hold recently because the uptrend broke, and I’ll stick with that rating for now. HOLD.

Q2 Holdings (QTWO) is our digital banking stock and it pulled back a little more over the last week but not to a concerning degree. We saw a few dips to 58 in July and August, and one to 56 in June. I don’t think a retreat to those levels is off the table or cause for concern. On the other hand, a move below 56 would not be viewed favorably. I like this company and while onboarding new customers might hold growth back a little I see the company eventually becoming much larger than it is today (market cap is $2.6 billion). BUY.

Rapid7 (RPD) has been holding up well. The company sells cyber-security solutions, and two weeks ago it announced the release of a security orchestration and automation solution that helps teams reduce manual workloads and work more efficiently and effectively with IT and development teams. The big thing we’re looking for on the next earnings call is customer growth—hopefully Rapid7 can start to attract more clients given its expanding solution set and streamlined cloud-based offering model. Continue to Hold. HOLD.

csc table